Financial Sense Newshour
The BIG Picture Transcription
September 9, 2006
- Apocalypse Now
- Seasonal Fears
- FSN Follies: "Wall Street Downs"
- Emails & Q-Calls
- Other Voices: Brian Pretti, ContraryInvestor.com
- It Really Is Different This Time
- The Commodity Boom Is Not Over
JOHN: �Yeah, but I don’t want to be here. It was really hard to take a vacation, because as you looked around there was the Middle East war, terrorism, the price of oil; Lopez Obrador says he’s going to make Mexico ungovernable because he doesn’t like the fact that Calderon was picked by the commission down there as the new President of Mexico; looming recession. I mean why do we even bother to crawl back here, Jim?
JIM: You know it was amazing, I spent a lot of time at the beach, sailing�well, first of all, I’d get up each morning and I’d turn on the news channels and I’d say, “ugghh! Turn that off.” And I’d come back at the end of the day, download some stuff for reading on the internet, and you’re right, John, if you take a look at it, terrorism � they caught a terrorist plot they were going to blow up 10 planes; the price of oil is skyrocketing; hurricanes coming in. All kinds of talk about apocalypse now for the housing market; financial stresses increasing with credit spreads; possible recession.
But you know what? On the other hand, one night I went to the mall, our favorite mall on a Monday night. Let’s face it, Monday night and you wouldn’t expect most people to be shopping but it was actually quite busy. I had to stand in line at one of the restaurants. I talked to some of the shopkeepers � Brooks Brothers has had the best Summer they’ve ever had; talked to a couple of other guys at the Bowes [ph.]store. Just making the rounds.
And on the other hand as I was going for my walks on the beach I passed the park right on the beach, it was absolutely packed with motor homes. In fact, this year when we had our employee party, one of the guys that works for me usually gets a spot � he has one of those weekend warriors � and he could only get a spot on the front part of the beach for 3 days. I mean they had full crowds.
So, yes, if you pay attention to the headlines, but look folks, when housing prices go up, or when stock prices go up, they don’t go up permanently; you are going to see a pull-back. So, yeah, there was a lot to worry about, probably you could keep a bottle of Maalox nearby, but I’m not convinced yet it is as bad as everybody is making it out to be. [2:27]
JOHN: Well, your philosophy is anyway, regardless of whether things are going up or down, as long as you understand what’s happening, and you’re ahead of the herd you can make money, you can make some wise choices.
JIM: It really surprised me � one of the newsletters I get is Marc Faber’s Gloom, Boom, and Doom Report, and he did something in the current issue that really kind of struck home with me. And if anybody knows Peter Bernstein, author of Against the Odds, and a book on gold, a very well respected analyst on Wall Street, and he wrote as Marc Faber is quoting him, I’m going to read this, he said:
The prophets of doom and gloom are increasingly prolific and apocalyptic. As we admitted in our June 1st issue this publication has contributed its own fair share to this process, but the dark voices we hear are always the same dark voices and the sheer volume and the lack of variety of argument has begun to dilute their impact on us. The sound of impending disaster is now so deafening in fact that we have been seeking for any rays of sunshine we could spot if only to relieve the monotony, and perhaps to find something substantive that might counter the deep pessimism flooding our mailbox.
And he goes on:
The stock market now may be less overvalued.
So I guess there’s a lot of things that you can look at today, and say, “oh, wow, I should worry about it.” Let’s face it, there’s a lot to fret over. But there’re also some good things that are happening. [4:00]
JOHN: Yes, try to convince me here, what would you see as being positive, and what keeps the whole thing from falling down and becoming what? Apocalypse Now, or something?
JIM: Well, first off, I think that the sentiment in the market and the focus in the markets is going to change from the current worries over inflation, to worries over economic growth. As that happens, at least by year end, or certainly next Spring, markets will be focused on interest rate cuts versus where they’ve been focused over the last couple of years. I mean it’s been this grinding process of every single time the Fed met, they raised interest rates 17 times. So that’s what the market’s been almost consumed by. So in fact the Fed just did another coupon pass, so they’re injecting liquidity into the financial system. And whenever you do that, that liquidity is going to go somewhere. It’s going to leak out, just as Marc Faber likes to talk about � picture this bowl that has water in it, and the Fed keeps pouring water into the bowl. Well, eventually the bowl fills up and the water spills over, it spills over somewhere. So I guess the key question is going to find out where that liquidity is going to go.
I also believe that money printing will be operating at full speed, as just witnessed by the series of coupon passes that the Fed has been doing as the year progresses. The money printing in my opinion will enable policy makers, especially the Administration worried about election, and also the 2000 Presidential election itself to keep printing money to keep this party going longer than would be possible under let’s say the good old days of the gold standard. But more importantly, politicians are good at debasing their currency and that’s been the pattern throughout all of history. [5:53]
JOHN: Jim, before you go on, you mentioned a couple of times the term coupon pass. You probably better explain that for some people.
JIM: Well, a coupon pass is the purchase by the Fed of Treasury notes, or bonds by the Fed from dealers. And the coupon refers to the coupons that distinguish Treasury notes and bonds from Treasury bills. Coupon and bill passes are two of the tools that the Fed uses at its disposal in Open Market operations. It’s trying to inject money into the system, and the way it does that is they buy the notes from the dealers, the dealers now have cash, so it’s one of the ways the Fed makes the system liquid. [6:31]
JOHN: Well, let’s go to the Maalox moment du jour and talk about blow-off in the real estate market.
JIM: Well, first of all we’re not done yet. In other words, real estate is a little bit different than the stock market. In the stock market you can see corrections of 10-15%, and they can happen very quickly � just look at what happened to gold this week where you get a nice 5-7% pull-back in a series of just two days. Real estate is different, because let’s face it, people live in their homes. Just because you’re worried, you’re not going to go say, “Ok, everybody sell their home at once.” In the first place that would be difficult, and the other thing is can you get buyers to do that. And when I mentioned that I think we have further to go, I do believe that you’re probably not going to see the bottom of the real estate market probably till the end of somewhere between the end of 2007 and maybe possibly the beginning of 2008. [7:28]
JOHN: How far does this thing go?
JIM: Well, let’s look historically. If you take a look at, for example recessions, booms and busts in housing are nothing new, just like booms and busts, or bull or bear markets. If we take a look at actually the 70s and 80s, housing prices or housing sales would decline an average of about 4 years, and you would see a 53% decline in existing home sales, and a 58% decline of new home sales.
If we go more recently to the housing bust in the late 80s and 90s, that bust lasted about 5 years. And you can think of the S&L crisis that began in the late 80s (89-90), going all the way to about 94, and there the decline in sales of new and existing homes were only about 30-46%, so certainly less.
Some of the worst times for housing have actually been in the 60s; there was a period definitely in the 70s. So far what we’ve seen is a decline in new home sales, or existing home sales of about 9% in the past year, and a drop of about 16% for new home sales.
So I guess what I’m saying here is that the decline in housing has further to go, it’s not done. It rolls over it takes a longer period of time to rise, it takes a longer period of time to decline. So, as I mentioned, a chief reason for that is we occupy our homes. And a lot of the extent of this is going to depend on the job market, obviously if maybe you’re a commission oriented person for your living, maybe sales slip, you have less income, you may be on the marginal end of the housing market over-extended so you start selling. So the key to this is going to be the job market, and that’s something to pay close attention to.
My son did an article this week in Market Wrap where he talks about all of these indicators, the job market, its relationship to the housing market, how this unfolds. It’s a very well done article and will give you some sort of insight, and I’d recommend people take a look at that. [9:38]
JOHN: Ok, at this point, what I’m reading is that you’re expecting housing to decline, but it’s not really going to dump down into a disaster. Are we going to see another up tick, or what?
JIM: No, I think you’re going to see it continue to decline throughout the remainder of this year. You’ll be hearing reports, I mean just look at what the homebuilders have just been reporting, those that are public companies: inventories are building. And this really gets down to what I call an inventory situation. You’re a homebuilder, maybe you have 50 foundations that you have poured, you are putting up these homes � you are going to complete those homes. What you’re probably not going to do is hold off on extending or opening up new phases in a development, especially when you have building inventories. So they’re going to finish out the projects that they have under construction, and then what they’re going to do is go into liquidation mode.
