Roubini’s four forces of Stag Deflation are: a slack in goods markets, a “recoupling” of the rest of the world with the U.S. recession, a slack in labor markets, and a sharp fall in commodity prices. These factors would, “reduce inflationary forces and lead to deflationary forces in the global economy,” he writes in an article in Forbes.

“Aggregate demand is now collapsing in the U.S. and advanced economies, and sharply decelerating in emerging markets,” he writes. “There is a huge excess capacity for the production of manufactured goods in the global economy, as the massive, and excessive, capital expenditure in China and Asia (Chinese real investment is now close to 50% of gross domestic product) has created an excess supply of goods that will remain unsold as global aggregate demand falls.”

You’ll have to bear with us a moment, dear reader, as we work out what this means. First, though, is Roubini right? Well, he’s certainly right that there’s a big fall in aggregate demand in the U.S. It’s obviously passing through to manufacturers and commodity producers (China and Australia). But won’t monetary and fiscal policy designed to combat deflation…you know…cause inflation?

Roubini takes that point head on. He says the liquidity measures taken on by the Fed to get credit flowing and recapitalise U.S. banks are not all inflationary. He says once liquidity is restored to the credit markets (banks begin lending, money market funds starts buying commercial paper again) the central bank can simply “mop up” excess liquidity before it seeps into the real economy to cause inflationary damage.

And what about the tendency of governments to fight debt deflation with inflation? Not a worry either, says Roubini. He says that most of the household debt in the U.S. is short-term variable rate debt that’s resistant to being “inflated away” by cranking up the printing presses. Is he right?

Well it all comes down to how much money the Fed and the Treasury are going to need before the recapitalisation of the American financial sector is over and how they plan to raise that money. The banks will probably need more capital than anyone’s expecting. And there are other landmines down the road.

In short, the Treasury and Fed will need more money. Roubini assumes the Fed can simply remove the lending backstops it’s provided once the market returns to normal. But what if it doesn’t and the Fed can’t? What happens next?

Governments get money three ways, taxing, borrowing, or printing it. You can rule out an increase in taxes large enough to fund the Fed’s needs. It won’t happen with an economy already contracting. Even if Obama raises taxes, it won’t be enough to meet the Fed’s immediate needs. That leaves borrowing and printing.

On September 17th, the U.S. Treasury announced a Supplementary Financing Program. It initiated the program at the request of the Federal Reserve. The Fed needed the Treasury to go out and sell more bonds so the Fed would have money to fund its various lending backstops. The Fed was nearly broke.

Since then, thanks largely to the huge flight to Treasuries sparked by deleveraging and the collapse of the dollar/yen carry trades, the Supplementary Financing Account set up by the Treasury has fed the Fed nearly $560 billion. Some of that may have gone to AIG. Some of it to Fannie and Freddie. Some may go to Chrysler, Ford, and GM. Who knows?

But the main point, from Roubini’s perspective, is that as long as the Fed can finance its lending with new borrowing from the Treasury, it’s not inflationary. The only thing that would make this armada of liquidity measures and loan guarantees and bailouts truly inflationary is if the Treasury couldn’t go out and sell new bonds to gullible foreign investors. As long as the Treasury can sell more bonds, the Fed can make more loans without sparking inflation.

But if we’re right and the bond bubble began bursting in late October, well then the Treasury’s line of credit with global savers is nearing an end. Global creditors will be reluctant to finance American deficits. In order to borrow, the Treasury is going to have pay much higher rates of interest to reflect the credit risk the U.S. government has become.

Trouble is, the U.S. can’t afford to borrow at higher interest rates right now. So that leaves the option Roubini thinks is least likely: printing money. The fancy term for it would be “monetizing the debt.”

That means the Fed would buy public debt issued by the U.S. Treasury with freshly printed money. And THAT, we reckon, is super inflationary. Any time you start rolling out new greenbacks to pay for new bonds which you give to corporations in exchange for their garbage securities, you’re going to damage the confidence people have in the currency (the U.S. dollar).

But then, Roubini has been right about an awful lot lately. It’s possible the Fed will not be forced to monetize the debt. It’s possible that a global contraction is truly deflationary. We don’t really know. But we’re not nearly as sanguine as Roubini that you can expand the monetary base as quickly as the Fed has and be confident it can all be mopped up later without causing inflation. Try getting motor oil out of an engine and back into the bottle.

Regards,

Dan Denning
November 05, 2008

Falling Commodities and Inflation in the Wings was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

At the end of the Second World War, Germany was an “emerging market.” It was industrializing rapidly and producing brisk economic growth. Today, Germany is a mature “developed market” that grows slowly if it grows at all. Today, China is the new Germany. The industrial dynamism that produced Germany’s post-war success is moving to the East…piece by piece.

