By James J Puplava CFP, October 29, 2004
History often repeats itself. The characters change. The events are different, but follow similar patterns. It may be a different time and in a different country and involve a different cast of actors on the world stage, but there are similarities. Wars, famines, depressions, booms, and busts are no stranger to historians. They have been repeated over and over again and have been documented by scribes, historians, and authors of the bible. We have had times of peace, followed by times of war. Famine and depression have followed booms and bull markets. What I'm saying here is nothing new to anyone who has ever picked up a history book and studied civilization. Mankind hasn't changed much in thousands of years of recorded history. From events recorded in the bible and hieroglyphics on the walls of the pyramids to the writings of the ancients, human drive, ambition, emotion, fear, greed, evil, avarice, and benevolence are evident for all to see. In the words of wise King Solomon, "What has been will be again, what has been done "
On Wall Street knowledge of history seems to be a dark hole. Either it hasn't been studied or it is simply ignored. How often has it been said that things are different this time around? The "new era" mantra was quickly shattered with the bursting of the tech bubble in 2000-2002. Bubble-like valuations collapsed as the Nasdaq fell from its loft heights of 5,048 to its nadir of 1139 on October 4, 2002. Despite repeated protestations by sell side analysts that the drop in asset prices was only temporary, technology stocks were not impervious to the vicissitudes of the economy. Tech stocks fell like any other industry during a
After three years of falling asset prices, stock prices recovered last year. This year all major indexes have headed south after a brief opening year rally. This brief recovery has been hailed as a new bull market. Is it? Or is last year's recovery simply a technical rebound, a brief respite in the long journey south in a major secular bear market? Time will tell. However, in an era of fiat currencies where central banks can inflate, intervene, and print money at will, we seem to be transitioning from one asset bubble to the next. First, it was the hyperinflationary stock bubble of the 90's. As that bubble burst, another rose to take its place in real estate and mortgages. Central banks cannot control where the money and credit flows within an economy. The first destination of that money seems to be asset markets either in paper or tangibles. Therefore, a more important question for investors going forward is What bubble will be inflated next? What will become "The Next Big Thing" for investors? In my opinion "The Next Big Thing"
Click to view full image (right)
20th Century Stock Market Chart
As the chart of the markets over the last 100 years illustrates, bull markets are constantly trading places. They rotate over time from intangible assets (paper) to tangible assets (things). Behind these alternating bull markets has been the inflationary policies of central banks. Periods of loose money and credit give birth to paper asset booms during their initial stages only to be followed by their inflationary consequences when money rotates out of paper and into things to protect purchasing power. It should be clear to investors at this point that what worked during one twenty-year period did not work in the next twenty-year cycle.
Markets change over time driven by policy and innovation. Investment booms are driven by price gains with money gravitating into the asset class with the highest investment returns. As money moves into a sector that is booming, it gives rise to investment opportunities. The sector expands along with capacity until enough supply has been brought on line and
As more supply is brought on line prices and margins fall reducing investment returns, which eventually ends the boom. While money is attracted to a booming sector that offers high returns, it is withdrawn from sectors offering lower returns.
Jones Semiconductor Index
Internet Technology Index
Financial Services Index
This shift can be seen in the charts above of the semiconductor, telecomm, Internet, and financial sectors over the last 10 years. During the 90's technology boom, money gravitated towards these sectors fueling capital investment and an investment boom. While money was drawn into the sector other sectors were simply ignored. In contrast to the boom in telecomm and technology, the energy and mining sector was virtually ignored.
