FSO Editorials: Another "Long Day's Journey Into Night" by Robert B. Gordon 04/22/2004

Another "Long Day's Journey Into Night"
Will Our Leaders Ever Learn?
by Robert B. Gordon, Sc. D.
April 22, 2004

As I write, the market appears to be starting down on what will be a very long journey and very difficult for every unequipped investor. The descent will be closely followed by only a few followers of the Elliott Wave Principle. Just try to remember that this decline will be made up of a series of five wave impulsive declines, each consisting of three waves down and two up. Each impulse wave down will be separated from the next one by a corrective wave up consisting of two waves up separated by a third wave down. This is the natural law discovered in the 1930’s by Ralph Elliott and known to only a relatively few investors. We also know that these waves are identical in every security market in every nation in the world. This one fact proves to the few believers that Elliott was a genius while most investors know nothing about it or consider it all to be a great fraud.

For this important essay, I borrowed the title of Eugene O’Neill’s greatest play, written at the close of the Great Depression, to emphasize that another immense tragedy is about to befall our world. Unfortunately, the current developing tragedy involves much more than one nation. It threatens to engulf the entire modern world in a series of huge depressions greater than any previous disaster. Our entire world economy is doomed to suffer for many years because of the tremendous ignorance in our Economics profession about the true cyclic nature of all booms and busts. Mr. Greenspan has now rebuilt the stock bubble and created enormous credit and real estate bubbles, so his name will surely be in ignominy for centuries to come.

As a result of the colossal failure of all world leaders and their economics advisors in understanding the real causes of the 1929 crash and Great Depression, essentially all of the free world will have to now endure an even greater tragic event. We will dedicate this essay to reminding our readers of the major steps they must take now to protect their financial and other important assets.

No one really has any clue. I have anticipated the year 2000 stock crash since 1995 since reading Robert Prechter’s monumental At The Crest of the Tidal Wave. This Grand SuperCycle crash is known to be the greatest in history and we can estimate its length in years by comparison with its similar bear wave that lasted from 1722 to 1784 in the London stock market. Virtually no one on this planet is thinking of a six decade bear market. But this is the easy part of the puzzle.

There is literally no historic basis for trying to guess the depth or severity of the world wide economic earthquake that will hit this globe. The tremendous growth in the world economy is now carrying an impossible debt load that is encumbered with huge amounts of leveraged derivative securities whose risks cannot be accurately known in advance. Our world has never before faced such a huge and incalculable risk.

The real estate bubble in the U.S. has been duplicated in England and other nations and has reached enormous levels. Mortgage debt has zoomed to unheard of heights. When sense returns to this area, as it will, the carnage in our nation and the world will be very large. The pseudo government agencies who loaned the money for this bubble will have to pay the piper. Millions of families may end out on the streets, causing huge emergency needs for our already bankrupt cities and states. Thinking our short "recession" to be over, they have foolishly borrowed huge emergency amounts in tax-free bonds that will be forced to default on their interest payments. This will badly affect the retirees who bought the bonds.

Over the next few years, our overloaded universities will be turning out millions of graduates for whom there will be a totally inadequate number of jobs. This is the area that can be most readily anticipated. We will need something like the old WPA to support high school and college graduates with no job prospects. I have no advice to offer families whose children will be involved. This is one of the many great tragedies that must be confronted.

Tens of millions of mutual fund investors will lose much, if not all, of their assets if they do not take corrective actions very soon. We define "conventional" funds as the thousands of funds who remain fully invested in all types of markets and do not build large cash positions to protect their client assets. We exclude from this sales recommendation only the few very stable funds we have chosen in our recent portfolio examples.

We also exclude short term Treasury bond funds and money market funds from this sell recommendation, as well as the short term foreign government bond funds.

If any of our readers have any doubts about selling their conventional "bull market" funds, please read carefully the words below of a "value" fund manager in a recent interview.

"Monday, April 19, 2004. By Ken Hoover, Investor’s Business Daily. Robert Rodriguez is the best-performing manager among U.S. diversified stock funds the past 20 years. His $1.12 billion flagship FPA Capital Fund has a 20-year average annual return of 17.6%

He's a deep value investor who likes to wait for panic to set in before he buys a stock. He was a big buyer in the wake of 9-11 and again in March 2003 as America readied for war in Iraq. Today, he finds little value in either stocks or bonds. He was interviewed in his office about the direction of the mutual fund industry and how he has managed to outperform through the past few tough years.

Rodriguez: There's going to be a massive rationalization of mutual funds over the next 10 years. Look at all the funds with $50 million or less in assets. Look at all the entities with just one fund. If you couldn't make your fund grow in the greatest bull market for mutual funds in the last 13 years, then why do you think it's going to grow in the next five or 10? Anything under $40 or $50 million is a dinosaur. A lot of funds are going to disappear from the face of the earth. They are going to merge, converge or close.

IBD: I'm sure you've been watching the fund scandal unfold. How did market timing become so prevalent?

