Over the decades, there have been a few pivotal periods of shift that have significantly affected investors – both positively and negatively.  Whether or not a particular investor ends up on the winning side of such events is determined by the ability to uncover the early warning signs and, perhaps more importantly, to correctly adapt investment strategy to the emerging direction of the primary trend.  We believe we have come again to such an important pivotal point.

In our opinion, the first quarter of 2004 represented an inflection point worthy of influencing substantial revisions in portfolio allocations.  The historically virtuous nature of globalization for the U.S. has now become the primary force behind a looming decline in many categories of U.S. equities. With globalization as the root cause for many onerous events spawned in our economy, we believe we are at the leading edge of a vicious cycle that will result in an inflationary price environment for tangible assets, along with a deflationary value trend for financial assets.  As such, we are advocating a major change into a commodity-based, “hard asset, weak dollar” investment strategy.

The year in review ….

The market seemed to lose its upside momentum during the first quarter of 2004 and the results for the quarter were not exciting: While most market measures showed small gains for the quarter, the best performing portfolios and mutual funds for the period were those that focus on investments in Japan and/or the rest of Asia.  Now that the second quarter is nearing the end, the lethargic market has persisted, with the NASDAQ and Dow indexes being down less than 1% for the year as of June 22.

Market averages do not always tell the full story.  Most of the popular indexes reported a small overall gain in the first quarter, but behind that facade other important negative measures gained traction.  For example, the index of the number of stocks on the NYSE reaching a new individual high peaked in early January and has been declining ever since.  Indeed, a growing list of internal market measures validate, at least for now, that money has been moving away from U.S. stocks. The various indications that we have likely seen the highs in most market indexes increasingly provide conviction for this contrary opinion. This unpopular view, of course, has not gained wide acceptance, as is always the case within such pivotal periods as mentioned above.

A message from corporate officers ….

Speaking of money leaving stocks, Thomson Financial reported earlier that corporate insiders continued to heavily sell their own company stock through the first quarter: For every share they bought, they sold more than 28 shares. Thus, at the end of March we had seen 11 consecutive months with an insider sales-to-purchases ratio greater than 20 to 1, the level of insider selling that has historically presaged significant market declines, and which compares to the long term average ratio of sales to purchases of only 2.25 to 1, only about 11% of current levels.  The numbers on insider selling for the second quarter are not in yet, but the early monthly numbers show that this ominous vote of “no confidence” on the part of corporate officers is continuing without abating.

The corporate officers of any given public company are likely to know a whole lot more about that company than outside investors and/or analysts.  These officers may know nothing about the stock market or other companies, but the fact that they are so aggressively pursuing the sale of their own stock is a danger signal that should not be ignored. It seems obvious that one should not want to have money in the stock of a company that is being sold heavily by its corporate officers, and this scenario exists within most of the large and popular investment names in our market.

Embrace or avoid stocks?….

As we will explore below, we believe that we are now at an inflection point in the primary trend of the financial markets.  Making major portfolio changes at a point such as this is a very uncommon thing to do and that is, of course, the reason that early changes by informed investors allows them to participate in the emerging and most profitable phase of the new cycle, before they are joined by the crowd.

Does the foregoing mean that we are advocating getting out of stocks in general?  No, simply because stocks are not a single homogenized group to be either embraced or avoided.  What we do believe investors must come to understand and accept is that a major change is necessary in the types of stocks that make up their portfolio. It will likely be a very different type of company that will prosper in the radical new world that we have already entered, despite not being generally recognized by investors.

We were struck by something Richard Russell said in his March 31 letter:

“The hardest thing to get across to people, and this includes professionals and money managers, is the power and the inevitability of the primary trend.  And the concept of major change.” (emphasis by Russell)

There is a lot of wisdom in that simple declaration, and the implications are profound.

Globalization is the inevitable primary trend ….

Taking our lead from Mr. Russell, the first thing to be done is to identify the “inevitable primary trend”.  There are lots of candidates for this one, such as the accelerating spiral of debt in the U.S. to become the greatest debtor nation in history, the conflict between the world of Islam and the West, the emergence of China as an industrial power, and the rising expectations and belligerence of Third World nations. Strategically, these are but bullet points -- effects, but not the root cause -- in the outline of the primary trend, which has at the top of the outline page just a single word: Globalization.  It is as inevitable as it is unstoppable.

Globalization used to be a great thing for the U.S., but like the globe itself, we have come full circle. What used to pull us forward is now looming to overrun us from behind, all the while nipping at our heels and causing us to worriedly look over our shoulders – increasing our chance of stumbling.

Just a few years ago, the U.S. increasingly outsourced the production of manufactured goods to Asia and we got lower domestic prices in return. For a long while, outsourcing caused no reduction in American jobs, and the U.S. continued to be the market of choice for global capital flows.  Indeed, we were the primary beneficiaries of a virtuous circle:  We consumed, Asia manufactured, we sent them our dollars in payment and they recycled the dollars by purchasing our debt, thus enabling the cycle to perpetuate itself.