And if I can give you an example. Let’s say, John, that you’re Best Buys or you’re a retailer, and you’re looking in your warehouse, and the guys in the warehouse are telling you the warehouse is full, the guys on the sales floor are telling you buyers aren’t buying. So what you’re going to do, you’re going to start doing incentives, you’re going to start marking things down, you’re going to put things on sale. We’re certainly seeing that with builders today: you’ve got people offering free cars; you’ve got people offering all kinds of upgrades which used to be a great markup item for a lot of these builders now they’re throwing them in just to get rid of existing inventory, that way they don’t have to just immediately lower prices which they’re reluctant to do. So in effect, they are lowering prices, but what they’re doing is they’re keeping the prices the same, and what they’re doing is throwing in all kinds of goodies. And I expect that to continue.
So what we’ve got is a liquidation mode here, and that liquidation mode is these guys want to complete existing projects which will add to inventory, as well as start liquidating existing inventory. In our neighborhood, as I left to go on vacation we had one home for sale that home has been on the market since probably around March when I came back, driving through the neighborhood, there are now an additional 4 new housing signs for sale. That’s just come up in the last month. You’re going to see more of that take place, but we’re going to be going into the liquidation mode.
And at some point, depending on what happens to interest rates, you may have buyers coming into the market depending on the unemployment rate in the job markets. So somebody that might have been saying to themselves, “gosh, it’s 600,000, and at 7% interest rates I can’t afford to buy the house I was looking to buy.” But if housing prices drop down, and the existing home market is going to drive what eventually will happen to the new home market, eventually you get to a point where maybe at 450 and 6% interest rates, all of a sudden the buyer that couldn’t afford to buy the home at 600, maybe stepping up to the plate at 450 and 6% interest rate. [12:46]
JOHN: So, not Armageddon, or apocalypse now?
JIM: No, I don’t think so. Further weakness that can continue for the remainder of this year, continue for all of next year. And next year I expect we’re going to be in a huge liquidity injection mode and interest rate cuts by the Fed. However, I don’t think the Fed has the same leeway this time around, which we’ll be covering in another topic in this segment, but certainly lower interest rates and that’s going to help mitigate, kind of put a floor in terms of how this goes, but we’ve got further to go. But I don’t think it’s going to be apocalyptic. [13:23]
JOHN: Let’s assume that for the present you’re sanguine, things are going on a predictable path. What would have to change out there to make you less sanguine � in other words, chewing your nails more?
JIM: One would definitely be for the headline inflation numbers to continue longer than expected, the Fed continues to raise interest rates. I think it would almost be suicidal if they were to do that. I think you’re going to see the headline numbers and inflation soften just simply by the way we measure them, so if we have some statistical gimmickry that’ll make them sound less. Also, there are inventory gluts that are being built in Asia, and that means they’re going to be slashing prices to move that inventory. That’s what you do, when you have inventory building you start slashing it.
And because we mislabel what causes inflation, in other words, the real cause of inflation is monetary policy, or an increase in liquidity in the money supply, we tend to measure inflation in terms of prices � “ah, rising prices, that’s inflation.” We judge it by its symptoms. So if you’re looking at just certain prices you could see manufacturing prices come down especially as inventories are built up in Asia. As they offload those inventories they’re going to be discounting � you’re certainly seeing it in plasma screens, electronics, look for those prices to go down. And the way they get measured into the CPI so the headline inflation numbers could come down.
But I guess a worry would be they don’t come down, the Fed raises interest rates; I think another matter would be concerned is a complete change in Washington come November, and a new Congress comes in and starts enacting tax increases at a time the economy is weakening. I think that would be a terrible thing to do, and that would make it so a political change, and then of course you know we have the standard wildcards, do we go to war. [15:23]
Woman: “I don’t know I’m not too optimistic. I mean, you know, September is usually a blah month.”
JOHN: Well, there you have it, Jim, just like it is off the Grand Banks off the coast of New England, especially September, October sailors don’t like to be out there because the weather is particularly bad. Obviously what the whole Perfect Storm was built around � the movie � and the concept of that, and people were saying that about the stock market. So what do you think?
JIM: Well, if you look back historically, equity returns in September and October have quite honestly been grim in the past 20 years, and particularly in the go-go period of the second half of the 90s. September-October, you’d see the market get nicked quite a bit. In fact, stock returns were negative nearly 50% of the time, and that number increases significantly when we get into the late 90s, the majority of the time over 60% of the time, and certainly as we have entered into this new century and this new decade the same thing has happened.
The majority of the time you’re going to see a negative September and October. And there are a number of reasons we’ll be talking about. But let’s face it analysts are downgrading companies because if you didn’t make your earnings in the first two quarters of the year, by the time you get to September, third quarter, you’re not going to make your earnings � so you’re going to have downgrades. It’s also a time of the year when mutual fund companies are saying, “Ok, let’s clean up the portfolio for the year end run, maybe we’ll take some profits in some of our winners, we’ll also perhaps dump some of the stocks we’re going to need to takes some tax losses” � some of the kind of ugly stuff you don’t want to see in the portfolio when you send that nice report out to shareholders at the end of the year. So traditionally this period of time is pretty rocky, you’ve got the big guys on wall street coming back from Summer vacation, and they’re saying, “Ok, strategically these are going to be our moves,” so you’ve got a lot of asset reallocation that may be going on, and there’s a lot of this that takes place during this period of time and that results in that. [17:50]
JOHN: If we look at this whole thing historically, say the 80s and 90s, we’ve always been up, let’s go to 2003-2005, maybe things are looking a little rough in September-October, but from the end of October to December things have always popped up and looked good � that’s been a consistent record.
JIM: Well, you know, just as I was mentioning for the last couple of decades over 50% of the time we’ve been negative in the September-October period � in the late 90s over 60% of the time. But also, on the positive side, after each period of negative returns in that September-October timeframe, returns in the traditionally strong months of the year for the stock market � November-January period � have only gone on to register further gains. And there’s only been a few periods where we’ve actually had negative returns � in fact, four in the last two decades. And two of these four periods occurred during an economic recession. Also, the other two phases were occurring during a time we had rising treasury yields as equity prices fell during that September-October period � in other words, the bond market relief valve was closed. In all of the remaining periods with the exception of the 87 stock market crash in October of 87, the November-January returns have surpassed losses during that September-October timeframe. [19:16]
JOHN: Well, Jim, let me throw some negative water on this whole thing. Everybody seems to know that the economy is slowing down and there would seem to be a correlation to that with lower earnings, at least that’s what people would be saying.
JIM: Well, absolutely. I think earnings have peaked, but the countervailing forces that I would put out there is on the one hand as you mentioned, John, earnings expectations are likely to be revised down in response to weaker economic activity. That just follows when people pull back, stores sell less, there’s less profits out there.
On the other hand another important factor is lower bond yields provide support for stocks. And valuations, as I see them, are stocks cheap? No, you aren’t seeing stocks paying �although we’re finding them �dividend yields of 5 or 6%. You’re not seeing outside the energy area, very few areas where you’re going to find stocks selling at 6, 7, 8 times cash flow or times earnings. But it is not looney bins times, John. You compare valuations today to where they were in the year 2000, I mean things were nutso back then. Gosh, I can’t think of anything that was cheap other than perhaps energy and natural resources and gold which we were buying aplenty. But there are pockets, there are values, and especially the large cap growth stocks which we’ve been pounding the pavements, and which are now coming into a leadership role in the market.
And the other thing that softens the decline in earnings is as interest rates come down the PE multiples can rise. Now, am I saying that we’re going back to the crazy period that we saw in let’s say, from 95 to 2000? No, but what I think you are going to see is anybody that’s employed as a money manager, or if you’re a hedge fund manager, you’re not going to go 100% to cash, and you’re not going to send a letter to your shareholders, “well, you know we think the economy is weakening and earnings have peaked so we’re going to be in cash for the next two years. Oh, by the way, leave your money with us, and we’ll collect our fees, and we’re going to do nothing.” That’s not going to happen.
