Winds of Change
By Tony Allison, May 13, 2005
“The sense of security more frequently springs from habit than from conviction. The lapse of time during which a given event has not happened is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent.” From Silas Marner by George Eliot.
The Fundamentals Still Apply
The markets seem perversely designed to evoke an emotional response from the largest amount of people. At market extremes, that response is either, “I’ve got to get in now; even the Fed Ex driver is getting rich,” or conversely “Let me outta here now, before my portfolio is sucked down a Black Hole.” At the moment, the latter scenario is sending precious metals investors screaming into the night, looking to avoid further bloodshed.
But before leaping into the dark void, it would be sensible to step back and calmly think about the fundamentals. Central banks around the world are inflating their money supplies. The global monetary base is growing at 20% per year. There is a 1,500 ton net deficit in gold every year. The unprecedented debt and deficit problems that haunt the U.S. dollar took years to reach these levels ($700+ billion current account deficit, $400+ billion budget deficit, and a national debt approaching $8 trillion) and they are accelerating. The money needed to finance these debts must also be borrowed (likely at higher rates), which will just add fuel to the debt storm. The dollar is currently enjoying a nice counter-trend rally, but look ahead. In 18-24 months, the dollar will face the same fundamental headwinds, only they will be howling at hurricane force.
Real Estate Floating on a Sea of Paper
Over the last decade, a sea of paper (Fed “easing”) has floated multiple asset classes ever higher. The Asia Bubble of the late 90’s gave way to the Internet Bubble of 2000 and now we have the Supernova of bubbles, the Real Estate/Credit Bubble. Investors, being human, persist in the belief that things “are different this time.” Encouraged by commentators and analysts, they rationalize that the laws of economics no longer apply. “Real estate is the only way to make real money.” “Real estate pretty much always goes up.” Those are the sounds of the great bubble leaking air, the last death rattle of an historic, credit-driven housing extravaganza.
The FDIC has stated there are 55 metropolitan areas in the United States in the middle of real estate booms, which it defines as places where residential property prices have risen more than 30% in the last three years. This is the largest number of individual real estate booms in the last 30 years, twice the level of the 1980’s. As you might expect, California is home to 21 of those areas, as of the end of 2004.
Jeremy Grantham, well-known institutional money manager, believes that every bubble is symmetrical. If prices rise 100% or 200% over their trend, the bursting bubble sends that asset class back to the trend line. Then it continues below trend, usually by an equal amount. He cites numerous examples, from U.S. stocks in the 20’s, to the Japanese stock market of the 90’s, to commodities and currencies.
As interest rates have begun to rise, the real estate market nears the top of the roller coaster ride. Most real estate investors (i.e. all homeowners) will grudgingly accept a fall back to the trend line. But a continuation below trend will bring shock, dismay and financial ruin to the overleveraged and unprepared. If history holds, the trend line will not just be breeched, but breeched with extreme prejudice.
Grantham also points out that the extreme price of housing is an international event. He notes that in the United Kingdom, house prices are selling for 6 times the buyer’s average earnings, more than three standard deviations above the earnings norm (3.6 times annual earnings).
Cheap Energy — A Bygone Era
The global economy can no longer take energy for granted. Quarter to quarter fluctuations will persist, but in the years ahead, energy will be a more sought-after, and more expensive commodity. According to a recent article in the Christian Science Monitor, the average American consumes 25 barrels of oil per year. In China, the average is roughly 1.3 barrels and India is less than a barrel. For India and China to reach even � of U.S. oil consumption per capita, world output would have to rise by 44%. To reach half of U.S. consumption, world production would need to nearly double. That is not geologically possible. With global production near full capacity, and no major oil discoveries since the 1970’s, accelerating global demand will inevitably hit the wall of limited supply.
China, with 1.4 billion people, is developing on a massive scale, which should last for decades. It will continue to devour enormous amounts of iron ore, copper, oil, natural gas, cement, silver, lead, zinc etc. as its industrial revolution progresses. There will be dramatic ups and downs, but short of a global pandemic, China is never going back to a rural economy.
Dr. Huang Fanzhang is a respected Chinese economist. In a recent interview he noted that there are currently around 10 million cars on the road in China, but in just 15 years there will be as many as 120 million.
Currently one barrel of oil is found in the world for every six consumed. Prices will fluctuate as always, but the days of cheap and abundant oil have come to an end. The rise of global political conflict over energy is on the horizon. The arrival of Peak Oil will accelerate the process of change exponentially.
Buffett was also “Out of Touch” in 1999
Don’t be surprised to see one month’s retail sales number or a favorable trade balance figure blast the dollar higher. Let the media and the hedge funds get excited over the passing news blips. Stay focused on the larger issues, the underlying fundamentals. Warren Buffett was called hopelessly out of touch and old-fashioned in 1998 and 1999. He later looked brilliant in 2000 for steering clear of the technology crash.
Once again, scribes are gloating that Buffet has lost his touch by owning foreign bonds and silver. Both are indeed down this year. But unlike so many, Warren Buffett clearly sees the long-term dollar weakness. He understands the fundamentals, and will patiently wait, as he did in the late 90’s, for the ultimate outcome to unfold. Investors would be well served to ignore the breathless media “experts” whose only master is the news cycle.
The unprecedented credit boom has created a false prosperity. We have yet to experience the hangover of deflating bubbles and accelerating inflation. It seems that the lessons of history are frequently noted, but ultimately ignored.
Sean Corrigan, of Sage Capital Zurich AG, recently made some very apt observations on the subject of commodities and inflation.
“Ultimately we can say only this; there exists nowhere on the face of the planet a constituency in favor of hard money and budgetary restraint. It seems safe to bet, in broad generalized terms, that things, physical, tangible things- things subject to the laws of science and the dictates of economics, will remain in much shorter supply than will the means with which to pay for them.”
Plain and simple, money is losing its value. While the U.S. has flooded the world with its dollars in recent years, other countries are keeping pace, according to noted investment manager Ken Gerbino. His research indicated in the last 12 months, 61 foreign countries increased their basic money supplies by an average of 15.2%. Significant inflation is on the doorstep of the global economy. When this realization hits home, millions of Chinese and Indians will be buying precious metals as a store of value. Both cultures have ancient traditions of owning and trusting gold and silver. Combined, China and India comprise 40% of the world’s population.
Despite the ravaging the markets have dealt the natural resources sector, especially precious metals, those who seek a sensible plan for long term wealth preservation would do well to keep an eye firmly on the fundamentals. The winds of change are building around the globe.
© 2005 Tony Allsion