Now the downside problems of American excesses and “too much of a good thing” are coming to light, and the true consequences of globalization are emerging. These consequences will be dire for the average investor whose portfolio looks today much like it did in the late 1990’s, and a bonanza for the prepared “major change” investor.  This inflection point will be seen in shrinking financial asset prices, rising prices for commodities and raw materials, and lower average incomes with intractable unemployment. We are in a new competitive environment and the U.S. is no longer in a virtuous circle, but rather has become caught in a vicious cycle.

Globalization is now quite noticeably forcing a trend towards the equalization of wage rates around the world, and the migration of relative economic advantage from the U.S. towards the East. Asia, especially China, enjoys competitive advantages in manufacturing because of abundant labor and rapid technological advances. Though not yet a major manufacturer, India, with the largest educated English-speaking population outside the Western economies, is providing professional and technical services to the world at very low prices.  The U.S. simply can no longer effectively compete against these forces.

The American economy is now caught between a rock and a hard place.  Clearly the very big rock is our gargantuan debt, the likes of which have never been seen in any country, both absolute and relative to the size of the economy.  The hard place is our increasing lack of competitiveness and the global trend towards the equalizing of wage rates and economies as a whole, creating recessionary slack in our economy that we haven’t been able to remove for the past three years – despite massive stimulation through government intervention.

The intended solution has created bigger problems ….

In an effort to get us out of the economic doldrums caused by Globalization, over the last three years our economic authorities engineered record fiscal stimuli and the loosest monetary policy ever seen, fueling money and credit creation at a scale that has no precedent in history.  So far this program has done little to get the economy going again, but it did create the greatest credit and debt bubble the world has ever known.

Total outstanding debt has expanded so much that each addition to debt is having less and less impact.  Six dollars added to indebtedness have become necessary for each new dollar of GNP, meaning, in effect, that our own policies in trying to create a solution have now become the greatest impediment for a solution.

Rather than going into capital investment, the profligate money and credit creation went blindly into asset markets: stocks, bonds and housing. When the equity bubble popped in early 2000, the consumer simply moved on to the incipient housing bubble, helped by the Fed-created bond rally, which pushed mortgage rates sharply downward. The obvious result was rampant mortgage finance excess. While the consumer continued to experience poor income growth, they offset this income loss simply by borrowing more.

About two years ago it had become painfully clear that the lowest short-term interest rates in nearly half a century were failing to create the customary strong economic recovery. Instead of creating consumer and business spending to stimulate “good” growth, the wanton monetary looseness and extremely low interest rates generated multiple price bubbles in the stock, bond, mortgage, and housing markets.

A strong economy can’t be built on bubbles ….

At this point, we have seen four interrelated bubbles that have propped up the U.S. economy after the stock market peak of 2000: 

1) falling bond yields
2) soaring mortgage loans,
3) rising housing prices, and
4) a consumer spending binge.

Unlike what the textbooks said was possible, the U.S. economic engine has now become detached from its basic pillars of savings and investment. It is on a treadmill now, which is driven by credit excess, which provides soaring collateral, which creates still more credit excess, then creating even more asset inflation for yet again more borrowing and spending excess. To some it happily seems like a perpetual motion machine that will forever crank out wealth and spending, but to others is a vicious cycle inflating bubbles in a world of sharp objects.

In his Strategic Investment newsletter, author Dan Denning said:

“in some ways, expectations are also to blame; the U.S. is still locked into a culture of 'getting something for nothing.' Americans still expect wealth as their political birthright. But as CEO Carly Fiorina told Hewlett-Packard shareholders, the days of enjoying privileged economic status because you were born American are over.

“We live in odd monetary times. In America, there is a growing divergence between the value of tangible real assets and the value of financial assets and derivatives. Because of that divergence, and because of the tremendous industrial-productive capacity in the world today - as well as the intense competition for jobs, fomented by globalization - I think you'll see both deflation and inflation in short order.

 “How can you have both? Well, the inflation in tangible assets (commodities) is fairly easy to identify. Commodity prices are determined largely by supply and demand. Demand for tangible assets and raw material is obviously growing, driven by Asia, and notwithstanding the languid economic growth in Europe, the United States, and Japan. Supply, however, is not keeping up. Add to that years of underinvestment in productive capacity, and you have all the elements for rising raw material prices - even if the dollar weren't falling off a cliff. We are at the start of a major, multiyear bull market in commodities.”

Commodity-based, hard asset, “real” investing is the major change ….

And thus we have come to the major change which has been wrought by the inevitable primary trend introduced by Mr. Russell above:  We are entering a world where markets will be led by commodity-based “real” investments, and where financial assets, particularly those asset prices fueled and supported by massive debt, will experience a long period of decline, if not outright blow-off.  Indeed, a market that is characterized by both deflation and inflation at the same time.