The Ruhr Valley was the heart of Germany’s industrial might. For more than 200 years, the smokestacks in this northwest corner of Germany pounded out the steel and iron that would form the backbone of the nation’s industry. And when the war drums rumbled, these factories supplied imperial Germany with its field guns, armored tanks and shells.

Prosperous communities grew up around these old blast furnaces and mills. People took pride in the stuff they could make with their hands. Tens of thousands found work in the factories of the Ruhr. Generations passed with the knowledge that their sons and daughters could make a life here and carry on the legacy of such a place. For a long time, that was the way it went.

But the winds of change patiently grind away at even the most impressive of advantages. In the early 1990s, the industrious workers of Asia powered the mortar and pestle that would crush the Ruhr’s traditional way of life.

It was a slow process, but the endgame was not hard to see. While the South Koreans became the most efficient producers of steel in the world, German workers were agitating for a 35-hour workweek. While the Chinese worked all day in their mills and new factories sprouted up like spring peepers all through China, Germany increased taxes and expanded its bloated government programs.

By the turn of the millennium, no one could ignore the stark reality any longer. The mills and factories of the Ruhr started to close — forever. In his terrific book, China Shakes the World, James Kynge tells the story of ThyssenKrupp’s steel mill in Dortmund, one of the largest in Germany. The Germans called it the Phoenix, inspired by its rise from the ashes of bombing raids in World War II.

Within a month of ThyssenKrupp closing the mill, a Chinese company bought it with the idea of disassembling the entire mill and taking it to China, near the mouth of the Yangtze River. Soon after this Chinese company bought the mill, 1,000 Chinese workers arrived in Germany to begin the process of taking the plant apart and bringing it to China. The Germans got an up-close lesson in why they could not compete. The Chinese worked seven days a week for 12 hours a day. The Germans started to complain. So the Chinese, in deference to local law, took one day off.

In the end, the Chinese dismantled the mill in less than one year — a full two years ahead of the time ThyssenKrupp initially thought it would take.

When the Chinese departed, they left the makeshift dormitories and kitchens they occupied for a year neat and clean. There was, however, a single pair of black boots left in one of the dormitories. The boots carried the brand name Phoenix, which was the same name of the plant the Chinese just took apart. The boots also carried the label “Made in China.” Kynge writes, “Nobody could tell, however, whether the single pair of forgotten boots was an oversight or an intentional pun.”

Over 5,000 miles away, the Chinese rebuilt the steel mill exactly as it was in Germany. As Kynge writes: “Altogether, 275,000 tons of equipment had been shipped, along with 44 tons of documents that explained the intricacies of the reassembly process.” Doing all of this was still cheaper — by about 60% — than building a new mill. Plus, in China, the demand for steel was such that the mill could start producing steel immediately at full capacity.

As recently as 1975, China’s entire output of steel could not match this one mill in Dortmund. Now, the Dortmund plant itself stands in China. And in Germany, you have a dying industrial city, unemployed steelworkers and the scarred earth where the mill once stood. Germany is thinking of turning the site into parkland and perhaps creating a lake and marina. But as one burly steelworker says in Kynge’s book: “Do we look like yachtsmen to you?”

This remarkable vignette captures, on many levels, how the game has changed. Comfortable workers in the factories and mills of America and Western Europe have no idea what they are up against. Even so, the nature of global competition keeps shifting. We tend to think of emerging markets, such as China, as occupying a place down on the food chain of the global economy. We tend to think of these places as sources for cheap labor and natural resources. But more and more, these emerging markets are home to world-class companies in all kinds of industries.

This is the thesis of Antoine van Agtmael, author of a new book called, The Emerging Markets Century. Agtmael is the man who coined the phrase “emerging markets” to describe growing, but less-developed economies such as China, India, Brazil, Argentina, Mexico, Thailand and other places. Before him, we called these markets “third-world” — which brings to mind many negative associations. To sell the idea, Agtmael came up with “emerging markets.”

I saw Agtmael give a presentation in Washington, D.C., one evening. I’ve also since read his new book. Agtmael spent 30 years in these kinds of markets. “I have helped IranAir lease airplanes and hire crews in Ethiopia, was involved in financing Ghana’s cocoa exports,” he writes, “and grew wise to the ways — many of them laughably one-sided — that developed nations interacted with what were in many cases recent European colonies.”

Agtmael selected 25 companies to profile in his book. All of them exemplify best practices and are widely recognized as leaders in their industries. All of them call an emerging market home.

Agtmael writes about spending time in High Tech Computer Corp.’s research lab in Taiwan in 2005 and how “Suddenly, my BlackBerry looked like a Model T.” He writes about how the regional jets we fly are made in Brazil (by Embraer). How computers are now not just made in China, but designed there. How Indian and Slovenian labs produce proprietary new drugs. And on and on it goes.

