UNCHARTED ECONOMIC WATERS
by Dr. Marc Faber
I must confess that I have no idea whether the US stock market will be higher or lower in a year's time. I sometimes recall these words of Lao Tzu, the sixth-century Chinese poet:
"Those who have knowledge, don't predict. Those who predict, don't have knowledge."
The problem that confronts investors was best summarized by Albert Einstein, who said: "Not everything that counts can be counted, and not everything that can be counted counts." We all know about the credit crisis, the Treasury's bailout plan, and the Fed's determination to cut interest rates in order to support asset markets and the economy, but it is extremely difficult - if not impossible - to quantify the problem and the effectiveness of the government's intervention in the market economy.
At the same time, we have a number of relatively reliable statistics - such as railcar loadings, the trucking index, the number of inbound containers, etc. - which indicate, if not a recession, then little economic growth. However, although all these indicators have a weakening trend and point to considerable economic slowdown, or even to a recession, they may have little or no impact on the performance of the stock market.
Peter L. Bernstein, the wise 88-year-young economist and strategist (author of five books in the last 15 years and of the excellent, but demanding, Economics & Portfolio Strategy report), explains in a piece entitled "Uncharted Territories" that "the current scene bears no resemblance to a typical economic peak or to the conditions usually preceding a slowdown in business activity. Those kinds of conditions feature excesses in the business sector, but the business sector at the present time has a relatively clean bill of health… There are no signs of the usual boom in capital spending that leads to a cyclical top and leaves an overhang of capacity. Growth of industrial capacity over the past five years has been a meager 0.8% a year. This piddling rate of expansion is a sharp contrast to the 4.2% annual growth rate in capacity during the 1990s or to the 2.7% rate from 1949 to 1969."
Peter further points out that there has not been an unusually strong accumulation of inventories; that there has been an absence of sharply rising interest rates, which in the past preceded recessions; and that there has been an absence of "strains in the resources of the system, such as high levels of capacity utilization and low unemployment". (Peter Bernstein has developed a "Strain Indicator", which indicated the problems we had in the 1970s, the over-optimism prior to the 1987 crash, and a clear peak prior to the end of the high-tech boom in 1999. However, this indicator "has been declining since mid 2006 and stands nowhere near where it has been at earlier business cycle highs".)
But Peter Bernstein isn't optimistic about the economy. In asking himself the questions "what is going to happen next?" and "what is the outlook?", he explains: "[T]hese questions are never easy, but they are more difficult than usual this time around. The experience is not only inexplicable. It provides no antecedents to guide us."
In referring to some of the unique features in the current scene - mentioned briefly above - Peter opines:
"[W]e are unable to choose which among them is most important, but we believe the key problem is not in the financial sector. Rather the basic difficulty is the impact of these financial shenanigans on households. The deflation in home prices is not only unsettling to homeowners; it has in effect removed a crucial part of the consumer's piggy bank. Home equity is no longer a source to finance consumer spending. This development is unsettling in its own right, but it is only a reminder to homeowners that their major asset is in deep trouble and is not likely to improve any time in the foreseeable future. If we are correct in placing primary emphasis on the problem faced by households, the economic malaise will not be brief, even though its depth is uncertain. The process is going to be like water torture - drip by drip over an extended period of time until all these excesses are squeezed out of the system and new and happier horizons can open up."
The author Dave Wilbur has said: "One of the world's greatest problems is the impossibility of any person searching for the truth on any subject when they believe they already have it."
Similarly, Peter Bernstein concludes his report with the observation that "there is a lesson here so obvious we hesitate to set it forth. History shows even the most knowledgeable people forget this lesson over and over again. We do not know what the future holds. Once we begin to make major and unhedged decisions on the assumption we do know what the future holds, we will have passed the inflection point on the road to disaster."
