Investment guru Marc Faber is living up to his “Dr Doom” moniker with a client newsletter this week that seems to be as cheery as the English weather.
“The global economy is decelerating rapidly, corporate profits are declining and the weakness in financial stocks is now spreading through all asset markets,” he notes. Oh happy days.
There’s a small spot of relief though – if Faber is correct in his prognosis that stocks and commodities are near-term oversold while the US dollar is short-term overbought. A temporary reversal is possible but then, he warns, as the credit crisis spreads into the real economy, be prepared for a slump in all asset classes.
Ultimately, just like in the 1970s, we are currently in “a stock and asset picker’s market”. Volatility will stay relatively high and there will be large moves in individual stocks, sectors and asset classes (up and down). But when it comes to specific stock recommendations, while certain stocks have performed well in dollar-terms, the picture is very different in euro terms, warns Faber.
The major equity indices are unlikely to make much headway in real (inflation adjusted) terms and rather, it is far more likely that equities will continue to decline in real terms for quite some time.
Ron Griess, who runs the excellent website thechartstore (highly recommended for a historical perspective of asset markets), notes there have been three major inflation adjusted bear markets over the last 100 years (1906-21, 1929–49 and 1966-82). The average length of an inflation-adjusted bear market was 191 months (almost 16 years).
His observation would suggest the possibility that the US stock market (provided we have entered a bear market in real terms) may only bottom out in 2016 in inflation-adjusted terms. But, stresses Faber, even after the decline of equities in real terms since 2000, the S&P500 inflation adjusted is still far higher than it was at the peaks in 1906, 1929 and 1966.
Therefore, it may be possible for Ben [Bernanke], Hank [Paulson] & Co to support asset prices with enormous support measures and all sorts of market manipulations and government bailouts in nominal terms but it is very doubtful that this very questionable group of government officials (a better term is group of “market manipulators” who in recent years completely mispriced the cost of capital through artificially low interest rates) will be able to boost equity prices higher in real terms.
Moreover, whereas I endorse the view that the right selection of a stock will be important for the overall objective of preserving wealth, the key will be the correct asset allocation – as it has been over the last few years. Clearly, the assets to have invested in from 2001 to late 2007 were emerging markets and commodities and not US equities, which badly underperformed world markets until late 2007.
So, asks Faber, will the winners of the 2002-07 global asset bubble continue to shine?
First, he says, the outperformance of commodities versus the US stock market will not necessarily continue (Faber has repeatedly suggested that US equities would outperform foreign markets in 2008 and that the second half of 2008 would not be friendly for commodities).
But for the preservation of capital in real terms and hopefully for some capital gains, they key factor is whether an investor is positioned in cash (in a strong currency or gold), bonds, equities (US, Europe, or emerging markets), commodities, or real estate.
After all, it is not very likely that anyone would have more than 10 per cent of his assets in a single stock whereas to have 50 per cent or even 100 per cent of one’s assets in dollars or euros would not be a particularly uncommon position.
Faber turns to his recent suggestions of some preventive selling of commodity-related and material-related stocks, in view of the financial crisis spreading into the real economy. His argument: that the bear market in equities “would only come to an end with strong sectors like commodity-related equities and strong stocks such as Research in Motion, Apple and Amazon.com also succumbing to the weakness in financial stocks”.
He admits to being puzzled that highly cyclical stocks such as those of companies related to steel, iron ore, copper and shipping continued to soar in the 2008 first half “when it was becoming increasingly obvious that the global economy was decelerating very rapidly and that corporate profits would disappoint”.
But we need to accept the fact that asset markets are increasingly driven by short-term momentum players who need to show month-by-month performance and, therefore, when the majority of stocks decline and just a few stocks appreciate, all the “long money” piles into still-rising equities, which then leads to mini-bubbles in the last few strong stocks and sectors
Remember, he says, that it is quite common for highly cyclical companies to perform well at the very tail end of an economic expansion and of a bull market. But when cyclical companies’ stocks begin to break down (including CVRD, Rio Tinto, BHP and Arcelor Mittal) and when industrial commodities sell-off and the Baltic Dry Index collapses, “we have to consider carefully what might be the reason for the breakdown”.
To recap:
Global liquidity is tightening because of the contraction in the US trade and current account deficit. This affects growth in the economies of manufacturing countries (China) far more than the economies of consumers (such as the US) and contains growth in demand for raw materials. In addition, when growth in manufacturing countries slows down it also affects capital spending as investment projects are cancelled.
It should be understood that during the global economic expansion (2001-07) the demand for industrial commodities increased not only because of higher consumption leading to strong industrial production growth, but also because significant new investments were undertaken in construction, infrastructure and in order to expand manufacturing capacity.
Hence, when demand growth slows down and capital spending no longer increases, industrial commodities and cyclical sectors and cyclical economies (especially emerging economies) are particularly vulnerable.
Considering the pull-back of investments and rising excess capacities amid slower global economic growth (or more likely because of an economic slump), capital spending could come under more pressure than expected. In this environment technology stocks, which are in the US over-weighted by institutional investors, are particularly vulnerable
In conclusion, then, what could happen in the next few weeks in Faber’s view is a rebound in the euro, “which is oversold near-term”, and a rebound in equities and selected commodities. However, he cautions, from a longer term viewpoint, stocks remain high and given the decline in corporate profits they are also far from inexpensive.
Furthermore, judging by the course of asset markets and individual stocks, the downside risks remain rather significant.
On commodities, “we have reached a top in the CRB Index”, says Faber, although it is unclear whether this top turns out to be an intermediate top or a longer-term top.
At some point, he says, money-printing by all the world’s governments will lead to higher inflation and commodity prices (this assumption would also be consistent with the Kondratieff Cycle).
However, we should not forget that the current financial crisis and credit growth slowdown is unprecedented in the last 30 years or so and that the through of the Kondratieff down-wave, which lasted in real terms from 1974 to 2001, was incomplete because it was not accompanied by a massive debt-liquidation.
As a result, a deflationary bust originating from debt liquidation should not be ruled out entirely before highly inflationary monetary and fiscal policies around the world bring about very high inflation rates. But that may only happen after 2012 and in the meantime, “all asset markets could continue to suffer badly as credit contracts and liquidity evaporates”.
In this scenario, gold is likely to shine again at some point. As indicated above, asset markets and non-US currencies have become near term oversold and could rebound shortly.
So, he concludes: use rebounds to lighten positions and to increase US dollar positions.
In particular, use any rebound in stocks like IBM, Apple, Amazon.com and Research in Motion as a shorting opportunity (with tight stops). For individuals the purchase of put options may be a less risky alternative.
Related links:
Dr Doom: ‘Let us just assume the financial system blows up…’ – FT Alphaville