How Long Will the Bloodbath Continue?
Source: Adrian Day's Global Analyst (10/17/08)
Adrian Day’s reputation for discovering big winners adds credibility to the global investing pioneer’s insights, which he is sharing with The Gold Report via excerpts from recent articles in Adrian Day's Global Analyst. In this segment, he evaluates the current carnage, and discusses the demise of the dollar, prospects for the Euro and emerging economies’ currencies, and the potential for commodities to recover before other sectors do.
How Long Will the Bloodbath Continue?
We all are painfully aware of the carnage in the markets in recent weeks and months. Very few markets or sectors, few funds or managers have escaped the carnage unscathed. Warren Buffett is down, even the bears are down. For the year to date, there is not a single major market anywhere that is not down at least 36%, while much of Europe and Asia is down over 50%. The Dow, at 36%, along with Switzerland, 37% and Japan, 40%, are the least bad markets this year.
Likewise, all sectors are down, with natural resource indices, funds and big-cap stocks down 50-70%. It is truly carnage on a wide scale.
These are extremely trying times for investors. The carnage in markets has been widespread, with few places to hide. We must recognize that we are not in a normal cyclical downturn, but rather a protracted de-leveraging process, and it will take time for the economy and markets to recover. So how will the crisis, and the governments’ responses, affect markets?
Destruction of the Dollar Underway
Most important of all, government policies in response to the crisis will destroy the purchasing power of the dollar, domestically and internationally, by dramatically increasingly availability of dollars.
The process is well underway. Forget Paulson’s $700 billion cookie jar. Already this year, loans from the Federal Reserve have exploded. From well under $10 billion a month last year, Fed loans (mostly to banks) have been rising throughout this year, to over $100 billion a month for the last six months, and an astonishing $2.7 trillion last month alone. The seeds of inflation and the destruction of the dollar are already sown.
And if only half of the spending plans of either presidential candidate are implemented, the government spending and the deficit will explode (further), aggravating the dollar’s erosion.
The long-term reasons for the dollar’s decline are well known: the U.S. financial situation, high debt levels and low savings rates. But foreign central banks still hold about 70% of their non-domestic reserves in U.S. dollars. The level is so high partly because of lack of alternatives—who wants to hold the Euro as insurance?—and because of heretofore trust in the fundamental health of the U.S. economy.
But global officials are realizing that such concentration is imprudent, all the more so given the overleveraged economy. A widely publicized article in the Chinese People’s Daily called for “a new financial and currency order that is no longer dependent on the United States and the dollar,”and said “the world urgently needs to create a diversified currency system.”
With over $4 trillion in U.S. dollar paper held by the world’s central banks—at least half of it by those who are not necessarily friendly with the United States (China, OPEC and Russia)—a move to become “less dependent” on the dollar is not to be taken lightly.
End of Empire
In my view, we can draw lessons for the U.S. today from the position of Britain at the end of World War II. Britain had been the world’s dominant economic, political and military power, with the world’s reserve currency. But by 1946 it was militarily stretched beyond its capacity, and highly indebted. The U.S. took over the #1 spot and the dollar became the world’s reserve currency, with the pound falling from five-to-one in 1946 down to parity four decades later.
The problem with being the world’s reserve currency is that more money is created than is necessary for the domestic economy’s needs. For decades, the U.S. has created far more dollars than it needs, but it didn’t matter so long as other countries were prepared to buy and hold those dollars. But those dollars still exist. As other countries lose confidence and diversify, those dollars eventually come back: too many dollars and too little demand equal a lower price.
Dollar Rally Ahead?
In the very immediate term, we may see a dollar rally, as investors liquidate assets and pull back home to restore balance sheets; in addition, some foreign investors go to a perceived safe haven in a time of crisis. We may even see a coordinated central bank move to support the greenback. The last thing global bankers need now is dollar rout. But it won’t last long; as one analyst put it, “these are the worst U.S. fundamentals I’ve ever seen for a dollar turn.”
