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Dr Doom: ‘Let us just assume the financial system blows up…’

Gold — and the division of assets - is on the mind of Marc (aka Dr Doom) Faber this week in a special interim note to his subscribers. It’s not a particularly attractive trade right now, he notes, although personally, he’s hooked. And anyway, people have been asking …..

For investors with all their assets in US dollar cash (and no other holdings), Faber suggests accumulating gold from here on down to possibly $600/oz. While not necessarily forecasting such a drop (from the current level of about $820/oz), he notes the metal could decline to that level.

Those with “99 per cent of their assets in gold and no cash flow” should hold for now, says Faber, as the gold chart looks “truly horrible” since prices fell below the key support levels of around $850.

For traders, however, gold may have some short-term appeal right now because it is becoming oversold. But what, then, is the immediate upside potential? Heavy resistance would seem to exist at $850-$900 while the downside risk is at least as large as the upside potential.

From a personal perspective, says Faber, of his total assets, about 5 per cent is in equities, 8 per cent in gold, 8 per cent in real estate and related investments and the rest is split between US and euro fixed-interest securities.

But Faber’s own cash flow (income) is to some extent dependent on the performance of equities, he acknowledges, since he receives some performance fees when stocks appreciate.

As a result, my indirect exposure to equities is higher than is suggested by the asset allocation figures listed above. From my fixed interest securities and from my business I have a relatively high cash flow and, therefore, I am a happy holder of gold and a buyer on the way down (in fact, irrespective of the price I buy every month some) for the following reasons: I am not a great believer in insurance policies, but since I think that sooner or later the entire financial system will blow up I want to make sure that whereas my assets, which are on deposit and could become worthless through default, I shall still be left with some assets that are mine (physical gold in a safe deposit box — not in the US). I should like to emphasise that this is also a point which speaks for owning some stocks.

So in typically cheery mode, Faber says, “let us assume the financial system blows up”. Large deposits could become worthless overnight. But if you own shares of companies — even though they may decline in value — you will still own these shares since they are a certificate of ownership and not liabilities of someone else.

So, no matter how negative a stance one might have toward equities, at this point the ownership of some solid companies might be more desirable than being a creditor in a financial system that may not be able to pay at some point in the future.

Also, I consider gold as a hedge against renewed US dollar weakness. Finally, I maintain the view that gold will over the next few years outperform US equities and bonds as it has done already since 2000.

Onto broader themes and Faber’s prognosis that we are amidst a significant liquidity contraction as a result of slower debt growth.

Don’t forget, he says, that lending standards are now tightening in earnest for both individuals and for commercial property lending. In turn, tighter lending standards hurt personal consumption and lead to a contracting US trade deficit as a result of lower demand for imported goods and also oil. Moreover, lower imports have negative implications for Asian economic growth rates.

In turn, slower Asian economic growth amidst high inflation depresses the domestic demand in the Asian region, which then leads to reduced demand for commodities.

In addition, a declining trade deficit leads to a decline in the current account deficit and a relative tightening of global liquidity as Foreign Official Dollar Reserve growth slows down. Since FRODOR growth is inversely correlated with the USD and correlates over time with the movement of gold prices, any contraction in FRODOR growth would be USD supportive and negative for commodities and gold

I have a friend who is an outstanding economist who thinks that the Asian current account surpluses will shrink in 2009 by about 50% from their peak in 2007. In this scenario, global liquidity would become extremely tight and would have a devastating impact on asset markets including real estate, commodities, non-AAA bonds and equities. Such a decline in the Asian current account surpluses would cut the US current account deficit by half and lead to a very strong USD.

Equities, meanwhile, look shakey — although the US markets less so than the rest of the world. Over the last 18 months, households have been heavy sellers of equities. The support for equities in 2007 came only from LBOs and share repurchases.

Demand from these important sources has now collapsed and will not come back as long as lending standards are not eased considerably and as long as the outlook for the global economy deteriorates.

Outside the US, equity markets look even more vulnerable, he adds. The US economy is in deep trouble but this is now widely known whereas other economies such as Australia, the UK and the eurozone are just starting to deteriorate very badly, most from an even more inflated level. So while housing affordability has improved in the US as a result of the sharp price decline, affordability in Australia is at a record low.