What you are going to see is rotation in the market. It’s been taking place just as we’ve forecast, it’s moving right in to the defensive issues. You’re seeing it in soft drinks, you’re seeing it in healthcare, you’re seeing it in consumer staples. So what you have to do is take a look at what is cheap, what is less susceptible to an economic downturn, what is paying a good dividend. And I think you’re going to see lowering interest rates with bond yields getting back down, that that’s going to take some of the pressure of the stock market because remember what has everybody been worried about? They’ve been worried about the Fed raising interest rates, and we’ve lived through that for two years. Watch how this sentiment changes as we get into the October-November period. The things people worry about are not going to be about the Fed raising interest rates, they’re going to be worrying about a slowing economy, they’re going to be worrying about companies that are subject to an economic downturn.
But by the same token you’re going to say, “Ok, where’s the safe place to be.” If so-and-so companies � let’s say cyclical type companies - aren’t going to grow as fast what area is in great demand now? Energy services are going to be in great demand; I think consumer staples; food is in great demand; commodities are going to soften but I don’t think you’re going to see a softening in gold; I don’t think you’re going to see a softening in energy. Maybe energy prices get down to $65 a barrel, but you can’t think about the United States anymore. You have to think globally today. You’ve got to think about other economies � in India and Asia.
And the other thing I would add is that corporations are flush with cash right now, and when you’ve got a lot of money, and you’re saying, “do I sit and build a new plant? No, but maybe my stock price is cheap, I start retiring stock.” In fact, we’ve just read a report and it’s something that we’ve been monitoring rather closely, insider selling is starting to diminish, increased share buybacks are coming in. So you have to look at companies that are buying back their stock, companies that are reasonably attractive, companies that are less susceptible to an economic downturn, companies that are paying good dividends, have a likelihood of increasing those dividends over time � and these are the kind of things that you can do.
And so, John, outside of an event that neither you and I expect right now, a wildcard that nobody sees on the horizon, I do not see apocalypse now. I just don’t see it right now. There is so much negativity that I would say that for every positive thing that I read, there are probably four negative things that I read. And the negative things I read are the same arguments for this negativity that have been given over the last 3 or 4 years. [24:33]
JOHN: I might say you’re not crying tonight, it’s not a 3 bottle night�
JIM: Yes, I mean, could this turn for the worse? Sure. How do you predict a 9/11, or how do you predict a Long Term Capital Management? But I do have faith in politicians to constantly inflate, central banks to constantly inflate. As I mentioned, they did another coupon pass this week and what you’ve got to think is where is that money going to start going? And that money is going to go somewhere. It’s not just going to sit in a bank account; it’s not just going to sit in a money market account. It’s going to go to some sector. So what you’ve got to really focus on is get a handle on sector rotation, follow the money. [25:22]
FSN Follies: "Wall Street Downs"
Good Afternoon, Ladies and Gentlemen, welcome to the fourth race at Wall Street Downs, brought to you by Prozac where your mental outlook can always be bullish; and by Maalox, “for an investor, it’s more than a Maalox moment, it’s a way of life.” Now in new mint julep flavor.
[sound of trumpets]
Well, it is a beautiful sunny day here at the Downs, the horses are moving towards the gate, and they are Lots of Bucks, Clinical Depression, Stagflation, Smart Investor, Greedy Oil Companies, Bernanke’s Core, Economic Growth, Will He Raise It, and Rising Prices. And it looks like most of the horses�Whoops! Aha, they’re having trouble keeping Economic Growth contained in that gate. it’s hard to slow that horse down, he just wants to run.
And they’re off in the fourth race here at Wall Street Downs, and Economic Growth broke right on top down the center. Lots of Bucks, and Smart Investor broke extremely well, and Rising Prices up on the inside. And they’re joined by Greedy Oil Companies, and Bernanke’s Core on the far outside. Three wide comes with Stagflation, Clinical Depression and Will He Raise It off the early pace.
Now, they pass the stands for the first time. Economic Growth has a neck out in front, Rising Prices moving up on the outside, and then it’s Greedy Oil Companies racing third. Smart Investor and Lots of Bucks being squeezed out of the leading pack. Stagflation moves up on the outside, and Bernanke’s Core followed by Will He Raise It on the far outside. Economic Growth on the inside is caught, tight course, oh, that horse is being jousted by Rising Prices and Greedy Oil Companies.
Look! Bernanke’s Core’s exceeding expectations, he’s hot on the heels of Rising Prices, he’s leading the pack. Will He Raise It is one length back in third place, backed by long shot Stagflation in fourth. Greedy Oil Companies, Economic Growth are back by two lengths with Lots of Bucks, Smart Investor, and Clinical Depression bringing up the rear.
And they’re coming into the final lap now with Rising Prices ahead by a nose. Economic Growth starting to roll now, trying moving up on the outside. Oh, no! Stagflation’s got economic growth up against the rail. Economic Growth stumbles, he’s fallen back. Bernanke’s Core’s at the top of the lane, Rising Prices ahead by a neck, Will He Raise It by a neck is starting to make his move on the far outside.
And here he comes, as they make their turn for home. Smart Investor shut down by Clinical Depression. Lots of Bucks in the back of the pack. Bernanke’s Core’s got a head in front. Rising Prices full bore on the inside. Greedy Oil Companies on the far outside. Bernanke’s Core looking upside the race, as Bernanke’s Core at 12 to 1 wins by a length and three-quarters over Rising Prices in second, followed by Will He Raise It, and Clinical Depression in fourth.
Well, there Ladies and Gentlemen you have it. Bernanke’s Core wins the fourth race here today at the Wall Street Downs. Brought to you, don’t forget, by Maalox: “for an investor, it’s more than a Maalox moment, it’s a way of life.” [27:59]
Emails & Q-Calls
JOHN: Well, Jim, it’s time to take a look at what’s coming in on the Q-Line. I should remind everybody you’re listening to the Financial Sense Newshour at www.financialsense.com. And our programs are posted every Saturday morning at 0700 hours Greenwich Time � that works out to about 3AM on the East coast. Time to look at our Q-Line now. The Q-Line is open 24 hours a day, you can call it toll free from the US and Canada, 1-800 794-6480. Please keep your questions brief, tell us your first name, where you’re from, and what the question is. The line does work everywhere in the world, it’s only toll free from the US and Canada. That’s 1-800 794-6480. If you’re calling internationally, remember to drop the �1’.
Alright, off to the first Q-Line question.
Hi Jim, this is Hayward from North Carolina, and I’m just a little curious about when you refer to the Fed’s printing money, or flooding the system with liquidity, exactly what that means. In other words, are they literally printing money off printing presses, and then putting them on trucks and shipping them to banks and things like that? Or is it just a figurative sense in that they have loosened the restraints on borrowing, and that’s what’s flooding the system with liquidity? Or maybe some kind of combination of both of those? I’m still not exactly sure when the Fed prints money where does the money then go. Does it go to banks, or lending institutions, or in the physical sense, where exactly do those sheets of money go. Thank you very much. [29:46]
JIM: Well, Hayward, the Fed has a number of tools available to get money into the system. One is through its Open Market operations, and I talked about a coupon pass. Let’s say that a bank is sitting on an inventory of government bonds. The way the fractional reserve system works as deposits or cash increase the more that you can lend. So what happens is the Fed goes in and buys those bonds from banks, or the Fed will buy it from government dealers. Now they have cash. And I refer you back to the first part of this show where I talk about the coupon pass.
Another way they can create liquidity or print money � they actually don’t print money per se, we do everything electronically � they could start monetizing debt which they still do on a consistent basis. So let’s say the government runs short of cash, the government issues a bond, and the Fed just simply credits electronically the money to the government’s bank account which will be held at some bank somewhere. So they’re not actually printing money, but what they’re doing is electronically creating money for the government in its bank account, or creating money through the banking system by putting cash electronically into the banking system by buying those bonds from government dealers and banks, and in exchange crediting them with cash. [31:13]
Hello, I am David from Napa, CA, my question is there any way to compare the present rate of excess printing of money that our government is doing and also the excess amount of credit from all types of finance going on? Can we compare this in any way to any other time in previous eras, such as maybe German inflation? Is it possible to make some kind of comparison to see maybe have an idea where we are along this road of financial excess we’re on? Thank you.