Rodriguez: Very simple. When did most of this start? Post-2000. What was happening in the mutual fund business post-2000? They were losing assets like crazy. You're at a firm here that doesn't mind shrinking. When you're in a marketing culture, that's anathema to you. So you go out and do things that are stupid and you betray trust. It takes 34 years to build a reputation and one day to lose it. Why on earth individuals and organizations would throw away their reputations for a mere pittance shows you the stupidity and arrogance that is in the business. They effectively had contempt for their clients. I hope these people are prosecuted to the fullest extent and that they never be allowed to be in the field again.

We think the transgressions in the mutual fund industry are terrible, but what is even worse is the amount of capital destruction that occurred from the top of the stock market through out and out unmitigated foolishness, arrogance and greed. In my opinion, probably close to 95% of investment managers, pension consultants, pension administrators and journalists failed in the greatest speculative blow off in the history of man. There was maximum exposure to equities on the part of pension funds and maximum exposure to the most aggressive forms of equity investing.

Rodriguez: I talk with some aggressive growth managers I know. I asked them when this thing was blowing off, why didn't you get out of that crap. They said, "Then we'd under perform relative to the market." And if you under perform, I assume you'll get redeemed (in that shareholders redeem, or sell, their fund shares) right? They say, "Right." So let me get this straight: You own this crap, you get destroyed and you get redeemed anyway. The only difference I see is that if you got out of the crap and don't take it on the downside as much, you've still got your ethics, integrity and business discipline. You can recover. There are funds out there that will never come back because they lost their credibility.

Rodriguez: In everything we do, we're dedicated to contrarian investing in out-of-favor areas and being very, very patient. Patience is defined by a portfolio that over the last 20 years has averaged a turnover rate of less than 20%.

Rodriguez: I've been in a few bear markets in my career. The first was the 1968-70 bear market. I was just coming out of school. That's when the Penn Central went bankrupt. The '74 bear market was a good one for me because I learned how truly stupid I was. I bought a stock personally at 22, averaged down at 18, averaged down at 16, averaged down at 12, bought more at 8. At 7/8 of a dollar, I asked a profound question: Am I doing something wrong? I learned what it was to destroy capital.

In the '74 market, when I was at Transamerica, our portfolios were in the neighborhood of 40% to 60% cash, and we were still getting killed. That has never left my psyche. It's as if it was yesterday. That period set me up for the 1998 to 2003 period. Every one of our portfolios did not succumb to the greed and stupidity that was going on at that time. They all made it through in very good shape.

Rodriguez: In the spring of 1998, FPA Capital's liquidity (cash) position rose to approximately 33%. From 1984 through 1997, on average, the liquidity position in Capital Fund was between 1% and 5%. We were getting the lowest number of companies qualifying in our screens, ever, based on various measures of valuation. We had something like 47 companies out of 10,000. Normally, we would get 250 to 300. I realized at the time, I was betting my business by being in cash.

What you will get from 95% of the people in this business is, "The clients have made the decision. It's my job to invest the money." We think our clients have retained our services so that we will exercise our best judgment. We saw high levels of risk and acted accordingly.

Rodriguez: In February, I was visiting clients to ask for greater flexibility in liquidity. Very much the same thing we did in 1998. Every one of our clients has given us flexibility.

Rodriguez: Today, the cash level in Capital Fund is about 33%. My guess is that by June, it will be between 35% and 45%.

Rodriguez: It's not about optimism or pessimism. We can't find anything that meets our valuation discipline. It doesn't mean the market can't sit up here or meander. It's a function of the lack of investment ideas. We are an absolute value manager rather than a relative investment manager. So we'll just sit tight until something comes along. We have no idea how long that will be. Now, let's just say that Mr. Market rallies into '05 and '06. My guess we will probably get redeemed. If we get redeemed, we get redeemed. But if we get a chance to deploy capital, we will. Those shareholders that have the patience will be rewarded.

IBD: How were you able to do well during the three years beginning in March 2000?

Rodriguez: In a shareholder letter in March 2000, we compared (homebuilder) Centex (CTX) to the Nasdaq. Dennis (Bryan, co-manager on the Capital Fund) and I were at a home-building conference the previous November in Arizona, where there were 34 presenters and 33 attendees. The Nasdaq Composite was in excess of 130 times earnings. Centex was selling at 4.5 times earnings and 85% of book at 17 a share. The valuation of Centex was arguing that we were on the edge of a recession, whereas the Nasdaq was arguing for continued economic recovery. These were polar opposites that could not co-exist. One of these was massively wrong. We chose Centex because it was already discounting the downside.

This is the worst investment environment I've seen in over 30 years. There is no value in high-quality bonds or high-yield bonds, so in my bond fund, New Income, we're sitting with a duration of 1.15 years and 36% in liquidity. That's pretty bearish. In the stock fund, you know where the liquidity is. This is a terrible time to deploy capital."

