Wednesday, March 16, 2011


In case you have not noticed, the evolving horrors in Japan have merged with the disorder in the Mideast and cycles in the U.S. (probable peaking of economic momentum) to cause a decline in numerous asset prices lately. In what strikes me as not a coincidence, the 10 and 30 year Treasury bonds have peaked in yield right around their long-term trend lines.

The Treasury bond bull lives on, in a sort of repetition of the 1940s experience. In that decade, during peace, then war, then peace, then war, interest rates stayed insanely low relative to the decade’s average price increases of 7%. Adjusted for inflation, the stock market did not do very well, but nominally, it was one of the best games in town. And we live in a nominal world, something one can forget if one reads too many exegeses written by economists. Of course, the market began and ended the 1940-49 decade with far lower fundamental valuations than it has today (meaning it was undervalued then), and thus had a margin of safety that I believe is lacking today.

So far as I can see, the major trends that have been in force for years remain in force. An aging and manipulated Treasury bond bull market is coexisting with and, in a sense that strikes me as a crucial sense, is driving the gold (and silver) bull market. In that context, the price of second-hand stocks (i.e. “the market”) is secondary in importance to the authorities keeping the government funded and, except for precious metals stocks, is of at most secondary importance to true “bugs” on precious metals.

Based both on average price-earnings ratios for the past 10 years and on replacement costs for the assets of the S&P 500, both as judged by Andrew Smithers, the stock averages are as of this writing near their 1929-level of overvaluation and are similar to their 1965 and 2007 overvalued states. By this analysis, a 50% off sale of the stock market would leave it only somewhat undervalued. Unfortunately, the factors that take markets from highly valued (i.e. overvalued) to undervalued essentially always involve fundamental deterioration that destroys actual value as well as it simultaneously destroys confidence and optimism. It also destroys liquidity. Thus at true market bottoms, as in 1932-3, 1974, and 1982, most people with cash are too scared to get in near the bottom.

So far as stocks go, space in this blog does not permit a full explanation, but it is important to emphasize that if one wants income, one should not think first of common stocks. Dividends are both not guaranteed and payment of a dividend results in the equivalent drop in the stock’s price. For example, several drug stocks are “high” dividend payers. Yet the stocks sell at high multiples of book value and price-sales ratios. They were hot growth stocks in prior decades. Thus they really are simply busted growth stocks but without physical resources that can hold their real value as central banks destroy the value of savings by creating unlimited new money at unfairly low yields.

In contrast, mature companies that own natural resources and that pay out significant dividends while yet retaining much of their cash flow may be especially attractive in the current environment of muddled finances, central bank money-printing, and a global “growth” agenda. Integrated oil stocks and some natural gas stocks fill that bill.

Unlike drug stocks, no one thinks of the major oils as fast growing companies, so their prices never get bid up far too high due to the delusion that they can save the world the way a drug stock can get wildly overpriced. The dirty not-so-little secret of the connected, wireless age is that it is an energy hogging world. With the increasingly uncertain future of nuclear, there is no technology to replace hydrocarbons to allow the world to “grow”. High-yielding energy stocks and precious metals stocks are the only major asset classes of stocks that appeal to me in the here and now. Lower stock prices, such as for owners and operators of base metals, and for top-tier tech and other companies, would change that assessment. No matter what happens in Japan in the days and weeks ahead, Chindia and Brazil want to achieve Western standards of living. They continue to be willing to save to get there to a degree that the West except for Germany has forgotten how to do. The marginal value of a gallon of gas is clearly greater to an Indian getting his first car or motorcycle that lets him get to a good job a distance from home than it is to an American who does a good deal of pleasure driving.

For some time, I have been feeling as I did in 2007, on the one hand that the 3rd year of a presidential term was bound to be a good one in the stock market–and so it was in 2007 from start to finish; but I exited financial stocks in the winter in 2007 and exited virtually all stocks in the late summer. That the averages hit new highs after I sold out was surprisingly not bothersome to me. I was confident that a recession had arrived and that the risk-reward for stocks was poor.

