When The Music Stops
This year the financial markets are following in the same path: rising and falling in tandem. The exception is the commodities markets, which are on fire again. The CRB Index is almost back to its highs set on March 1st. At some point soon, the real bull market will surface as the returns on all asset classes can not all rise at the same time forever. If commodity prices continue to rise, as I believe they will, then trouble will start to surface in the stock and bond markets. As the year progresses, gradually the number of asset chairs to land on will eventually diminish, leaving very few chairs to safely land on as an investor.
Confused Financial Seas What becomes apparent from viewing the financial markets and the economy is things aren’t playing out as usual. Commodity and gold prices are rising, while bond yields remain suppressed. Stock prices rose far more sharply than they should have given current valuations. Bond prices remained far below the norm given the size of America’s twin deficits. The U.S. twin deficits at 5% of GDP are now at levels where currency crises begin. With global economic growth slowing down its pace, it appears that there are very few economic engines outside the U.S. and China that are large enough to drive world economic growth. Outside the U.S. there is still a dearth in spending around the globe. European economic growth has been feeble. Asia and parts of Latin America seem to be the only areas that are doing well economically. With U.S. consumers still maintaining a brisk pace of spending, the U.S. trade deficit will get even larger in the months ahead. This will bring more pressure on the dollar notwithstanding Japanese intervention. Japan’s recovery is gaining economic momentum as Japan’s exports pick up steam. Japan is supporting its export drive through currency intervention. Japan’s central bank is actually spending more money each month on intervention than the total value of all of its exports. Japan’s central bank will devote close to $575 billion this year to keep the yen’s appreciation versus the dollar minimal. Central banks around the globe from the U.S. to Europe and especially Asia are printing money as never seen before. This tidal wave of money is what is driving up asset prices. There is simply too much money chasing too few good investment opportunities. This explains why we have seen prices rise in all asset classes from paper assets to tangibles such as commodities. However, these trends where all ships rise at the same time will not continue forever. At some point--maybe as soon as this summer--a major paradigm shift will begin in the financial markets. By then the bond market will wake up to the fact that monetary inflation is global and begin to demand higher compensation in the form of higher interest rates. With monetary reflation running globally, we should also begin to see the price of gold rise against other currencies. Up until now gold has risen mainly in U.S. dollars. Upheaval Looms Ahead As asset trends begin to decouple, volatility will begin to rise substantially in all asset classes as the ocean of central bank liquidity moves in and out of asset classes and sectors on a moment's notice. The financial markets, especially stocks and bonds, will become increasingly vulnerable to sudden mood changes rising and falling on the latest economic news. As the U.S. presidential election season kicks into high gear, politics will also play a growing role in the financial markets as investors try to position themselves on the wining side. Current thinking on Wall Street is evenly divided. The Street thinks Bush’s reelection would be good for stocks, while the election of John Kerry would be good for bonds. Kerry would raise income taxes substantially. The Street believes this would alleviate the deficit problems. However, Kerry claims he would raise taxes only on the rich (anyone making over $200,000 a year). However, there aren’t enough rich people in this country to close a $500 billion budget deficit much less than pay for nearly $200 billion in additional social spending. Deficits will rise no matter which candidate gets elected. Politicians in both parties are advocating policies that led this nation into the Great Depression. [For more detail read Murray Rothbard’s America's Great Depression.] Increased government spending on social programs, a runaway entitlement budget, raising minimum wages, various price control schemes, raising taxes and increased calls for protectionism, harkens back to the failed polices of the Hoover and Roosevelt Administrations that turned a market crash into The Great Depression. However, this time around the politicians face a more perilous situation, which is America’s spiraling debt burden. Corporations are heavily indebted, consumers are up to their eyeballs in debt, and the federal government’s take of the economy is getting larger each decade.
Baby Boomer Benefit Demands The real crisis begins in the next four years. By 2008 the first batch of baby boomers head into retirement. They will put an increasing burden on Social Security and Medicaid. Just about every budget expert is in agreement that something needs to be done with entitlements, especially Social Security and Medicare. The most important point to understand regarding this issue is there is no trust fund! All of the money has been spent. The surplus revenues from Social Security have been spent by the politicians. All that remains in the Social Security Trust fund is a bundle of IOUs. In reality our budget deficits here in the U.S. are larger than reported. Budget deficits don’t count surpluses taken out of the Social Security Trust Fund. If those borrowed surpluses were reported, this year's reported budget deficit would be $700 billion. If corporate CEOs did what our politicians are doing with Social Security surpluses, they would all be wearing orange stripes instead of pin stripes. The Growing Gap This brings up the most pressing issue regarding the economy and the financial markets going forward. The main cause of U.S. government budget deficits is spending, not taxes. Democrats all invoke the need to balance the budget, but never mention the main source behind our deficit problem, which is government spending. There is no way if present spending patterns persist that deficits will ever go away. If present spending patterns continue, this country is headed for a major fiscal crisis in the next few years. In a recent Fortune article titled “The $44 Trillion Abyss”, Boston University Professor Larry Kotlikoff refers to America’s massive underfunded entitlement liabilities as ”the great Treasury cover-up.” The first wave of baby boomers hits four years from now with fewer workers to pay their benefits.