In the next leg down, the Euro won’t be a leader, as we’ve suggested before. Its economy is also sluggish, with interest rates set to come down, and with fundamental structural problems. Indeed, the Euro itself may not survive another decade. The leaders in the next stage are likely to be the Asian currencies, including the yen and renminbi, as well as those of other major emerging nations, and gold.
Weakening Economies Are Not Positive for Stocks
As the U.S. economy de-levers, it will be next to impossible to avoid a recession; consumer spending is falling amid rising unemployment. Europe too is slowing, with German GDP falling last quarter amid weak manufacturer numbers. Ironically, Japan is best positioned of the major industrial economies. Its economy is nowhere near as leveraged as others, with strong balance sheets in the corporate, financial and household sectors, and with considerably less exposure to U.S. “toxic assets.” With over half its exports going to vibrant economies in Asia, it may avoid a deep contraction.
Are Stocks Cheap?
There are those who suggest the U.S. stock market is at a bottom. Certainly, one needs to be careful dumping into a panic liquidation and some recovery would be expected. Similarly, we are beginning to find more and better buys. The S&P is now selling at an estimated forward price-to-earnings a little over 13, below average p/e levels.
But the stock market is not yet fundamentally cheap. First, we have the question of how reliable those earnings estimates might be. Analysts are notoriously optimistic and have been continually revising estimates downwards. The consensus analyst estimate is for 34% growth in S&P earnings next year. We seriously doubt that. (The S&P is trading at 21 times trailing earnings.)
But note also that even that low estimated p/e is still considerably above the typical historical bear market low (of 8 times). The same applies for book value and yield levels, barely at average levels even after these massive price declines, let alone bear market lows.
Where Are the Global Values?
Just as U.S. analysts have grossly mis-estimated earnings, so too have European analysts, who are calling for a minor rise in earnings for the balance of the year. But for next year, they are calling for a 12.6% increase in earnings, which is also unlikely to come about.
Having said that, there are some very good values in both the U.S. and Europe, as well as elsewhere, companies trading for less than their intrinsic worth, with good managements and strong balance sheets. But in a market like this, in the near term at any rate, value is so much less important than sentiment and liquidity, and both of those are extremely negative, meaning markets—despite any rallies—will remain under pressure.
The same applies to emerging economies, the largest of which have been responsible for much of the world’s recent economic growth. Their stocks represent better fundamental value in many cases. Yet given liquidity issues, we are not recommending buying yet.
Commodities, Badly Hit, Have the Best Prospects
In the last several weeks, prices of commodities have dropped, in many cases precipitously, amid concerns of a global recession cutting demand, capping a generally weak several months. The stocks have tumbled alongside, with major global mining stocks down 50-70% from their peaks, while most juniors are down even more. No doubt, we can expect demand to be less robust than prior. Yet most demand growth is coming, not from major industrial countries, but from the larger emerging countries. For most resources, what happens in China is more important than a decline in the U.S. economy.
So we expect slower growth, but also expect demand for resources to continue to grow in the years ahead, even as supplies for many commodities are struggling to keep pace.
Despite huge increases in exploration budgets as prices moved up, major companies are simply not making sufficient new discoveries to meet increased demand or even to offset existing production. This is true of a range of resources. The major integrated oil companies, for example, are replacing only 70% of their output; gold production is actually down over the past seven years; and so on.
Commodity Super-Cycle Is Not Over
So we view this as a correction, albeit a particularly severe one, within a secular bull market. Secular markets in commodities tend to be long, partly because of the long lead times in supply response to higher demand and prices. This secular bull market is driven by the urbanization and industrialization of China in particular, and the growing middle classes from Asia to Brazil, which demand the products we take for granted. And that requires basic resources. That’s not changing.
But secular bull markets have cyclical cycles within them. During the current slowdown, there is de-stocking of inventories and a slowdown in new projects. So when demand resumes growth, prices could recover quickly, as firms rush to build up stocks again. In China, it’s different: demand is already coming back as factories reopen following the shutdown ahead of the Olympics, but first they have to work through the inventories built up at that time.
