Selectively Bullish in Times Like These

Nut job. Alarmist. Fear monger. Dr. Doom.

I’ve heard them all. When you make your living as a financial analyst and commentator, as I do, you aren’t going to get a lot of invitations to the ol’ country club - especially if you spend a lot of time spotlighting the problems that are created by greedy Wall Streeters, sleepwalking regulators, or indentured elected officials.

But when you repeatedly warn investors that the U.S. financial system is on a collision course with disaster, and state that some investors will experience "extinction-level events" - and when you broadcast these warnings when virtually everyone else is in denial and is dismissing the market problems as "minor" - you’re bound to become a marketplace pariah.

Until, of course, your predictions are proven correct.

We may be hearing from my critics again - and soon - for I’ve got another prediction they aren’t going to like.

There clearly are countries - such as the United States and much of the European Union - that are going to collapse into recession, even if only unofficially. But this doesn’t necessarily have to evolve into a global recession - a position that most of the traditional Wall Street establishment disagrees with, by the way.

Let’s take a look at several of Wall Street’s current misconceptions - and see why I’m selectively bullish:

• The Red Dragon (China) is ready to hibernate: Wall Street is worried that a U.S.-induced recession will slay the Red Dragon. There’s no way. If a country can fall into a recession when its economy (as measured by gross domestic product, or GDP) is advancing at a 9.6% clip - at a time when its U.S. counterpart will be lucky to eke out a 1.0% growth rate - well, I’ll eat my hat. The Armani Army, in its infinite wisdom, is worried about a recession in China even though its $1.9 trillion in foreign reserves are more than 32.10% of GDP and external debt is a minuscule 7.6% of GDP (external debt is defined as the amount of debt that China owes external creditors, including consumers, central governments and commercial institutions, according to the CIA Fact Book). By contrast, the U.S. reserves are 4.84% of GDP, while external debt is 84%. The United Kingdom and Switzerland are in even worse shape, with external debt of 382.2% and 279.1%, respectively.
• China won’t be able to survive a drop-off in exports to the United States: Then there’s the myth of China’s export economy. The last time China took a header and export business dropped by 35%, its GDP dropped by less than 1%. I’m betting it will be an even smaller bump this time around, especially since China’s middle class now is increasingly responsible for internal growth - independent of what China exports to the rest of the world.
• The Asian economies are an economic train wreck just waiting to happen: This was true a decade ago, when the United States and Western Europe held all the cash. But no longer. Today, nations such as Singapore, Thailand and Malaysia are running trade surpluses. So is Canada. That suggests that the currencies of these countries are significantly undervalued at a time when their economies are increasingly tied to that of China. What does that tell us? Today, China is the growth engine of Asia; tomorrow, it will be the growth engine of the world.
• The U.S. economy remains the financial center of the world: Today, an estimated 78% of global economic activity takes place outside U.S. borders, which means that even in a recession, an increasing amount of capital circulates beyond the U.S. shores. Indeed, the U.S. stock market now represents less than 30% of total world market capitalization, down from roughly 45% as recently as 2004. Don’t be surprised to see the United States continue to decline in economic relevance. One day, the lion’s share of the financial trades will take place beyond U.S. borders.
• Because it’s a developed market, the United States remains the world’s safest and most promising place to profit: In the 1980s, the United States accounted for one-third of the global economy; by 2030, that ratio will be cut in half. The reality is that U.S. investors who want to be successful in the years to come will have to learn all they can about markets whose names they can’t yet pronounce.

Wall Street may not agree, but the real adage to embrace and remember is this one: It’s easier to become No. 1 than it is to stay there.

There’s no doubt that the "experts" who are projecting that the world markets will decline further and perhaps even collapse will take issue with my analysis. But it’s important to note that I agree with you - at least in the near-term. Barring a governmentally induced Hail Mary, I think there’s no question that the worst remains ahead of us.

But longer term - I’m talking three, five to 10 years - I am intrigued by the fact that so many emerging markets have collapsed in the chaos, even though the underlying economies haven’t really changed. Everything we know about financial markets history and changes in market behavior suggests that countries backed by high cash reserves tend to emerge from periods of market chaos faster - and stronger - than the economies that had been at the top of the heap when the crisis first struck [for some insight into which countries have the biggest reserves as a percentage of GDP, take a close look at the accompanying chart].

Where does that leave us? Well, in spite of what Wall Street would have us believe about the Red Dragon, this cash-reserves indicator suggests that China - and countries that have close economic ties with that country - may actually be getting more attractively valued (and not less) by the minute. That’s especially true for longer-term investors.

As for the types of investments that seem most promising, given the troubled times we live in, keep focused on the simple ones. As I’ve long suggested, such simple profit plays have always played well during periods of similar market turmoil. So there’s no reason to believe it will be any different this time around.

After all, the financial history books are filled with notable examples of real earnings and real products enjoying success over long periods of time. Particularly when those profits are being generated by companies focusing on such basic societal needs as energy or infrastructure. Barring a complete collapse in the oil business (or any perfect substitute that’s eventually developed), energy, commodities and infrastructure companies will continue to offer solid upsides.

