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This is a shortened version of the latest Euro Pacific Capital's Global
Investor Newsletter.
The past four years or so have been extremely frustrating for
investors like me who have structured their portfolios around the belief that
the current experiments in central bank stimulus, the anti-business drift in
Washington, and America's mediocre economy and unresolved debt issues
would push down the value of the dollar, push up commodity prices, and favor
assets in economies with relatively low debt levels and higher GDP growth.
But since the beginning of 2011, the Dow Jones Industrial Average has rallied
67% while the rest of the world has been largely stuck in the mud. This
dominance is reminiscent of the four years from the end of 1996 to the end of
2000, when the Dow rallied 54% while overseas markets languished. Although
past performance is no guarantee of future results, a casual look back
at how the U.S. out-performance trend played out the last time
it had occurred should give investors much to think about.
The late 1990s was the original "Goldilocks" era of U.S.
economic history, one in which all the inputs seemed to offer investors the
best of all possible worlds. The Clinton Administration and the first
Republican-controlled Congress in a generation had implemented policies that
lowered taxes, eased business conditions, and encouraged business investment.
But, more importantly, the Federal Reserve was led by Alan Greenspan, whose efforts
to orchestrate smooth sailing on Wall Street led many to dub Mr. Greenspan
"The Maestro."
Towards the end of the 1990's, Greenspan worked hard to insulate the
markets from some of the more negative developments in global finance. These
included the Asian Debt Crisis of 1997 and the Russian debt default of 1998.
But the most telling policy move of the Greenspan Fed in the late 1990's was
its response to the rapid demise of hedge fund Long term Capital Management
(LTCM), whose strategy of heavily leveraged arbitrage backfired spectacularly
in 1998. Greenspan engineered a $3.6 billion bailout and forced sale of LTCM
to a consortium of Wall Street firms. The intervention was an enormous relief
to LTCM shareholders but, more importantly, it provided a precedent that the
Fed had Wall Street's back.
Not surprisingly, the 1990s became one of the longest sustained bull
markets on record. But in the latter part of the decade the markets
really started to climb in an unprecedented trajectory. As the bubble
began inflating in earnest Greenspan was reluctant to follow the dictum
that the Fed's job was to remove the punch bowl before the party
got out of hand. Instead he argued that the Fed shouldn't prevent bubbles
from forming, but simply to clean up the mess after they burst.
But while U.S. markets were taking off, the rest of the world was
languishing, or worse:
 
Created by EPC using data from Bloomberg
All returns are currency-adjusted
But then a very funny thing happened. In March 2000, the music stopped and
the dotcom bubble finally burst, sending the Nasdaq down nearly 50% by the
end of the year, and a staggering 70% by September 2001. When investors
got back into the market their values had changed. They now favored low
valuations, real revenue growth, understandable business models, high
dividends, and low debt. They came to find those features in the non-dollar
investments that they had been avoiding.
Over the seven years that began at the end of 2000 and lasted until
the end of 2007 the S&P 500 inched upwards by just 11%, for an average
annual return of only 1.6%. But over that time frame the world index (which
includes everything except the U.S.) was up 72%. The emerging markets, which
had suffered the most during the four prior years, were up a staggering 273%.
See table below:
Created by EPC using data from Bloomberg
All returns are currency-adjusted
Not surprisingly, the markets and asset classes that had been decimated by
the Asian debt and currency crises, delivered stunning results. South Korea,
which was only up 10% in the four years prior, was up 312% from 2001-2007.
Brazil, which had fallen by 4%, notched a 407% return, and Indonesia, which
had fallen by 50%, skyrocketed by 745%.
The period was also a great time for gold and gold stocks. The earlier
four years had offered nothing but misery for investors like me who had been
convinced that the Greenspan policies would undermine the dollar, shake
confidence in fiat currency, and drive investors into gold. Instead, gold
fell 26% (to a 20-year low), and shares of gold mining companies fell a
stunning 65%.
But when the gold market turned in 2001, it turned hard. From
2001 - 2007, the dollar retreated by nearly 18% (FRED,
FRB St. Louis), while gold shot up by 206%, and shares of gold miners
surged 512%. As it turned out, we weren't wrong about the impact of the Fed's
easy money, just too early.
2010 - 2014
In recent years, investors who have looked to avoid the dollar and the
high-debt developed economies have encountered many of the same
frustrations that they encountered in the late 1990s. Foreign markets,
energy, commodities and gold have gone nowhere while the dollar and U.S.
markets have surged as they did in 1997-2000.