Well, David, we can’t compare the rate of money printing. The last time that we had reasonable figures before the Fed stopped reporting like for example M3 figures � the money printing rate or M3 was growing at close to 9 or 10%. But there are other ways that money is being created today, not just through the Fed but also through the securities system. For example, a bank may lend money on a mortgage and lets say they lent money to 100 home owners to buy a home. Now the bank is sitting on mortgages. What banks typically do now is take those mortgages, package them up into some kind of mortgage security, and then sell it to investors. And once they sell it to investors, now they have that same money back and they can relend again. So it’s not just the Fed that’s creating money, it’s also the credit system. And we’re at a high level right now, but we’re not at the levels that we saw in hyperinflationary periods in Germany where they printed so much money that it became worthless at the same time that they printed it. We’re a long ways from that, but we’re certainly printing enough of this stuff and creating it that we’re high single digits, and if you look at globally like in China and other areas of the world they’re in double digits in terms of how fast they’re increasing the supply of money. But we’re nowhere near what we saw in the inflationary era of Germany in the 20s, or let’s say in Argentina, so we’ve got a long way to go. I think we’re going to get there as we get into the next decade, but we’re several years off from that. [33:29]
[Child’s voice - garbled]
JIM: John, interpretation?
JOHN: Well, I understood that, didn’t you? If you want to know exactly how much the M3 money supply which doesn’t exist anymore is going to go up in the next year.
JIM: Oh, Ok. Thanks. We’ll call that one baby talk. Not sure I clearly understood that one.
JOHN: And having heard from a number of callers there, it’s time to go to Other Voices. And this week we’re hearing from Brian Pretti. [34:01]
Other Voices: Brian Pretti, ContraryInvestor.com
JIM: Well, it’s that time of the year, September and October, you’ve all heard the saying, go away in May, come back in the Fall, and you do much better in the market. Joining me on the program on Other Voices this week is Brian Pretti, one of my favorite newsletter writers at Contrary Investor.
You know, Brian, during the month of August I was sort of on a working vacation, and the stuff that I was downloading each day. I mean there was a moment at one time I thought, you know what, the world is coming to an end, I just want to find a bunker and hide. But maybe this is just a seasonal factor � let’s talk about where the markets are going.
BRIAN: You bet, Jim. And first, I very much appreciate your and your listeners’ time today. Always an interesting time when we hit this part of the year, and maybe now more so than in prior years. First, as you know Jim, I think every morning I flipped on CNBC and very rarely do I have the volume turned up, but just recently I have. A lot of talk in the early couple of days about how terrible Septembers usually are etc. So many of these things seem to get overplayed in the media more than not. I guess there’s an old saying, does the market ever really know what month it is or what day it is � I’m not so sure.
But here we are, the media is what it is, investors memories are what they are in terms of carrying that � if you will � historical baggage about what Septembers have been, what fourth quarters have been etc. And I guess as we sit here today we’re facing maybe a multiplicity of little cycle dynamics that may or may not play out as we move ahead. First, and there’s been a lot of ranting and raving about this is the proverbial four year cycle which is set to bottom, maybe between September and October, November of this year. I guess one question I always have is bottom from what? There really hasn’t been much of a downturn point to point as you look at the markets this year.
The second part of the cycle is the seasonality � the calendar seasonality. We’re coming to the end of the quote-unquote bad period, you know if you will � the sell in May, and go away period. Because as we get through the middle part of October into early November that again starts the proverbial good part of the year.
And then lastly and again we’ll see how this plays out we have the presidential cycle. Again, whether history comes true or not remains to be seen, but it just so happens that if you had looked at a chart of the average of presidential cycles, historical performance of the Dow Jones over the last 50 years, the markets usually bottom somewhere around the late Summer, early Fall, of the second year. And then quite literally � and again this is just history speaking, it has no bearing on what really, really happens ahead, it’s just giving us some hints, some soft messages if you will � we go into one of the greatest price acceleration periods of the entire 4 year cycle � the Presidential cycle � for equities. And between � call it near the end of that second year, and the middle part of the third year on average � and again this is just historical average � the Dow Jones Industrial Average has gone up almost 25% over that period of time.
I think potentially you would agree with me especially after doing all that wonderful reading while on vacation, Jim, during August about doom and gloom, that indeed it would probably be very easy for us to give your listeners about a million and one reasons why that should not be happening � whether it’s housing, whether it’s a deceleration in consumer spending related to housing that will ultimately have the economy slow down. The fundamentals don’t sound too good. They don’t, but maybe now more than not, maybe I’m speaking to myself more than anyone else, it always pays in this business to be very, very flexible and try not to impose our own opinions on where the market should or shouldn’t be going, but rather let the market show us where it intends to go. And vis a vis risk management in investment management over time, I think those are very, very important things to remember because � I know you feel this way and I sure do � I have some very strong opinions on what I think is happening, but in the bigger picture my opinions per se don’t matter.
So we’re moving into that period of the year where historically investors remember bad September, and then all of a sudden the bright lights come on. And in a recent tiny little study we did, this is very simplistic stuff, we looked back at the October 15th through the end of the year period for the S&P, the NASDAQ, the Russell 2000 from the year 2000 to the year 2005. So we have some pretty bad years and a few really good up years too. And it just so happens, for instance last year as an example between October 15th and the end of the year, the S&P 500 actually gained more than its entire year to date gain; In 2004 it was almost the same number.
So, again, history is just telling us whether we like it or not that this October 15th � mid-October period to the end of the year � has historically been very, very strong. Part of it clearly in today’s world without sounding conspiratorial is the fact that there’s so much institutional money out there these days that as you head into the end of the year � whether it’s hedge money, whether it’s mutual fund money, whether it’s proprietary trading desk money at the large brokerage firms. Let’s be honest with each other there’s a big vested interest to end the year on a positive note, not only for perception’s sake but also for the sake quote-unquote investment management fees and bonuses and all those other little wonderful things. And the last maybe portion of the rationale here would be that tax loss selling for the mutual funds, some of the large institutions, they are literally booked by the middle of October. You know, a lot of cap gains, numbers are really determined by the end of October in the large institutional mutual funds. So a lot of selling pressure sort of comes off during that period as a result of seasonality.
So we add all these factors up, we look ahead, fundamentals on one side of the plate, market being what it is on the other side of the plate, it’s time to just be very, very flexible and open to any outcomes, and not trying if you will to impose our own will and our own thoughts on where the market should go over what is literally a 10 week space of time. [40:46]
JIM: You know, Brian, one thing that kind of struck me and I wonder if there are some answers about this, you talked about for example the seasonalities that come into play with mutual fund managers: “Ok, if we want to take profits, we’ll take profits here. We have some stuff we don’t want on our balance sheet at the end of the year to our shareholders � these are our dogs, we’re going to dump them.”
And I also wonder if some of it comes into play with Wall Street itself for example I’m a Wall Street analyst, I’m saying that xyz company is going to earn a dollar a share this year, so let’s say it’s 25 cents a quarter, the news in the first and second quarter becomes in below expectations. All of a sudden now we’re getting into the third quarter and the company’s making rumbling that maybe things aren’t going [well]. You also see a lot of downgrades, if a lot of the economic forecasts aren’t coming true or the financial forecasts, do you think some of this comes into play around this time of year?
BRIAN: Jim, I think it does, maybe in today’s wonderful world of instantaneous news releases and instantaneous news reactions maybe that’s every quarter these days. But I think that’s very, very true. You know one of the things that we may have to live through here, Jim, over the next call it 4 weeks is that we’re going to have a plethora of earnings announcements coming. As you saw, even with this week, with the home builders reporting what were basically disastrous results. We haven’t seen these stocks crater, you know, and again, maybe more of that’s to come but it’s showing us that maybe some of that bad news that had been impacting the markets over the Summer time etc, maybe a lot of that has flowed through. I mean let’s be honest with each other, who doesn’t know at this point that the homebuilders are having a very, very tough time? You’ve probably gone on vacation during August, right? Far on vacation, somewhere where there’s no news. So you know, again, who hasn’t sold who wanted to sell by this time. And I think you get a lot of that in there, Jim.