As for the U.S. dollar, after years of benign neglect, the U.S. Federal Reserve and U.S. Treasury Department will do everything they can to prop up the credit markets. In the short term, most investors will misconstrue this as a legitimate rise; all that’s really happening is that longstanding risks are being overcome by governmental guarantees.

Longer term, the damage has been done. No nation I am aware of in recorded history has done more than temporarily dodge the inevitable by debasing its currency as the United States is doing right now. And that’s why - at the risk of inflaming yet another bunch of Wall Street folks - I’m increasingly of the opinion that the United States is headed for a major currency crisis in the next few years. Wall Street doesn’t see it, and I sure hope that I’m wrong.

For the same set of reasons, I don’t think that investors should be the least bit surprised if U.S. regulators (in conjunction with their counterparts overseas) actually shut down the financial markets for a week or two while they try to sort out the credit crisis and reevaluate currency relationships that are right now being pushed to the brink of oblivion.

While this is regarded as an impossibility by many - and simply incomprehensible by others - Bloomberg News reported Oct.10 that Italian Prime Minister Silvio Berlusconi said world leaders were discussing shutting down global exchanges. He later retracted his comments, saying that he didn’t mean what he said.

But I think he (Berlusconi) did, and I believe they (U.S. regulators) are.

There are historical precedents for so-called "bank holidays," even here in the United States. In fact, the New York Stock Exchange closed its doors from March 4-14, 1933, as part of U.S. President Franklin Delano Roosevelt’s forced holiday (Emergency Banking Act), and did so again from Sept. 11-17, 2001 following the terrorist attacks against the U.S.

In both instances, what’s critical to understand is that the closures were designed as part of a government plan and not an overall solution. If not backed by a plan or ultimate objective, a shutdown would simply delay the inevitable, or move additional losses offshore until the U.S. markets were to reopen. Thus, even though a bank holiday would provoke terror among most investors, a globally coordinated stock market closure could also be viewed as a tremendous sign that central bankers and regulators finally understand the gravity of the situation we’re facing today and are literally rewriting the rules of finance in a united, global front.

That’s why this reminds me of iconic investor Warren Buffett, who once reportedly quipped that investors shouldn’t buy anything they wouldn’t want to own for five years, if the markets were to close for that period.

Or something to that effect…

Original post

Comments

[peterthepai...:]

nice one keith...

2008 Nov 04 10:08 AM

[Costard:]

I don't necessarily disagree, but where's the value in predicting that the sun will rise? It's understood that massive inflation stands on the horizon - but one's investment risk should depend upon the path taken to get there. If in the immediate future we face a greater collapse and resulting deflation, then how is longer-term bullishness warranted, at the present time?

Regarding China, my impression has been the exact opposite of yours; the bursting equity bubble has been marked by a distinct lack of panic and analytical reevaluation. People are only now beginning to consider a future less vertical. However, the equation you present for China's up-and-coming success leaves out a few key variables. It's true that China reports a strong GDP and a flush governmental balance sheet. But how can one put complete faith in the official whispers of a country that has a vested interest in putting the best face on things? And how quickly will things turn if tax revenue falls, given the (potentially) hyper-cyclical nature of their manufacturing/exportin... economic base? And what about corporate accounting? Chinese companies involve an endemic risk for foreign investors, precisely because we don't live in China, we often can't evaluate first-hand these companies' products, and there's no way to perform due diligence on their reported numbers. Enterprises are often run or backed by local government officials, and consequently they, too, have an incentive to value appearance over efficiency. Finally, it's important to remember that Chinese companies are globally competitive **at the current valuation of the Yuan**. If the currency were allowed to reflect its proper valuation, China's manufacturing base - and the nation's jobs, debt market, and what domestic consumption it has - would implode. You can form your own opinion as to whether or not this forms a sound basis for investment. It seems foolish, thought, to ignore the risks altogether.

2008 Nov 04 10:24 AM

[Chinese Zod...:]

I was very skeptical going in, but your piece was very well argued. I didn't know that the last time exports fell by 35% GDP dropped by only 1%.....

2008 Nov 04 11:26 AM

[User 291418:]

Why does the chart show "United" and "States" as if its two separate countries?

2008 Nov 04 12:09 PM

[huangjin:]

China's stock market and real estate prices point to a big credit bubble which popped. PMI is below 50. China's debt is hidden on the balance sheets of state banks. Although not external, the debt is large. Furthermore, the Chinese banking system does not allocate savings efficiently.

I expect the nation will snap back rapidly, as it did in the 1990s, but there is a lot of malinvestment to be cleansed from the economy.

2008 Nov 04 12:27 PM

[cyclingscholar:]

Boy have I heard this argument before. Japan in the 1980s was supposed to be the next superpower, we were now in the end of history, we may as well teach our children to say Toyota before they say mama, ad nauseum.

Anyone can stand on a pedestal and yell "RECESSION" like some cassandras have in the last few years, and they will eventually be right.

I love the way people who would NEVER trust US data (e.g. inflation) but will swallow Chinese data hook, line, and sinker.

