Undervalued Weekly
The Undervalued Reports Company’s weekly newsletter
Towson, MD
January 10, 2003
http://www.dynamicinvestors.net
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It was back to work this week for most of us. I hope you’ve been able to stay healthy. Your editor has been sick all this week, trying to shake the “cold that won’t go away”. But fear not, dear reader, it didn’t keep me from my work.
I decided this week would be about my thoughts for 2004. Every financial writer ends up doing predictions at the beginning of the year. It’s almost an obligation. So that’s what we’ve got this week, my “predictions” for 2004. I welcome your feedback on anything I’ve said, and would be interested to hear your thoughts.
Despite a big drop on Friday, the stock markets were up for the week. The Dow finished up 48.99 to 10,458.89; The S&P was up 13.38 at 1,121.86; and the Nasdaq finished up a whopping 80.24 points to close the week at 2,086.92. Weakness in employment numbers for December triggered a sell-off on Friday, after it was reported that only 1,000 new jobs were added to the US economy in December. This sent the US dollar to record lows against the Euro, at the $1.2868 range, before retreating some to $1.2822.
Coincidentally (or not), gold was up $11.20 for the week, a gain of 2.7%. Silver did even better, up $0.51 or 8.6%. You’ll read in this week’s article that I expect silver to outperform gold this year on a percentage basis, and so far I’ve been right. Bonds rallied this week on weak economic news. It looks as though the Fed won’t be raising rates any time soon, and the weak employment data indicates the economy may not be rebounding as strong as expected. This is good news for bonds, which really took off on Friday after the employment numbers were released. 10-year treasury bonds are now yielding 4.08%.
This is the strangest I think I’ve ever seen the markets act. Stocks are up, bonds are up, gold is up, and the dollar is down. Things aren’t supposed to work this way. If you consider that each of these markets serve as an economic indicator, there are some serious contradictions here. With the dollar dropping like a rock in the currency markets, it makes sense that gold is rising, because of the inflationary pressures on the dollar. But bond yields should also be rising, not falling. The low yields indicate a low inflation environment, contradicting the dollar and gold markets.
The contradictions are incredible, and eventually they’ll work themselves out. The Federal Reserve is fighting the forces of nature, trying to spark a recovery in an economy that never took a serious downturn. The gold markets are betting on the forces of nature, while bonds are betting on the Fed. I know where my bets are placed, and I look forward to watching it unfold.
If you’d like to get a view of the great game from where I sit, be sure to check out the daily update. I’ll be back next week with a look at the structure of corporate balance sheets.
Until we meet again, best wishes to you and yours.
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Musings for 2004
I don’t normally do predictions, mainly because every other columnist and financial writer does them for me. In the time it takes me to drink a cup of coffee, I can read that the Dow is going to be at 13,000 by year-end, then read that it’s going to be around 8,000, then read how it’s going to be right where it is now. Then I have this guru tell me why interest rates will stay low, while this other guru can tell me why they’re going to rise. Needless to say, I don’t put much stock in predictions.
Yet, I’m somehow sucked into the trap of doing predictions. It’s the curse of every financial writer who dares to express his opinion. The ego just won’t let us rest until we’ve given others a taste of our limitless knowledge. So here are my predictions for the New Year: Summer will be warmer than winter. I’ll be another year older, as will you. The world won’t have ended, but it will be different. I will find a way to irritate my wife more than once.
Other than these few prognostications, I don’t know for sure what’s going to happen this year. I’m sure something will happen – life would be boring if nothing happened – but your guess is as good as mine. I do have some thoughts on what might happen, or should happen. I’m not going to say any of this will happen, just that I think it might. These aren’t predictions mind you, just thoughts and rationalizations. That way, you can’t hold me accountable if they’re wrong.
Here’s something to think about. While it looks as though gold has been in a bull market, it’s only risen significantly in dollar terms. Translated into euros, gold is only up about 14% since the beginning of 2001. That’s about a 7% annualized return. Hardly the markings of a bull market.
While some people might tell you otherwise, I don’t believe gold is a good investment for its own sake. It makes pretty jewelry, and has its usefulness in industrial applications. For the average investor, though, gold isn’t something you would invest in for the long-term. It doesn’t pay a dividend, it’s costly to store, and isn’t useful as currency any more. It’s the fact that the dollar is in such trouble that makes it worth owning. Gold passes the ultimate judgment on currencies, and the US dollar is falling out of favor. But until a gold standard is re-instated (which is unlikely) gold is at best a long-term trade.
Now don’t misunderstand me. I think gold is in the first phase of a major bull market, one that will see it surpass its all-time high of $850. Should gold break out against other major currencies, things will heat up pretty fast. There’s no reason why it shouldn’t, either, as all currencies are just paper, subject to over-printing and devaluation.