I will admit, there is one factor that may play a little bit of havoc as we move into the 3rd quarter here with earnings and that is �it’s not just in the tech sector by any means but it’s literally across the board and we saw it in the 2Q GDP numbers � inventories have been building. So I think there is a little bit more capacity in the system and again, this is a near term comment with very little meaning for the next x years, but maybe more meaning for the next x weeks. As we get into this 3rd quarter earnings announcement period �just to me � you’re going to see some heaviness inventory-wise with the techs and maybe some of the broader sectors that are here too. You look at the retailers that recently again have not been spreading sunshine on the Street, it’s probably going to be that they’re going to have to deal with some of these inventory issues too.
So, do we have maybe this little mini valley to run through here over the next x weeks before we hit this quote-unquote strong calendar seasonal period? I think the answer to that is yes, but again remaining open and flexible. We already know housing is not in good shape, we already know that high end retail is starting to soften. The market knows this, so again, it’s really that matter of who hasn’t gotten out of a lot of these stocks up to this point. And clearly, again with the mutual funds doing what they’re going to need to do for tax reconciliation before the end of October, again I think we’re seeing a lot of them have already done the evil deed of selling. Who’s left to sell? That’s a big issue as we move into these latter 16 weeks of the year. [44:22]
JIM: Even Marc Faber in his recent newsletter quotes his friend Peter Bernstein, and I’m just going to quote this, he goes:
Bernstein writes: the prophets of doom and gloom are increasingly prolific and apocalyptic. As we admitted in our June 1st issue this publication has contributed its own fair share to this process, but the dark voices we hear are always the same dark voices, and the sheer volume and the lack of variety of argument has begun to dilute their impact on us. The sound of impending disaster is now so deafening in fact that we have been seeking for any rays of sunshine we could spot if only to relieve the monotony and perhaps to find something substantive that might counter the deep pessimism flooding our mailbox.
And then Bernstein goes on:
The stock market now may be less overvalued, or as some observers will argue even undervalued.
One of the things that really strikes me about this comment by Bernstein, and Brian, you and I have talked about this personally, is if you look at the markets today, and let’s say, go back to the first quarter of 2000 where I don’t care what you looked at whether you were looking at Coca-Cola, Pfizer, Walmart, GE as well as the tech stocks which were in almost outer space in terms of their valuations, there are pockets of value. You have written about it, I’ve talked about it, we’ve written about it where you look at the oil sector despite record earnings you can still find companies selling at 6 and 7 times cash flow, PE’s of 6 to 8 to 10 � even Warren Buffet’s buying oil considering it cheap. And even some of the stellar growth companies in the consumer staple side are selling at valuations that I might not say, “hey, these are screaming bargains,” but we’re not talking about GE selling at 40 and 50 times earnings, or some of these other companies that everybody would have sold their kids to own in the late 90s, which now are simply being ignored. Your thoughts on that.
BRIAN: Jim, without sounding melodramatic by any means, I think you’ve hit on one of the key issues for the broader equity markets, really not over the remainder of this year but maybe over the next few years. And clearly, you have a divided camp on the Street looking at absolutes in valuations right now, and arguing quite rightly that these are not in outer space. A lot of the big blue chip growth stocks etc. have come down to levels as you say investors would have sold their first born child for, you know, five years ago. And admittedly, looking back only 5 years and comparing to the highs of valuations, or the anomalies we saw at that time, sure that’s an unfair comparison, and when we look across a broad spectrum of time and ask ourselves where have we seen fair value, has it been in the low to mid-teens type of PE multiples? Sure. And for a lot of stocks we’re getting there.
Jim, these are truly my personal thoughts and I guess I’ve been screaming about this for a number of years now, sector selectivity I personally think is still a key, key issue. And as you suggested, like some of the energy stocks here and a lot of these have been roughed up pretty badly over the last few weeks with a little drop in oil prices. These are things I think people need to take a long term view of. Ask themselves what they really think are the long term fundamentals of the sectors look like, and at what point in time are they willing to own these based on valuation issues. Because the one key as we move into 07, clearly Jim, is going to be the �E’, it’s very easy to look at a lot of these stocks these days that appear to have reasonably valued PE multiples, you know, to use just one valuation indicator, but the big issue will be the �E’.
And I think just this morning if I’m not incorrect, and here we are talking on Friday morning, we had a company like General Mills tell us they’re just unable to pass through all of the price increases they’re seeing on the input side of the equation. So what might have been, you know, a consumer staple stock that not only has a defensive characteristic in a bad market and would attract institutional money just based on that sight unseen, but also valuations which aren’t in the stratosphere, it’s that �E’ part of the equation that we have to be very, very sensitive to as we look ahead.
And just maybe some very initial thoughts, Jim, if we look at the broad macro and we’re looking at housing, housing’s impacts not only psychologically on consumer spending, but housing’s impact on payroll employment etc., it may indeed be that a lot of the companies that have exposure to consumers, especially discretionary, and in many cases staples, the �E’ is in question, the �E’ is going to be in question. If indeed we see oil prices or energy prices continue to back off a little is there going to be some pressure on the �E’? Maybe. Maybe not. We’ll see how it all works out.
One of the things we have not seen on the energy side is a drop in demand and a drop in global demand. And again that’s the long term, but you know over the near term, I think that’s one of the biggest tensions in the market � you’ve hit pay dirt with this � that valuations, and again, this is a very generic broad comment, are starting to look more attractive than they’ve looked in many a many moon, and all we have to do is get through the valley of the �E’. What are earnings going to look like, and what is earnings momentum going to look like?
As I know you know, and I’m sure your listeners know this too, on a rate of change basis we have been looking over the last x quarters at some of the greatest growth rates in corporate earnings that we’ve seen in a long, long time. So when you go back and look at the market historically, when the markets have run into trouble � if you will it’s the second derivative, it’s the rate of change of the rate of change � if companies were growing their earnings at 20% now all of a sudden it’s going to be 15, or 13 or 9, that’s still a very respectable absolute growth rate, but in terms of deceleration of the growth rate it’s obvious, and markets run into trouble when growth rates start to decelerate. So although I know, I sound like a broken record because I’ve been saying this for years, sector selectivity is still really, really important. Picking your spots and making sure that you are taking into account risk of deceleration in �E’, in earnings, you know, in any sector or stock you are looking at. [51:16]
JIM: And also the risk there too as you talked about these earnings coming down, in other words, if a company was growing its earnings at 20% or even 30% as would be the case with energy companies, if I was paying 30 times earnings for that, or 20 times earnings for that, that’s something to take into consideration. But when a company has been growing at 20%, or 30%, and I can buy them at a PEG of 1, or less than 1, as many of the energy companies, you know, the thing that surprised me, and I think it surprised you, Brian, that during this period of earnings acceleration that we’ve seen in the energy sector over the last 3 years, it was a lack of belief I think on Wall Street that people weren’t ready to pay up. So you’re not buying energy companies as they were priced � in fact Exxon had a more expensive PE ratio, and many of the oil companies in the late 90s when their earnings were far less stellar than where they are today.
BRIAN: You know, Jim, I’ll admit to you personally that I’ve probably drunk the Kool-Aid here so be careful with the next x words out of my mouth in terms of energy, but I agree with you virtually wholeheartedly. There was no pay up for that originally as there was with tech, or as there was with other sectors in prior cyclical movements. So to watch some of these stocks do what they are doing � Jim, I’ll tell you there’s one other issue and you know this full well, and I’m sure your listeners do too, the weight and movement of money is so important. And I think quite honestly and this is just an example and it’s an example of sector thinking and hopefully watching the dynamics of various sectors, one of the things which is happening with energy right now is if you take a peak at and everyone knows Fidelity has a plethora of sector funds that are out there, the amount of money which are in the Fidelity sector funds these days is at one of the highest points we’ve seen in 15 years at least, and probably higher � it probably goes back all the way to the 1980s. I have to believe the same is true of quote-unquote faster moving momentum money in the market � you know, if you’re a hedge player, or prop desk player � that’s where the action has been over the last x time period. So one of the things that probably seems very true on a short term basis is energy is a crowded trade. A lot of money has gone into energy, and whenever you get these little back offs, they almost become self-fulfilling prophecies in that they move further down than you would expect based on valuations just because of the weight and movement of money. But if I could go back to what is probably an overworked and very tired phrase emanating probably from the Jesse Livermore book if you will, one of the toughest things to do in long term bull markets is nothing; or one of the toughest things to do is to teach yourself to be very accepting of buying stocks that are giving you the opportunity to do that as they correct in what may be a longer term bull markets, because nothing on Wall Street moves in linear fashion � ever. Bull markets never move in linear fashion. I think, until proven otherwise, what we’re seeing in the energy’s per se is weakness within a longer term bull market. Opportunity to do what, to buy, or to sell? And clearly that’s up to the individual, but one of the key factors at least at the fundamentals of the moment is that we have not seen a breakdown whatsoever in global demand for crude and other energy assets, and that says a lot. But on Wall Street, as you know, the real world and the world of stock prices can be two different things over very short spaces of time. [55:09]
JIM: Well, Brian, unfortunately we’ve run out of time but before we end why don’t you tell listeners about your website and your newsletter. It’s one of my favorites.
