There is an old investor’s maxim that says:  “Bull markets climb a wall of worry”. However, investors today are clearly not worried and are confidently optimistic and fully invested in the market. Thus, whose new money will take the market higher? This is a particularly valid question right now, since foreigners, threatened by the declining dollar, have become skittish and have already started to take their money out of U.S. markets.

Background: Blind Optimism

Six months ago, we had this to say in our comments at the end of the first half of 2004:

“The markets have been a fun place to be since March of 2003 and investors have enjoyed the party so much that they are failing to notice that the band is packing up (the bandleader, of course, being that great author of fabulous bubble music, Alan Greenspan) and the intoxicating punchbowl has nearly run dry.  All of which has been provided to the crowd without immediate charge, through the liberal use of borrowed money.  Even worse, tomorrow, the partygoers will wake up with a hangover, only to be confronted with the reality of paying their share of the party expenses. Alas, even after the most memorable party, reality always returns.

“With the lackluster market environment, we are puzzled by the persistently high level of investor enthusiasm, which has not subsided as the market has lost upside momentum. Investors seem to have no fears and have become very complacent.  That attitude has historically not fostered higher equity prices, and gives us a heavy dose of skepticism.”

Others Agree

We’re happy to see that someone else is now using our punchbowl analogy.  Stephen Roach, famed global economist of Morgan Stanley, wrote this on January 10, 2005:

“In the end, denial is usually the only thing left (before a bear market begins). In my view, that's pretty much the case today in world financial markets. Imbalances on the real side of the global economy have moved to once unfathomable extremes. And now the Federal Reserve belatedly enters the fray threatening to take away the proverbial punch bowl from a rip-roaring party. Financial markets hardly seem concerned over this impending collision. Spreads on most risky assets have fallen to razor-thin margins. Steeped in denial, investors have once again become true believers in the sure-thing syndrome.

 “There can be no mistaking the absence of risk aversion in most segments of world financial markets.  In most cases, the arguments rest on perceptions of "improved fundamentals." Awash in cash flow and riding the wave of a new era of sustained productivity growth, Corporate America has nothing to worry about, most believe. That impression is evident across the risk spectrum, from high-yield to investment-grade companies.

“The recent trading rally in the greenback has given some investors hope that the currency-adjustment cycle has run its course -- offering the tantalizing prospect of reinvigorated foreign capital inflows triggering the ultimate virtuous circle for US financial assets. (Note: See our earlier piece, ‘The Virtuous Circle Turns Into a Vicious Cycle”, posted on our web site)  My advice: Don't count on it. Back in 1994, when the Fed was faced with a similar normalization challenge, the dollar fell like a stone even as the US authorities pushed the federal funds rate up by three (3) full points. In today's climate, with a US current account deficit that is nearly three times what it was back then, the downside for the dollar can hardly be minimized. There's far more to currency-adjustments than swings in relative interest rates.”

Short Memories

Overconfident investors apparently need to be reminded that most bear markets begin with the Fed raising interest rates.  However, the bear doesn’t come out of his lair until some 6 to 9 months after the Fed starts the process.  In this cycle, the first increase was on June 30, 2004, and we have had five increases since then.  Thus, we are just now entering the critical 6 to 9 month time frame from which other interest rate driven bear markets have begun, but investors seem to be too busy checking their stock quotes to take a look at the calendar.

Similar rounds of interest rate increases were imposed by the Fed in 1973, 1977, 1980, 1987, and 1994.  Substantial market declines followed shortly after every one of these cycles, with the drop in 1994 being the most muted of the bunch.  The worst market declines in post-depression history came in 1974, 1978, the crash of 1987, and the more recent sharp drop which began in March of 2000.  These declines were all immediately preceded by a round of interest rate hikes exactly like those we are experiencing today.  How can investors remain so complacent in the face of such obvious and compelling caution signs?

The answer to that question may be explained by the gains these investors have experienced over the last couple of years in conjunction with their notoriously short attention span.  Most people take what they’ve experienced most recently and extend those experiences, on a linear basis, into the indefinite future. In light if their recent and fortunate past, the tendency is to believe that: “Next year will be a lot like last year, and even a little better”.  This thinking is certainly the case now, despite the evidence we see to the contrary.  Investors seem to have forgotten what happened between March of 2000 and March of 2003, when, lest we forget, the NASDAQ declined 78%.

The Speculative Nature of a Complacent Consensus

We like what Mark Rostenko, editor of the Sovereign Strategist, had to say recently on this point:

“The general mainstream consensus is now much the same as every year:  everything will do a little bit better and nothing bad will happen.  The economy will continue to grow a bit, stocks will go a bit higher, and the dollar will rally a bit.  Nice, neat, safe and tidy, the same annual forecast touted year after year.  Everything good about last year will get a little better this year and so too will everything that was bad about 2004”.

Another analyst and money manager whose observations we have found to be quite helpful, Bill Fleckenstein of Fleckenstein Capital, was recently quite blunt and direct in his distain for the unbounded (and unfounded) optimism of most investors:

“It seems to me that financial insanity is rampant. Folks are speculating in houses, with many having more than one real-estate investment due to the financing that's available and the belief that real estate is now bullet-proof. Insanity pervades the stock market generically, and Internuts/single-digit midgets (with no real businesses) specifically. The fact that Google could have a $50 billion valuation is a sign of the times.