Chinese growth has to be in the upper single digits just to absorb labor force growth and keep those flocking to the cities employed. Slow that growth and the country will collapse from within due to riots.

Bring it on!

2008 Nov 04 02:05 PM

[aarc:]

The US and other industrialized countries have no more firepower to mount additional 68 years stock market rally since their baby boomers are already approaching retirement age and will be going after security in life - they are going to save money for the winter years.

China, India, Indonesia, Brazil, Mexico and other developing countries do have an emerging baby boomers that dwarfs the wester baby boomers by the billions.

Emerging markets stock markets are plunging not dissimilar to Dow Jones of 1929 to 1932 for the very reason those markets are still young and immature. Likewise, with a miniscule portion of their population having direct exposure to their own stock markets, their markets are naturally more volatile than Dow Jones did in 1932.

But that will not be the end of stock markets in the developing world. They do not practice bankcrupcy the way the west do. If a company goes into trouble, they have centuries of experience of just going with the flow until those companies become profitable again. They do not declare bankcrupcy just to evade creditors and creditors do not ask payments for fear of the future.

Likewise, unlike the bankcrupt govt of US in 1932, the developing countries have learned their lessons of 1987 and have been building their cash reserves until the now.

Never in their centuries of experience did they ever tasted success and prosperity as they did 2002 to 2007. Now that their time has come; the plunging demand from the west is not enough for them to abandon time tested frugality and patience. Their baby boomers are still young and resourful and will usher another global boom of the future potentially bigger than the west did.

Likewise, the baby boomers of the West, do have the money, the knowledge and the experience of producing and selling products to the baby boomers of their own and the world in general. They will simply have to tailor existing product to the taste and cultural differences of the developing countries baby boomers. No need for radical change since most of those developing countries' baby boomers have been brainwashed already by the west during the 80's, 90's and 2000's.

Also the US has lots of investments into the developing countries primarily in technology and manufacturing plants.

In effect, the US is in the best position in order to capitalize once the emerging markets are able to develop their own consumer markets. China in particular has already discounted the downward spiral of demands from the West and is now starting additional programs to stimulate local demands.

It is going to take time.

Meanwhile, it is very hard to ascertain how the west is going to handle the current financial crises. US baby boomers are not so old not to be able to mount another rally; their knowledge and experience put them in exactly the right place and time in history to be able to surmount such kind of "once in a century" crises.

2008 Nov 04 02:32 PM

[phdinsuntan...:]

Globalization was a nice trade: Japan private savings funded China production, sustained in commodities from developing economies for US/EU final consumption, with profits and debt payments expected to
return to Japanese exporters, banks and government bonds, with all enjoying a piece in the middle. Is sad that investment banks were greedy enough to pollute all the chain selling low quality debts as AAA assets.
Now nobody trust in anyone and is a sort of ice age for global trade.

The news on closing the exchanges may create a massive selloff, Silvio Inc. must be shorting a lot of things for sure, and I will use this voters or PPT spring to short some more. Is a baaad idea, specially if they dont have an agreed plan. I been reading some proposals, like a 20% devaluation of the US$ in exchange of a chunk of Asia saving to cover the hole, and continue the nice trade. The club of the 20s has the last word, in the mean time mermaids can be dangerous: China is screwed with a zombie trading partner, same as Asean in 1998 they are collapsing, the difference is this time they can make some voodoo tricks
with their 2 trillions, (like a Euro revival for example).

Treasury gringos may be happy to dump their debt somewhere and go shopping again, but Ben holds only 25% of US treasuries now, a healthy move that is telling to me has no problem with the mentioned devaluation as an option to the IMF medicine of fiscal responsibility. But also means that China will not colect more green barbage this time (or will charge a reasonable yield to do it). So make your own bet: who will get a lifejacket in the sinking globalized Titanic? Not the countries outside of the 20s club for sure: there will be the next massacre and probably some compassive Japanese PM will fund the IMF with lots of highly indebted yens to praying the Washington Concensus once more.

This deal really sucks! They will bailout themselves once more at GS style...

2008 Nov 04 03:02 PM

[hook:]

times like these? yeah? like when? we've never had times like these

2008 Nov 04 03:28 PM

[aarc:]

How about Dow Jones 5000?

Wanna buy or still too afraid to buy.

Only if Dow Jones rallies above 11,000 and possibly touch 12000 will there be enough confidence amongh the benchsitters to hop in the bandwagon.

10,100/200 is the danger zone with projected 7300 to 7500 target before the next bounce.

China and Japan plunges are still too fast for comfort but they are practically too tempting to ignore either. DAX is just about right, not too hot not too cold but still unpredictable.

We will know in the next few weeks how things are going to pan out.

2008 Nov 04 03:50 PM

[bsmith:]

PRC GDP ~ 2 trillion?

US GDP ~ 9 trillion?
70% of US GDP is from consumer purchases, which are/will drop like a rock...

Now bring in all other G7 in a similar boat as US and what happens to China's GDP???

2008 Nov 04 09:26 PM