BRIAN: Jim, you’re very kind. Our website is called www.ContraryInvestor.com, and what we’re trying really to do is just provide perspective: try to look at the institutional world; try to look at the retail world; and you know, some of the things I talked about, money movements, valuations etc. And just try to give subscribers �and those who are just reading our open access pieces � things to think about themselves that we hope they haven’t thought about before, or little provocative ideas that maybe aren’t quite consensus thinking that we hope just spark thought and reflection. [55:52]
JIM: Well, I’ll tell you, you do a great job in providing a lot of stuff. I call it outside of the box stuff because you don’t see a lot of what you talk about. You guys do a great job. Once again, give your website.
BRIAN: ContraryInvestor.com. Thank you very much, Jim, much appreciated.
JIM: Alright, thanks for joining us. [56:08]
It Really Is Different This Time
JOHN: Well, back into the last part of the Big Picture here, and Jim, do you really think despite everything we’ve said � don’t panic, it’s not as bad as everybody says � do you really think things are going to be different this time around? Are we going to see some new territory?
JIM: I really do, John. And I just want to go back to a couple of things that we’ve seen transpire. If you go back to let’s say the 70s, the 60s � the economic cycle is normally about 4 to 5 years in duration � you would have boom for 4 or 5 years, and then you would have a recession. The recessions were always shorter than the boom period. Then we got to the 80s, we had a recession in 79 and 80, had another one in 81, but we went almost from 81 to 91 � a full decade � before we had a recession. And then from the 91 recession to the year 2000 we went another decade before we had a recession. So instead of the 3 to 4 year period �in fact, the late 70s was actually a two year period � the extension of the boom has gotten longer.
Let’s face it, John, if you’re a President or a Congressman you do not want to talk about a recession with your constituents because typically people say, “my circumstances have gotten worse under this presidency, or this congressman and so I’m going to vote the guy out, or vote the woman out of office.” So, the business cycle has gotten longer to some extent and we sort of have these mid-cycle slowdowns � we had one on the middle of the 80s, we had one in the 90s � and maybe some are suggesting that’s what we’re going to have here. So that’s something that has changed with the years.
The US economy has changed. It’s no longer a manufacturing economy, it’s a service-based economy � more of our jobs are created in the service sector than the manufacturing sector. It’s also morphed into a financial economy, and a lot of things are involved in the financial industry, the credit industry. One of the things the United States does a lot of manufacturing of is credit. So these are the things which are making the business cycle a little bit different that what we’ve seen in the past. [58:43]
JOHN: Well, if we translate that into something functional that people can understand, things have changed so how is that going to change what’s going on in the markets as well?
JIM: Well, let’s go back for example, we had the Fed rate raising cycle that began in 1999 and then ended in the year 2000. What happened? We had a bear market in stocks because of the crazy mania that lasted 3 years; we had a recession in 2001. But John, unlike previous recessions it was a business-led recession. Businesses pulled back on spending money, and when they did that there was a business recession but contrary to what normally happens in a recession � meaning that normally housing would lead you into the recession as it did in 81, and as it did in 91 � that did not happen in 2001. Housing took off on an almost 4 or 5 year cycle boom where we saw real estate prices approach levels that we’ve never seen before.
Secondly, the consumer did not retrench as they typically do in a recession. In the 91 recession according to the Wall Street Journal the average consumer paid down debt, increased savings by $1400 � that’s what you would do in a recession. You’d probably say, “hey, they’ve laid off some people at work, I’m probably not going to be excited about going out and spending a bunch of money, maybe I’ll retrench a little bit. The Fed’s lowered interest rates, I’ll refinance my house, I’ll use the savings to pay down debt and increase my savings account.” That didn’t happen in 2001. Interest rates came down to the lowest levels we saw in half a century, that’s what it took to revitalize the economy. Consumers went on a spending binge, instead of a savings and retrenchment in consumption. We saw that at the same time, as I mentioned earlier, real estate prices went up.
And at the same time we saw markets react in a very different way. We saw for example the prices of commodities continue to rise beginning in the lull of 2001, we saw energy prices go up, we’ve seen commodity prices go up, and yet we saw bond yields come down � that was an anomaly. We saw for example as the Fed began to raise interest rates in this last cycle that instead of the stock market going down the stock market went up � not by much, but we had positive years in 2004 and 2005, just as we’re having a positive year in 2006. And a lot of that I believe is the transformation to this financial economy. As I mentioned earlier, the central banks are creating more and more liquidity in the system and that liquidity has to go somewhere, and I think what you’re going to see as they continue to do that and we begin another liquidity cycle � in fact, we may have begun one already � that we’re going to see it go into what I believe are hard assets.
And in an inflationary type cycle you have to be very careful in terms of how far real estate will go down � why I don’t think it’s going to be apocalyptic. I think James Turk also agrees with that point. I think you’re also going to see it go into commodities because people will be looking for hedges. And also there’s been a whole cycle that’s been built into commodities here that we’ll get into our 4th segment.
So there are a lot of things different. We talked about it in the Morgan report. If I told you, John, there were stories in the news that inflation was on the rise and going up, what would you think of investing in? [1:02:28]
JOHN: Well, obviously, things that are going to hold value or make money in that kind of an environment.
JIM: Yes, would you think of going into bonds, and selling gold and oil.
JOHN: No, you’d probably invest in gold because you know that at least traditionally has risen with inflationary eras.
JIM: But that’s not what happened, we had this week inflationary fears, the gold market got hammered, the oil market got hammered, bonds did well this week. In fact, if you were making money this week it was probably in the bond market, it wasn’t in the stock market. So we have atypical reactions to what goes on in the real world. There’s more and more of somewhat of a disconnect. And I think you have to be very careful at a time in my own belief the Fed cannot afford to see the housing market bubble crash and the real estate bubble crash at the same time, because then we have 1929-1930 again.
Secondarily, I don’t think with all the liquidity that we’re seeing in the world � remember, OPEC account surpluses from the rising cost of oil � from oil going from below $20 a barrel in 2001, to today’s price in the upper 60s, and remember we’ve spent most of this year in the 70s � are larger than Asia’s. That is savings and liquidity which are coming in from account surpluses in Asia, account surpluses with OPEC countries, and then also liquidity being created by central banks injecting liquidity into their financial system. There is a sloshing world of money that is looking for a place to land. And so that is what is creating and changing a lot of these dynamics that we’re seeing actually in the financial markets. [1:04:18]
JOHN: Well, what goes up must come down. If it’s different in the Fed’s rate raising cycle � if that’s what we’ve experienced � how is it going to be different (assuming that it would also be different) when they lower?
JIM: I think this time what’s going to be different for the Fed, I don’t think they’re going to have the same leeway in slashing interest rates as they did between 2001 and 2003 when they brought interest rates from 6% down to 1%, and kept them there for quite a long period of time to make sure the economy was coming out. That was another thing � this is probably the most lethargic economic recovery we’ve seen in terms of new jobs created and economic activity. In other words, more of the activity or recovery went into the financial community � stock market, financial planning, banks, credit creation, asset bubbles such as real estate. So that was different.
