|
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 subscribers via excerpts from recent articles in Adrian
Day's Global Analyst. Acknowledging what trying times these are for
investors, in this first segment of a five-part series, Day discusses what
led to the current economic crisis and how he sees Washington’s $700 billion (and
counting) bailout playing out.
The Current Crisis—Causes and Consequences
The house of cards built on easy credit has
finally come tumbling down, triggered by the failure of one of the most
flimsy of the cards, subprime mortgages. We’ll look at the
causes—it’s important to understand causes if one has any
reasonable chance of analyzing the present and assessing the
outlook—and weigh the likely outcome of the government’s actions.
Not to keep you in suspense any longer, we
believe the bailout and associated actions, adding yet more credit to an
economy already over-ripe with easy credit, far from solving the problem
(i.e., getting banks to lend again), will make matters ultimately worse, by
postponing the necessary adjustments, building up inflation, and destroying
the dollar and its purchasing power, devastating savers and undermining the
foundations of the economy.
This will be a protracted slowdown as
corporations and households de-lever and attempt to restore some health to
broken balance sheets. Nevertheless—to jump ahead to the critical
conclusion for investors we’ll discuss next time—we are far
beyond the time for wholesale liquidation, if it means selling quality
companies well below their intrinsic values. It may be too early for
aggressive across-the-board buying, but remember the words of the late, great
John Templeton, who advised us to “buy at the point of maximum
pessimism.”
What Brought Us Here?
It is critical to start by analyzing the causes
of the problem, and assessing the likely outcome. Only by understanding that,
can we hope to know what to do. So what brought us here, and what’s
next? The root cause of our current problems is clear: excess credit creation
over these many years. Too much money and artificially low interest rates
always and inevitably lead to speculation and mal-investment. Whatever
excesses there have been on Wall Street—and there have been many, as
well as the abject ignoring of any sense of fiduciary
responsibility—nonetheless, blaming “Wall Street
speculators” for the mess is a little like blaming a drunk child when
the parent left the open bottle in the playpen.
Critical to understand is that this is not a
normal cyclical downturn. Such is triggered by tightening money and higher
rates in a deliberate attempt to cool an “overheated” economy and
restrain inflation. The resulting recession can be sharp but is typically
short. Similarly, it is relatively easy to get out of a cyclical recession:
do the opposite of what triggered it, that is, ease money and lower rates. But
this is not a cyclical downturn; it is, rather, a secular de-leveraging
contraction. Tighter money and higher rates did not trigger it, and easing
money and lowering rates will not get us out of it. Au contraire. We
currently have easy money and low rates, rates that are actually negative at
the short end. And easier money and even lower rates, such as we’ve
seen over the past year, have not helped. (Indeed, despite the Fed slashing
the overnight loan rate from 5¼% to 2% in the seven months to April,
rates in the real market—mortgage rates, credit card rates,
etc.—actually increased and, of course, available credit contracted.) This
is important to recognize.
Selling Begets Selling
Thus, this de-leveraging process is likely to be
a protracted process as banks, other firms, and households restore health to
their balance sheets. But such a process feeds on itself, as we have
all-too-painfully seen this year. Companies sell assets to raise capital,
which pushes down prices, which forces others to raise capital, pushing
prices down further, which causes banks to contract credit. And as banks
contract, small businesses have difficulties, reducing purchases, and so on. So
much of the selling in the market has been forced (by financial companies
needing to raise capital to meet ratios; by investor receiving margin calls,
and funds getting redemptions). The waves of forced selling then cause panic
among investors, leading to the very worst kind of selling, blind liquidation
of thinly traded securities into down markets. This can, and has, driven
prices down sharply and suddenly.
Will the Bailout Work?
The banks have no capacity or appetite for
lending, which is why lower rates haven’t helped. And why, given that
for investment banks to reduce their average leverage from 30 times to 20
times would require that $6 trillion of assets be sold, the
government’s $700 billion bailout won’t change the picture
either. (Another question: Do they buy bad assets at prevailing prices, in
which case it won’t improve banks’ capital ratios at all, or do
they defraud the taxpayer and buy back at above-market prices, as Paulson
seemingly wanted to do?) It may plug a hole short
term, but it doesn’t mean the banks open up and start lending again.
Washington is attempting to solve the problem by
doing more of what caused the problem in the first place (and—greatest
irony and travesty of all—with the very same people in charge who
caused the problem in the first place, who encouraged the excesses, and who
didn’t see the problem until too late). By trying to keep asset prices
up, Washington
is repeating the error of the 1930s and ensuring that the downturn lasts
longer.
No parallel is precise, but we might look at what
happened when Japan’s
stock market and real estate bubbles burst at the beginning of the 1990s. The
Bank of Japan slashed rates, down to ½% on long-term government bonds,
and bought up bad assets from the bankrupt banks. (They didn’t open the
monetary spigots, as has Washington.)
Neither high interest rates of shaky banks have been
a problem in Japan
for many years.
But that didn’t cause banks to resume
lending. Japan
also increased deposit insurance (covering accounts in full until 2006.) That
simply slowed the needed restructuring, and caused the banks to withdraw, as The
Wall Street Journal put it, “led to the establishment of zombie
banks.” There has been essentially zero net capital investment in Japan in the
last 15 years. Despite near-invisible interest rates and strong banks, Japan has
been in either recession of deflation (or both) for most of the past 18
years. And Japan had one
huge advantage over the U.S.
today, namely that households had low debt and high savings.
It’s Not Pretty Ahead
Not only will current policies not solve the problem, they protract the downturn and delay the needed
resolution. But they make matters worse by ensuring more inflation, already
at a 17-year high in the U.S.,
adding another disincentive to save. Taxes will go up, further suppressing
economic growth or chances of a recovery. The likely result is a severe case
of stagflation
So the economy is likely to enter a recession
soon, but it will be a long and painful experience coming out of it, a
protracted period of sluggishness, with other economic problems. And the
market, likewise, is likely to be sluggish for some time, though once we see
some stability return, specific sectors and individual companies will recover
sooner, while we will see short-term rallies.
Next time, we’ll look at the outlook for
various markets, including, most importantly, the dollar, and then discuss
how investors should act in the current crisis (clue: don’t dump
quality companies below their intrinsic value into a declining market).
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
The Gold Report
www.theaureport.com
Visit The GOLD Report - www.theaureport.com – a unique, free site featuring summaries of
articles from major publications, specific recommendations from top worldwide
analysts and portfolio managers covering gold stocks, and a directory, with
samples, of precious metals newsletters. To subscribe, please complete our
online form, or send an email with the word 'Subscribe' in the subject field
to subscriptions@theaureport.com.
The GOLD Report is Copyright © 2005 by
Streetwise Inc. All rights are reserved. Streetwise Inc. hereby grants an
unrestricted license to use or disseminate this copyrighted material
only in whole (and always including this disclaimer), but never in part. The
GOLD Report does not render investment advice and does not endorse or recommend
the business, products, services or securities of any company mentioned in
this report. From time to time,
Streetwise Inc. directors, officers, employees or members of their families
may have a long or short position in securities mentioned and may make
purchases and/or sales of those securities in the open market or
otherwise. Streetwise Inc. does
not guarantee the accuracy or thoroughness of the information reported.
|
|