Jones US Basic Materials Index
Jones US Energy Index
Energy stocks did okay, but their returns were dwarfed by the returns offered in
Very few mining companies expanded capacity or explored for new resources. Instead the industry contracted and consolidated. Who wanted to invest or finance a new mine, a new copper smelter, build a new refinery or nuclear power plant, a new shipping yard or build a new railroad line? As a result of the past investment boom in technology, the natural resource sectors were largely ignored by investors. They have been
However, markets eventually correct themselves. Money flows out of one sector and moves on to another. We are now experiencing higher energy prices due to decades of neglect. We'll need to find more oil and natural gas, build new power plants and refineries, find alternatives sources of energy, develop ways of farming that conserve water and energy, find new means of protecting and expanding water supplies, while exploring for new mineral resources. During this process sectors that previously were deflated or ignored from a capital investment perspective will experience shortages and a rise in prices. This will fuel the next investment boom, which has already begun. The graphs of energy stocks, the CRB index, and gold and silver attest to this fact. "The Next Big Thing" is taking shape. It is reflected not only in the charts of the commodity indexes, but also in the charts of individual resource stocks.
Research Bureau Index
What we are seeing unfold is the eventual convergence of the natural resource sector with the financial sector. Financial assets have been the recent beneficiary of the Fed's inflationary policies in this new century. Money and credit has flown freely, fueling asset booms in real estate and mortgages. This sector is now breaking down, while the energy sector, base metals, gold and silver are breaking out. Once again history is repeating itself and asset markets are trading places.
Financial stress is starting to show up in the financial system as one sector after another begins to breakdown in the market. There have already been three corrections in the broad market this year. Credit spreads are starting to widen again and a flattening yield curve is starting to cut into bank margins. The profit outlook is beginning to deteriorate as one company after another warns or disappoints investors. Higher energy and commodity prices are starting to eat into profit margins with the full effect of rising commodity prices now starting to work their way through the economy and financial system.
I believe the rise in energy prices and Fed rate hikes are acting as powerful headwinds for the economy and the financial markets. If they continue, the U.S. economy could slip back into recession. There is a lot of talk of a soft landing or the Goldilocks economy. The truth is that the Fed can’tdeflate asset bubbles without creating havoc in the process. When have we ever seen a soft landing accompanying a Fed rate hike cycle? There is always financial fallout that accompanies a Fed rate raising cycle even one that is "measured" as this one has been. The last time the Fed tried a soft landing was back in 1999. They raised rates throughout the later half of 1999 and the first half of 2000. The rate hikes burst the technology bubble and led us into a recession. I'm surprised at the amount of complacency on Wall Street that somehow this time will be different. The economy is far more leveraged than it was back in 2000.
It's Just a Game of Chicken
The markets and the economies of the world are on the edge of a precipice. The Fed is playing a game of chicken with the markets by insisting it can proceed with measured interest rate hikes. Its insistence that higher oil prices won't have a major impact on the economy is a clear case of denial. Already the outlook for capital spending is showing signs of rolling over and there are emerging signs of financial stress among consumers. I suspect that this game of chicken will end soon with the Fed reversing or going to a neutral policy after one more rate hike. After that the Fed could just as easily shift back into hyperinflation mode with buckets of money thrown at the economy. When this happens, most of this new money will not go into the economy as expected, but instead it will fuel the next asset mania, which I believe will be in natural resources.
The table below shows sector weightings of the S&P 500 over the last 25 years:
|S & P 500 Sector Weightings by Decade|
The first column, taken from 1980, reflects the weighting of the last bull market in commodities, which ended in 1980 with $40 oil prices, $850 gold and $50 silver. At that time, basic materials and energy made up almost 40% of the S&P 500. Oil stocks and oil services also made up 7 out of the top 10 S&P 500 market cap weighted stocks.
|S& P 500 Ten Biggest Stocks by Decade (Index Weight)|
|Source: Wall StreetJournal, 8/27/99 and Bloomberg|
By the end of the next decade, that percentage had fallen in half by 1990. During the next decade it would fall in half again. During the bull market in paper assets, the sector weighting of technology, healthcare and financial services continued to expand.