During the Battle of Britain, in the Second World War, a saying went the rounds of the Royal Air Force: "There are old pilots and there are bold pilots, but there are no old, bold pilots." Therefore, as we move into 2008, I would rather err on the side of caution in terms of taking large onesided and leveraged positions in any asset market, individual stock, or sector. As Peter Bernstein has argued, we are indeed in uncharted waters and economic and financial history provides us with only an incomplete and outdated set of signposts to go by.
While I generally accept that obstacles provide opportunities, at the same time I feel, at least for now, that it may be better to be prepared for a great buying or selling opportunity and not have one for some time, than to have a very unusual opportunity, such as occurred after the Asian economic and financial meltdown in 1997/98, and not to be prepared. My advice is therefore, as mentioned in recent reports, to hold an above-average cash position in US dollars and to lighten up on high, and especially leveraged, asset positions during rallies.
Nevertheless, I recognise that some investors feel they must have an exposure to financial assets, and so I should like to offer here three investment opportunities that, at least on a relative basis, would seem to have some appeal. In this letter on various occasions I have discussed agriculture as an investment theme. I believe that agricultural commodities will - albeit erratically and amidst high volatility - continue to increase in price. Larry Hatheway, an economist at UBS, believes that "a shift in relative food prices owing to rising Chinese or Indian affluence is likely to manifest itself as an increase in food prices for industrialized economies. This is because the food groups most favoured by more affluent developed economies will tend to become mainstays of food consumption in the faster growing economies of Asia."
In addition, UBS points out that shifting demand patterns will create opportunities in global trade and production. As an example, demand for sugar from China is expected to surge in the next decade. In fact, as indicated in previous reports, I consider that sugar prices are relatively low following their correction, and currently offer a favourable entry point. My friend Mac Overton alerted me to the fact that sugar prices are down 21.5% over the past two years, whereas wheat is up 185%, corn is up 105%, soybeans are up 93%, and cotton is up 18.3%. So, at least in relative terms, sugar is very inexpensive. Mac also notes that, "while not totally inter-changeable, I suspect that many farmers, especially in the southern US and Brazil, have an option of what to plant. I'm betting that they plant more acres of wheat, corn and soybeans next year and less of cotton and sugar. If the area in which they plant allows it, they'd be crazy to do otherwise at current prices…."
Jonathan Anderson, a UBS economist with a special interest in China, pointed out in an earlier report that whereas China's state procurement system maintains precautionary stocks for large-scale durable agricultural products such as wheat, rice, corn, coarse grains, cotton, etc., "ending stocks dropped sharply between 2003 and 2005 across all grain categories as state boards were forced to sell down to prevent overly aggressive price increases. Since then grain stocks have stabilized, but they are not rising, and remain at very low levels by Chinese historical standards". Ritesh Menon, of DBS Bank in Singapore, also reminded me that arable land per capita in China and India is only 18% and 26% of US levels, respectively: "Environmental degradation is further reducing available land supply; soil erosion occurs in 2/3 of China's agricultural land (largely due to heavy fertilizer use), which undermines the longterm sustainability of agricultural production. Furthermore, water scarcity will be increasingly problematic.
First, water availability is relatively scarce in China (water resources per capita are 25% of the world average). Second, water pollution is widespread, with 44% of Chinese rivers classified as polluted. Third, the demand for water increases dramatically as meat consumption increases. The net result of the above two phenomena is dangerously low inventories of agricultural products". In his report dated September 28, 2007, Larry Hatheway said that, "rising food prices will tend to have a disproportionate impact on real purchasing power of lower income groups. This is because lower income groups spend a higher proportion of their income on food. Furthermore, lower income groups spend proportionally more on food items that have a lower fraction of labour and a higher fraction of commodity inputs in the final price.
Hence, rising commodity prices hit lower income groups hardest." As can be seen from, more than 95% of American households spend more than 20% of their income on food - excluding alcohol, which is now also increasing in price. But then consider, which shows the CPI food weights for different countries. If you compare how much of their income (over 20%) most American families spend on food with the CPI Food Weight, it is obvious that the CPI, as calculated by the US Bureau of Labor Statistics (BLS), grossly understates the true rate of inflation by underweighting food, which has lately been rising at an annual rate of more than 10%!