At the end of 2003, the Wilshire 5000, the broadest index of US equities, was trading at 25.6 time trailing earnings. This means that an investor who buys the market today is expecting to either wait 25 years to get his money back, or that earnings growth will be strong enough to justify the multiples. Or maybe investors have re-subscribed to the Greater Fool theory, expecting someone to buy their stocks from them at even higher multiples. Or maybe Americans still believe that buying and holding stocks is the way to get rich.
Regardless, stocks are expensive. They never really got cheap, even after the bubble burst. The S&P 500, which coincidentally is trading at 32 times trailing earnings, never traded much below a P/E of 20 during the “bear market”. Historically, bear markets end when P/Es hit the 8-10 range, not 20-30. My gut feeling is that we’ll see P/Es in that 8-10 range one day again. Maybe not this year - maybe not next year - but one day.
Commodities are already in a major bull market. The developing economies, particularly China, are using ever-increasing amounts of raw materials as they industrialize. This is raising the competition for resources, and therefore raising prices. Couple the increasing demand for commodities and materials with a steadily-depreciating dollar, and you have the recipe for serious price inflation in the US.
It’s also possible that at some point this year competitive currency devaluations will occur as nations race to keep their currencies low against the dollar and each other. Global price inflation will likely occur, which will be very good for gold investors, and very bad for bond investors.
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In conclusion, I think 2004 is going to be good until it goes bad. A lot of other writers think this year will be great, and that things won’t come crashing down until 2005. There’s some logic to what they say, considering it’s an election year and the feds will do everything they can to maintain the semblance of prosperity. It’s possible there won’t be any major economic problems this year, and that the day of reckoning will be held off until next year. I just don’t agree with that assessment.
I have a two-part rationale for why I think we won’t make it through this year. First, the fed has just about run out of stimulus. Money supply growth is already slowing, despite easy credit. Even with the pump primed, there’s not enough capacity to suck up the extra money, signaling that the economy has reached its debt limit. If that’s the case, the economy should noticeably slow this year.
The second reason I believe we’re going to have trouble sooner, rather than later, is a bit more emotional. The longer the global economy takes to start the healing process, the worse it’s going to be. If we go through another year of over-consumption, stock market bubbles, overheated housing markets, and rampant money growth, the crash in 2005 will be much worse than if it happened this year. I would much prefer it happen this year than have us keep pushing the limits.
Honestly, I’m no doom and gloomer. I’m just a realistic investor who is fascinated by the current state of affairs in the global economy. It’s like a morality play unfolding before our eyes, in which the hubris of the mighty eventually brings them down in a dazzling display of karmic retribution. Money and power are funny like that. They eventually corrupt and destroy those whom they build up. I choose to stay humble, and hope Mr. Market doesn’t wish to pass judgment on me.
This is an exciting time to be alive; a time unlike any that’s come before. I believe we stand at a focal point in history, a time that will mark the shift of power from one part of the world to another. It’s just beginning, and the world will look very different when it’s all over. I hope I live to see it. The Chinese say “May you live in interesting times.” We should be thankful for the opportunity.
I’ll leave you with some words from one of the country’s most respected economists, Stephen Roach, in his final column of 2004…
“The world economy, as I see it, remains very much in a state of fundamental disequilibrium. A US-centric global growth dynamic has given rise to extraordinary external imbalances around the world. America, the world’s unquestioned growth engine, is facing unprecedented imbalances of its own; the national saving rate, current account, Federal budget deficit, and private sector debt ratios are all at historical extremes. And an increasingly powerful global labor arbitrage continues to keep high-wage developed economies mired in jobless recoveries. The result is a unique confluence of tensions that have left the global economy in a state of heightened instability. The venting of those tensions could well be the main event in world financial markets in 2004.”
You can read Stephen Roach’s commentary at the Morgan Stanley Global Economic Forum page. It’s excellent reading by an excellent economist.
And I promise next week, it’s back to financial analyis.
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Quotes of the Week
"We cannot guarantee success, but we can deserve it."
-George Washington
“In war, the stronger overcomes the weaker. In business, the stronger imparts strength to the weaker.”
-Frederic Bastiat
Until next week my friends, happy investing. Don’t forget to forward this newsletter to a friend.
Sincerely,
Christopher M. Mallon
P.S. – If you’d like to learn about some investments that will protect you during the storm, check out Four For ’04 – The Undervalued Reports Company’s Guide to Defensive Investments for 2004. It contains detailed analysis on four quality defensive investments. And it’s only $10 for UW subscribers.
Have you checked out the Dynamic Investors Marketplace?
How about the Required Reading?
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