According to the good professor, the government doesn’t really know what it owes, which makes the situation even more frightening. What’s more our politicians refuse to level with voters and tell them the truth. How do you level with a voter and tell him all of the surpluses have been spent as politicians from both parties have persistently raided the trust fund and spent all of the surpluses? Even more worrisome is the fact that this underfunded gap gets bigger each year growing by close to $2 trillion a year. The latest drug prescription benefit program raises that underfunded liability to $51 trillion.
Voters should also not be fooled by soothing words coming from politicians. Kerry is promising balanced budgets with his tax increases while failing to mention his plans to increase spending, a problem that politicians from both parties share. According to the Smetters & Gokhale report, the government would have to hike income taxes by 69% or raise payroll taxes by 95% to close the $44 trillion gap. Tax rates at that level would produce another American revolution. If the government was to decide to cut expenses in order to meet unfunded liabilities, it would take a 100% across the board cut in all discretionary spending or a 45% cut in Social Security and Medicare benefits. With liabilities this large there is only one way out. The easy way out is to inflate. I interviewed Professor Kotlikoff back in December of last year. He agreed with my own assessment that the only way out is to inflate our way out of this abysmal fiscal mess. [Kotlikoff Interview] The Developing Trend This brings me back to the investment markets. By summer or no later than this fall, the real trend in the financial markets should begin to emerge. Are financial assets such as stocks and bonds in a new bull market? Or are tangible assets such as silver, gold, copper, and oil the Next Big Thing? I believe the commodity markets are sending investors a message. They are signaling the next paradigm shift. As food for thought, investors should examine the precious metals sector in an era of depreciating paper. Energy and water are two other areas to examine. The world will face two crises in this new century. One will be an energy crisis as the world runs out of cheap oil. [See Hubbert’s Peak and this week’s issue of Barron’s “Half Empty”] The other crisis is diminishing supplies of fresh water, a future topic that will be released soon under a new Perspective series to be titled “The Next Big Thing.” If I had to invest in only four sectors over the next decade, they would be as follows:
Each of the above areas is in short supply or is running large supply deficits. Despite repeated efforts by central banks to suppress the price of silver and gold, they are gradually losing the battle. The price keeps going up despite heavy intervention. Central bankers are gradually losing their grip over the metals markets because the markets are far bigger than central banks. Silver first and gold next will out perform every asset class this decade. The next category is energy. Natural gas should take the lead over oil, but both should do well this decade and next as we come to the end of the oil era. Following close behind energy is water. Without water mankind could not long survive. What is happening to fresh water supplies around the globe will become front-page news as surely as the crisis in energy. Finally there is the world’s food supply, which is dangerously low. Population growth around the globe has put a severe strain on the earth’s available resources in energy, water, and food. If you want to make money this decade, invest in “things” or necessities. We all need them and can not live without them. As economies weaken globally in the months ahead, investors should focus on what people need and have to have in order to live. That is where, in my opinion, the big money is going to be made in this decade. When the music stops, there will only be only a few chairs remaining. That chair will become “The Next Big Thing.” Today’s Market If you were looking for a reason to sell today, you might blame it on terrorism. Last week's Madrid bombings raised investor concerns that more terrorist attacks were in the world’s future. Perhaps the next attack would be on U.S. soil again? Whatever the reason, investors were in the mood to sell on Monday. Selling volume picked up over last Friday. Investors sold off shares of airlines since they would be the first impacted by a renewal of terrorist attacks. The Bloomberg Travel Index, which tracks 36 airlines and hotels, fell 3.6 %. The Index has lost 5% since the bombings last week. The major indexes all lost ground with the NASDAQ shedding 45.53 points for a daily loss of 2.3 percent. All three of the major indexes, the Dow, S&P 500, and the NASDAQ are now in negative territory for the year. The NASDAQ has lost 10% from its January peak. Besides terrorism the major indexes have fallen recently on news that the economy is slowing down again and news that the employment picture isn’t improving. There is a growing feeling on Wall Street that corporate earnings may have peaked (except the energy sector). The current Wall Street consensus calls for only 12.4% growth this year versus 18.4% last year. Lower earnings means that present stock prices are too high. Investor sentiment has now turned negative--a big change in the last week.
On the plus side, Lowry’s reports that selling pressure remains very low and that there are no immediate signs that a liquidation stage has even begun to set in. The advance decline line remains at near record highs, indicating that overall buying interest remains. You might say that the current pullback is climbing a wall of worry. Liquidity conditions remain positive. What appears to be taking place is a major market sector rotation. Investors are getting out of speculative issues like tech and getting into more reasonably-priced sectors. There is strong money flow into defensive issues such as energy, food, and metals. Volume hit 1.5 billion on the Big Board and 1.7 billion on the NASDAQ. Market breath was decisively negative by 24-8 on the NYSE and by 25-6 on the NASDAQ. Jim Puplava © 2004 Jim
Puplava Chart courtesy: www.stockcharts.com and www.bcaresearch.com |
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Last
year was a good year for investors. You made money in just about every
asset class. If you bought stocks and bonds, you made money. If you were
in foreign currencies, you made money. If you invested in commodities,
especially gold and silver, you made a lot of money.
While
stock prices plunged, bond prices held steady. The yield on the 10-year
note ended the session at 3.77% up slightly from the beginning of last
week. The dollar fell with the price of gold, silver, oil, natural gas
and heating oil all climbing. The CRB Index is back to record territory
again rising by 4.26 points to close at 278.36.