The world has changed in a profound way, but the typical investor probably doesn’t appreciate this fully. One more nugget from Agtmael: In 1988, when he started his fund, there were only 20 emerging market companies with sales of more than $1 billion. Most of these were banks or commodity companies. (Overwhelmingly, they were located in Taiwan.) Today, there are over 270 companies with over $1 billion in sales, and 38 with more than $10 billion.

Many of them are high-tech companies or provide consumer products and services. This bolsters Agtmael’s point that many of today’s emerging market stars do not rely on cheap labor, abundant natural resources or protective government policies. Instead, they have developed competitive advantages in technology, design, logistics and other areas.

Agtmael also gives his tips for investing in emerging markets. The most important of these may simply be this: “Don’t be afraid to invest in them.”

Regards,
Chris Mayer
June 3, 2008

Emerging Economies was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

William Stanley Jevons
(1835–1882)

INTRODUCTION

A friend of mine, Marcel Tjia, whose father was the founder of Indonesia’s PT Astra Group and who had the misfortune to work for me when I ran Drexel Burnham Lambert’s Hong Kong office in the 1980s, sent me the following tale:

It was autumn, and the Red Indians on the remote reservation asked their new chief if the winter was going to be cold or mild. Since he was a Red Indian chief in a modern society, he couldn’t tell what the weather was going to be. Nevertheless, to be on the safe side, he told his tribe that the winter was indeed going to be cold and that the members of the village should collect wood to be prepared.

But, being a practical leader, after several days he got an idea. He went to the phone booth, called the National Weather Service and asked, “Is the coming winter going to be cold?”

“It looks like this winter is going to be quite cold indeed,” the meteorologist at the weather service responded.

So the chief went back to his people and told them to collect even more wood.

A week later, he called the National Weather Service again.

“Is it going to be a very cold winter?”

“Yes,” the man at the National Weather Service again replied, “It’s definitely going to be a very cold winter.”

The chief again went back to his people and ordered them to collect every scrap of wood they could find.

Two weeks later, he called the National Weather Service again.

“Are you absolutely sure that the winter is going to be very cold?”

“Absolutely,” the man replied.

“It’s going to be one of the coldest winters ever.”

“How can you be so sure?” the chief asked.

The weatherman replied, “The Red Indians are collecting wood like crazy.”

Now, this tale may seem to be irrelevant to today’s investment environment. However, when I continually hear and read about “excess liquidity”, “sustainable record corporate profits”, “new highs”, “Goldilocks economy”, and that “central bankers today are smarter than in the past”, I wonder whether the 19th-century economist John Ramsay McCulloch wasn’t on to something when he wrote: “In speculation, as in most other things, one individual derives confidence from another. Such a one purchases or sells, not because he has had any really accurate information as to the state of demand and supply, but because someone else has done so before him” (J. R. McCulloch, Principles of Political Economy, 2nd ed., London, 1830).

What McCulloch omitted to add is that speculators not only buy assets because someone else has done so in the past, but because they expect that in the future someone else will enter the market and purchase the asset from them at an even higher price, since “excessive liquidity” will surely push asset prices higher.

This is certainly the view of Stanley Gibbons (Guernsey) Ltd, one of the world’s largest stamp dealers, who recently sent me an email offering guaranteed return contracts on a basket of rarities stamps. According to Adrian Roose, a director of Stanley Gibbons, “The actual returns which will be achieved are expected to exceed the minimum returns based on the quality and rarity of items included within investment contracts and backed up by a 50 year history of long term price appreciation in the rare stamp market averaging 9.5% per annum.” (The returns, in British pounds, on the guaranteed contracts offered by Stanley Gibbons vary according to the duration of the contact as follows: 4% per annum for four years, 5% per annum for five years, and 6% per annum for ten years.)

According to Stanley Gibbons, the 35-year history (decimal) of the Great Britain Rarities Index shows that stamps within the index haven’t dropped in value in any five-year period. “This highlights the long term stability of the rare stamp market, underpinned by many millions of stamp collectors worldwide.” The GB Rarities 30 (Rare Stamp Index) has increased as follows: 1970–1975: 83.2%, 1975–1980: 593%, 1980–1985: 10.3%, 1985–1990: 8.6%, 1990–1995: 5.3%, 1995–2000: 29.4%, and 2000–2005: 70.4%, which works out to an average annual increase of 10.6%. (All Stanley Gibbons’ portfolios are offered with free insurance and storage — with a proof of ownership certificate, free annual valuation, and no further management fees.)

