THE SKEPTICAL INVESTORTM

Issue No. 15. November 1998

Posted 21.XI.1998


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CONTENTS

Global Overview

Despite what looks, on the surface, to be returning stability in Asia,the obvious renewal of investor confidence in America, and other superficial evidence, The Skeptical InvestorTM continues to see a deflationary slump ahead. Under the surface there has been no real amelioration of the awful economic problems facing most of the world, and the urgency of three interest rate decreases in quick succession (over only seven weeks) by the US Federal Reserve, especially after such an extended period of interest rate stability, merely (to me) brings into sharp focus the fact that the mighty US economy is now starting to experience problems too.

The Coming Deflation?

The nature of all the varied and confusing monetary, economic and business shocks around the world since mid-1997 follow a pattern that fits with what would be expected at the start of a major deflationary cycle. And the underlying picture of long-term inflation, excessive credit expansion, over investment, and malinvestment suggests that such a corrective cycle is long overdue. Neither argument of course proves that that is what is going to happen. There have been false alarms before. When the economist C. V. Myers wrote his excellent little book "The Coming Deflation: its dangers and opportunities." ( Arlington House, New Rochelle, NY) in 1976, signs of an impending collapse were all around him. But it didn't happen. Then in 1992, James Dale Davidson and Lord William Rees-Mogg, going in part over much the same ground as Myers, forecast an imminent collapse in " The Great Reckoning". They too got the timing wrong. So, why now? Well, perhaps the reckoning can and will be deferred yet again. I do not have a crystal ball. But I do know that (a) this time the crisis is already truly global, and (b) this time the economic anchor of the world, America, is facing the biggest equity bubble in its history. My position is only that the most probable outcome of the current global turmoil is a global deflationary slump. How bad? - I have no idea. But neither do those commentators who state that a major depression is now impossible because, they claim, we now know how to prevent depressions. Such a claim is silly. If it were true the experts wouldn't come up with so many different and mutually exclusive economic recipes!

There are now a number of sources and commentators on the Internet who are discussing and explaining such matters as why the current market stability may be a matter of appearances only, and the nature of the deflationary process. These things have become somewhat hot topics! I give an external link below to a useful site that provides regularly updated links to a lot of the most current articles. And Myers' book, mentioned above, is worth reading. It seems to have been largely forgotten but offers a clear cant-free explanation of inflation, fiat money, the gold standard and the underlying causes of deflation. Myers well understood the non-linear nature of the process of credit collapse which he likened to a chemical precipitation. Understand it, and think it through to its practical consequences, and you will have a pretty good grasp of the basics.


[EXTERNAL LINK] Fiend's SuperBear WWW Site.
As for my own interpretation, which is only a very tentative working hypothesis to help me structure my thinking, I see us as being at a similar stage in the process as we were at after the October 1929 stock market Crash. On October 29, 1929, the Dow index tumbled 11.7 percent, The initial bottom was reached at 230.07. There was no short-term effect on industrial production, but as a precautionary measure, during November the Fed quickly reduced the discount rate from 6% to 4.5%. The market then recovered over the next few months and got back near 300, but the rally failed and the vicious bear market resumed and continued for 34 more months. This year, we witnessed a decline of 20% in the DJIA. That is a much lower percentage decline than occurred in 1929, and without the single great "crash" experienced at that time, but is not a great deal less than the first phase of the decline of the Japanese markets in 1989-1990. And now the Fed is reducing interest rates in an attempt to head off problems that it sees ahead. We may well yet experience something sudden and dramatic triggered by, for example, problems in China or Brazil, but I am concerned that that may not be an essential prerequisite: so it will be prudent to watch out for an accelerating slowdown in the US economy - a decline in bank loans to businesses despite falling interest rates - widening spreads on bonds - a sharply rising percentage of cash in the total money supply. Those are some of the things that will tell the tale.

Investing During a Deflationary Slump

What I want to do in this Issue is continue my look at what I think will be some of the effects on investments (offered, as always, merely as food for thought, not as investment advice). I began this last month with some thoughts about currencies and short-term government bonds. [LINK]. I pointed out that because we now live in a world of floating exchange rates and fiat currencies, even cash can no longer be regarded as an absolutely safe store of value. I suggested however that this could be dealt with by currency diversification, and that a portfolio of high-quality government bonds and cash deposits held in several major currencies could be the way to preserve ones purchasing power. This applies wherever you live. This month I have some thoughts about patience, about bonds, and some cautionary words about buying equities with the intent to buy-and-hold.

Lying behind what I say is the belief that the best way for an investor to make money from a deflation is to concentrate on preserving his capital intact and then using it to buy up sound real assets later at what will be bargain-basement prices compared with the unreal valuations reached at the end of the preceding inflation.

Some people of course will have made fortunes riding the asset inflation on the way up, but they will only retain their wealth if they get out in time. Simple arithmetic proves that most must lose what they have made on paper. That is the danger inherent in following a buy-and-hold strategy.

Some very skilled traders succeed in making money trading the bubble all the way up, and then shorting it down. A very few make overnight fortunes being short during a crash, but that, I would claim, is more by good luck than good management: such events are notoriously unpredictable.

Patience is a virtue

Sitting around in cash and short-maturity bonds waiting for the economy to fall apart is an easy strategy to plan, but can be extremely difficult to stick to. It certainly takes patience! But it is very important to have a realistic idea of the speed at which events unfold.