This really reinforces my view that the BLS publishes totally bogus inflation figures and that, even worse, Mr. Bernanke relies on these figures for his monetary policies….
Tom McClellan, editor of The McClellan Market Report (mailto:tom@mcoscillator.com?subject=), calls the CPI "the World Office of Obfuscation Price Index (WOOPI)". I am certainly not an accomplished statistician, but I can't help shaking my head in disbelief that the government gets away with this distortion of hard economic facts, which is also leading to a gross overstatement of real economic growth data (real GDP) and of real retail sales in the US.
I believe, as mentioned in earlier reports, that we are already in stagflation: no real economic growth - or recession - amidst inflation, which the Ministry of Truth understates in order not to depress the population further. My South African friend Faisal Kalla, who has previously described for this report how grocery prices in that country have increased this year (he should know, since he is a grocery wholesaler), recently sent me the following email:
"Something very strange is happening in South Africa. The Christmas season has started early for us. Our trade is mostly groceries and related items. There seems to be a shortage of products from most companies. We are battling to get supplies of food products such as sugar, baked beans and staples. Also the price increases do not stop. Yesterday, the manufacturer of body creams said the price will go up 9%. On the converse, furniture, automobiles and real estate are suffering, especially autos whose price devaluation is ferocious. Real estate is also suffering but at a slower pace. The delusion is still alive…"
Well, what is happening in South Africa is representative of what is happening everywhere in the world. Grocery sales are up because of price increases, whereas sales of discretionary items are either down or sluggish because household incomes are being squeezed by cost-of-living increases and declining home prices.
In the US, the November Producer Price Index increased by 7.2% year-on-year, which will lead to higher consumer prices and inflation, or pressure on corporate profit margins, or both.
I must confess that I have no idea whether the US stock market will be higher or lower in a year's time. I sometimes recall these words of Lao Tzu, the sixth-century Chinese poet:
"Those who have knowledge, don't predict. Those who predict, don't have knowledge."
The problem that confronts investors was best summarized by Albert Einstein, who said: "Not everything that counts can be counted, and not everything that can be counted counts." We all know about the credit crisis, the Treasury's bailout plan, and the Fed's determination to cut interest rates in order to support asset markets and the economy, but it is extremely difficult - if not impossible - to quantify the problem and the effectiveness of the government's intervention in the market economy.
At the same time, we have a number of relatively reliable statistics - such as railcar loadings, the trucking index, the number of inbound containers, etc. - which indicate, if not a recession, then little economic growth. However, although all these indicators have a weakening trend and point to considerable economic slowdown, or even to a recession, they may have little or no impact on the performance of the stock market.
Peter L. Bernstein, the wise 88-year-young economist and strategist (author of five books in the last 15 years and of the excellent, but demanding, Economics & Portfolio Strategy report), explains in a piece entitled "Uncharted Territories" that "the current scene bears no resemblance to a typical economic peak or to the conditions usually preceding a slowdown in business activity. Those kinds of conditions feature excesses in the business sector, but the business sector at the present time has a relatively clean bill of health… There are no signs of the usual boom in capital spending that leads to a cyclical top and leaves an overhang of capacity. Growth of industrial capacity over the past five years has been a meager 0.8% a year. This piddling rate of expansion is a sharp contrast to the 4.2% annual growth rate in capacity during the 1990s or to the 2.7% rate from 1949 to 1969."
Peter further points out that there has not been an unusually strong accumulation of inventories; that there has been an absence of sharply rising interest rates, which in the past preceded recessions; and that there has been an absence of "strains in the resources of the system, such as high levels of capacity utilization and low unemployment". (Peter Bernstein has developed a "Strain Indicator", which indicated the problems we had in the 1970s, the over-optimism prior to the 1987 crash, and a clear peak prior to the end of the high-tech boom in 1999. However, this indicator "has been declining since mid 2006 and stands nowhere near where it has been at earlier business cycle highs".)