But this time, when the Fed goes to lower, I just don’t think they’re going to have the same leeway to go from 6% down to 1% for a number of reasons. Unlike what we saw in 2001, commodity prices are much, much higher; headline inflation rates are much, much higher than they were in 2001. We were dealing with 80 to $20 oil in 2001; 60 cent copper prices; commodity prices at almost a record bottom. That’s not what we’re seeing today. We’re seeing oil prices I believe oil prices are going to stay firm; you’ve got gold prices in the 600 level; you’ve got base metals � although I think they’ll get weaker � still at levels we have never seen before. So a lot of the things that we need to use and consume on a daily basis are at prices that we have never seen before. And so they’re not going to have the same leeway.
The other thing is we have never seen this kind of global liquidity creation in terms of OPEC surpluses the way they are today; central banks printing globally the way they are today, because remember we’re on a full fiat system. So money is going to find a home somewhere, and that is going to lead us into what’s going to be our next topic, which is the commodity boom is not over. [1:06:35]
The Commodity Boom Is Not Over
JOHN: Well, Jim, people are chattering away out there, talking about the rise in oil prices, the rise in gold prices, the rise in commodities, the bubble we have going here. So if we do have a bubble. Is the bubble going to burst? Or is this simply � to coin a phrase � in the markets a midcycle adjustment?
JIM: You know I strongly disagree that we’re in a commodity bubble because one of the things that are very characteristic of a bubble is you see excess surplus or supply come into the market as a result of prices that we’ve never seen before. I mean just take a look at what happened to stocks, technology companies and internet companies. We had just this plethora of IPOs and people going public trying to raise money in the tech bubble, and we saw a surplus of just about everything � in telecom broadband. Just surpluses of everything that you can think of. When it comes to commodities right now, we do not have an abundance of surpluses that we can say this is very bubble-like � that we have more than we need, or because the inventory levels �just like housing are at such levels that there’s such a big supply of housing on the market � or big supply of commodities on the market you know this whole thing’s going to burst. We just don’t have that. So I would disagree rather strongly with the concept that this is a commodity bubble. I’m more in the Jim Rogers camp, the Marc Faber camp, who think that this is a long term cycle, that these things tend to last around 18-20 years � a couple of decades in length and there’s a reason for that and we’re going to get to that in just a moment, but you know, I disagree with the bubble assumption. [1:08:37]
JOHN: But Jim, there are critics of the bubble. You keep hearing this all the time. For example, why should oil prices go up? I mean there’s no increased usage here, so obviously this is something on the part of price-gouging on the part of the oil companies.
JIM: You know, if you look at, for example, demand for commodities, especially in the Western world. You’re right, John, it’s only up about 1%, not rather strongly. And I think this was one of the arguments, for example, Bill O’Reilly was making against the oil companies. He would say, “Gosh, you know, demand for oil in the United States has been flat, it hasn’t been up, how come prices are up?” And he’s absolutely correct when he says that. If you just look at consumption of commodities from the point of view of the demand side � whether it’s copper, lead, zinc, energy � it’s up marginally in the Western part of the world. It’s up a little over 1%. And quite honestly, the greatest increase in demand for commodities is coming from Asia, especially China and India. They are really accounting for the greatest marginal increase in demand for commodity products.
But that is only looking at one side of the equation. The problem this time is on the supply side. Ok, we’ve got the demand side, which has been moderate in Western countries, stronger in Asian countries especially China and India, but you know the demand side has been rather moderate. So you can make the argument: gosh, demand is not that high in those parts of the world, and if the economy is going to slow down as the experts are predicting, well therefore the demand will slowdown along with it, and this whole thing is going to come crashing down. But if you look and take that argument, and most of the arguments I’ve taken a look at, that’s what they’re saying, you’ve got to look on the supply side. And the real problem with any bear market as we had in commodities that lasted more than two decades, what happens in a bear market? Companies go out of business because they can’t compete because the price of what they sell goes down, they can’t make a profit, the weaker companies go out of business, the stronger companies consolidate, the industry contracts. Eventually nobody invests in new plant and equipment, nobody invests in going out and looking for oil, nobody invests in going out and looking for mines. I mean, what mining company was spending a ton of money in the late 90s trying to find new supply? In fact, it wasn’t until recently � 2004 and 2005 � that an increase in mining expenditures and exploration actually took place. So, looking at the demand side is only half the equation. [1:11:25]
JOHN: So Jim, if we go back and look at things we’ve talked about here on the program before � go back to 1985, world demand for oil was 60 million barrels, the world supply was about 70 million barrels, so we had a surplus of 10. That no longer exists, and in oil and other areas what we could be looking at is maybe the surplus for the commodities are just simply gone. They don’t exist.
JIM: Yes, I mean you don’t have a surplus of a lot of commodities. It takes time, for example, you’ve recently heard about the new oil discoveries in the Gulf. Just as if you go back to the oil discoveries in the North Slopes of Alaska, and the North Sea at the end of the 60s, it was a full decade before that oil could come online and supply. It’s going to take a while for any new discoveries to come online. It takes a long time today � 7 to 10 years � to bring a mine into production. You don’t just go out and poke a hole in the ground, discover new oil and it’s on the market on Monday. And it’s the same thing with mining.
And the other thing is one of the things we’ve also been talking about on the program, there is a lot of skepticism in the mining industry and the natural resource industry. There’s a lot of guys that are running mining companies today that have spent the bulk of their careers in a bear market. And when you go through a bear market that lasts for two decades, it’s kind of like somebody that went through the Great Depression. That has an impact on you in terms of how you’re going to spend money. These guys are not cutting loose with the checkbooks in the same way that they might have done let’s say towards the tail end of the bull market in the late 70s. [1:13:21]
JOHN: We talk a lot about mining and exploration and a lot of the companies out there are increasing their exploration budgets, but you seem to have a different take on that.
JIM: You’ve got to remember what has happened to the mining industry and the energy industry. Yes, energy exploration has increased in dollar terms; yes, mining exploration has increased in dollar terms. But last year alone, if we take a look at a year over year period price inflation in the mining industry is up over 35%. I can’t read a quarterly report by a mining company talking about what their cost structure � you know, the cost of steel has gone up, the cost of labor has gone up, the cost of acquiring earth moving equipment has gone up, the cost of acquiring trained geologists and skilled personnel has gone up, benefit costs have gone up, energy costs have gone up. And so yes, the price of gold has gone from 250 to over $600 but margins have not gone up in the same measure, and the reason is cost structures have also gone up.
So it’s a little misleading if you say, “well, gosh there’s an x amount of dollar increase, that means sure we should see a lot more supply.” Remember, a lot of those dollar increases are simply going to keep pace: it costs more money to get a trained geologist today, it costs more money to get a permit today; it costs more money to get a drilling rig. I mean just take a look at some of the day rates for drilling rigs even in the oil industry. You have drill ships in the Gulf of Mexico that are getting over half a million dollars a day today, versus � million dollars a day two or three years ago. [1:15:07]
JOHN: If we look overall, both the mining and the oil companies seem to be spending more money, so at least you would think on the surface that we would be seeing more supply out there.
JIM: Yes, there’s more money spending, but you know what, John, one of the things, and this is as everybody knows I’m a big believer in peak oil, in fact at our client meeting that comes up at the end of September, I’m presenting the culmination of almost 3 years worth of research and over 70 books in my conclusion. I’m a big believer in peak oil. And one thing we’ve seen is the discovery rate of new exploration has been very disappointing by any historical standards or even past standards, let’s say in the last decades. So the correlation between increased spending for exploration and future output gains or results is considerably weaker this time. You’ve also got the same thing outside of companies like Aurelian that made a major find in Ecuador, there just haven’t been a lot of elephants. Yes, we’ve just got news this week, for example, that Chevron and Devon and Statoil have made a major discovery in the Gulf of Mexico, or that perhaps Mexico has made a discovery. But John, it may be 10 years before we get the full benefits of all of that coming online. So you’ve got to take the time factor between discovery.
There’s always this inclination in my mind that people make, and I think this is how the media tends to distort this: “Wow, this is a big discovery” or “I can’t believe the size of the Aurelian discovery in Ecuador, so all this gold is going to come online.” It may be a major new mine, it may be a major new oil discovery but from the time of discovery, the lag period could be 7 to 10 years. In the meantime, demand continues to grow each year.
