From an intraday low at 1,370 on August 16, the S&P 500 rallied by more than 100 points to a recent high at 1,479. Coming from a deeply over-sold condition the rally was not surprising but disappointing, says Marc Faber (aka Dr Doom), in the latest issue of his gloomboomdoom.com monthly subscriber report, “for two reasons”:
Volume diminished, and on each day of this rally the number of NYSE stocks making 52-weeks new lows exceeded the number of stocks reaching 52-weeks new highs. And while the optimists remain convinced that the recent correction was just another correction in a rising trend which will give way to new highs before the end of the year, my friend Jim Walker at CLSA has a different take.
According to Jim Walker:
“In order to believe that (this is all a bad dream and easy money will return soon) you have to believe that the US subprime market will settle down and the CDO issuance that is associated with it will resume as if nothing has happened after the dust has settled. You also have to believe that structured finance products are readily modelled and are not subject to market gyrations or risk changes. You also have to believe that all the people that have already been burned (hedge fund clients, pension funds, Asian and European banks, ordinary investors and so on) will be willing to take on the next set of issues at the same price as they did before.
You have to believe all this because systems built on easy money demand more and more of it every year. If you are willing to believe all that then ‘buy the dips’ because, in my view, the person that is selling to you deserves the money more than you do”.
Faber highlights Walker’s point about the decline in asset-backed commercial paper outstanding to emphasise his view on slower credit growth. The slow-down, notes Faber, “has already been evident for some time in the case of household debt growth”, and if you combine the decelerating growth rate of credit and the fact that significant overhead supply exists for the S&P 500 between 1,500 and 1,540, “new highs will be difficult to achieve”.
But, he adds, the following should also be considered: Since October 2002, all asset prices have “inflated” in concert. “At the end of a major bubble it is common for the leadership to narrow with just one sector of the market still soaring while the rest of the market falls by the wayside. It is, therefore, conceivable that US stocks could still make a new high while most other assets would no longer appreciate.”
But the Fed is unlikely to “resist supporting the stock market at the expense of a weaker US dollar and higher inflation”, he notes.
This would mean that a new high for the stock market in dollar terms is possible. In this context we should not forget that Mr Bernanke’s main thesis – about which he has both repeatedly written and spoken – is that the Great Depression could have been avoided if the Fed had flooded the system with liquidity right away.”
Ben Bernanke, says Faber, “is also the man who suggested that if deflation became a real threat the Fed could always drop money from a helicopter onto the US”. Thus, Faber remains sceptical “that the Fed will refrain from engineering a major monetary bail-out of the system.
The problem with such policy, he warns, “is that the stress in the system is shifted from the lower quality credit market and the stock market to the US dollar, which will continue to be debased (certainly against gold)”.
Another point to consider, says Faber:
US mortgage debt as a percent of GDP is now at 70% compared to 40% at the time of the 1998 LTCM crisis…Unless the Fed is prepared to accept a vicious recession it has no other option but to bail out the system no matter how unpleasant the consequences… in the future. The problem is really that in recent years the Fed has never controlled credit growth and that the monster needs now to be fed with even more money and credit growth.
Admittedly, “easy money” may not do the trick for housing, which is likely to continue to deflate in real terms (inflation adjusted), but it is possible that amidst a deteriorating global asset bubble advance/decline line (fewer and fewer assets making new highs) the one or the other asset market will still make a new high. After all, the Shanghai stock market has so far not been affected by the mortgage related credit crisis.
Faber’s point, he says, is simply this:
“When emerging markets break down some time in the next nine months, the US stock market is likely to out-perform foreign markets.”
Since I assume that this insight will not have escaped the attention of large global money managers, they are likely to increase their exposure to US equities in future – particularly, if the US dollar weakens further. Therefore, despite being negative about the US economy and its financial market, I am reluctant to be heavily short US equities.
If it’s all a bit confusing – considering Faber’s twin views that new US stock market highs are “unlikely for the rest of the year” and his “relatively positive” view on US equities – blame the Fed, he says.
“The confusion arises because of the market manipulation by the Fed… In fact, the Fed is so driven by asset price changes that one could envision the following scenario: If by the next Fed board meeting on September 18, the S&P 500 is above 1,520, Fed fund rate cuts would unlikely be announced. Conversely, if by then the S&P 500 is around 1,400 or below, Fed fund cuts become highly likely.”
The question, says Faber, is “whether Fed fund cuts will re-ignite the bull market. In two previous instances, stocks rallied repeatedly on Fed fund cuts, but the overall trend was down.”
If I look at the investment environment I cannot get excited about participating in the ongoing battle between market fundamentals, which are, in my opinion, a disaster, and the manipulation by the Fed (and possibly at some point also by the government), which could boost US asset prices or at least prevent them from declining as much as the bears (including myself) would like them to do. In military battles, even the victors have a very high casualty rate.
Therefore, concludes Faber, “in the ongoing financial battle between the optimists, who expect a new high shortly, and the pessimists, who expect a new low before the end of October, the best course of action may be to only take small positions and to patiently await better entry points both on the long and the short side.”
However, for the optimists among his readers, Faber recommends they “buy gold and gold shares rather than the S&P 500 and other major US indices”. At the same time, he warns: “continue to avoid the financial sector, which in a credit contraction is the most vulnerable
industry. It is only a massive injection of liquidity that could reignite a further upward move in the global asset bubble, which would be nothing else than another major debasement of paper currencies”.