RBG Comment: Please reread the wise words of an honest fund manager who sees bad times ahead but, in my opinion, has no idea of the huge market plunge that is now beginning. Only those who have the full up to date Elliott Wave information can visualize the carnage that lies ahead.

This is the time to sit down and list all of your financial holdings under 4 categories:

Safe - Short term U.S. Treasuries and equivalent securities, physical gold and silver.

Probably Safe - Short term foreign govt. bonds, hedged Hussman funds, Permanent Portfolio fund modified to correct weak areas, gold and silver bullion in safe storage. Recommended stable funds with added short fund protection.

Maybe Unsafe - Highly ranked bond-stock funds with good performance over the past 4 years of bear market. May be correctable with added short fund protection. Small gold and silver mining companies, especially owned in large quantities.

As the bear market builds its downward momentum my thinking is about safety of principal and how to achieve it. I am unaware of any new portfolio candidates, so am inclined to include the list of old reliable names but with an intent to limit precious metals for the time being until the gold market tells us whether it is going to continue down or turn up. Here is the thinking that produced this list of funds. I did not have any number of funds in my mind but listed them under 3 categories and ended with eleven funds: four stable funds, three short funds and four volatile funds. I separated the short funds because I wanted to emphasize their importance as the bear market continues. Six of the funds are equally weighted at 10% each, the volatile funds are weighted at 7% each. We gave BEARX, the heaviest listing of 12% to emphasize full discretion for the manager, with 10% each to the reverse S&P500 index fund and the reverse 30 year Treasury bond fund.

		One Year Performance
Asset Class		to 4/20/04	Weighted
Stable
Permanent Portfolio	10%	20.3%	2.03%
Hussman Str. Growth	10%	29.0	2.90
Hussman Tot. Return	10	10.7	1.07
Prudent Global Income	10	10.0	1.00
Total			7.00%
Short
Prudent Bear Fund	12%	-5.2%	-0.62%
Rydex Rev. S&P 500	10	-22.1	-2.21
Rydex Rev. Long Bond	10	-0.9	-0.09
Total			-2.92%
Volatile
CEF Closed End (AMEX)	7%	30.5%	2.13%
Canadian Oil/Gas Trust	7	51.8	3.63
Leading Energy Fund	7	42.2	2.95
PCL Large Timber REIT	7	35.8	2.51
Total	100%		11.22%
Grand Total			15.30%

Please note that, as of the last report, Permanent Portfolio held a permanent 25% position in gold and silver, Hussman Total Return held 9%, Prudent Global Income held 16% and Prudent Bear held 20%. Since those assets cannot be sold separately, they cannot contribute to any profits from rebalancing so we added CEF which holds gold and silver bullion in a large western Canada bank. If and when a major rally in the precious metals occurs, investors can add more gold weight to the portfolio at any time they wish to do so.

In the very volatile markets we expect ahead, this portfolio should present many profit opportunities such as those shown in the one year’s retrospective performance which showed large profits in Hussman Growth and in all 4 of the volatile funds. There will be a large advantage in owning this portfolio in a tax free account to give the owner freedom to rebalance without having to worry about taxes.

Note from the performance figures that the 3 short funds are still in the red from last years market rally. Rebalancing now would shift money from the 4 volatile assets to the 3 short assets just before they are due to gain in the coming bear market. There is no question the market will be quite volatile and this portfolio will benefit greatly from the many rebalancing opportunities that are bound to arise in the future.

If readers have questions about how or when to rebalance and why it is important, please first read the many essays I have written on this subject recently. It is very important that everyone fully understand the purpose of rebalancing and how it can increase gains.

I have some very vivid memories of real estate in the 1930’s Depression which you should consider. Many, many home mortgages defaulted and thousand of banks went bankrupt. House sales plummeted because of a dearth of buyers. Extended families were much closer geographically than they are today, so three generation households were very common. I lived in one for my first 20 years. In high school, I had planned to be an architect but there were no jobs for architects since there was no building. So in 5 years of college I made two career decisions and finally picked my present one when MIT offered me $600 per year as a Teaching Assistant in a third course of study.

I am now in my 14th residence in 62 years of marriage and own no significant amount of real estate for which I am very happy. I have heard from a few readers who have sold their home and are now renting for the duration. This is not easy to do and will be followed by very few families. But it cannot fail to be very beneficial to a family’s finances. House prices will collapse to unbelievable values and rentals will be dropping in cost for perhaps decades.

I trust that my experience will be of some help although the conditions in the 1930’s were much better than I expect they will be in the coming Depression. Further, World War II brought an early end to the last Depression and may not reoccur to help this time.

In the past 2 1/2 years, I have written many scores of essays on all aspects of the coming Depression. It is still not known whether the inevitable depression will be postponed till after the November election. In the near future, I am going to write much less and concentrate on preserving what’s left of my declining health. But I literally live for a constant flow of e-mails from my far flung readership. So please keep them coming and I will answer them as best I can.