Gold: The Ultimate Money
Gold is a unique case, because of monetary factors. Thus gold had a run in recent weeks as the crisis unfolded, jumping over 20% to over $900, even as other commodities slumped and the dollar recovered. This came amid a worldwide rush to buy physical metal in “unprecedented” amounts, driven unusually by the world’s very rich; imports into Abu Dhabi, a key Middle Eastern gold trading hub, have jumped 300% from last year.
But there’s also stronger-than-usual demand from India, the world’s largest gold market, while retail investors in the U.S. and around the world have flocked to buy, leading to extreme shortages of coins and small bars.
With Demand So Strong, Why Isn’t the Gold Price Higher?
There is a dissonance between the physical market and paper market (COMEX and other futures and derivatives). The latter have pushed the price back on massive short positions (as well as, no doubt, some further forced liquidation by funds and others). Such contracts are settled in cash, not bullion, but any failure of some large contracts could expose the shortage in the physical market. Ongoing concerns about the global monetary system and about further collapses in erstwhile reputable firms will support gold buying.
Why Have Not the Gold Stocks Kept Pace?
There are long-term reasons the stocks have lagged: mining costs have increased as much as the gold price; political and environmental pressures have caused delays; and the gold ETFs have diverted some demand (though also created new demand). More recently, the most critical factor has been liquidity, both with senior and particularly the junior stocks.
When hedge funds get margin calls or mutual funds redemptions, funds are forced to sell, and they dump large positions onto a market without enough buyers. One by one the stocks are taken out back and shot (though most not fatally). That causes panic and despair among ordinary investors, leading to more wholesale liquidations. It’s also clear that a tremendous overhanging is building up in many situations.
The stocks, in our view, are inexpensive now. The seniors are trading at some of their lowest valuation levels in 20 years, and are cheap relative to gold. A gold/XAU ratio over 5 typically foretells a rally in both gold and the stocks. Today, it stands at a record high of 7.5 and well outside the normal range. As for the juniors, many are trading well below their net asset values, and several below cash. And in many cases, these are companies with low burn rates and multiple projects.
When Will the Gold Stocks Move?
So what will cause this to change? Right now, it’s important to emphasize that liquidity issues are more important than valuation in driving prices, pure and simple. Forced liquidations are driving prices down below any reasonable value. Certainly, gold at $950 on its way to $1,000 would help.
More importantly, however, more acquisitions by senior companies of juniors or their projects will see interest back in the sector, as would another major discovery in a politically friendly jurisdiction, that is, without politicians trying to rewrite contracts or environmental groups blocking development leading to the long drawn-out battles that wear out investors. But first, there needs to be some semblance of stability returning to the credit and stock markets in general.
Many Investors Ready to Strike
When this will happen is difficult to say. But we do know that several major savvy players with large amounts of cash are circling the wagons, believing the time to pounce, if not yet, may not be far off. So we hold the best exploration companies, those with strong balance sheets that ensure survival, and multiple projects to increase the odds of eventual success, and we continually look to upgrade overall portfolios.
In sum, we see a protracted period of weakness in the U.S. and other major industrialized nations, caused by ongoing de-leveraging, while inflation, here and elsewhere, picks up. Most importantly, we expect a long decline in the value of the dollar. But growth in many countries, particularly the emerging countries in Asia, will continue, albeit at a slower pace. This means ongoing demand for basic resources.
So, this is clearly a global crisis unlike typical cyclical recessions, and the fallout will be protracted. Though there will be rallies, often quite sharp, we should not expect sustained strength in stock markets for some time, though resources, and particularly gold, could regain strength soon.
Adrian Day is President of Adrian Day Asset Management, which manages portfolios in resource and global equities. Contact him at Adrian Day Asset Management, 801 Compass Way, Suite 207, Box 6643, Annapolis, MD 21401; Tel: 410-224-2037; Fax: 410-224-8229; Email Adrian Day