My readers shouldn’t assume that I have mentioned stamp guaranteed return contracts as an investment because I will receive a commission from Stanley Gibbons for any clients I introduce to them, or because I recommend stamps as an investment. I haven’t invested in stamps and don’t intend to do so. However, I do admit that I inherited boxes filled with stamps from my grandparents, who owned a hotel and, therefore, received mail from all over the world. The stamps were diligently cut from the envelopes and put aside, and for a while when I was a child I put them in albums. Unlike my superb electric train, which I stupidly sold in the mid- 1960s in order to buy a flashy secondhand Italian Motobi motorcycle, whose life expired shortly thereafter, I held on to the stamps, which are stored in my 91-year-old mother’s attic.

The reason I have mentioned stamps as an investment is because they show clearly the depreciating value and erosion in the purchasing power of paper money over the last 50 years or so. Moreover, not since I started out in the glorious business of investments in 1970 have I seen so much conviction among investors that all asset prices will continue to increase in value based on “excessive liquidity” and “money printing”.

Let me explain: to date, I have experienced four investment manias of epic proportions. By “epic proportions” I mean investment bubbles that, when they burst, caused serious economic pains to either an important sector of the economy, a whole country or an entire region. Those four investment manias were the parabolic increase, between 1970 and 1980, in the prices of precious metals, oil, mining and energy-related equities, as well as the Kuwaiti stock market, whose market capitalisation in 1980 exceeded that of Germany.

The second “big” investment mania surrounded Japanese equities and real estate, and Taiwanese equities, in the late 1980s. It culminated in Japanese stocks commanding a larger market value than the combined values of the US, British, and German stock markets. At the same time, the trading volume in Taiwan frequently exceeded the daily turnover on the New York Stock Exchange! Then, in the 1990s, we had several rolling investment manias in the emerging markets, which ended with the devastating Asian crisis of 1997, and the Russian crisis and LTCM in 1998. In the fourth and last great investment mania, the object of speculation was the TMT sector on a worldwide scale and we all know very well how that ended.

These four “epic” investment manias — I have omitted mini manias such as the US casino stock boom in 1978 ahead of the opening of the Atlantic City casinos; the 1978–1980 Philippine oil frenzy, which collapsed when no meaningful oil deposits were discovered; the 1983 personal computer mania (remember Commodore, Wang, Televideo, and Atari?); the 1986–1987 US stock market and leveraged buyout (LBO) boom; the 1993–1994 Mexican investment euphoria; and the 1996–1997 Hong Kong property market surge — all had one common feature: they were concentrated in just one or very few sectors of the economic or investment universe and were accompanied by a poor performance in some other asset classes.

CHRONOLOGY OF MAJOR INVESTMENT MANIAS IN RECENT TIMES

The 1970–1980 Precious Metals Boom

Best-performing assets: Silver, gold, oil, and platinum. Energy-related shares and mining companies, the Kuwaiti stock market, and Japanese equities (the Nikkei rose from 1,900 in 1970 to 8,000 in 1981, while the Yen strengthened from US$1 = ¥369 in 1969 to US$1 = ¥177 in 1978.

Worst-performing assets: Bonds and the US dollar against hard European currencies and bonds. Bonds performed much worse than anyone could have imagined in the early 1960s, when bond yields never exceeded 6%, but subsequently rose to more than 15%. What may be relevant to the current environment is that, with the exception of a brief period in 1970, bond yields in the US were consistently lower than nominal GDP.

Characteristics of the period: Very high volatility in stock prices and sector rotation within the commodities bull market. (This is the reason I describe the 1970s as a precious metals boom rather than as a commodities boom.) Sugar, wheat, corn, and soybeans peaked out in 1973 and coffee and cocoa in 1977. Precious metals and oil topped out in 1980, but the CRB had already made its inflation-adjusted high in 1974.

A homebuilding, REIT, and shipping investment frenzy from 1971 to 1973 collapsed in 1974. Moreover, the leaders of the late sixties (conglomerates, electronics, and growth stocks in a variety of industries) and the nifty fifties (stocks such as Polaroid, Xerox, Avon Products, Burroughs, Digital Equipment, Mohawk Data, etc), which performed superbly from the1970 low up to 1973, didn’t do well for the rest of the decade as the leadership had shifted to energy and mining stocks.

Consumer price inflation accelerated largely due to easy monetary policies, which kept interest rates below the rate of inflation and below nominal GDP growth.

Consensus at the end of the 1970s: Oil and precious metal prices will continue to rise, consumer price inflation will accelerate, the dollar will become worthless, and bonds are certificates of confiscation. Kuwaiti stocks will never decline because there is so much liquidity about!

The 1980–1990 Japanese Asset Boom

I realise that one could use as a starting point for the Japanese asset boom the early 1950s, and certainly 1970 since Japanese equities quadrupled between 1970 and 1981. But because I am focusing here on epic investment booms I personally experienced, and also because there were no symptoms of a mania in Japanese equities in the 1970s, I use the early 1980s as a starting point.