But Peter Bernstein isn't optimistic about the economy. In asking himself the questions "what is going to happen next?" and "what is the outlook?", he explains: "[T]hese questions are never easy, but they are more difficult than usual this time around. The experience is not only inexplicable. It provides no antecedents to guide us."
In referring to some of the unique features in the current scene - mentioned briefly above - Peter opines:
"[W]e are unable to choose which among them is most important, but we believe the key problem is not in the financial sector. Rather the basic difficulty is the impact of these financial shenanigans on households. The deflation in home prices is not only unsettling to homeowners; it has in effect removed a crucial part of the consumer's piggy bank. Home equity is no longer a source to finance consumer spending. This development is unsettling in its own right, but it is only a reminder to homeowners that their major asset is in deep trouble and is not likely to improve any time in the foreseeable future. If we are correct in placing primary emphasis on the problem faced by households, the economic malaise will not be brief, even though its depth is uncertain. The process is going to be like water torture - drip by drip over an extended period of time until all these excesses are squeezed out of the system and new and happier horizons can open up."
The author Dave Wilbur has said: "One of the world's greatest problems is the impossibility of any person searching for the truth on any subject when they believe they already have it."
Similarly, Peter Bernstein concludes his report with the observation that "there is a lesson here so obvious we hesitate to set it forth. History shows even the most knowledgeable people forget this lesson over and over again. We do not know what the future holds. Once we begin to make major and unhedged decisions on the assumption we do know what the future holds, we will have passed the inflection point on the road to disaster."
During the Battle of Britain, in the Second World War, a saying went the rounds of the Royal Air Force: "There are old pilots and there are bold pilots, but there are no old, bold pilots." Therefore, as we move into 2008, I would rather err on the side of caution in terms of taking large onesided and leveraged positions in any asset market, individual stock, or sector. As Peter Bernstein has argued, we are indeed in uncharted waters and economic and financial history provides us with only an incomplete and outdated set of signposts to go by.
While I generally accept that obstacles provide opportunities, at the same time I feel, at least for now, that it may be better to be prepared for a great buying or selling opportunity and not have one for some time, than to have a very unusual opportunity, such as occurred after the Asian economic and financial meltdown in 1997/98, and not to be prepared. My advice is therefore, as mentioned in recent reports, to hold an above-average cash position in US dollars and to lighten up on high, and especially leveraged, asset positions during rallies.
Nevertheless, I recognise that some investors feel they must have an exposure to financial assets, and so I should like to offer here three investment opportunities that, at least on a relative basis, would seem to have some appeal. In this letter on various occasions I have discussed agriculture as an investment theme. I believe that agricultural commodities will - albeit erratically and amidst high volatility - continue to increase in price. Larry Hatheway, an economist at UBS, believes that "a shift in relative food prices owing to rising Chinese or Indian affluence is likely to manifest itself as an increase in food prices for industrialized economies. This is because the food groups most favoured by more affluent developed economies will tend to become mainstays of food consumption in the faster growing economies of Asia."
In addition, UBS points out that shifting demand patterns will create opportunities in global trade and production. As an example, demand for sugar from China is expected to surge in the next decade. In fact, as indicated in previous reports, I consider that sugar prices are relatively low following their correction, and currently offer a favourable entry point. My friend Mac Overton alerted me to the fact that sugar prices are down 21.5% over the past two years, whereas wheat is up 185%, corn is up 105%, soybeans are up 93%, and cotton is up 18.3%. So, at least in relative terms, sugar is very inexpensive. Mac also notes that, "while not totally inter-changeable, I suspect that many farmers, especially in the southern US and Brazil, have an option of what to plant. I'm betting that they plant more acres of wheat, corn and soybeans next year and less of cotton and sugar. If the area in which they plant allows it, they'd be crazy to do otherwise at current prices…."
