The Daily Reckoning PRESENTS: "When the world is engulfed
in a wave of speculation," says Marc Faber, "the wave
doesn't end abruptly, but tends to carry on for a while and
spreads to assets other than equities, such as real estate,
commodities, art etc..."
LESSONS OF HISTORY, Part II
By Marc Faber
Investors should never forget the lessons of the South Sea
Bubble and John Law's experiment with paper money,
discussed in yesterday's Reckoning. The Mississippi Scheme
in particular is relevant to the current situation in the
U.S.; in fact, there are several lessons contemporary
investors can learn from John Law's rise and ultimate
demise.
It is true that Law's policies were initially a great
success, boosting the French economy considerably. In fact,
at his peak in 1719, Law was one of the most admired
personalities in Continental Europe. But the Mississippi
Scheme failed, and Law fell from grace because the Banque
Royale held for too long the firm belief that it could
solve every problem simply by increasing the supply of
paper money. When Law finally realised that the enemy was a
loss in confidence in paper money and accelerating
inflation, the damage had already been done.
There will surely be a time when the present 'chain letter'
type of fiat money operation practised by the U.S. Federal
Reserve Board will similarly no longer work and lead to a
sharp depreciation of the U.S. dollar. The other
possibility, of course, is that the dollar begins to
depreciate, not compared to foreign currencies, but - as
was also the case at the time of John Law - against
commodities and real assets.
In my article, "The South Sea Bubble and Law's Mississippi
Scheme" [Ed note: to read the article, follow this link: ],
we looked at how the excessive money supply creation by the
Banque Royale led to soaring prices for commodities and
real estate, as the French public realised that the
banknotes were depreciating in value.
Concerning real estate, it is very common for prices to
continue to rise for some time after a stock market bubble
has burst, for two reasons. Once speculators realize that
stocks have hit a peak, they shift their funds to another
object of speculation. In other words, when the world is
engulfed in a wave of speculation, the wave doesn't end
abruptly, but tends to carry on for a while and spreads to
assets other than equities, such as real estate,
commodities, art, etc.
Furthermore, towards the end of a speculative stock market
bubble, the smart investors and (especially in the case of
the recent high-tech bubble) corporate insiders realise
that prices have shot up too much and bear little
resemblance to the underlying fundamentals. Therefore, they
shift and diversify part or all of their funds into assets
that didn't participate in the whirlwind of speculation and
are consequently absolutely, or at least relatively,
'cheap.'
Thus, real estate prices continued to rise in Japan
throughout 1990, for example, although the stock market had
already topped out on December 29, 1989. And in the case of
Australia, real estate prices continued to rise for another
two years after its stock market peaked out in the summer
of 1987.
But although real estate prices can stay strong for some
time after a bubble bursts, as money shifts from liquid
assets into real assets, in due course some kind of a
bubble also occurs in real estate because the property
market becomes - in the absence of a strong stock market -
kind of the only game in town. As a result, real estate
prices eventually also succumb to the forces of demand and
supply, and then follow the declining trend of equity
prices.
The Mississippi Scheme and the South Sea Bubble are also
interesting from another point of view. The wave of
speculation in the period 1717 to 1720 spread across the
entire European continent and the subsequent crisis was
international in scope. The initial success of the
Mississippi Company attracted investors from all over
Europe and Britain to Paris, where they speculated in the
company's shares. At the same time, many investors from the
Continent also bought shares in the South Sea Company and
other hot new issues in London. (The conservative Swiss
canton of Bern speculated in London with £200,000 of public
funds and sold out at a profit of £2 million.)
In fact, in early 1720, a 'bizarre' reallocation of assets
seems to have taken place among international investors. As
we have seen, the shares of the Mississippi Company began
to collapse in January 1720, but in London the shares of
the South Sea Company only really took off at that time. In
other words, British and international investors were in no
way perturbed by the collapse of Law's scheme. In fact, in
London the view was that the scheme had collapsed because
of a political conspiracy against Law, since he was of
Scottish origin.
However, in the summer of 1720, just about as the South Sea
stock peaked out, speculators moved funds from England to
Holland and Hamburg in order to speculate on Continental
European insurance companies. I mention this because once
excess liquidity has been created, money will flow from one
sector or country to another very quickly and can therefore
lead to a series of new bubbles somewhere else.
