It should come as no surprise that I also receive every day a large number of e-mails from readers and from investors who have read some of my articles or interview in which I have expressed my thoughts about the investment markets. So far, I have disciplined myself to answer every e-mail I receive, although I have to admit that my responses are frequently brief and incomplete. Moreover, I am often asked questions to which I simply don't have a precise answer, or about topics for which I am not qualified to give an educated opinion. Our global economy is as complex as life itself. The pricing of asset markets depends not only on fundamentals endemic to the specific markets we may be looking at, but also on numerous exogenous factors that can suddenly become more relevant than a market's specific fundamentals.
Most of my day is spent reading and studying, but when I see so many highly intelligent and knowledgeable analysts, strategists, and economists coming to totally different conclusions concerning the outlook for the economy and investment markets, I usually finish my reading with far more doubts than firm convictions. I am also mindful that, as Don Marquis (the creator of "Archy and Mehitabel", a cockroach and a cat who offered witty observations about life in the 1920s and 1930s) remarked, "The more conscious a philosopher is of the weak spots of his theory, the more he is to speak with an air of final authority." The same could be said of us so-called financial experts, whereby the problem usually arises because investors will avoid listening to or reading the comments of an analyst, economist, or strategist who expresses doubts because of the many opposing economic and financial trends. Investors want to believe in an "expert", in the same way the sick will often believe in a faith healer. They want a clear opinion about the future direction of the investment markets, without any recognition of the fact that, at least 50% of the time, deference to such views will lead to significant losses, as, no matter how diligent we "experts" are, we nevertheless remain largely ignorant of the future. Therefore, as I sit down every month to write this report, I frequently feel, as Wittgenstein observed in his seventh aphorism, "When you don't know what you are talking about, shut up." Moreover, in view of my conviction that the future is totally unpredictable, my insecurity about providing any advice grows when for some time my forecasts have been proficient. I then feel that my lucky forecasting streak will inevitably be followed by some horrible calls, which will greatly disappoint investors who have built up great expectations about my ability to analyze economic and financial trends. Now, this admission may sound like an invitation to my readers not to read this report, when it is simply a warning that, no matter how much we may study and inform ourselves, our knowledge remains extremely limited, and that the markets don't pay any attention to our "strong" convictions.
But even this observation isn't entirely correct. In the very short term, famous market timers and analysts can move markets, but I'm not aware of anyone who wasn't eventually buried by the market. In the 1970s, Joe Granville was so widely followed around the world that his buy and sell signals could temporarily move the US stock market. However, one bad call in the early 1980s, when he remained bearish, destroyed all the credibility and fame he had enjoyed earlier. I suppose the same thing happened to some well-known high-tech analysts and strategists when, in March 2000, the NASDAQ reversed its rise and began to fall like a stone. I have tried to overcome my inability to forecast the future by stressing relative values among the various asset markets since in a credit induced asset bubble all assets rise in price but at different rates of appreciation. Nevertheless, I have to admit that in the last few months I have become increasingly apprehensive about how the various asset markets will move as I struggle with the following issues.
It isn't clear to me whether we shall experience more inflation in the years ahead, or whether deflation is still a serious threat. In particular, we must be aware that there is always some relative inflation in some assets or sectors of the economy, and especially so in a monetary system that enables, even frequently encourages, central bankers to print an unlimited quantity of money. Even under a gold standard, an economy will always have some sectors that are inflating relative to others. As a market observer, it is imperative, therefore, to think about which sectors will relatively inflate compared to others, since this phenomenon of relative inflation can also be observed in periods of serious deflation, as was the case in the last quarter of the 19th century and in the 1930s. As an example, bond prices and cash inflated relative to the overall price level in the 1930s and in Japan over the last 15 years. Interestingly enough, the same could be said of commodity prices during the Great Depression. But whether we shall experience an overall increase in prices (the manifestation of inflationary symptoms) or declining prices will depend on an unknown factor and this relates to the quantity of money the American Federal Reserve Board will inject in the system. From figure 1, we can see that money supply growth has been decelerating since 2001. Further deceleration in the growth of monetary aggregates will lead to even more US dollar strength and poorly performing asset markets (except US treasury bonds), whereas renewed strong money supply growth will bring about what we had over the last two years - rising asset markets accompanied by a weak US dollar!
