Something Will Give!
A commentator characterized the year 2003 as an investors' "flight to garbage." Indeed, some assets perceived to be of lower quality, such as Ecuadorian and Brazilian debts, Argentinean and Venezuelan stocks, as well as money-losing high-tech companies, enjoyed huge price gains in 2003.
In fact, 2003 will enter the financial history books as the year in which all asset classes - including equities in developed as well as emerging markets, government as well as any kind of corporate bonds, industrial commodities, precious metals, real estate, and art - increased in value.
That is, of course, with the exception of the U.S. dollar, which slumped not only against gold (mentioned here as a currency, whose supply cannot be increased ad infinitum by some intellectually dishonest central bankers), the euro, and the currencies of the resource-based developed economies of Australia, New Zealand, and Canada, but also against the currencies of more "controversial" economies such as Brazil and South Africa.
As a result of the slumping U.S. dollar, the performance of U.S. equities in 2003 was nowhere near as "fantastic" as the media have suggested. It is true that, in U.S. dollar terms, the Dow Jones Industrial and the S&P 500 rose in 2003 by 25% and 26%, respectively; but in Euro terms, these gains were just 4% and 5%. Admittedly, the Nasdaq, and especially the Philadelphia Semiconductor Index (SOX), did better, rising by 50% and 76%, respectively, in terms of the U.S. dollar and by 25% and 46%, respectively, in Euro terms, but this was hardly a match for the emerging market gains (in U.S. dollars) of 138% in Thailand, 131% in Brazil, 119% in Venezuela, and 104% in Argentina.
Moreover, if we look at the performance of the Nasdaq since the Euro bottomed out in October 2000 at 82.27, the recent rise appears to be more muted in a longer-term context than the bullish camp is trying to convey to the "dollar weakness unconscious" investment community.
When asked about the performance of President Bush over 2003, the elderly but jovial Jewish taxi driver who took me to John F. Kennedy Airport in New York following the yearly Barron's roundtable exclaimed enthusiastically that Bush was the "greatest American president ever."
Taken somewhat aback by this firm and unshakable support for the present U.S. government, and at the same time concerned that I might be offloaded somewhere in an alley on my way to the airport if I said anything wrong, I hesitantly, and as diplomatically as possible, asked my driver, who proved to be smart and honest, why he felt so positive about Mr. Bush's administration. "Bush doesn't take any BS from anyone in the world," he replied. "And look at the stock market... it's up!"
Fearing a confrontation, and concerned about missing my flight, I remarked in a conciliatory way that the dollar had declined in value, concurrently with the stock market's rise, thereby largely neutralizing - currency adjusted - any stock market gain. But this stock market gain/dollar weakness issue didn't seem to strike a chord with my driver, whose only concern seemed to be to enjoy additional price gains on his home and his stock portfolio in U.S. dollar terms.
After checking in at the airport, I reflected further on my driver's views, which I initially considered to be rather naive. But then it struck me that the entire global investment community has been seduced by strong economic indicators (published by governments, we must remember, which have a political agenda) and easy monetary policies into believing that all asset classes will continue to appreciate in 2004.
The commodity bulls believe that we are at the beginning of a long-term secular bull market for raw materials and precious metals, while the stock bulls believe that the rise since October 2002 is the first leg in a multi-year stock bull market. Home buyers believe that the housing industry will continue to thrive and expand and never again be a cyclical industry in the way it has always been, and at the same time the "deflationists" remain convinced that deflation will lead to a resumption of the bond bull market. So, wherever you go and to whomever you speak, everybody around the world is very optimistic about some asset class or some kind of "very special situation."
In addition, every investor you speak with is convinced that he is savvier and smarter than the public, and that he will know, just minutes before it turns down, when to get out of his favorite market, stock or commodity! In other words, every investor seems to be suffering from the massive delusion that he is an above-average investor who will be able to "beat the crowd."
Yet it should be clear to any rational thinker that commodities, and especially the precious metals, cannot forever rise in price while at the same time interest rates decline and bonds continue to appreciate. At some point, continuously rising commodity prices must lead to higher inflation rates and depress bond - and probably also equity - prices. Conversely, bond prices can only continue to rise if global economic growth disappoints and deflationary forces reassert themselves.
The year 2003 was unusual in as far as all asset classes rose in price - that is, with the exception of the U.S. dollar. In 2004, we expect asset markets again to show diverging performances, as has always been the case in the past, because every major up-trend in one asset class was also simultaneously accompanied by a major bear market in another asset class. Take the 1970s: commodity prices including precious metals and oil rose more than 20-fold in price, but bonds and the US dollar collapsed and equities performed miserably. Or look at the 1980s. Japanese stocks went through the roof, but commodities collapsed. Finally, in the 1990s, we had huge bull markets in the stock markets of the western industrialized countries, but devastating bear markets in Japan and, after 1997, in Asia. I wish to emphasize that the simultaneous occurrence of bear markets in one asset class while another one is in a steep up-trend, is a very important insight into the long term behavior of investment markets. A "Win Win" type of environment such as we had in 2003, when every investment market moved up is exceptional and totally a-typical.
So, what kind of investment markets should we expect in 2004? In my opinion, the surprise of 2004 could be renewed economic weakness in the US and a weakening of the torrid industrial production and investment growth in China, which would be temporarily negative for commodity prices and likely also for extended stock markets (developed and, especially, emerging markets) and sectors, which in 2003 performed superbly, such as US home builders and semiconductors. On weakness, I would, however, accumulate oil and oil servicing stocks, as the fundamentals of the oil market look very promising. My friend, Barry Bannister of Legg Mason in Baltimore has produced the following figure, which shows how oil demand increases as countries industrialize.
As can be seen oil demand per capita rose during Japan and Korea's phases of industrialization from 1 barrel per capita to 17 barrels per capita. And, while I do not expect the same to necessarily happen in China, oil consumption, not only in China, but throughout the emerging economies of Asia is likely to double from 20 million barrels per day, today, to around 35 to 50 million barrels over the next six to 10 years. That such an increase in demand on a total current global crude oil production of daily 78 million barrels will drive prices in the long-term higher should be clear. I would also add, that the necessity of China to secure reliable oil supplies, which cannot be interrupted by the US, will add to international geopolitical tensions, and could put some day pressure on equity markets. Don't forget that one of the main reasons the Japanese entered the Second World War was the drive to secure its supplies of oil and other resources.
Lastly, the U.S. dollar has become very oversold and sentiment is as negative about the U.S. dollar as it is positive about the U.S. stock market. Time for a contrarian to take the other side of the trade - that is, long U.S. dollars and short the U.S. stock market???