Created by EPC using data from Bloomberg
All returns are currency-adjusted
It is said history may not repeat, but it often rhymes. If so, there
may be a financial sonnet brewing. There are reasons to believe
that relative returns globally will turn around now much as they did back in
2000. Perhaps even more decisively.
Just as they had back in the late 1990's, investors appear to be ignoring
flashing red flags. In its Business and Finance Outlook 2015, the
Organization for Economic Cooperation and Development (OECD), a body that
could not be characterized as a harbinger of doom, highlighted some of the issues
that should be concerning the markets. Reuters provides this summary of the
report's conclusions:
- Encouraged by years of central bank easing, investors
are plowing too much cash into unproductive and increasingly speculative
investments while shunning businesses building economic growth.
- There is a growing divergence between investors rushing
into ever riskier assets while companies remain too risk-averse to make
investments.
- Investors are rewarding corporate managers focused on
share-buybacks, dividends, mergers and acquisitions rather than those
CEOS betting on long-term investment in research and development.
While these trends have been occurring around the world, they have become
most pronounced in the
U.S., making valuations disproportionately high relative
to other markets. As we mentioned in a prior newsletter, looking at
current valuations through a long term lens provides needed perspective.
One of the best ways to do that is with the
Cyclically-Adjusted-Price-to-Earnings (CAPE) ratio, which is also known as
the Shiller Ratio (named after its developer, the Nobel prize-winning
economist Robert Shiller).Using 2014 year-end CAPE
ratios that average earnings over a trailing 10-year period,
the global valuation imbalances become evident:
As of the end of 2014, the S&P 500 had a CAPE ratio of well over 27,
at least 75% higher than the MSCI World Index of around 15. (High
valuations are also on evidence in Japan, where similar monetary stimulus
programs are underway). On a country by country basis, the U.S. has a CAPE
that is at least 40% higher than Canada, 58% higher than Germany, 68% higher
than Australia, 90% higher than New Zealand, Finland and Singapore, and well
over 100% higher than South Korea and Norway. Yet these markets, despite
the strong domestic economic fundamentals that we feel exist, are rarely
mentioned as priority investment targets by the mainstream asset management
firms.
In addition, U.S. stocks currently offer some of the lowest dividend
yields to compensate investors for the higher valuations (see chart
above). The current estimated 1.87% annual dividend yield
for the S&P 500 is far below the current annual dividend yields
of Australia, New Zealand, Finland and Norway.
If a dramatic shock occurs as it did in 2000, will investors again turn
away from high leverage and high valuations to seek more modestly valued
investments? Then, as now, we believe those types of assets can more readily
be found in non-dollar markets.
Another similarity between then and now is the propensity to confuse an
asset bubble for genuine economic growth. The dotcom craze of the 1990s
painted a false picture of prosperity that was doomed to end badly once
market forces corrected for the mal-investments. When that did
occur, and stock prices fell sharply, the Fed responded by blowing up an
even bigger bubble in real estate. When that larger bubble burst in 2008, the
result was not just recession, but the largest financial crisis since the
Great Depression.
But once again investors have mistaken a bubble for a recovery, only this
time the bubble is much larger and the "recovery" much
smaller. The middling 2% GDP growth we are currently experiencing is
approximately half of what we saw in the late 1990s. In reality, the Fed
has prevented market forces from solving acute structural problems while producing
the mother of all bubbles in stocks, bonds, and real estate. A
return to monetary normalcy is impossible without pricking those
bubbles. Soon the markets will be faced with the unpleasant reality that the
U.S. economy may now be so addicted to monetary heroine that
another round of quantitative easing will be necessary to keep the bubble
from deflating.
The current rally in U.S. stocks has gone on for nearly four full years
without a 10% correction. Given that high asset prices are one of the pillars that
support this weak economy, it is likely that the Fed will unleash
another round of QE as soon as the market starts to fall in earnest. The
realization that the markets are dependent on Fed life support should seal
the dollar's fate. Once the dollar turns, a process that in my opinion began
in April of this year, so too should the fortunes of U.S. markets
relative to foreign markets. If I am right, we may be about to
embark on what could become the single most substantial period of out-performance of
foreign verses domestic markets.
While the party in the 1990s ended badly, the festivities currently
underway may end in outright disaster.
The party-goers may not just awaken with hangovers, but with
missing teeth, no memories, and Mike Tyson's tiger in their hotel room.
Read the original
article at Euro Pacific Capital.
Best Selling author Peter Schiff is the CEO and Chief Global
Strategist of Euro Pacific Capital. His podcasts are available on The Peter
Schiff Channel on Youtube
Catch Peter's latest thoughts on the U.S. and International markets
in the Euro Pacific Capital Summer 2015 Global Investor
Newsletter!
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