This was without forecasting the disaster of 2008 or the “Keynesian” lunacy that subsequently”solved” the crisis. Just as the surprises with Bear Stearns funds in the spring of 2007 began to explain the underperformance of financial stocks over the prior year, the increasing comparisons of Barack Obama with Jimmy Carter suggest to me that Mr. Obama’s inexperience and his laid-back manner (i.e. lack of leadership skills) can allow negativity to surge as it did during Mr. Carter’s tenure as people sense drift at the top during difficult times.

I think the American economic system and related financial markets have a malaise that in some ways is similar to that of the extended Johnson-Nixon-Carter era and that in some ways is quite different. Thus, both equal (in some ways) and opposite (in other ways), in fine Newtonian thermodynamic fashion. With 3-month T-bills collapsing to new lows of 7-8 basis points, the markets are again going “Japanese” (pre-earthquake sense), and thus there are no imminent signs of hyperinflation from the markets.

As I said from the time I began blogging in late 2008, “stimulus” was not going to stimulate. The Austrian economists got it right. The money-printers got it wrong. Other than technical advances in some gadgets, what has really been accomplished in the economic “expansion” of the past almost two years? Extend and pretend, that’s mostly the extent of it.

Compare the current situation to the manifest improvement in real economic conditions and in psychology by mid-1984, with disinflation the order of the day and reversal of the sense that the Soviets were unstoppable. Or to 1993, when employment surged massively just a bit too late to help Bush 41 and when it was apparent that the system was putting numerous S&L malfeasors in jail and was rapidly liquidating the associated malinvestments. This time it’s different. It’s the first American credit collapse since the Great Depression, and it’s playing out with just as hollow a recovery as occurred in the FDR era. It’s simply not easy to get out of a credit collapse, and it’s typical for stock prices to get ahead of the economy and then, unpredictably, again reflect reality and sink back as the economy does its difficult thing of adjusting to years of unsound allocations of capital.

As I write this (early Tuesday morning New York time), gold and oil are down in price, futures on American stocks are plunging, and Treasuries are continuing their surge up in price (down in yield). The non-barking dog is that the U.S. dollar is unchanged against the basket of currencies comprising the widely-followed dollar index, DXY.

In the Reagan-thru-Clinton period, the buck would be surging in the aftermath of the Mideast turmoil and then the disaster in Japan. This non-barking dog is in my mind the greatest tragedy of all, and the blame has to go primarily to the political leadership in Washington and to the Fed, along with their enablers in Big Finance and the lapdog media.

What maddens me the most about today’s financial system and our markets is that since the world’s fiat money is a debt instrument (in contrast to a gold standard where money has its own value and also in contrast to true helicopter drops of paper currency), the process of inflating the base money supply involves selling more debt. The extra money created goes, nowadays, in large part to purchasing the debt the issuance of which created the money. If that seems circular to you, then you now understand the essence of Bernanke-ism. The implications of this mean, in part, that the pricing of bonds can increasingly become divorced from positive real returns, and the market can stay irrational longer than you can believe; again, think 1940s. Add all the opaque derivatives and unknown status of bank balance sheets, and one cannot really know what’s going on in the financial markets.

As with nuclear power plant design and seawall height in tsunami-prone zones, so it should be with capital. Safety first, especially so when valuations are stretched. Even more so when the government has abandoned sound economic principles but brooks no financial diversity, maintaining its monopoly on money within a largely unfree command and control structure guiding several of the critical sectors of the economy.

Buyer beware; seller beware; owner beware.

Risk off, in other words, till it’s risk on again. But eventually the public may just “fuggedaboutit” and let the insiders trade with each other. If and when that happens for real, you will see asset prices get cheap in a hurry, because true insiders buy low. Personally, given the reflex of the Bank of Japan to create massive amounts of additional money in the face of a deflationary disaster, I can sleep at night owning gold, because while you can’t eat gold, neither can you eat yen, and central banks can’t print metal out of thin air; nor can they provide adequate levels of electricity without uranium or hydrocarbons.

A back to basics mentality may be coming in financial markets, and money and energy are, along with food, basics of any semi-modern economy. If investors keep their focus on what’s vital rather than what’s peripheral, I think they will be well prepared for the times ahead, whether they be good or bad.

(Note: This was written early AM March 15 and posted later March 15 on Posted here March 16 . . .)

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