Days after Marc Faber (aka Dr Doom) advised “every American to hold his gold outside of the United States” - see the commentary and video at Credit Writedowns - he comes back into the issue of the yellow metal in his latest client newsletter, “High Volatility, a feature of the new investment environment”.
Faber is a “hard money, old school investor who thinks that the US government is going to reflate in order to avoid depression and that means gold is more valuable”, notes Credit Writedowns’ Edward Harrison. He also seems to think the government could confiscate your gold again very soon - but some of Harrison’s readers argue Faber is dead wrong.
On many things, however, Dr Doom has been right, many times before. This time, like many observers, Faber uses that much over-used word in his latest newsletter to describe the scale of wealth destruction over the last 12 months around the world: complete and unprecedented.
Stocks around the world are down by 50%, property prices have collapsed and commodities are in some cases down by 50% or more. World stock market capitalisation is down by approximately 50%, which equals to losses for equity holders of around $30 trillion. Add to this the losses from non-government bond portfolios, CDOs, MBSs and assets such as ships (the Baltic Dry Index is down by more than 90%) the losses that investors and businessmen have taken are simply colossal.
In the case of commodities, losses have been staggering especially for industrial commodities whose demand is driven by industrial production and capital spending. Nickel is down from a May 2007 peak at $53,452 per ton to around $10, although he adds, individual commodities can have widely diverging performances the same way in the stock market different sectors and stocks do not reach peaks and troughs at the same time.
But he admits miscalculating, having originally thought that the liquidity injections and fiscal measures by the US Fed and Treasury would lead to a “water torture bear market” such as seen in 1973-74 when stock market declines were followed by sharp recovery moves to give way again to renewed weakness.
But a key difference between then and now is the huge leverage built up in the system since 1980 - afterall, in 1973, he reminds us, derivatives hardly existed and securitisation was largely absent.
Hence, when credit growth began slowing in 2007 and when asset markets sold off, a huge deleveraging process was triggered, which then brought about further price falls and caused further deleveraging. In addition to the severity and speed at which asset markets collapsed globally, volatility also increased to record highs — not just for equities but also for commodities, currencies and bonds.
When volatility is above average, equity returns tend to be weak whereas low volatility leads to higher returns, says Faber citing research by Philip Isherwood of Dresdner Kleinwort.
When volatility is below average, winners are headed up by tech companies, telecoms, mining, oil equipment and life insurance and industrial and cyclical stocks. Other sectors that perform well in above-average volatility include food retailers, pharmaceuticals, and electricity. This is significant because between 2002 and 2008, all asset markets increased in value, he contends. “The only asset class that fell in value was the US dollar”.
The 2002 to 2007 period was also a time of first diminishing and then ultra low volatility and not surprisingly, the most cyclical sectors of the global economy performed best: emerging economies, cyclical stocks like iron ore, steel and shipping companies.
Since then, the US dollar bottomed out in the first quarter of this year and commodity prices peaked in July followed by the collapse of all asset markets.
Hence, the “connectivity” between various markets:
2002–07: diminishing volatility, rising asset markets with emerging economies’ stock markets and commodities out-performing the US amidst a weak dollar and amidst growing US trade and current account deficits, which increased global liquidity. Then, 2008: rising volatility, falling asset markets, with emerging economies, commodities and cyclical stocks such as steel, iron ore and shipping companies underperforming the US stock market amidst US dollar strength and a shrinking US trade and current account deficit, which tightened global liquidity.
With governments around the world now throwing money at the system, a relief rally is the most likely scenario, in Faber’s view, although, he adds, as seen in Japan post-1990, it may only be temporary and not lead to fundamental improvement of economic conditions
But such a rally, even if temporary, would lift assets that have been most battered, such as emerging markets, commodities and in particular gold mining companies, he believes.
To navigate successfully between all these volatile and often unpredictable market movements you “need to be a genius”, notes Faber. Or else, look for a safe heaven such as physical gold (gold miners and silver could, however, outperform for a while).
In any event, an environment of negative real interest rates is gold friendly and will be highly inflationary in the long run.
In Edward Harrison’s view at Credit Writedowns, Faber’s central point is valid, once deflationary threats subside:
…The arguments for holding gold and worrying about inflation are still valid and I do think that gold is a good hedge against that eventuality. Faber makes a very good argument for why inflation may be the endgame here and I wouldn’t dismiss him out of hand.
However, so far, the deflation scenario is the one that seems to be taking hold - lower commodity prices, lower asset prices, and eventually lower consumer prices. As debt levels are high, this is the scenario to fear.