Jonathan Anderson, a UBS economist with a special interest in China, pointed out in an earlier report that whereas China's state procurement system maintains precautionary stocks for large-scale durable agricultural products such as wheat, rice, corn, coarse grains, cotton, etc., "ending stocks dropped sharply between 2003 and 2005 across all grain categories as state boards were forced to sell down to prevent overly aggressive price increases. Since then grain stocks have stabilized, but they are not rising, and remain at very low levels by Chinese historical standards". Ritesh Menon, of DBS Bank in Singapore, also reminded me that arable land per capita in China and India is only 18% and 26% of US levels, respectively: "Environmental degradation is further reducing available land supply; soil erosion occurs in 2/3 of China's agricultural land (largely due to heavy fertilizer use), which undermines the longterm sustainability of agricultural production. Furthermore, water scarcity will be increasingly problematic.
First, water availability is relatively scarce in China (water resources per capita are 25% of the world average). Second, water pollution is widespread, with 44% of Chinese rivers classified as polluted. Third, the demand for water increases dramatically as meat consumption increases. The net result of the above two phenomena is dangerously low inventories of agricultural products". In his report dated September 28, 2007, Larry Hatheway said that, "rising food prices will tend to have a disproportionate impact on real purchasing power of lower income groups. This is because lower income groups spend a higher proportion of their income on food. Furthermore, lower income groups spend proportionally more on food items that have a lower fraction of labour and a higher fraction of commodity inputs in the final price.
Hence, rising commodity prices hit lower income groups hardest." As can be seen from, more than 95% of American households spend more than 20% of their income on food - excluding alcohol, which is now also increasing in price. But then consider, which shows the CPI food weights for different countries. If you compare how much of their income (over 20%) most American families spend on food with the CPI Food Weight, it is obvious that the CPI, as calculated by the US Bureau of Labor Statistics (BLS), grossly understates the true rate of inflation by underweighting food, which has lately been rising at an annual rate of more than 10%!
This really reinforces my view that the BLS publishes totally bogus inflation figures and that, even worse, Mr. Bernanke relies on these figures for his monetary policies….
Tom McClellan, editor of The McClellan Market Report (mailto:tom@mcoscillator.com?subject=), calls the CPI "the World Office of Obfuscation Price Index (WOOPI)". I am certainly not an accomplished statistician, but I can't help shaking my head in disbelief that the government gets away with this distortion of hard economic facts, which is also leading to a gross overstatement of real economic growth data (real GDP) and of real retail sales in the US.
I believe, as mentioned in earlier reports, that we are already in stagflation: no real economic growth - or recession - amidst inflation, which the Ministry of Truth understates in order not to depress the population further. My South African friend Faisal Kalla, who has previously described for this report how grocery prices in that country have increased this year (he should know, since he is a grocery wholesaler), recently sent me the following email:
"Something very strange is happening in South Africa. The Christmas season has started early for us. Our trade is mostly groceries and related items. There seems to be a shortage of products from most companies. We are battling to get supplies of food products such as sugar, baked beans and staples. Also the price increases do not stop. Yesterday, the manufacturer of body creams said the price will go up 9%. On the converse, furniture, automobiles and real estate are suffering, especially autos whose price devaluation is ferocious. Real estate is also suffering but at a slower pace. The delusion is still alive…"
Well, what is happening in South Africa is representative of what is happening everywhere in the world. Grocery sales are up because of price increases, whereas sales of discretionary items are either down or sluggish because household incomes are being squeezed by cost-of-living increases and declining home prices.
In the US, the November Producer Price Index increased by 7.2% year-on-year, which will lead to higher consumer prices and inflation, or pressure on corporate profit margins, or both.
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Hello, I just read Marc Farber's article commenting on Faisal Kalla from South Africa. Just to inform him that Faisal Kalla died of a heart attack yesterday aged 41. My apologies for using this forum, but I had no other way of informing him.
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