This article just appeared in Financial times and it is the one thing you should read if you care to understand where in the market we are. You will thank me one day.
Dr Doom: ‘Let us just assume the financial system blows up…’
Gold — and the division of assets – is on the mind of Marc Faber this week in a special interim note to his subscribers. It’s not a particularly attractive trade right now, he notes, although personally, he’s hooked. And anyway, people have been asking …..
For investors with all their assets in US dollar cash (and no other holdings), Faber suggests accumulating gold from here on down to possibly $600/oz. While not necessarily forecasting such a drop (from the current level of about $820/oz), he notes the metal could decline to that level.
Those with “99 per cent of their assets in gold and no cash flow” should hold for now, says Faber, as the gold chart looks “truly horrible” since prices fell below the key support levels of around $850.
For traders, however, gold may have some short-term appeal right now because it is becoming oversold. But what, then, is the immediate upside potential? Heavy resistance would seem to exist at $850-$900 while the downside risk is at least as large as the upside potential.
From a personal perspective, says Faber, of his total assets, about 5 per cent is in equities, 8 per cent in gold, 8 per cent in real estate and related investments and the rest is split between US and euro fixed-interest securities.
But Faber’s own cash flow (income) is to some extent dependent on the performance of equities, he acknowledges, since he receives some performance fees when stocks appreciate.
“As a result, my indirect exposure to equities is higher than is suggested by the asset allocation figures listed above. From my fixed interest securities and from my business I have a relatively high cash flow and, therefore, I am a happy holder of gold and a buyer on the way down (in fact, irrespective of the price I buy every month some) for the following reasons: I am not a great believer in insurance policies, but since I think that sooner or later the entire financial system will blow up I want to make sure that whereas my assets, which are on deposit and could become worthless through default, I shall still be left with some assets that are mine (physical gold in a safe deposit box — not in the US). I should like to emphasise that this is also a point which speaks for owning some stocks.”
So in typically cheery mode, Faber says, “let us assume the financial system blows up”. Large deposits could become worthless overnight. But if you own shares of companies — even though they may decline in value — you will still own these shares since they are a certificate of ownership and not liabilities of someone else.
So, no matter how negative a stance one might have toward equities, at this point the ownership of some solid companies might be more desirable than being a creditor in a financial system that may not be able to pay at some point in the future.
Also, I consider gold as a hedge against renewed US dollar weakness. Finally, I maintain the view that gold will over the next few years outperform US equities and bonds as it has done already since 2000.
Onto broader themes and Faber’s prognosis that we are amidst a significant liquidity contraction as a result of slower debt growth.
Don’t forget, he says, that lending standards are now tightening in earnest for both individuals and for commercial property lending. In turn, tighter lending standards hurt personal consumption and lead to a contracting US trade deficit as a result of lower demand for imported goods and also oil. Moreover, lower imports have negative implications for Asian economic growth rates.
In turn, slower Asian economic growth amidst high inflation depresses the domestic demand in the Asian region, which then leads to reduced demand for commodities.
In addition, a declining trade deficit leads to a decline in the current account deficit and a relative tightening of global liquidity as Foreign Official Dollar Reserve growth slows down. Since FRODOR growth is inversely correlated with the USD and correlates over time with the movement of gold prices, any contraction in FRODOR growth would be USD supportive and negative for commodities and gold
” I have a friend who is an outstanding economist who thinks that the Asian current account surpluses will shrink in 2009 by about 50% from their peak in 2007. In this scenario, global liquidity would become extremely tight and would have a devastating impact on asset markets including real estate, commodities, non-AAA bonds and equities. Such a decline in the Asian current account surpluses would cut the US current account deficit by half and lead to a very strong USD.”
Equities, meanwhile, look shakey — although the US markets less so than the rest of the world. Over the last 18 months, households have been heavy sellers of equities. The support for equities in 2007 came only from LBOs and share repurchases.
Demand from these important sources has now collapsed and will not come back as long as lending standards are not eased considerably and as long as the outlook for the global economy deteriorates.
Outside the US, equity markets look even more vulnerable, he adds. The US economy is in deep trouble but this is now widely known whereas other economies such as Australia, the UK and the eurozone are just starting to deteriorate very badly, most from an even more inflated level. So while housing affordability has improved in the US as a result of the sharp price decline, affordability in Australia is at a record low.
So, predicts Faber, US stocks will continue to outperform foreign equity markets as they have since the start of the year — but that’s not because he thinks US equities will move higher but because they are likely to move down less than foreign markets and also because the USD should continue to strengthen. Central banks around the world will shortly begin to cut interest rates, which supported foreign currencies so far. The NZ dollar, the Australian dollar and the British pound are particularly vulnerable, he adds.
In the US, the most vulnerable sectors are now material and energy related companies and increasingly the last sector that has held up well: technology, including companies such as Apple, Research in Motion, Amazon.com, Google and IBM.
In recent commentaries we have also suggested that Japanese equities were relatively attractive. They have indeed begun to outperform the Hang Seng Index and also other Asian markets and I expect this outperformance to last for some time.
Again, this does not mean the Japanese stocks will move up but that they will move down less than other Asian markets.
In sum, credit growth and global liquidity are contracting, a vicious economic downturn is about to unfold (China could surprise on the downside and put additional pressure on commodity prices) and asset markets are still very high by historical standards and, therefore, remain vulnerable.
In conclusion, advises Faber, use equity rallies as a selling opportunity and further weakness in gold as a buying opportunity for long term holders with significant cash and cash flows. But if his great strategist friend is right and the S&P500 trades down to the 500 level, “you should be careful not to be eaten by bears in all asset market”.