Hiding from the Bear

Despite the carnage that has been inflicted on American investors in technology shares over the last twelve months, despite the collapse of consumer confidence, and despite earnings warnings from companies in almost all sectors of the economy, the mood of investors in the U.S. remains stubbornly bullish. From experience going back as far as 1974, they have learned to “buy the dips”, “don’t fight the Fed”, and that “over the long term, equities offer a higher return than other investments”. Such mantra are understandable, because the Federal Reserve has, since 1974, always been quick to stimulate the economy when it showed signs of fatigue or to calm the credit markets when a looming financial crisis threatened. By reducing interest rates and increasing the money supply, the Federal Reserve has seen off the Mexican debt crisis, the Savings and Loans debacle, the Stock Market “crash” of 1987, the Asian currency crisis, the Russian default, and the Long Term Capital Management muddle. Surely this downturn in the Nasdaq can be cured with the same medicine. While it is not impossible that it can be, each dose of medicine to date, while making the patient feel better, has actually weakened his resistance to the next onslaught. I believe that this time a much more radical cure is going to be necessary. Consider the structural imbalances that now afflict the global economy:

Since 1989, when the Japanese bubble burst, the US has suffered a trade deficit with East Asia of US$1.5 trillion. The trade deficit with East Asia rose to an annual rate of US$200 billion following the “Asian Crisis” in 1997. As a result, foreign investors now own US$7,500 billion of US financial assets while US domestic savings have turned negative to a level that is historically unprecedented. Recycling this huge Asian savings surplus has been possible only at a horrible cost. Since January 1996, US Nominal GDP has increased by US 2,800 billion: US corporate and consumer debt has increased by US$4,750 billion: US financial sector indebtedness has increased by US$4,150 billion so that total debt outstanding in the US economy now exceeds US$27,000 billion or 270% of GDP.

In the banking sector, loans to deposit ratios have reached 104%, while, in the commercial paper markets, the spreads over Treasury Bill rates have soared. The credit markets are showing signs of stress everywhere.
I am always exceedingly sceptical of claims that “this time it is different” but this time I believe it is. For the correction that is necessary is not a short term adjustment of inventories but a long term balance sheet repair. The easy liquidity which the Federal Reserve (abetted, albeit unwittingly, by the East Asian savers) created to avert each crisis led to an unsustainable stock market boom, appalling misallocation of investment capital, and levels of debt which cannot withstand any sort of downturn in the economic cycle. All concept of risk has been forgotten in America.
However, today, with the Nasdaq Composite index almost 60% down from its high, that index sports a dividend yield of 0.27% and a price/earnings ratio of 125. Furthermore, those earnings are overstated, for almost every major company has been able to raid its pension fund in recent years and transfer the “excess contributions” to the profit and loss account and, of course, employment costs have been totally understated by rewarding all levels of staff with stock options. Asian investors will be acutely aware that once the virtuous circle is broken, it quickly turns into a vicious one. As stock prices plunge, consumers strive to repair the damage to their personal balance sheets by curtailing spending and increasing savings. This results in a fall in earnings at corporations, which then respond by laying off staff and otherwise reducing costs and capital expenditure. The stock market falls further on weak earnings, adding to the gloom and making it difficult for companies to raise equity to reduce excessive debt. The panic spreads to the credit markets as companies fail. The Federal Reserve can and will respond by making credit cheaper and it can expand the money supply by buying Government paper. However, it cannot oblige the banks to lend nor can it force the consumer to spend when he is struggling to repair his balance sheet. Savers will want income and safety and their recent experience will tell them that the stock market offers neither. U.S. stocks, therefore, will continue to fall until they offer an acceptable dividend yield.

Where then can investors hide? A severe economic downturn in the U.S. is going to make growth in Asia more difficult. Interest rates, therefore, are
likely to continue to decline and so high quality bonds should provide good returns. Asian stock markets have largely gone through the wringer already and so it is possible to find good companies with minimal debt and excellent dividend yields. Such stocks are unlikely to provide the excitement that investors often seek but they will bring home the wonders of compound interest. Finally, there is one asset class which not only acts as insurance against the vicious circle spiralling out of control but offers investors dividend yield and the chance of spectacular capital gains. This is the gold mining sector.
The price of gold, at least in US Dollar terms, has fallen relentlessly since the peak of US$860 an ounce in 1980. In real terms, today’s price of US$263 per troy ounce is now equivalent to levels last seen in 1973. Last year the average cost of production for the gold mining industry globally was US$246 so that operating margins are now minuscule. The supply and demand numbers also suggest that the long downtrend in prices has ended, for physical demand now exceeds new mine supply annually by almost 1,000 tons and the Central Banks undertook, in September 1999, not to sell more than 400 tons a year. The annual shortfall therefore is being met by short-selling, both by the producers, who have sold forward over 4,000 tonnes to protect their tiny margins, and “investors” who, for years, have been borrowing gold at 1% p.a., selling it, and earning, say, 6% on the proceeds. The extent of such “naked” short positions is unknown but, from Central bank lending statistics, must be no less than 1,300 tonnes. Unless the price rises to permit the mining of poorer ore or justify exploring new deposits, production is set to decline in coming years (last year South Africa had its lowest level of production since 1954.). Furthermore, as interest rates decline, there is no longer benefit in selling forward, or shorting, so one would expect that those positions might be unwound. Everything suggests that this asset, which has been totally sidelined while the American bull market has surged, is likely to serve again as a refuge for frightened capital. If gold as much as regains US$400 an ounce, the gold mining companies should see margins increase five-fold and their share prices more so. This may sound like a contrarian view, one to be discarded as the work of a gold-bug. However, look at the volume figures in the accompanying long-term charts of the major gold miners. Someone, quietly, is remembering to buy low!

David Crichton Watt - Kuala Lumpur, March, 2001

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