And the other thing that you have to look at is depletion. If you have a mine, you may mine that mine and over a 10 year period you’ve gone through your high grade, you’re going to lower grades, it’s getting more costly, and the amount of ore that’s left to process may be diminishing. You also have the same thing with oil fields that you pump out at a very high rate when you first bring it online, and then eventually you start getting into a decline rate as depletion starts to set in. So that’s another thing you have to factor in. [1:17:46]
JOHN: Yes, let’s tag in on something you and Dave talked about earlier that right now it’s actually cheaper to go out and buy somebody today than it is to do your own work.
JIM: You know if you take a look at what happened in the last bear market, we got these big behemoths in the mining industry. You know, it’s hard to believe that for example, over half of the world’s copper is produced by a handful of companies � about 7 or 8 companies. Just take a look at the gold mining industry, the behemoths � the Newmonts, the Barricks, and the Anglos, some of these companies. You know, it is very hard to replace that, and you’ve got this mind set with a lot of these guys who have come through this bear market who say, “you know what, do I want to really sit there and expand capacity.” What they’re doing, John, and you’re seeing this over and over again, and I think you’re going to see this accelerate, is what a lot of the mining executives, even the oil guys are thinking, it’s far easier to expand their capacity via mergers and acquisitions than by developing new mines. Because let’s face it, if you’re going to go out and discover new oil, you’re going to go out and discover new copper, lead, zinc, mine a new gold mine, a new silver mine. You’re going to have to go out there, and you’re going to have to stake a claim, you’re going to have to drill it, you may get dry holes when it comes to oil or natural gas, you may get dry holes when it comes to discovering gold and silver. And even if you do find it you’re going to have to spend a couple of years drilling it out, you’re going to have to go to feasibility, you’re going to have to get environmental permits, and then who knows, you may get ready to bring it online, and then Greenpeace or some environmental group shows up and says, “nope, we’re going to stop this.” And so you’re fighting the environmentalists. And so there’s also a risk there.
You have no assurance today that even if you find something that you can bring it online. There’s a lot of risk. So a lot of these guys are basically saying, “you know what? It is far easier to focus more on buying somebody else.” And this is also a function as you see the industry become more concentrated as it has � whether you’re looking at the oil industry or the mining industries � companies just become more focused on projects that produce relatively quick returns to their shareholders. They get more cautious about these risky adventures of going out and trying to find a new project or a new prospect. And so how can you get immediate benefit? Well, here’s a junior mining that’s selling at a discount below market value, let’s buy it. Or here is an oil company that has good natural gas reserves, let’s buy it. Or here’s a copper company, or a lead and zinc company, let’s go out and buy that. So that’s what we’re seeing in the news, and that’s what these guys are thinking because that’s really the way the industry functions. [1:20:43]
JOHN: Well, if the big guys aren’t doing it � and I know you’re a big believer in juniors � are the juniors the guys that are really taking the risk.
JIM: That’s exactly what’s happening. It’s some guy that’s got a dream, who’s got a stake on a piece of property, a small company. It’s your juniors that are really taking your development risk and the exploration risk today � whether you’re looking at the mining industry, silver, gold, lead, zinc, or you’re looking at the oil industry. That’s where the risk is being taken. [1:21:13]
JOHN: Well, Jim, I know you’re a believer in juniors, you’ve written a lot of articles on this. You believe this bull market in gold and silver is going to be a lot different than that bull market that we saw way back in the 60s and 70s. Why is that?
JIM: The easiest way to explain this is growth. When you get to be the size of let’s say a Barrick or a Newmont or an Anglo, it’s almost the equivalent if I can use the analogy of the tech bull market that took place in the 90s. The Anglos, the Newmonts, the Barricks � those are what I call the IBMs. They got to be so big � it’s just hard to grow � I mean Newmont’s not going to go from 6 or 7 million to 15 million; or you’re going to see a Barrick � Barrick just went from 5 or 6 million to 8 million with its purchase of Placer � but watch what’ll happen, they’ll have a hard time maintaining that 8 million ounce production. So, the big companies just have a harder time growing, especially the behemoths that we have that make up the industry today.
And if I can use an analogy, IBM in the tech market of the 90s, if you bought IBM throughout the tech market, and especially after Gerstner started the restructuring of the company in the 90s, you know you might have gone from let’s say, in the mid-20s, all the way up to the high of 120 at the end of close to 1999. So yes, you made money if you bought IBM; and yes, you were going to make money if you own a Newmont or an Anglo, if you own a Barrick. But on the other hand, if you invested in a Cisco, or a Dell, Dell went from the equivalent of about 18 cents a share in 1991 � this is of course after splits � to almost $54 in the first part of the year in 2000. So think of that � 17 or 18 cents to $54. Cisco went from equivalent of 7 cents in 1990 from a split basis to a high of over $77.
Compare that kind of growth to IBM � you made money in IBM but it is more difficult for an IBM to grow at a very accelerated pace versus let’s say a Dell or a Cisco. So your junior producers, your junior development companies, they have a higher growth rate, or a much greater potential reward than let’s say investing in a Newmont. Your mid-tier producers � your Glamis’, your Agnicos � those kind of companies have a much higher growth rate than what you’re going to see in some of these other companies. So a lot of your mid-tier companies will become major producers as we’ve seen with Goldcorp. You know, they start out at about � what? � 3 or 4 hundred thousand ounces of production, and they’re working their way to 2 million ounces of production. So that’s the kind of growth you’re going to see in the mid-tier companies, in the junior producers, the junior development plays versus let’s say the Newmonts. [1:24:38]
JOHN: Well, Jim, we back for the first show of what I guess we call the season, we almost tend to match the school year, except we go a couple of months into the Summer. What are we looking at here in the Fall?
JIM: Well, we’ve got a great line-up for September. Next week, Ike Iossif will join me for Ahead of the Trends. The following week we’re going to have Doug Noland from the Credit Bubble Bulletin. Also, you don’t want to miss, at the end of the month, I’m going to have Matt Simmons � we’re going to talk about is this peak oil, we’ll talk about some of the new discoveries and a presentation that he made to the Defense Department, rather critical. We’ll open up the month of October � you have asked for it and we are going to have them � we’ll have Bob Prechter who’s going to be talking about an update on Conquer the Crash, his views on deflation; we’ll have also Richard Heinberg; we’ll have Ike Iossif. And something that we’ve also been requested, we’re going to have G. Edward Griffin � he wrote a book about the Federal Reserve, The Creature from Jekyll Island will be joining us in October.
And something that I thought I wasn’t going to get through but I did during Summer vacation � Andy Kilpatrick, who’s probably almost considered the official biographer of Warren Buffet, his latest edition of his book called A Permanent Value � the longest book ever written, it was over 1700 pages. I managed to get through that through Summer vacation. We’re going to have Andy Kilpatrick on the program.
And a great lineup we’re working on for November, but we haven’t got commitments from everybody, so I’ll hold off until we know. So great lineup of guests coming up in the months ahead. [1:26:15]
JOHN: I feel really badly, you know I thought it was an achievement to get through War and Peace.
JIM: You know, I read Andy’s earlier book, it was like 900 pages; we interviewed him a couple of years ago. And then as I browsed through Amazon I’m always looking for new books, new things to read because I’m a voracious reader, and for some reason I was looking at value or something, and this book came up, and I looked at it, and I said oh, Andy’s got a new book. And so, you know I pressed the button, ordered it on Amazon with one-click. It shows up, John, I mean this thing, I can lift weights with this book, but fascinating stuff, just the way Buffet thinks. I’m fascinated to ask him his relationship with Bill Gates � the two richest men in the world, the smartest financial guy in the world, one of the best business men in the world and these guys have been buddies, so he gets more into that relationship. Also about some other professors, the value school. Just a great, great book � it gets into a lot of his deals from arbitrage. I think an individual would be fascinated to find out the number of companies that Berkshire owns today. It’s just incredible. So he’ll be joining us on the show as well.
Well, John, it is that time, this is our first show, good to be back in the saddle again.
In the meantime, on behalf of John Loeffler and myself we’d like to thank you for joining us here on the Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend.[1:27:50]