So, predicts Faber, US stocks will continue to outperform foreign equity markets as they have since the start of the year — but that’s not because he thinks US equities will move higher but because they are likely to move down less than foreign markets and also because the USD should continue to strengthen. Central banks around the world will shortly begin to cut interest rates, which supported foreign currencies so far. The NZ dollar, the Australian dollar and the British pound are particularly vulnerable, he adds.

In the US, the most vulnerable sectors are now material and energy related companies and increasingly the last sector that has held up well: technology, including companies such as Apple, Research in Motion, Amazon.com, Google and IBM.

In recent commentaries we have also suggested that Japanese equities were relatively attractive. They have indeed begun to outperform the Hang Seng Index and also other Asian markets and I expect this outperformance to last for some time.

Again, this does not mean the Japanese stocks will move up but that they will move down less than other Asian markets.

In sum, credit growth and global liquidity are contracting, a vicious economic downturn is about to unfold (China could surprise on the downside and put additional pressure on commodity prices) and asset markets are still very high by historical standards and, therefore, remain
vulnerable.

In conclusion, advises Faber, use equity rallies as a selling opportunity and further weakness in gold as a buying opportunity for long term holders with significant cash and cash flows. But if his great strategist friend is right and the S&P500 trades down to the 500 level, “you should be careful not to be eaten by bears in all asset market”.

Thanks for that, Marc.

This entry was posted by Gwen Robinson on Wednesday, August 20th, 2008 at 7:56 and is filed under Capital markets, People, Commodities. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

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Comments

  1. Aug 22   20:09 Posted by Alex Grey [report]

    I have always found Faber’s commentary very insightful. I started to become very negative about the economy in 1999 and expected things to grow steadily worse. When the US economy rebounded post-March 2003 I found Faber was one of the only ones I read who saw storm clouds on the horizon. My only disagreement is that I saw the ultimate outcome as an economic depression with deflation whereas Faber raised the prospect of a sharp devaluation of the US dollar leading to inflation almost like something experienced by Latin American countries. However, for Latin American countries that have faced this situation inflation and depression really walked hand in hand. The key point is that the US (and for that matter the global economy) face a deep crisis. So I am glad Faber is getting space on AV.

  2. Aug 22   17:29 Posted by Integrity Research» Blog Archive » Glass half full or half empty - with Faber it may just be empty [report]

    […] New York - Marc Faber, an investment strategist and contrarian economist, recently wrote an interim note to subscribers of his firm’s Gloom Boom and Doom Report. According to Faber, gold charts are looking “truly horrible.” With gold at the current level of $820/ oz (key support levels are around $850) Faber believes that this number could potentially drop to as low as $600/oz.  His advice to investors is the following. Those with assets in U.S dollars cash should move to the purchasing of gold as the price continues to fall. For investors with the majority of their assets in gold and no cash flow- stay put for the time being. […]

  3. Aug 22   2:18 Posted by Dr Doom: ‘Let us just assume the financial system blows up…’ | Trading Made Easy Blog [report]

    […] For traders, however, gold may have some short-term appeal right now because it is becoming oversold. But what, then, is the immediate upside potential? Heavy resistance would seem to exist at $850-$900 while the downside risk is at least as large as the upside potential….MUCH MORE […]

  4. Aug 20   17:18 Posted by gloomy [report]

    Foreign governments currently purchase 600 billion dollars each year in treasury debt. If foreign current account surpluses shrink by 50%, that implies that there will be a 300 billion dollar shortfall in US debt purchases by these entites. At the same time, the US will be issuing more debt due to an exploding deficit and Fannie and Freddie bailouts. IMO this would not be a favorable scenario for the dollar.

  5. Aug 20   17:01 Posted by D Benson [report]

    I’m glad that some think Faber is not “worthy of AV,” or that his “predictions have been way too pessimistic.” I have subscribed to his newsletter for 20 years, and he has made far more $ for me than any other strategist [how many others were recommending Russian stocks in 1994, avoiding US homebuilding stocks in 2005-6, or buying gold in the early 2000’s, etc.?]. If everyone thought he was so good, his recommendations would not nearly successful as they have been.