The sad and repetitive record clearly shows that all market bubbles throughout history were created by excess liquidity, and the massive money wave in the U.S., which was financed by low interest rates, has created a huge bubble in financial assets. The price inflation of these assets, fueled by cheap money, has pushed those assets to risky and unsustainable levels. Simply put, just about anything not tangible is overpriced and in danger of significant price decline.

Quoting Dan Denning:

“Anything bought with money borrowed at low interest rates is susceptible to a sudden decline in value if that money becomes worth less. That money is the dollar. As the dollar declines, it makes financial assets bought with borrowed dollars virtual locks to deflate in value.” 

Reservations about the “Reserve Currency” ….

What is the outlook for the dollar?  Despite weakness for the last two years, no comfort can be found that we have seen the bottom in our currency.  If certain members of the Federal Reserve Board are to be taken at face value, we will see a much weaker dollar for some time to come.  How else can we pay back our massive debt except to give the holders a highly depreciated currency?

Despite already historic levels of government and personal debt, the government's latest budget calls for another $528 billion in deficits in 2004. This budget deficit is on top of a record-high trade deficit that topped $480 billion in 2003 and is rising daily. In response, U.S. and foreign investors alike have begun shifting money into foreign currency denominated assets, causing the dollar to further weaken.

Since February 2002, a basket of six leading currencies has moved up by 27% against the U.S. dollar, and some individual currencies have done even better: the Euro is up 40% against the Dollar, and the Australian dollar is up 50% over the same time period.

Foreign investors are also growing skittish. This is important because they are now the leading purchasers of U.S. Treasury bonds. According to analysts at Merrill Lynch, U.S. Treasury note sales this year will need to exceed $800 billion to finance the 2004 U.S. budget deficit.  Willing foreign buyers, however, are increasingly hard to come by. As the U.S. dollar falls, currency-related losses directly and very negatively affect the returns earned by foreigners, raising the specter of an even further decline in foreign investment in U.S. securities and bonds.

Thus we may be on the edge of a tipping point that has the potential to trigger a persistent and vicious cycle that moves the U.S. dollar still lower, even while interest rates in the auction end of the longer maturity Treasury market (not directly controlled by the Fed) are forced higher in an attempt to attract necessary foreign investors. One thing is certain:  We do not have adequate domestic reserves to take up the slack created by a dearth of foreign buyers.  It is sad but true that control over our long-term interest rates now resides more in Tokyo and Beijing than in Washington, D.C.

Quoting Dan Denning a final time:

“It's an odd world where you can have debt deflation (falling prices for assets bought on credit) and inflation in natural resources and raw materials (as central banks print more money to devalue the nominal value of the debt) - AT THE SAME TIME.

“We may soon see falling prices for houses, stocks, cars, and bonds... even as prices for precious metals, oil, and raw materials continue to rise. The dollar will lose purchasing power against tangible assets (assets not purchased with debt) while debt-financed assets will fall in value.

“The implications for investors are clear. Beware of the U.S. 'financial economy.'  Decrease your exposure to debt. And if you've got money left over, the commodity bull market might not be a bad long-term place to be.” 

Tactics dictated by the primary trend ….

Applying our strategy involves removing or reducing stocks that do not fit within categories mentioned below.  On the purchase side, we are shopping in different aisles within the supermarket, but are always applying our stringent value-based purchase philosophy.  Our accounts don’t hold domestic bonds, but we believe that U.S. dollar denominated bonds of all types should also be removed or reduced, as we expect bonds to be pounded by the double-whammy of higher interest rates and a weaker dollar.

Categories for emphasis

• Water

• Base Metals

• Precious Metals

• Oil & Gas

• Energy Services and Pipelines

• Hydro-Electric Power

• Basic Materials

• Raw Land, Timber, Paper and Pulp

• Farming and Agricultural Commodities

• Select Foreign Value Equities

• Select Foreign Bonds in Commodity-Based Currencies

What is the risk of this strategy? ….

The risk of any strategy, including what we advocate here, is that it can be wrong.  Therefore, investors should always look at the downside risk of embarking on a new approach.  “If I employ this strategy, and we are wrong, what is the downside risk?”  In this case, we think that the biggest risk is one of perhaps some minor downside, but more likely the risk of “dead money” while other alternatives continue to advance.

We therefore believe that a commodity-based, “hard asset, weak dollar” approach offers an excellent risk/benefit ratio at this pivotal point in the market.  If the strategy proves incorrect, it appears that the main damage will come in the area of opportunities lost, but if the strategy is correct, solid gains will likely be earned while substantial losses generated by remaining with a more traditional portfolio approach will be avoided.

John Dickerson
April 15, 2004

© 2004 John Dickerson
Editorial Archive