Something does not add up!

Of course, I found many horrible recommendations as well as a few timely calls. Thus, a well-meaning journalist could put together a list of wonderful recommendations, while someone who was out to discredit me could compile a lengthy list of disastrous forecasts. But this is not the issue I want to discuss.

All of us in the investment business made some good, as well as bad calls, and took great investment decisions and bad ones, which we later bitterly regretted. What, however, struck me is that in the 1970s, 1980s and early 1990s, there were again and again some real bargains around in the financial markets amidst economic fundamentals, which either looked favorable or which had the potential to improve significantly. Today I find it hard to find valuation jewels given the systematic risks in the financial markets. Let me explain.

One of the recommendations I made in early 1982 (Dow Jones hovering around 800) was to buy US automobile stocks, which were then terribly depressed. Chrysler, Ford and General Motors were all lower than they had been 20 years earlier. From their highs in the late sixties, General Motors had declined by 70%, while Chrysler was off 95%!

At their 1982 lows, GM and Ford had dividend yields of over 6%, whereby the dividends had already been cut. But this is not all, if one took inflation into account, which had been high between 1964 and 1982, the auto sector was down from its high, adjusted for inflation, by more than 90%. At the same time the entire US financial market was extremely depressed.

Consider the following: The US dollar had in the 1970s lost about 70% against the Deutsch Mark and the Swiss Franc. US long dated treasury securities were yielding close to 15%. In the late 1970s and early 1980s bond prices had totally collapsed. The Dow Jones had a P/E of less than seven, and a dividend yield of over 6%. Sentiment among investors was horrible and the economy was in the midst of one of its worst recessions, with unemployment having shot up to above 10%.
Even so called 'safe' stocks, whose earnings are less cyclical than the profits of auto companies sold for extremely depressed prices. Clorox traded with a yield of 7% from 1980 to 1982 and sold for as little as six times earnings and three times cash flow. Colgate-Palmolive sold for a P/E in the six-to-eight range and at 30% of sales, while Proctor & Gamble traded around eight times earnings.

I hope you get the point. In 1982, the economy was depressed and the world's economy did not look particularly promising. But stocks in the US were incredibly cheap, after having declined by an inflation adjusted 70% between 1964 and 1982. Thus, the risk/reward looked enticing.

Sure, the economy might not have rebounded. Sure the US dollar might have continued to decline. Also the rate of inflation could have risen again. But at least you bought into a very depressed asset class at a time the economy was already in a deep recession and investors' sentiment extremely bearish.

The overall level of bearishness was evident from the fact that investors had been liquidating equity mutual funds throughout the seventies and, in 1982, equity mutual fund assets, at just $40 billion, were no higher than they had been in 1970! Thus, while buying US stocks and in particular the auto companies in 1982 was an opportunity that did entail some risk, the upside potential was huge in the case the economy and corporate profits were going to recover.

Or consider some other examples of low valuations. In March 1985, we published our first report on the Philippines. At the time, because of a massive slide in the value of the Philippine Peso and a collapse in stock prices courtesy of the Marcos family's brilliant economic management, the entire stock market capitalization had been reduced to less than $500 million - and this in a country of then 50 million people.

We wrote at the time: 'In the Philippines we are faced today with the most depressed stock market of any country. San Miguel sells for three times earnings and at an 80% discount to asset value.' Similar low valuations were also to be found in the mid 1980s in Thailand, Indonesia, South Korea Singapore, Malaysia and Taiwan, and this at a time the US economy was in the early stages of an economic recovery and while the Dow Jones soaring.

Then in the late 1980s, it became evident to me that incredibly low equity valuations existed in Latin America, which led us to write several reports with titles like 'Latin America - The Last Bastion of Depressed Stocks', 'Argentina - A Treasure Among Depressed Markets' and 'Latin America: Shining in the Nineties.' The reason we liked Latin America so much was that it had experienced in the 1980s a depression coupled with hyperinflation.

This perfect combination of depression and hyperinflation had, however, led to incredibly low stock prices. At its low in 1987, the entire Argentine stock market capitalization was less than $600 million and stocks sold for about four times depressed earnings and at a discount of 80% to replacement costs.

In addition, Argentine commercial and residential properties could be bought for less than half their replacement costs. Again, there were plenty of risks, but just in case of improving fundamentals the up-side potential was going to be enormous.

The point is the following. Whereas in the past I saw repeatedly very low valuations when economic fundamentals looked horrible, there was at least a chance or some probability an improvement. But, today, with the exception of Asia and Russia and gold mining stocks, I do not encounter extremely low valuations anywhere.

The S&P 500 still sells for about 25 times earnings and the popular NASDAQ commands a P/E of more than 100! In other words, even if all goes well in the US, one has to ask oneself 'what is the up-side potential?'

At the same time, the risks would seem to be rather high, since no one knows for sure how deep a future recession in the US might be. Certain is only that after the longest economic expansion on record combined with exceptionally strong credit growth in the corporate and private sector, the economy is likely to require a more prolonged adjustment period than just the six months, which the consensus expects.

Of some concern ought to be as well that the 250 basis points cut in the Federal Reserve fund rate since January 3 of this year has only produced a modest stock market rally. Just consider how the market soared following the LTCM crisis when the Fed fund rate was cut by just 75 basis points!

Worrying too is that while short-term rates have been cut aggressively, long-term interest rates have been rising since the first rate cut in January, and this, although the economy has continued to weaken. Possibly inflationary expectations have been rising, possibly inflation is even accelerating.

It is also conceivable that the supply of corporate bonds, now at an all time record, is weighting on the market. As hinted at above, the US has been on an unprecedented borrowing binge. During the last three years (1998 through 2000), total net non-Federal Reserve (including financial) credit market borrowings increased $6.1 trillion, or $2.05 trillion annually.

This compares to $8.6 trillion, or an average of less than $1.1 trillion annually during the previous eight years (1990-1997). Please note that the US economy is expanding by about $500 billion annually in nominal terms, which shows that credit has to grow far more rapidly than nominal GDP to make the economic engine run.

Thus, it would appear that in order to hold its altitude, the US economy requires an ever faster and larger increase in private sector borrowings and money supply, which will, in my opinion, lead at some stage to more inflation or debt defaults, which may reach a colossal scale. To me, this continued credit market expansion and the exploding money supply coupled with the total OTC derivative positions, which according to the BIS now exceed $ 95 trillion, spells at some future date big and unavoidable trouble.

The US economy is on a collision course; we only don't know when exactly and against what the collision will occur. Therefore, the absence of extremely low valuations aside (except selectively in Asia and Russia), I am troubled by the fact that the global economy and especially the US have financed their growth through an excessive credit and monetary expansion, which in the long run simply does not add up.

Something will give. Possibly the economy will not respond to the Greenspan interest rates cuts. In this case a Japanese type of recession will take place, which will be accompanied by soaring default rates. Alternatively, growth resumes, but inflation accelerates far more than expected.

Admittedly, higher inflation rates may bail out the system temporarily, but only just, and later even more pain will be inevitable. However, in either case, the economic and financial environment will not be conducive to the huge capital gains, which only arise when assets can be bought for a song, as I have explained above at length!