“If one looks at credit spreads, they are also at record lows. And then, I see Fannie Mae at $71, barely flinching after the discovery that the company manipulated their earnings. So, I just shake my head and say, there's not one pocket of insanity, it's everywhere.

“I continue to believe that our stock market is the financial equivalent of an 8.0-plus earthquake waiting to happen. The fact that it has not happened doesn't mean it won't, any more than the fact that the Indian Ocean was earthquake-free for so long didn't mean it was immune to an enormous tragedy. Furthermore, I also believe that the speculation I have detailed over the course of the last couple years has only guaranteed that whatever damage is slated to befall the stock market has only gotten bigger by the month.

“So, the question you have to ask yourself is: If you knew that a place was vulnerable in the not-too-distant future to an earthquake and tsunami, would you go there? Most likely, the answer would be: of course not. Similarly, if you knew that a financial market was prone to epic dislocation, would you aggressively allocate money to that market? My guess would be no.

“However, the timing of such events is very hard to predict. The longer markets do well (especially in the face of bad news), the more people believe that nothing bad can ever happen. (Of course, sometimes markets "defying" bad news means the news is going to get better. However, when the news doesn't improve after a market has gone up, the stage is set for disaster.)

 “That is where we find ourselves today, with our stock market and, by extension, our real estate market and the economy. I don't believe that there has been a moment in time in the last 50 years where the stock market has been more lopsidedly tilted toward all risk and no reward. This year, when problems start, they are liable to get out of control very quickly. Given that I believe the stock market is a dislocation waiting to happen, the knock-on effect (i.e., the tsunami that comes after it) will be enormous and far-reaching.”

Run for the Hills?

Does the foregoing mean that we at Summit are advocating getting out of stocks in general?  The answer is a resounding no, and the reason is that stocks are not a single homogenized group to be either embraced or avoided, particularly if one is willing to look beyond U.S. markets. What we 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 in varied markets that will prosper in the radical new world that we have already entered, despite not being recognized by overconfident investors.

Our early warning of six months ago remains our conviction today: “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.” (NOTE: Some might say that we were early in these comments, but we would point out that stocks in general are no higher today than when these words were written, and the signs of the major shift we discussed then are now abundantly clear.)

“In our opinion, the first half 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 resource and commodity-based, ‘hard asset, weak dollar’ investment strategy”.

Suggested Strategy

Applying our strategy involves removing or reducing the broad range of U.S. stocks that do not fit within the categories mentioned below.  On the purchase side, we are shopping in different aisles within the global supermarket, but are always applying our stringent value-based purchase philosophy.  Our accounts do not hold domestic bonds, but we believe that U.S. dollar denominated bonds of all types should soon be removed or reduced, as we expect bonds to be pounded in 2005 by the double-whammy of higher interest rates and a weaker dollar.

Groups for Emphasis

• Global Water Industry and Related

• Base Metals

• Precious Metals

• Oil&Gas

• Petro-Energy Services and Pipelines

• Hydro-Electric Power

• Basic Materials

• Raw Land, Timber, Paper and Pulp

• Farming and Agricultural Commodities

• Select Foreign Value Equities

These groups are not listed in any necessary order of preference, and, as always, we will be buying only individual companies that meet our strict value standards for purchase. Where possible, we prefer to buy foreign stocks in these groups, domiciled in strong currency nations and purchased in their local currency. We prefer that a large portion of our portfolio assets not be denominated in U.S. dollars.

Epilogue

We can think of no more fitting a way to conclude this discussion than to quote the words of Dr. Kurt Richebacher, a global investment economist who authors the Richebacher Letter, perhaps the most respected publication in its field at this time.  In the paragraphs below, Dr. Richebacher expounds on “The Paradox of Overconfidence”.

“It is generally argued that the dollar’s accelerated fall arises from pessimism about the soaring U.S. trade deficit.  We would say that the rising deficit as such is sufficient reason. As to the role of pessimism, we read and hear nothing but highly bullish forecasts for both the U.S. economy and its asset market, contrasting with pretty pessimistic forecasts for the eurozone.

“It is widely assumed that rising stock and house prices will keep the American consumer both willing and able to keep the U.S. economy on track for strong growth. Never mind that this tends to boost the trade deficit. Very few have realized that this pattern of growth — with its evil effects on saving, investment, trade balance, and internal and external debt levels — is relentlessly corroding the economy’s stability and viability.

“To be sure, the bulging U.S. current account deficit and the falling dollar are posing the greatest and the most acute risks to the U.S. economy and its financial markets. So far its decline has been orderly. Continuous large dollar purchases by some Asian central banks are, of course, one reason. But an even more important reason seems to be the widespread hope that the falling dollar will go a long way to bring down the trade deficit and spur economic growth from the trade side.

“For sure, Americans possess an extraordinary propensity towards optimism. But that is, of course, what policymakers, Wall Street pundits, and headlines in the media are permanently hammering into their heads. Still, there can be too much of a good thing. Call it the paradox of overconfidence. 

Confidence is good, but overconfidence or false confidence has been the key cause of every severe economic and financial crisis.”

© 2005 John Dickerson
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