Figure 1: MZM Growth 1984 - 2005
Source: www.yardeni.com
A second issue that preoccupies my mind relates to the growing imbalances in the world. It would seem to me that the US consumer is the all-time champion at borrowing and spending on consumer goods and irrelevant services, while China is the undisputed champion at spending on capital goods, including structures, and producing goods. In the meantime, India and, increasingly, Vietnam are emerging as impressive forces in the tradable service sector. How will these imbalances eventually be resolved, and who will emerge from this imbalance-induced collision course relatively better off? Conventional wisdom, as well as the media with its focus on China's great achievements, a view I tend to endorse, argue for a relative adjustment in favor of China, India, and the other emerging markets. However, could this almost unanimous view, at least temporarily, be erroneous? After all we should not forget that China has built enormous excess capacities in the manufacturing sector, which could lead when demand disappoints to a hard landing as a result of a significant reduction in the growth rate of capital spending (see figure 2).
Figure 2:
Source: CEIC and Dresdner, Kleinwort, Wasserstein
Moreover, we should not overlook the fact that periods of decelerating US money supply growth and, especially improving US current account deficits, have in the past led to crises in emerging markets.
An increasing number of economists, myself included, have become more and more concerned about the diverging performance between the financial economy and the real economy. It is an undisputed fact that the financial economy, which now provides almost 50% of S&P earnings, has been growing (inflating) at a much faster rate than the real economy (see figure 3). Eventually a readjustment is inevitable, but could it be that we all underestimate how much further the financial economy could grow relative to the real economy?
Figure 3: Financial Sector as % of S&P 500
Source: Bob Hoye, www.institutionaladvisors.com
Also, is it possible that this dichotomy between the financial economy and the real economy could be corrected through a significant pick-up in the real economy, as today's central bankers ardently hope? And if the financial economy were, sometime in the future, to badly deflate, could it be that the real economy would also suffer just as badly when the process of eliminating the strongly diverging trends between the two gets going in earnest? For now, it would appear that some deflationary forces are emerging in the financial sector since numerous financial stocks led by Fannie Mae and followed by sub-prime lenders such as Accredited Home Lenders (LEND), Capital One Financial (COF), and New Home Financial (NEW) have begun to break down (I am short these stocks).
Lately, it has become common wisdom that the incremental demand for commodities coming from China's industrialization will drive commodity prices higher in the longer term. Again, I find myself leaning on the side of the consensus, which as a contrarian worries me and leads me to think about the possibilities of being wrong. Given my near term positive view of the US dollar, I am out of industrial commodities and focus this year on the accumulation of the grains such as wheat, soybeans and corn (see figure 4)
Figure 4: Corn 1996 - 2005
Source: www.futures.tradingcharts.com
Lastly, I can't help but consider the likelihood that the world has entered an upturn in geopolitical tensions, which could be the prelude either to unpleasant civil disturbances or, in the worst case, to serious military confrontations and vicious acts of terror. In addition to rising geopolitical tensions, I am also concerned that recent events surrounding the spread of the bird flu from human to human will, in time, lead to a pandemic of historic proportions.
Therefore, in view of all these uncertainties, the best option for investors might be to maintain low leverage, small positions and bet on some further recovery in the US dollar, which has completed a five wave decline (see figure 5)
Figure 5: US Dollar Index 2001 - 2005
Source: Elliott Wave International
Still, the US dollar has quickly rallied by more than 5% against the Euro, and, therefore, a correction should be expected in the near term, which would offer a better USD entry point. In fact, a retest of the US dollar lows and even a marginal new low would not surprise me and would not alter the view that the US dollar is about to enter a recovery phase, which could last longer than the consensus believes.
Since Asian currencies weakened against the Euro over the last two years, as they tracked the US dollar, a lower risk speculation, at least for now, might be to short the Swiss Franc against the Yen (see figure 6) rather than to go long the US dollar.
Figure 6: Japanese Yen versus Swiss Franc
Source: Rolf Bertschi, Credit Suisse Private Banking.