Best-performing assets: Taiwanese, Japanese, and Korean stocks; Japanese and Taiwanese real estate.

Worst-performing assets: Middle Eastern and Latin American stock markets (following the 1981 Petrodollar crisis), commodities, Texas banks, oil servicing and mining companies.

Characteristics of the period: Stocks and bonds around the world soared and vastly exceeded the expectations investors had in the late 1970s and early 1980s regarding their future performance. Also, whereas the Dow Jones and the Nikkei had already performed well between 1982 and 1985, most Asian stock markets — such as those of Korea, Taiwan, the Philippines, and Thailand — took off only after 1984–1985. (The increase in Japanese asset prices created a positive domino effect around the region.) The inflation scare of the late 1970s only dissipated very slowly. Bond prices tumbled in 1983–1984 and in 1986–1987. US bond yields were consistently higher than nominal GDP.

Equities underwent a serious correction in 1983–1984 and in 1987. And whereas by the end of the decade US and European equities had failed to exceed their 1987 highs — or did so only marginally — Japanese, Taiwanese, and Korean stocks continued to soar. From its 1987 high at 26,600, the Nikkei rose to 39,000 at the end of 1989. The Taiwanese stock market rose from around 500 in 1985 to 4,700 in 1987, dropped by 50% to 2,300 in the 1987 crash, and then soared — with another almost 50% correction occurring in 1988 — to 12, 500 in early 1990.

In the US, LBO became a buzzword and the decade ended with the demise of Drexel Burnham Lambert (February 1990) and the S&L crisis. In Japan, Zaitech and Tokkin funds became buzzwords.

Consumer price increases decelerated (disinflation) and the US dollar remained very strong between 1980 and 1985. The US dollar doubled against the Deutsche Mark during that period. Thereafter, it resumed its downtrend and declined by more than 50% between 1985 and 1987. As was the case in the 1970s, volatility in bonds, equities, commodities, and currencies was extremely high.

Consensus at the end of the 1980s: Forget about investing in US equities, as Asia will continue to outperform. Japanese banks, insurance companies, and brokers will own all the world’s financial institutions by the end of the 1990s. Japanese and Taiwanese stocks will never decline because there is “so much liquidity around” and because “the government will support prices”. Japanese real estate prices cannot decline because there is a shortage of land. However, in the unlikely case that Japanese asset prices were to decline and lead to a recession in Japan, the few pundits who were then bearish about Japan expected the global economy and financial markets to suffer badly.

The 1990–1998 Emerging Markets Mania

Best-performing assets: Latin American markets between 1989 and 1994, selected Asian stock markets until 1994, Hong Kong real estate and property stocks until 1997, and Russia until 1998. Japanese bonds (until 2003).

Worst-performing assets: Japanese and Taiwanese equities and properties, commodities, and mining and metal stocks.

Characteristics of the period: Investors by and large failed to recognise that US equities would significantly outperform emerging markets and Japanese equities in the 1990s (see also below). The Latin American equity boom between 1989 and 1994 came to an end with the Tequila crisis. (The Brazil Fund rose from $6 in 1990 to $34 in 1994.) Thereafter, the Latin American and Mexican stock markets failed to make new highs in the 1990s.

And whereas, in Asia, Japanese stocks plunged from 39,000 in late 1989 to 14,000 in 1992 and thereafter traded in the 1990s between approximately 13,000 and 22,000, and Taiwan experienced a historic crash from 12,500 in early 1990 to 2,500 at the end of the year, other Asian markets (Malaysia, Singapore, and Thailand) reached new highs in 1994 and Hong Kong in 1997. (Hong Kong even made a new high in 2000 despite the 1997–1998 Asian crisis.)

Between 1994 and 1997, Asian stocks traded in a wide trading range amidst very positive sentiment among especially international investors. The Asian crisis came out of the blue and long after economic fundamentals had begun to deteriorate. (Most Asian countries had already gone from current account surpluses to deficits in 1990–1991, and vast overbuilding was already evident in 1994.) In US dollar terms, most markets declined during the crisis by between 70% and 90%.

The Russian Trading System Index calculated in US dollars (RTSI$ index) increased from 69 in 1995 to 571 in 1997 and fell during the 1998 Russian crisis to 38. (Currently, the RTSI$ is at 1900.) The 1990s were an extremely volatile and difficult period for emerging economies and their financial markets (equities, bonds, and currencies).

Consensus before the Asian crisis in 1997: A Latin American crisis such as occurred in 1994 (the Tequila crisis) is out of the question in Asia, because whereas Latin American equity markets had been boosted in the early 1990s by volatile foreign portfolio flows, Asia’s current account deficits were offset by strong and more consistent foreign direct investment flows! The already strong performance of US technology stocks in the early 1990s went largely unnoticed, whereas each time the Japanese market rallied investors believed that a new bull market had begun. Buzzword before the Asian crisis: “Foreign investors are buying!”