For today's investor, however, the most interesting effect
of excess liquidity creation is perhaps found in commodity
prices. In the future, just as during the Mississippi
Scheme, a bull market in commodities is a distinct
possibility and could exceed investors' expectations. I
have no doubt that the Federal Reserve Board will continue
to flush the economy with liquidity, which at some point
could spill over considerably into the commodities markets,
in the same way that the excessive liquidity created at the
time of John Law's Mississippi Scheme, and also in the late
1960s, led to a sharp rise in the price of commodities and
real assets.
In particular, I want to emphasise that commodity prices
can increase sharply under any economic scenario, provided
that there is excessive money and credit creation and that
investors' confidence in financial assets is shaken. Take
the early 1970s, for example, when commodity prices soared,
even as the global economy headed for the worst recession
since the 1930s. Even more impressive than the rise in the
CRB Index was the performance of agricultural commodity
prices. From their lows in 1968/69 to their highs in
1973/74, wheat rose by 465%, soybean oil by 638%, cotton by
317%, corn by 295%, and sugar by 1290%.
Or take the deflationary depression years of the 1930s. At
the time, the price of silver had been in a bear market
since 1919, but made a first bottom at US$0.2575 on
February 16, 1931 and a marginal new low on December 29,
1932 at US$0.2425. From there, however, silver prices
advanced to US$0.81 in 1935 for a gain of more than three
times their lows. In addition, if an investor bought silver
in 1929 instead of the Dow Jones, which was then above 300,
by 1980, when silver hit US$50, he would have realised a
profit of close to 200 times, whereas by 1980 the Dow was
up by less than three times above its 1929 peak.
(Admittedly, the performance of the Dow was far better if
dividends were included; also we have to take into account
that the 1980 peak in silver prices was similar in nature
to the March 2000 Nasdaq peak at over 5,000 - in other
words, a once-in-a-generation bubble peak.)
I might add that gold shares performed superbly in the
Depression years. From a low of US$65 in 1929, Homestake
Mining rose to a high of US$544 in 1936. Also, from 1929 to
1936, Homestake paid a total of US$171 in dividends, which
was more than twice the price of its stock in 1929. (Dome
Mines rose from US$6 in 1929 to US$61 in 1936.)
The most dramatic commodity bull markets all originated
after extended bear markets, such as we have had since 1980
and which accelerated on the downside following the Asian
crisis and again in 2001, when it became clear that the
global economy was in trouble. At issue is the fact that
off their lows - whenever these lows occurred - commodity
prices experienced dramatic upward moves within a brief
period of time.
If the global economy doesn't improve dramatically, it is
likely that commodity prices will be boosted because of
further liquidity injections by the monetary authorities as
well as expansionary fiscal policies. Moreover, if the U.S.
economy and the investment climate for financial assets in
the U.S. don't improve, it is likely that the U.S. dollar
will weaken much more.
Now consider this: investors have little faith in either
the Euro or the Yen. Therefore, if, in the future,
international investors lose confidence in U.S. dollar
assets, where will they go with their liquidity?
Take as an example the Asian central banks whose assets are
concentrated in U.S. dollars and who only hold about 3% of
their reserves in gold (down from 30% in 1980). If the day
should come when their faith in the U.S. dollar is shaken,
will they pile into Euros or the Yen? Possibly, but it is
also conceivable that, given the less than stellar
fundamentals for these currencies - a diversification into
gold will be considered.
Regards,
Marc Faber
For The Daily Reckoning
P. S. As a holder of gold shares and physical gold myself,
I sincerely hope that there will be genuine deflation in
the domestic price level in the U.S. In this case, the
economic mess will be complete, as the default rate among
corporate borrowers will soar. At the same time, the
confidence and blind faith of investors in the omnipotence
of Mr. Greenspan will finally collapse and lead to a panic.
That in such an environment gold prices could go through
the roof isn't difficult to envision.
With or without inflation, investors should therefore
continue to accumulate gold and silver shares and a basket
of commodity futures.
Editor's note: Dr. Marc Faber is the editor of The Gloom,
Boom and Doom Report. Headquartered in Hong Kong for the
past 20 years, Dr. Faber has specialized in Asian markets
and advised major clients seeking down-and-out bargains
with deep hidden value, unknown to the average investing
public.
Looking ahead to where the real growth opportunities of the
next 30 years lie, Dr. Faber has distilled his analyses
into the ground-breaking book, 'Tomorrow's Gold' - a wake-
up call to Western investors.