Financial survival in 2002

First let us look at some broad trends. Since 1998 the US stock market has been tracing out a major top formation and a resumption of the bull trend is most unlikely. A large number of stocks - mostly old economy stocks - peaked out already in 1998, while the NASDAQ, which is heavily weighted by high tech stocks, made its final high in a speculative euphoric blow-off in March of 2000.

The reason that it will be difficult for stocks in the US, from here onwards, to make new highs is that interest rates will no longer decline, but rise if the economy and corporate profits improve, as most Wall Street strategists and economists presently expect. Conversely, if a bullish case for stocks were made based on a continuous decline in interest rates, one would have to assume that a further decline in interest rates could only occur in an environment of additional economic and corporate profit weakness.

Thus, the US stock market is caught between the prospect of rising interest rates amidst an economic recovery scenario and a further contraction in the economy in 2002 with no corporate profit recovery in sight - something I personally suspect will happen. This dilemma for the stock market would not be particularly dangerous if valuations were as low as at the bottom of previous bear markets.

Since the end of the Second World War, the S&P 500 sold at major market lows, on average, for just about 11 times earnings, had a dividend yield of more than 4% and an average price-to-book ratio of just 1.5 times. But, today, with the S&P 500 selling at more than 35 times trailing earnings, a dividend yield of just 1.3% and a price-to-book ratio of more than 6 times, I would, at very best expect the S&P 500 index to trade in a range of between 900 and 1250 for the foreseeable future.

Moreover, it would not surprise me in the least if we had not already seen the stock market's highs for the year 2002, in early January, when the S&P 500 reached the 1180 level and when stocks had become quite overbought among widespread optimism in the investment community about a V-shape type of recovery. So, while I can see a volatile trading range for the US stock market for the next 12 months or so, I still do expect the market to eventually sell-off badly, and the S&P 500 to decline to around 600 or lower.

However, we should not forget that the US government can by means of the Federal Reserve Board's monetary policies and the Treasury's ongoing market support measures and financial manipulations support the market for quite some time, as it already did in 2001. Still, based on my studies of financial history and my personal experience, I have never seen or read about any market support measures, which succeeded beyond the short term.

Eventually, market support and artificial stimulus measures create further imbalances and additional unintended consequences, and fail as badly as Japan's and Argentina's economic policies have done in the last few years! Therefore, the final bottom for the US stock market may only be reached in the 2003 to 2005 time frame, which would still be an improvement on Japan whose stock market is still hovering at an eleven-year low!

Regarding US bonds, I feel that the upside potential from here is also limited. Maybe, investors will not lose much money in bonds and even earn around 5% per annum, and so, at least, outperform US equities. But the huge gains, which were achieved since 1981, when interest rates reached an all time high and thereafter steadily declined, seem to be a thing of the past.

From here on, interest rates will be in a bottoming phase and sooner or later show a rising tendency, as inflation will accelerate as soon as the economy picks up. Of more concern to me is that inflation could accelerate even before the economy does pick up, as recent rapid money supply growth in the US could lead to a period of stagflation.

After all we ought to be aware that Mr. Greenspan and other American policy makers will - in desperation - not hesitate to flood the system with more and more money in order to stimulate the economy and, therefore, lay the foundation for an inflationary spiral in the years to come.

I also feel that the days of a strong US dollar are numbered. In due course the US dollar will weaken, as foreigners lose their appetite for US dollar assets. The only question is against what the US dollar will weaken? It is difficult to imagine how the US dollar could weaken much against the Japanese Yen. Similarly, it is improbable that the Euro will appreciate by more than 10% to 20% against the Greenback.

However, I believe that the US dollar will begin to depreciate against Gold and Silver, as the world begins to realize that the excessively expansionary monetary policies of central bankers will lead to inflation sometime in the future. Thus, I still recommend investors to allocate some of their financial assets for the purchase of gold bullion, physical silver and gold shares.

I may add that since the beginning of 2001, gold shares have begun to outperform equities and in particular financial stocks. The market, therefore, seems to indicate that there might be something rotten in the financial system. Consequently, while we recommend the purchase of mining stocks and physical gold, we also suggest investors to liquidate US financial stocks such as banks, consumer finance, credit card companies, sub-prime lenders, and the highly leveraged government sponsored enterprises such as Fannie Mae and Freddie Mac.

In the course of 2001 another important change occurred. For the first time in many years, emerging markets began to outperform the US stock market. Consider the following. Since 1990, US stocks are up by about 5 times - even after their weakness over the last 18 months - whereas most Asian emerging markets are down in dollar terms by 80% from their highs. But, there was a sea change in the trend in 2001. While the S&P and the NASDAQ declined, the Shenzhen B and Shanghai B markets rose by 85%, South Korea by 38%, Taiwan by 5%, and Thailand by 12%.

At the same time Russia was up by more than 60%. So, if we compare the performance of the Asian markets with the US stock market, we can see that, from 1990 until 1998, the Asian markets were in a steep downtrend against the US market. However, since 1998, the Asian stock markets have built a longer-term base against the US stock market, from which I expect a powerful breakout on the upside in 2002.

Thus, I recommend investors to take long positions in depressed Asian stocks and hedge this exposure by shorting the US stock market whose valuation is still far too high. As a proxy for the over-valuation of US stocks, investors should consider shorting IBM, which has so far held up better than the market.

In Asia we like depressed Indonesian, Thai, Philippine and Malaysian second line stocks better than the Hong Kong, Korean and Taiwanese stock markets, all of which are much more closely correlated to the S&P 500 and the NASDAQ in the US. So, in simple terms, go long Asia and short the US!