The 1990–2000 High-tech Boom

Best-performing assets: High-tech, media, and telecommunication stocks on a worldwide scale.

Worst-performing assets: Emerging markets and Japanese stocks (see also above), oil (until late 1998), gold, industrial commodities, metal and mining stocks, and “old economy” companies in general.

Characteristics of the period: Although it is common to put the high-tech mania in the 1995–2000 time frame, I use 1990 as a starting point. Above, I explained that we had a personal computer boom in 1982– 1983. Thereafter, US high-tech companies, with very few exceptions (Microsoft was one), performed miserably until 1990. In 1990, stocks such as Texas Instruments, Micron Technology, and Intel were selling for less than half their 1983–1984 highs. But between 1990 and 1995, Microsoft and Intel rose 10-fold, Micron Technology 60-fold, Texas Instruments 6-fold, and newly listed Cisco and Dell 50-fold and 15-fold, respectively.

The strong performance of high-tech stocks and the US stock market in the early 1990s went largely unnoticed by the investment community. After 1995, the high-tech mania took off in earnest, whereby newly listed companies such as Yahoo! (listed in 1996) and Amazon.com (listed in 1997) performed significantly better than more established high-tech companies such as Motorola, Texas Instruments, and Micron. Between 1996 and 2000, Yahoo! rose 200-fold, and Amazon.com rose 70-fold between 1997 and 2000, whereas between 1995 and 2000 Cisco soared 15-fold, Microsoft and Texas Instruments rose 8-fold, and Micron rose by just 112%. The bull market in high-tech companies was interrupted by minor corrections in 1995–1996 and in 1997, and by a severe correction in the fall of 1998. In 2000, mergers and acquisitions in the US hit an all-time record as a percentage of GDP, which hasn’t yet been broken.

The 1990s also saw in the US the proliferation of investment clubs, and the most popular books were about how novice investors such as the Beardstown Ladies could make a fortune in the stock market. Main Street Beats Wall Street described “how the top investment clubs are outperforming the top investment pros”.

In the meantime, mining and metal shares were hardly higher than in 1990 (Newmont Mining was down 67% from its 1990 high), although the US stock market had risen almost five times between 1990 and its 2000 peak.

The 1990s were also characterized by four major bailout and credit easing operations by the US Fed and the US Treasury: massive easing in 1990–1991 to bail out the S&L industry, in 1994–1995 in order to save Mexico, after the LTCM and Russian debacle in 1998 to bail out the financial system, and ahead of Y2K because of unfounded concerns that the new millennium would disrupt computer systems.

Consensus in early 2000: “New economy” stocks will continue to flourish, “old economy” stocks and commodities are out forever, the 21st century will be the century of the US, and “gold only goes down”. Fascinated with high-tech stocks, investors neglected to notice the extreme undervaluation of emerging stock markets and commodities.

COMMON FEATURES OF PREVIOUS EPIC INVESTMENT MANIAS AND DIFFERENCES TO THE CURRENT INVESTMENT ENVIRONMENT

I realise that documenting the chronology of previous investment booms is boring. It is nevertheless necessary to recognise the differences between previous investment booms and today’s unique investment environment.

As mentioned in my introduction, the feature most common to the previous investment booms was that a bull market in one asset class was accompanied by a bear market in another important asset class. Precious metals soared in the 1970s, but bonds collapsed. Equities and bonds rose in the 1980s, but commodities tumbled. In the 1990s, we had rolling bubbles in the emerging markets, but Japanese and Taiwanese equities were in bear markets while commodities continued to perform poorly.

Finally, the last phase of the global high-tech mania (1995–2000) was accompanied by a collapse of the Asian stock markets and Russia, as well as a continuation of the Japanese and commodities bear markets. By the late 1990s, most emerging markets (certainly in Asia) were far lower than they had been between 1990 and 1994. In the 1990s, emerging markets grossly underperformed the US stock market.

Currently, looking at the five most important asset classes — real estate, equities, bonds, commodities, and art (including collectibles) — I am not aware of any asset class that has declined in value since 2002! Admittedly, some assets have performed better than others, but in general every sort of asset has risen in price, and this is true everywhere in the world.

In the early phases of all previous investment booms, investors failed to recognise that the “rules of the game” had changed and continued to play the asset class that had been the leader in the previous investment mania. In the 1980s, every increase in gold and silver prices was perceived to be the beginning of a new bull market in precious metals (after silver prices collapsed in January 1980, prices doubled three times between 1980 and 1990 — all within a downtrend), while investors maintained a very sceptical view of bonds. In the early 1990s, investors failed to recognise the emergence of a high-tech sector uptrend, although, as explained above, high-tech stocks were already performing extremely well between 1990 and 1995. Global investors continued to believe in the merits of Asian stocks right to the end and actually stepped up their buying in early 1997!

