Contrarian Lethargy
The Daily Reckoning
London, England
Wednesday, September 22, 2004
The Daily Reckoning PRESENTS: The least desirable asset
today is cash. Therefore a contrarian investor should
consider holding above-average cash positions. Marc Faber
outlines his views on the future of the global economy...
CONTRARIAN LETHARGY
by Marc Faber
A friend of ours recently described the stock market as
boring and lethargic.
It is true that the indexes display little volatility and
that all the volatility indexes are hovering near multiyear
lows. But not too much importance should be assigned to the
present low volatility, except that it indicates
complacency among investors because, during major market
sell-offs such as we had in 1987, 1998, 2001 and 2002,
volatility picks up sharply.
Nevertheless, volatility can stay low for years, as was the
case in the 1991-1996 period, when the stock market was
rising. Therefore, if for years volatility stayed low while
the market was rising, I suppose that volatility could
remain at very low levels for a long time while the market
is sliding the slope of "the mother of all hopes" among the
investment community.
Moreover, while low volatility tends to be associated with
complacency, within the stock market internals there, are
some powerful trends that are diverging strongly. Moreover,
in recent weeks, an increasing number of stocks have hit
air pockets, tumbled and failed to recover.
These strongly diverging trends may well be exacerbated by
the $1-trillion hedge fund industry, which is under
tremendous performance pressure (in order to retain their
assets under management) and is therefore almost forced to
take a long position in the strong sectors of the market
and to short stocks in the weak sectors. In this respect, I
should remind our readers that historically low returns on
cash - courtesy of the Fed - are a colossal, and dangerous,
incentive for not only hedge funds, but also all investors
to speculate in just about anything from art, propert,
and direct investments in oversaturated industries in
China; homes in the United States, the UK and Australia;
foreign currencies, commodities, emerging market bonds and
stocks; and funds of funds; to a plethora of the most
imaginative derivative products.
Like in a casino or lottery, some players who are
particularly skilful or lucky will leave with huge profits,
while the majority will end up with losses. I suppose that,
eventually, even the casino (the investment banking
industry and other financial service providers, real estate
and all kinds of other commission agents) will lose money
when the majority of players, discouraged by their poor
returns, leave the global investment bazaar or when a
systematic crisis puts them out of business for good. In
fact, if we look at the recent performance of brokerage
shares (note the well-defined "head-and-shoulders top"
formed between November 2003 and June 2004), one gets the
impression that the casino is already under some
considerable stress.
So, what should the prudent and wealth preservation-
oriented investor do in this environment?
As I have explained in earlier reports, the least desirable
asset today is cash. Therefore, a contrarian investor
should consider holding above average cash positions. Cash
won't provide you with a high return, but in an environment
where the stock market is unlikely to climb this year above
the JanuaryMarch 2004 highs, this may be the proper
strategy for the average investor. I am purposely writing
for the average investor, because it should be clear that
some investors with a particular knowledge of the market,
individual sectors and stocks will be able to capitalize on
the diverging trends that I discussed above.
Now, I am perfectly well aware that every investor is
convinced that he is an above-average investor, but, as one
can imagine, this cannot be the case from a mathematical
point of view. (The evidence from the performance of equity
mutual funds, which are run by mostly diligent
professionals but tend to underperform the market, does
rather support the view that most investors are below-
market-averages investors. This is likely due to the
casino's fees and the transaction costs involved in playing
the game.)
The question then arises of what kind of cash to hold.
There is at present a widespread consensus that the U.S.
dollar is in trouble, and while this may be true as far as
the long-term is concerned, counter-trend rallies will
repeatedly occur, as (with the exception of the Asian
currencies) paper currencies such as the British pound, the
Australian, Canadian and New Zealand dollar, and the euro
don't appear to be particularly undervalued against the
U.S. dollar.
Over the longer term, all paper currencies will lose their
purchasing power, as they have done so since the invention
of central banking and the end of currencies that are fully
backed by gold. Hence, it makes sense to hold some cash in
gold and silver. The return on holding gold and silver may
be low, and at times even negative (in an environment of a
strengthening U.S. dollar), but over longer periods of
time, precious metals whose supply increases at a far
slower rate than the supply of paper money will at least
maintain their purchasing power. Moreover, as we wrote in
recent reports, we believe that other commodities such as
sugar, orange juice and coffee will perform better than
precious metals and industrial commodities over the next
two years.
The other widespread consensus that stands out is that U.S.
bonds will decline as the economy and inflation pick up. I
agree that, eventually, U.S. long-term interest rates will
be higher than they are now, as inflation is bound to
accelerate in the next 10 years or so.
However, the question is: What will happen between now and
then? From the monetary and other economic statistics I
follow, and from the performance of economic sensitive
stocks such as semiconductors, retailers and now also,
increasingly, homebuilders, I wouldn't be surprised if the
economy didn't gather strength over the next six months,
but then weaken once again far more than even the
pessimists expect as a result of shrinking real personal
incomes. In this scenario, I believe, as indicated in last
month's report, that long-term bonds could rally another
5%, or even 10%, from their present level, as investors
might panic out of equities into the highest quality bonds.
I should also like to mention that if this scenario of a
weak economy does come into play, the dollar could surprise
on the upside simultaneously with the bond market. Why?
Because weakness in U.S. consumption will lead to an
improvement of the U.S. current account deficit as imports
falter. I should like to emphasize that this view of dollar
and bond market strength isn't a long-term call, but
intermediate in nature, based on the prevailing negative
consensus about bonds and the U.S. dollar and my
expectation that the economy might suddenly fall off a
cliff.
Lastly, whenever I hear that a market is lethargic, boring
or without any conviction, I think of a market where most
participants are paralyzed because they are either losing
or not making any money. Maybe the big hedge fund returns
of the last 25 years or so are a thing of the past, because
in the good old days of hedge funds, a small number of
smart operators made a living from "average" or "below-
average" investors.
But today, there are, in my opinion, far too many hyper-
smart operators in the hedge fund industry, who are
constantly trying to outdo each other for this industry's
own good. Is it time to make a bet against the hedge fund
industry altogether?
Regards,
Marc Faber
for The Daily Reckoning