In 2005 well before most people had even heard of subprime mortgages, Russell Napier wrote the cult classic book, "Anatomy of the Bear, lessons from Wall Street's Four Great Bottoms." In it Napier made a startling prediction: In 9 years, around 2014 or so, the S&P 500 (SPY) would reach a bottom of 400.
Six years later many of the events that Napier predicted would lead to this awful bottom in equities appear to be coming to fruition. Critically, the financial crisis that began in 2008, has never ended, it has simply been transferred from a broken private-sector financial system onto the triple A rated balance sheets of western governments.
Napier is still today convinced that the bottom has not yet arrived, but is yet to come.
He is convinced that what we see happening today in Greece, Ireland, Portugal, and now Spain and Italy will, in time, happen here in the United States. He says it is then that, "A terrible realization will dawn."
The realization is that the same reality that now confronts Europe will confront us here in the states: Governments are broke, and there is nobody left to bail them out.
In his book Napiers says:
The debt cycle will end when the world realizes that the US government is a terrible credit risk. This is the most likely catalyst to reduce equities to a 70% discount to the replacement value of their assets (the valuation that marked the bottom in the previous bottoms of US equities through history). It will be then that you should re-read this book, as great fortunes will be made by investing in very cheap US assets. Until then you should be wary of equities, unless you feel comfortable investing in bear market rallies, and you should be terrified of Treasuries.
Perhaps it is time to really listen to Napier and others like him who have recently been pounding the table about the looming sovereign dept crisis.
The cracks forming in balance sheets of western governments are appearing in the headlines almost daily. From the bankruptcies of huge banks and broker-dealers like Dexia and MF Global (OTC:MFGLQ), the continuously rising bond yields of Italian and Spanish debt, to the riots that started in Greece and seem to be spreading across the globe.
Just how close to the edge are we? Speaking to the BBC from his home in Texas, hedge fund manager Kyle Bass, (Bass became well know in the hedge fund community for making a fortune betting against subprime mortgages, and is now betting against various western government defaults) explains just how near the precipice really is:
"Fifty percent of Japanese tax revenue goes to debt service. If the yields on their bonds were to rise by just 2% the cost to cover their sovereign debt would exceed their tax revenue." Says the somewhat brash Texan, who is obviously extremely intelligent, "Japan has the single worst on balance sheet sovereign problem with debt in the world."
But the story gets worse.
Listen to Bass explain the reason a Japanese default is imminent, "Why did the scheme by Bernie Madoff fail? Bernie only needed one thing to keep the scheme going, more people entering the scheme than exiting. The reason it failed is at one point in time he had more people exiting than entering. Japan has an inexorable population decline. They lost about 3.5 million people in the last 4 years. They are going to lose 27 million people in the next 40 years. They have the worst demographics out of any country in the world."
The western world's debt crisis has, since the bursting of the tech bubble, been kicked down the road, leading to the bursting of the housing bubble, and ending with the current sovereign debt crisis. "Capitalism without bankruptcy is like Christianity without hell." says Bass, "There has to be atonement." Napier puts it this way, " In Austrian terms, the Austrian's always tell us we have creative destruction. We have had several business cycles (where) governments have refused to permit creative destruction of the private sector. They threw their balance sheets and the balance sheets of the central banks on the line to stop creative destruction. So the ultimate situation we have to get to is the creative destruction of the government."
Back to the present, what we have today is a world with politicians telling us that it is going to be OK. Even though the process may be ugly, a resolution will ultimately be worked out.
But Napier and Bass say a resolution is impossible. It ends when sovereigns default. Checkmate.
Checkmate? Can't central banks simply print more money to inflate away their debt burden before they default? Both Napier and Bass see this scenario as the probable outcome to the crisis. "The bigger problem for QE3," says Napier in a recent interview speaking with a mild Scottish accent, "is how do the emerging markets feel about it. It is important if you're going to start printing money to consider how your creditors might consider this...They might question if buying our bonds is a reasonable investment...Our creditors might not have the stomach for QE3 or 4, and that is a much more frightening scenario."
Even though the whole western world has experienced more than a decade of rock bottom interest rates fueling an ever-increasing mountain of debt, it appears now this may be coming to an end. Investors became aware of "Herbert Stein's Law" in 2008, "If something can't go on forever, it will stop." As the bond vigilantes circle the wagons around the western world's mountain of sovereign debt, we may well learn this lesson again.
Where does this leave ordinary investors?
As in 2008 the investing world appears confusing and contradictory. On one hand we see Warren Buffett buying huge stakes in companies like Kraft (KFT) and IBM, and on the other you have extremely credible prognosticators like Napier and Bass predicting huge calamity on the horizon. Kyle Bass predicts the coming crisis will result in a rupture in the social fabric, "Things could get really bad." Since it is impossible for ordinary investors like you and me to purchase credit default swaps effectively insuring against sovereign default, then Bass suggests; "Guns and gold," indeed he says, "All roads lead to gold." Russell Napier suggests hiding in "gold and emerging market currencies."
I would content the reason Warren Buffett continues to purchase equities in the face of the current macroeconomic environment is due to the fact that stalwart American blue-chip stocks are unusually cheap compared with the historic premium they have commanded. The other consideration is time. Buffett invests with a 10-year plus horizon. This gives him the luxury of largely ignoring macroeconomic data.