Similarly, in the current asset inflation, investors have continued to focus on the high-tech bull market and have largely missed out on the huge increase in price of commodities, and of Indian, Latin American, and Russian equities.

At the end of each investment mania, investors believed in some sort of “excess liquidity” that would drive the object of the speculation forever higher. At the end of the 1970s, the “excess liquidity” related to the OPEC surpluses; at the end of the Japanese stock and real estate bull markets, “excess liquidity” centred around the enormous Japanese current account surpluses; during the 1990s emerging markets mania, “excess liquidity” was perceived to come from foreign buying and the Yen carry trade; and at the end of the high-tech boom the investment community believed that “excess liquidity” would come from record mergers and acquisitions, a reallocation of funds from bonds to equities, and easy monetary policies by the Fed (a belief that was fostered by the Mexican and LTCM bailouts and money printing ahead of Y2K).

But as Albert Edwards so eloquently explained in a recent scathing report entitled “Lies, rhubarb, poppycock, bilge, utter nonsense, caravans and liquidity” (see Dresdner Kleinwort Global Strategy Report, January 16, 2007), “liquidity is the hocus pocus of the investment world. It means totally different things to different people but is often cited as being a major driver for buoyant markets”.

Most presciently, Edwards explains that with respect to investment manias, “when markets are rallying but seem expensive, when new issues fly out of the door and when fundamental analysis often appears to fail to explain events, the safe haven for the market commentator is often to rely on the explanation that there is lots of liquidity” (see also below). I urge our readers never to forget these words!

What is peculiar to the current investment environment is that liquidity is supposed to come from not just one or two sources, but from everywhere! From OPEC surpluses, from the US Fed and other central banks, from the Asian current account surpluses (excess savings), from the Yen and Swiss Franc carry trade, from the large size of money market funds and bank deposits, from rising asset prices, leverage, and a tidal wave of private equity funds, and from artificially low interest rates. It’s no wonder that, given such beliefs, asset markets are all flying to the moon!

In all the previous investment booms we discussed, the bull market was interrupted by severe corrections. Gold corrected by more than 40% between December 1974 and August 1976, equity markets corrected violently in 1987 (Taiwan and Hong Kong dropped by 50%), and bonds corrected sharply in 1983–1984, in 1986–1987, and in 1994. In the high-tech mania, technology stocks corrected sharply in 1995–1996 and in 1998. Between its 1997 high and its 1998 low, the Russian stock market gave back almost all its previous gains.

In the current asset bull markets, we have, with very few exceptions (copper, zinc, oil, and sugar), not had a concerted and strenuous correction phase à la 1987 and 1998 (and certainly not in US equities).

As the advance in previous investment manias matured, its leadership tended to narrow considerably. At the end of the 1970s’ commodities bull market, only oil, copper, precious metals, and energy and mining shares were still rising. In Japan, most of the listed equities peaked out in 1987–1988, but financial stocks, including insurance companies, banks, and brokers, drove the index up until the end of 1989. In the rolling emerging market bubbles of the 1990s, most markets peaked out between 1990 and 1994 but some markets such as Hong Kong still managed to make a final high in 1997. In the TMT boom, the advance became extremely concentrated after 1999, with many tech issues only making marginal new highs in March 2000 or failing to better their 1999 peak prices.

In the current asset boom, we haven’t yet seen any significant narrowing of the asset markets’ advance (although Middle Eastern markets tumbled last year). Aside from a few commodities and US home prices and housing-related stocks, most asset prices are still rising, although admittedly with varying intensity.

A feature common to all great asset booms is that they were born from either an extremely low valuation in real terms, an extended base-building period, or from a lengthy and pronounced underperformance compared to other asset markets. In 1970, the gold price was no higher than in 1933, and down in real terms by 70% from its 1897 high. The Japanese asset boom, which had in fact begun back in the 1960s, led to the entire Japanese stock market having a stock market capitalization in 1970 lower than that of IBM. In other words, in 1970, Japanese equities were very inexpensive compared to the US stock market.

In 1982, US stocks had declined by more than 70% in real terms from their 1966 highs. And although, at the time, US equities were, adjusted for inflation, no higher than they had been in 1899, to be fair their total real return (including dividends) was far higher. Still, by 1982, including reinvested dividends, US equities were no higher than in 1961. Also extremely depressed were US bond prices, with bond yields at their highest level in the 200-year history of the US capital market. Taiwanese and Korean equities in 1984 were at about the same level they had been in the early 1970s and, adjusted for inflation, dirt cheap.

