From Boom to Bust to Dust

Let's revisit a commentary I wrote one year ago titled, "Is the Party Over?"

The gist of the article was to ponder the implications of the violation of the long term Dow Jones Industrial Average (DJIA) trend line dating back to 1974 and whether gold would continue outperforming the DJIA.

At the time the DJIA was trading around 12,500 and gold was priced around $875/oz.  The correct call for traders would have been to buy gold and short the DJIA.  You would have earned a return in excess of 50% rather than watching your portfolio shrivel (a 33% loss for the DJIA).  The same holds true for this entire decade.  $100,000 invested in the DJIA  in the year 2000 would be worth about $60,000 today whereas a "long-short" strategy - go long gold and short the DJIA in equal dollar terms - would be worth almost $400,000.  If you had allocated a mere 10% of your portfolio to that strategy you would have at least broken even.  The chart below makes this clear as the Dow/Gold ratio has descended from 42:1 to 9:1.

Source: www.sharelynx.com

Potentially more worrisome is the next chart:

Source:  www.sharelynx.com

The term "reversion to the mean" should send shivers up the spine of investors who own a "Dow-like" portfolio.  The fact that we had never experienced a 10-year period where the market did not register a gain and the ugly "double-top" chart pattern are certainly cause for continued concern and vigilance. 

Though the market has rebounded nicely (up almost 40% from the lows), and the second derivatives are improving (the rate of change in most of the indicators of bad news is declining, or becoming "less bad") market fundamentals still tend to support the ugly chart presented above.

I think it is safe to conclude that we have at least a few years of repair ahead us to work off the debt overhang which took decades to amass.  The virtuous cycle fueled by debt, money printing, historically-high consumption, and asset appreciation has been replaced by a vicious cycle of thrift, austerity (for consumers, not the government), saving, asset depreciation, and job losses.  Negative feedback loops are still the order of the day and many shoes are still lining up to drop-namely commercial real estate, ARM resets (in 2010), rising unemployment,  and increasing foreclosures.  Once we get through the inventory replacement cycle and stimulus in the coming months, what do we have to look to to propel the US economy ahead?  I am not a big believer in "green jobs" leading the way. 

The picture for the US economy over the next decade remains clouded at best.  As global imbalances are addressed and eventually resolved, this will likely lead to happy times for residents of countries whose currency will appreciate and somewhat troubled times for those who live in countries who experience the devaluation in their currency.  I think you know what category the US lies in.  We will be stronger for making it through this period of adjustment, however.

On this point, I wish some commentators would lie to rest the concept of pursuing a "strong dollar policy".  A country's currency is more a reflection of the long term economic fundamentals than is it a policy tool that can be manipulated over any extended period of time.  Just because you wish your country to have a strong currency doesn't mean that it ‘deserves' it or can support it.  Ultimately, Americans need to save and produce more and consume less, and many of the exporting countries (Asia) need to do the opposite.  I question the value in members of the BRIC (Brazil, Russia, India, China) assembling in Russia over the past week to gripe about the decline of the US dollar and rise in treasury yields.   This is all part of an inevitable adjustment process everyone should see coming.  The leaders of these countries would be better served to share ways to build institutions and safety nets to facilitate increased domestic consumption.  All of the exporting countries were complicit in the arrangement where they would produce, the US would buy, and they would continue to ‘vendor finance' by buying our bonds which supported the US dollar and artificially-low interest rates, allowing US citizens to borrow to continue living beyond their means.

Well I suppose old habits are hard to break, but the developing countries will soon learn that this model now resides underneath a tombstone.  There are glimmers of hope reality could be setting in.  Marc Faber points out in a Barron's Interview ("Too Far, Too Fast") that, in March, car sales in emerging countries began to exceed those in developed countries.  This needs to happen.  Our currency will decline, but during this period of adjustment, our businesses will innovate, retool, and adopt new techniques that will make us competitive in the production of goods.  This will lay the groundwork for our road to recovery.  The solution lies at the hands of the workers in the private sector.  I hope that government policy, well-intentioned as it may be, does not hinder their efforts.