The fact that the series of financial and economic shocks that have been experienced around the world were not followed within a few weeks or months by a significant downturn in the US is not evidence of anything. It is surprising to me, given the historical record which is open to anyone to read, how, simply because some event such as the Russian debt default has not led immediately to a collapse of the US stockmarkets, it is assumed therefore that nothing serious is now going to happen.

I have discussed this problem of the foreshortening of historical time scales before and have pointed out how it leads to unrealistic expectations of the speed at which events actually unfold [LINK].

To give a concrete example that may help put current events in perspective, members of the US Federal Reserve became concerned about excessive stock market speculation some time before 1929. They saw some real and worrisome evidence: particularly a surge in new bank credit of which 90% consisted of loans on securities. A request by the Boston Fed for an increase in the discount rate from 3.5% to 4% to slow this speculation was rejected at first, in favour of "moral suasion" that banks become more cautious of extending credit for such purposes. (As an aside, that is an almost exact parallel to Alan Greenspan's attempt to talk down the "irrational exuberance" of the market, instead of raising interest rates, in 1996). That was in October 1925. Four years to go before the market crashed. And another three for it to reach bottom.

Bonds

High quality bonds (diversified by currency) look to be a good bet even if there is no deflationary slump. That is because the alternative much more optimistic view is for continuing healthy disinflation, which is also bullish for bonds. At the time I am writing this (November 1998) there are no meaningful signs of inflation: even the worrying growth in the US money supply looks to be slowing somewhat. Bond investors certainly must stay alert for any sign that inflation may be about to resume, but the current outlook remains bullish.

We are in a long secular bond bull market that began in 1981, and which looks set to continue. This is not unprecedented: there was another great bond bull market in America which began in 1920 and lasted right through the Roaring Twenties, the Great Depression, and the Second World War. It did not end until 1946. (Keep that in mind when you read any analyst who says that our falling interest rates must be good for equities: interest rates indeed were trending down as stocks soared through the 1920s: but they continued to fall as stocks plummeted in the 1930s [and they still continued down as stocks began to recover in the early 1940s]). There were two significant, but short-lived, reversals in this long trend, both directly associated with the Fed raising interest rates. The first was in 1929, when the discount rate was raised as high as 6% in a by then ineffective attempt to slow the out-of-control stock market bubble. The second occasion was in late 1931-early 1932 when Fed rates, which had been substantially reduced in the intervening period, were again jacked up, this time in response to the growing outflow of gold bullion from the US. Both episodes proved to be good buying opportunities both for government bonds and for prime corporate bonds (see below).

We are used to interest rates and being linked to inflation expectations, and because of that there remains some tendency to see any spike in bond yields as evidence of an inflation threat. But, in the current environment, interest rates and bond yields are now dependent more on different considerations. The setting of key rates by many Central Banks is no longer driven by the desire to stamp out inflation, but by the need to bolster a weak currency (e.g. The Canadian CB increased the bank rate by a full 1% a few weeks ago because the dollar was collapsing), or in an effort to prevent or reverse economic problems (e.g. recent US Fed action). Bond yields will respond to CB moves, but not necessarily in the same direction (e.g. a too vigorous easing by a CB may trigger inflation fears which would drive bond yields up). Bond yields are an additive of both inflation expectations and of a risk premium: the former has mostly been decreasing but the latter has been increasing and is now the major factor that the bond investor must gauge. The risk is not only the possibility of default by the borrower, but also, increasingly, currency and interest rate volatility.

Corporate Bonds

Although I have been emphasising government bonds, the highest quality corporates may be rewarding investments too. In his "History of Interest Rates" Sydney Homer showed that the average yield on prime long-term corporate bonds continued their secular trend down throughout the Great Depression. According to his data, average yields fell from a high of 5.56% in May 1920 to 4.04% in January 1928. Due to Fed tightening they had increased to 4.59% by September 1929, but in the immediate aftermath of the stock market collapse they rapidly fell, reaching a temporary low of 3.99% in May 1931. Then the Fed increased rates again resulting in a short-lived bond bear market. Rates peaked at 4.83% in June 1932, but then resumed their long decline:-

YEAR .......... AVERAGE YIELD

1932 .......... 4.61%
1933 .......... 4.19%
1934 .......... 3.83%
1935 .......... 3.44%

1940 .......... 2.70%

1945 .......... 2.54%
1946 .......... 2.45%

They bottomed in April 1946 (2.37%).

Clearly many holders of the highest quality corporate bonds were satisfactorily rewarded during the Depression years.

The Buy-and-hold Myth

Most equities will be clobbered in the event of a deflationary slump.

On December 29, 1989, the Nikkei stock average peaked at 38,916. On Friday (November 20, 1998) it closed at 14,780. In other words, after nine long years, Japanese stocks are still down 62 percent from their high. In fact, on average, anyone who purchased Japanese stocks at any time from 1985 on and held on to them is still waiting to break even. Who will still believe in buy-and-hold if by July 2007, the DJIA has fallen to 3540 ?

Adam Smith in "The Money Game" tells the following story that illustrates the potential perils of investing for the long term. A certain Timothy Bancroft come through the Panic of 1857 unscathed by holding on to his investments and not selling. This experience convinced him that the only way to invest was, in his words, to "buy good securities, put them away and forget them." He carefully selected and accumulated stock in good companies dealing in essential goods and services. When he died his estate was valued at $1,355,250. But unfortunately for his heirs, by the time the estate was settled the shares of Southern Zinc, Gold Belt Mining, Carrel Company of New Hampshire, and American Alarm Clock Company, [all the bluest of blue chips in their time], and his entire estate, were worthless.

Take care!


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