In the late 1980s, Latin American stock markets were, in US dollar terms, no higher than they had been in the late 1970s and far lower than in the early 1970s and early 1980s. In 1990, US high-tech stocks were selling for about the same prices they had reached at their 1973 peak and for around ten times earnings. Compared to the valuation of the Japanese stock market in 1990, US high-tech stocks were then extremely depressed.

The 2002 asset price increase in all asset classes also included some asset classes that started to rally from extremely low inflation-adjusted prices or low valuations compared to some other asset prices. Particularly low inflation-adjusted prices were evident for commodities (which bottomed out between 1999 and 2001). And whereas the Nikkei had massively underperformed US and European equities in the 1990s, and was therefore relatively inexpensive compared to these markets, emerging markets had both underperformed US assets since 1990 and were, adjusted for inflation, very depressed. However, not depressed (adjusted for inflation) or compared to other asset prices, were US equities. Moreover, following their 20-year bull market, US bonds — and especially Japanese bonds — were by no means depressed!

Every epic investment boom lifted prices far higher than anyone could have imagined (although I concede that in the mid-1990s, Richard Strong told me that if Japanese stocks could sell for 70 times earnings in 1989, US equities could also sell in future for 50 times earnings). In 1970, no one dreamt that precious metals would increase by more than 20-fold. In the early 1980s, it would have been considered heresy to forecast that the Dow Jones would double and bond yields would decline to less than 4%! And investors certainly didn’t expect the Japanese stock market, which had already quadrupled in the 1970s, to rise by almost another six-fold between its low in 1982 and its high of 1989. In the late 1980s, few people expected the Latin American markets would ever recover; and in the early 1990s, no one (including myself) expected US high-tech stocks to become the best performing asset class in the 1990s.

Since the current asset price increases got under way in 2002 — and contrary to the expectations of some of the perma-bulls on US equities — commodities, and emerging stock markets and economies, in which, fortunately, platform companies are largely absent, have performed substantially better than US asset prices. Since 2000, the Dow Jones has lost more than 50% of its value against gold and much more against industrial commodity prices. Moreover, since 2002, the Argentine and Russian stock markets, whose economies are perceived as “knowledge absent” when compared to the great “knowledge-based” American economy, are up ten-fold or more! Now, I will concede that the current “asset inflation” (a pompous and potentially dangerous notion, to quote my friends at GaveKal Research) may be far from over and that the end game in the current asset price increases is far from predictable, but, based on the experience of the previous four investment booms, it is likely that the significant diverging trends in the relative performance of asset classes (underperformance of US assets) will persist for far longer than is now expected.

Another common feature of the last stage of every asset boom was high trading volume, widespread public participation, high leverage, and money inflows into all kinds of money pools (Zaitech and Tokin funds, investment clubs, mutual funds, LBO funds, venture capital, private equity, emerging market, art and collectibles, and equity, commodity and index funds). In this respect, the current asset boom is no different than previous investment manias, except that it includes all asset classes and is taking place practically everywhere in the world.

In the four great investment booms we have described, and also in previous investment manias, once the boom came to an end, most, if not all, of the price gains that occurred during the mania were given back. In 1992, silver prices were lower than they had been in 1974. In 2003, the Nikkei was lower than at its high in 1981. In 2002, in dollar terms, most Latin American markets were no higher than in 1990 and most Asian markets had declined to their mid- or late 1980s level. By 1998, the Russian stock market had given back its entire advance since 1994; and in 2002, most high-tech and telecommunication stocks were no higher than they had been in 1996 or 1997. And in those manias where prices didn’t retreat in nominal terms to the level — or, as frequently happened, to below the level — from where the investment boom had begun (as was the case in 1932), prices retreated in inflation adjusted terms to those levels. Adjusted for inflation, in 2001 the CRB Index was far lower than it had been in 1971, while precious metals, oil, and grains were all either no higher, or lower, than they had been in the early 1970s.

Following all great investment booms, the leadership changed. The 1970s’ precious metal boom was followed by the boom in financial assets in the 1980s. The Japanese stock and real estate mania of the late 1980s and the emerging market boom of the early 1990s were followed by the parabolic rise of high-tech stocks in the late 1990s. Therefore, while it is possible that in a prolonged environment of “excess liquidity” all asset markets could continue to increase in nominal value, it is most unlikely that the leaders of the previous boom — the US stock market and, specifically, the TMT sector — will be the leaders of the current asset inflation. And whereas it may be premature to make a final judgment about this point, as the current asset inflation could last for much longer, so far the gross underperformance of US equities and especially of the Nasdaq (still down by 50% from its 2000 high) compared to the emerging markets and commodities seems to confirm that the leadership has indeed changed.

Best regards,
Marc Faber

March 9, 2007

When Too Many Investors Think Alike, Nobody Is Thinking! was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.