There was a train of thought that believed that we should outsource as much manufacturing as possible because those jobs were more commoditized and lesser-paying than the so-called "higher-value", "higher-skilled" jobs such as strategy and development, marketing, technical and product development, product management, etc.  The problem is there weren't enough of those "higher-paying" jobs to absorb the American work force.  I think that we will recognize the need for less "soft-skills" (law, business, finance, liberal arts) and for more schooling and training that is technical in nature going forward.  This is not to say that there will not be new future industries and applications to capitalize on.  Rather, it is a recognition that we are still digesting the technological advances of the last 20 years and that improvements and advancements over the next 20 are likely to be more supplemental and incremental in nature.  

That is just how these cycles tend to play out.  You have a major period of innovation, followed by a period of improvements.  The major growth story over the next decade or so will be the resumption of urbanization and industrialization in China and India and other emerging markets.  The US can participate and benefit.  This is the driver.  Recall back in 2000 when we thought we were on the brink of solving many of the problems known to man.  Stock prices on genomic, nanotechnology, and fuel cell technology companies (promising to cure diseases and answer the world's energy needs) rose to insane levels.  Perhaps developments in those areas will return to the forefront after the rest of the world industrializes.  In other words, we are not yet in a ‘post-industrial' world.

Despite the rough road ahead for the US, I find it highly likely that most equity have bottomed.  The capitulation has likely already occurred as evidenced by a 0% Fed funds rate and the trillions of dollars sitting in money market accounts earning less than 1%.  The 1929-1932 scenario - 50% drop followed by a 50% rally, ending in an 89% overall collapse -- is doubtful, if not totally off of the table.  The fact that the US markets hit new lows in March of this year calls into question of replay of the 1930s.  But what is an investor to do?  From a technical perspective, investors who want to outperform the overall market should consider overweighting those areas that did not make a new low in March as the US equity indices (DJIA and S&P 500) were bottoming.  Marc Faber, during the market depths of March, offered would proved to be bold and sage advice in recommending one such example in Chinese holdings in his March "Market Commentary".  See the chart below:

Source www.decisionpoint.com

To be clear, I certainly am not advocating running out to buy shares in Chinese companies, especially as they have just since rallied 50%.  The point is that, if we have indeed reached a ‘generational low' in the equity market, investors should look for clues to invest in areas which will assume new market leadership.  The second point is that American investors need to appreciate that a well-diversified portfolio does not necessarily consist of a mix of large-cap, mid-cap, and small-cap growth...or a blend of growth and value...or whatever your breakdown of US stocks.  The world is changing and other asset classes and groups of investments need to be strongly considered for many investors.

Natural resources could be such an asset.  Several commodity-producing companies also made "higher lows" back when the US markets were falling in March.  Dr. Faber also appears to have also nailed the bottom in commodity prices (as represented by the CRB index) in his same March newsletter:

Source:  Credit Suisse

The technical aspects of the above chart are gripping.  Equally compelling is the fundamental story behind this chart that looks primed to rebound as much of one-third of the world enters modernity.  As big as the demand for raw materials should be, supply concerns could place even greater pressure on prices.  Many of the projects that were on the drawing boards to grow, mine, or drill in 2008 were aborted when commodity prices collapsed.  Stricter environmental guidelines, political risks for drilling and mining in unsafe parts of the world, and increased exploration and production costs are all setting the stage for what could be another monstrous rally in natural resources.

Before you back up the truck to take advantage Investors need to be mindful of the risks (several but certainly not all have been mentioned in this commentary) that loom.  Many of us learned an expensive lesson in not being diversified or having the appropriate amount of cash on hand (or, heaven forbid, being margined).  The threat of a "W-shaped" economic recovery and stock market (the dreaded "double-dip scenario) needs to be factored into any investment strategy.  The days of relying on hefty stock market gains as a major supplement to income to sustain lofty lifestyles are likely behind us. 

Most would agree that the "Asset Party" is in fact over.  In the "new normal" (the newest lexicon brought to you by the same fine folks who coined the term "shadow banking") investors may learn about investing in new asset classes, but they will do it in a way that is measured, responsible, and disciplined.  We are hopefully beginning to recover from the hangover effects of the last party, but with the pain still fresh in our minds we should have a keen appreciation for temperance and moderation.

Investors should prepare themselves for a continued period of uncertainty and eventual inflation, but still factor in the possibility of another sharp decline in the economy and deflating asset values.  The bust will one day soon be dust and as we work off our profligacy we make the necessary adjustments and recover.  We will hopefully learn the correct lessons from the past and once again show our strength and resiliency as we move ahead into the new world and begin another cycle afresh.