  6. Aug 20   13:55 Posted by Anonymous [report]

    Let’s just assume for a moment that the financial system doesn’t blow up, and just keeps bumbling along, with some winners and some losers…

    Ahhh, that’s better I can enjoy my lunch now

  7. Aug 20   13:18 Posted by Swede [report]

    To Anonymous: Holding gold (as a non-American) through a strengthening dollar environment should not matter unless you hedge the FX. On the contrary, USD, like gold, is still considered a safe haven by, albeit few, some investors. With Euroland made up in part of economies like Greece, France and Italy I would rather be long USD than EUR from these levels, and gold could be a nice parking spot for these dollars.

  8. Aug 20   11:09 Posted by T Price [report]

    Don’t quite know why gold arouses such strong passions in people. Suffice to say this spivvy zero yield metal has outperformed and outlasted every fiat currency since the dawn of creation. And as even arch-inflationist Greenspan has conceded, in extremis (which is what Faber is referring to here) gold is always accepted as a means of exchange and store of value. US dollars …?

  9. Aug 20   11:02 Posted by G Cox [report]

    fxtrader
    Yes gold has risen rise a great deal since ‘ Greenspan kept rates at 1%’. it was oversold at that time.

    But in the early 2000s that you speak of, US index linked bonds could be bought at 4% yield plus. That would have been the sensible safe recommendation rather than a spivvy zero yield metal.

  10. Aug 20   10:28 Posted by fxtrader [report]

    Generally, I’m bullish gold - and provided one has accummulated gold since Greenspan kept rates at 1% (the clearest signs of loose policy) then one is still sitting on a massive profit. If one’s edgy about gold going further down, then what about getting a few put with a 500/600 strike to compensate? But still, the supply/demand is still good for gold - true, jewellery usage went down but that’s simply because gold had risen too high too quickly. Longer term, gold is far less abundant than oil - though it’s ever lasting. Still, the biggest reason, in my mind, to be long gold is that gold mining companies are continuing to remove their hedges. (many still had to sell gold at 350/400 while market price was above $1000)

  11. Aug 20   10:07 Posted by PhilA [report]

    Monkey: if you own shares in a company which owns productive assets, then those assets will presumably continue to generate revenue presumably? Stock holders in the big conglomerates did OK through the hyperinflation in Weimar Germany I believe, although it was something of a wild ride.

    Owning stock in a company which has large outstanding debts which require re-financing on a regular basis, well those are going to go to zero in this kind of environment.

  12. Aug 20   9:48 Posted by Monkey [report]

    I dont get this:

    “But if you own shares of companies — even though they may decline in value — you will still own these shares since they are a certificate of ownership and not liabilities of someone else”

    Is this summary correct as his direct post implies buy gold as your liabilities may become worthless which makes sense? In the payout upon default heirarchy surely equity is the last place you want to be. Share of a company worth less than nothing is, after all, nothing. At least as a depositor (or lender you may have liens over the assets. Or is he just talking about lending to banks?

  13. Aug 20   9:46 Posted by taxloss [report]

    If the global financial system is going to collapse, gold won’t be any use. I’m buying guns. Lots of guns.

  14. Aug 20   9:08 Posted by VP [report]

    Nonsense - it’s a view, an extreme one and possibly a “broken clock” one, but still a view, & well worth a read.

    My point re gold very much stands.

  15. Aug 20   9:02 Posted by tdpane [report]

    There is a logic in all this… except for buying gold, if all the rest is going to happen.

  16. Aug 20   9:01 Posted by G Cox [report]

    This is mish mash of time horizons and scenarios and not really worthy of AV any more.

  17. Aug 20   8:59 Posted by Anonymous [report]

    There’s always a market for Nostradamuses. Investors forget how many times Faber’s predictions have been way too pessimistic. Maybe he is right this time. Who knows? It’s all inspired guesswork. BTW, if the US$ does strengthen, then I hardly think gold will be a good investment!

  18. Aug 20   8:41 Posted by VP [report]

    Enjoyed that, thanks. Good to see someone espousing physical gold; far too many seem to think holding gold in any other form is completely “safe”.

This post is closed to further comments.