Today sector weightings are once again trading places. Basic materials and energy are on the rise. This reflects the new bull market in commodities as reflected in the graph of the CRB commodity index above. While energy and basic materials increase in their size, the weighting of the financial and technology sector are in decline. This reflects a truism of the markets as market leadership changes with time. In the words of King Solomon, there is a time and season for everything.
Something I wrote back in April of 2002 is just as applicable to today. "Once a long-term trend is broken, it is replaced by another trend". At such milestones in financial history, the rules of the investment game are altered; but alas, the vast majority of investors continue to play by the old rules and therefore either lose money or miss out on the substantial capital gains which the new opportunity or leadership brings about, "I suppose that one reason the road to ruin is broad, is to accommodate the great amount of travel in that direction" The key to successful investing is to understand that, with nearly 100% certainty, the bursting of a bubble leads to a permanent change in leadership."
Being schooled in value investing and viewing the markets from a contrarian perspective, it is far better to invest in a sector that has been beaten down and ignored by investors than to chase a fading mirage or "The Last Big Thing." Commodities remain in short supply and are vastly undervalued. In summary, go long basic materials, precious metals and energy and go short financials and technology.
Trading Investment Styles
One of the big mistakes made in investing is that investors tend to overpay for growth and underpay for dividends. In the short-term, this may occasionally work. As Ben Graham was often fond of saying, "In the short term, the market is a voting machine, but in the long term, it is a weighing machine." An investor may make a lucky trade, but very few traders are successful over longer periods of time. In the pantheon of great investors, you'll find it dominated by value investors. Historically, growth stocks have outperformed value stocks by an average of one and a half percentage points per year. However, value stocks yield more than three full percentage points in yield over growth stocks. Combining dividends with capital appreciation, which gives total return value, stocks are the clear winners.
As the chart of the Long-Term Effect of Dividends illustrates, on a total return basis, dividends play a more important role in generating superior investment returns.
The reason is the compounding of investment returns. The next chart shows this holds true across a broad spectrum of global investment markets. In the U.S. investment markets dividends have accounted for 65% of equity returns.
When you hear advisors or financial experts refer to 10 percent returns in investment markets, 65% of that return came from dividends.
The role of dividends in generating returns for investors will become even more important in the decade ahead. Historically, high returns in markets are followed by periods of low returns. With capital appreciation providing less of an investor's return, the ascendancy of dividend investing takes on greater importance in generating investment results. Dividends can not only anchor a portfolio during a financial storm, they can also cushion a portfolio from high rates of volatility. High dividend stocks tend to hold up better during market downturns.
|Dividend Yield by Index|
At a time that the dividend yield offered on the major indexes remains miniscule, an investor would be wise to concentrate his search in forgotten or neglected sectors. Here again there is good news for investors. The highest dividend yields today are offered by defensive sectors such as utilities, energy, food, and natural resources.
I believe that most investors would be surprised to find out that the total return from utilities has exceeded the returns from the technology sector on a total return basis. This also holds true for the energy sector. Given the new bull market in commodities that is unfolding, the herd has yet to pick up on this fact. Natural resource stocks not only outperformed technology and other sectors of the market, but they also provided investors with higher dividend yields that are growing.
In summary, the investment markets are trading places. Former dominant sectors such as financials and technology are descending in value, while natural resources are ascending in importance. Dividends are also beginning to play a more important role in determining overall investor return. Furthermore, the best dividend values can be found overseas, especially in places like Europe and Asia. In addition natural resource stocks offer investors the best chance for total returns both in higher dividend yields and the potential for capital appreciation. I end with a quote from Horace that is meaningful to value investors.
"Many shall be restored that now are fallen and many shall fall that now are in honor."
The Dow Industrials gained 22.93 points to close at 10,027.47. For the week the Dow gained 2.8%. The S&P 500 added 2.76 points on Friday finishing the day at 1130.20. The S&P 500 gained 3.1% for the week. The Nasdaq lost 0.75 points closing out the season at 1974.99. For the week the Nasdaq advanced 3.1%.
© 2004 James Puplava