The Silly Season
It's the silly season. We call it the silly season because so many crazy things are going on. In Hollywood it's awards time and as day follows night it is the Razzies followed by the Oscars; the ugly followed by the wishful thinking. In US politics several Democratic candidate hopefuls are slugging it out to meet Dubya in November. While polls indicate that one of them might stand a chance they do not seem to remember that this is the President that was elected by one Supreme Court Judge (and a hanging chad) and has an arsenal of money to fight anybody. Nor will he have to face any competition for the right to represent the Republicans.
Here in Canada the silly season is represented by the annual RRSP schmooze fest. The funds will be hauling out their 2003 returns to brag about how well they did. While numerous specialty funds especially the gold and resource funds did very well in 2003 most large equity funds underperformed their benchmarks. And if you were in a US$ equity fund even if the fund was up 20% you probably lost money as the Canadian $ rallied against the US$ by an equal amount.
But that won't stop the funds from touting their fund as the best thing you can do. Too bad most fund managers can't even match the averages but then they are weighed down by their sheer size, they are all chasing the same stock universe, and they must be invested in good and bad markets. But with the markets up sharply last year and continuing the run thus far into 2004 they will want you to forget about 2000-2002 as anomalies and guarantee that the silly season will be frenetic. After all with the markets going up do you want your money stuck in 1% savings accounts?
What investors need to know, however, is that we are caught in the grips of a multi year bear market and often what they do in bear markets is they fall for two years rise for one then fall for two more years. If one looks back on the bear markets of 1929-1949 and 1966-1982 those periods were characterised by numerous up and down years often in wide swings and they failed to take out the highs of the previous bull market (with brief exceptions during the 1966-1982 bear). The bull markets of 1950-1966 and 1982-2000 were on the other hand characterized by continual up years punctuated with some nasty shakeouts but no correction on the way took out the previous lows at least not until the drop in 2000-2002.
With the huge rally of 2003 the market has created expectations that cannot be fulfilled as we go into 2004. Valuations on the S&P 500 are in the 37 range versus around 43 at the highs of the 1999-2000 market. When one looks at trailing earnings we discovered it was hard to believe but at the bottom in October 2002 12 month trailing P/E valuations on the S&P 500 were higher than they were at the top in 2000, a significant bearish divergence if there ever was one. Yet in 2003 the market marched to higher and higher levels and the valuations kept rising. Normal fair value is 15 with 10 considered undervalued and 20 overvalued. But they have been preaching for years that valuations don't matter anymore and this is the new normal. And obviously investors don't seem to care either as they were chasing numerous companies with P/E's over 100. No one, repeat no one ever made money buying stocks with P/E's over 100.
What has happened over the past decade is unprecedented growth of money and debt that has created a bubble of immense proportions. Consider that from 1990 to 1994 (a recessionary period) money supply (M3) in the USA grew by $284 billion while debt was up by almost $2.8 trillion. GDP during this period grew in by just under $1.6 trillion. The Dow Jones Industrials was up during this period by 76.7% (15.4% annually). The debt numbers here and going forward exclude social security debt growth and to trusts. Roughly it took $1.75 of debt to buy a $1 of GDP.
Now compare this to the bubble period from 1995 to 2000 when money supply (M3) exploded $2.7 trillion, debt was up an astronomical $5.1 trillion while GDP grew by $2.7 trillion. It took $1.89 of new debt to buy $1 of GDP. The Dow Jones Industrials was up during the period 181% or 30.2% annually. The debt numbers were constrained by the fact that the US government was actually paying down debt during this period and growth was largely due to all other debt primarily the consumer and corporations which increased by $5.2 trillion accounting for more than the entire increase.
During the next two years when the Dow Jones fell 23% (11.5% annually) money supply continued to expand up another $1.4 trillion while debt jumped almost $2.5 trillion. GDP on the other hand was up $663 billion for a debt/GDP ratio of 3.8 even higher than the previous periods yet it was still a struggle for GDP to grow during this period. In 2003 for the first nine months for which numbers are available, M3 grew by $428 billion but debt was up a huge $1.8 trillion and GDP grew by $415 billion. Debt/GDP ratio grew to 4.33 an astounding number when compared to previous periods. In 2003 the Dow Jones was up 24.3%.
For comparisons purposes the period after 1970 contains the period of explosive debt and money growth. From 1970 to 1989 M3 was up $3.5 trillion, debt grew $8.8 trillion and GDP was up $4.5 trillion. Debt/GDP ratio was 1.95.
We still have not seen the debt and GDP numbers for the 4th quarter 2003 but we have seen the M3 numbers and for the first time since the early 1990's M3 actually fell by $147 billion in the period September to December 2003. This is not a positive sign as it suggests that there could be problems going forward and that the Federal Reserve's attempts to maintain high levels of liquidity could be compromised. Since the US$ was falling sharply during the period the decline may be due in part to withdrawals of foreigners from the US banking system. It doesn't of course tell us whether they converted their dollars to another currency or merely shifted them to other markets outside the USA.
The environment of low interest rates, easy money and credit has helped contribute to a bubble in the US stock market and as well in the housing market in 2003. All that money has to go somewhere an invariably it chases the most speculative. The question is whether it can be sustained going forward. If the declining M3 numbers are a portend then debt growth could start to slow unless they can generate more out of their credit cards and another round of mortgage refinancing. If it falters at all the market will stall and begin to fall.
The recent Fed announcements that they would be dropping the "considerable period" of time that interest rates would be held down had an immediate and predictable reaction in the markets. Both stock and bond markets (prices) fell. While a one day drop does not a return to the bear market of 2000-2002 it is sign that the market is susceptible to news that was unexpected. Overvaluations, complacency in the market that hasn't been seen since the highs of 2000, and major indicators all flashing warning signs of an overheated market are clear signs that expectations are beyond what can be delivered.
In 2003 investors were net sellers of mutual funds especially in the early part of the year. But in the past few months the investor has been coming back again and the fund flows have been positive. Selling at the bottom. Buying at the top. Once again the public has got it wrong taking risk at the wrong time. The vulnerable areas are the major ones that led the market up particularly financials (higher interest rates) and technology (huge overvaluations). Our chart of the Royal Bank of Canada (RY-TSX) (www.royalbank.com, 416-974-8393) below typifies the dangers that lie in the stocks. A classic short sell candidate.
It is the silly season and the mutual fund sales pitches are beckoning. With the monstrous rise in the markets over the past year investors would be better suited to spurn the siren call and wait out the correction. Remember we are in a secular bear market that will take years to run its course and the next move down could be as sharp on the downside as the one we just witnessed to the upside. The rally over the past year was a very impressive bear market rally. Markets that are undergoing corrections in bull markets such as the metals and mining, Golds and energy stocks are the ones where investors should focus to buy on weakness.