The Eerie Zone
by Wynn Quon
Canadian MoneySaver, February 2009.
To start the year we’ll take a look at what’s happened since our last column in September and then look forward to what is likely to happen in 2009.
MoneySaver readers know that we’ve been bearish for some time. As one reader remarked, I have predicted five of the last three recessions. It may be easy to spot a bubble but just about impossible to predict the exact time of its implosion. The situation between 2005 and last year was like an illicit poker game where someone has tipped off the police and a bust is inevitable: One is tempted to stay to maximize profits but the longer one plays, the greater the chance of being tossed in the slammer. As a coward, I sat at the table with my coat on, ready for quick exit. I would rather fold my hand early rather than plead a weak case from the prisoner’s dock.
Looking back, the danger signs were in plain sight (something that we’ll come back to later on). Unfortunately, people were unable or unwilling to see it for themselves. All through 2006, there was a steady flow of news about the booming real estate market in the U.S. But there were many that saw through the euphoria. One example: The cover story in Businessweek magazine on September 11, 2006 titled “Nightmare Mortgages”. The article detailed widespread, fraudulent and foolish mortgage practices. The writers named twenty-three mortgage lenders deemed most at risk. It’s an extraordinary list because two years later, all of these formerly prestigious names have been publicly disgraced. Most are bankrupt or were bought out at pennies on the dollar. (You can find the article at http://www.businessweek.com/magazine/content/06_37/b4000013.htm. ) At the top of the list was Countrywide Financial. This company was little known outside the U.S. but became world-famous when its implosion in 2007 signaled the deluge to come. I mentioned Countrywide Financial as a company to stay clear of in my September 2006 column. The credit goes to the authors of that article: Mara Der Hovanesian and Emily Thornton.
Other Warning Signs
There were plenty of other signs as well. A somewhat unusual one was visible literally from miles away: The imminent completion of the Burj Dubai skyscraper in the United Arab Emirates. How so? Let’s take a short historical detour: It’s a little known fact that almost every time the record for the world’s tallest skyscraper is broken, the world economy takes a beating. The Empire State Building was started in early 1929 just before the Crash and was completed in the brutal depths of the Great Depression. The Empire State building’s record stood for forty years until the completion of the World Trade Center and the Sears Tower in the early seventies. No sooner were they built that the 1973-74 bear market, the second worst of the last century, slashed share prices by almost fifty percent. The global economy went into a decade-long slump. The next brave record contender, the Petronas Towers in Malaysia was erected in 1998. It proved to be another disastrous year, the year of the Asian financial crisis. Fast forward to the present day. Someone visiting Dubai in the last year or two would have witnessed the building of the greatest monument of them all. The Burj Dubai makes the Empire State Building look like a motel for munchkins. When they finish it a few months from now, it will, at 808 metres be more than twice as tall as the Empire State. What can loose financing and overbearing ego accomplish? It can build a skyscraper in the middle of nowhere, a monument to pure speculative excess that’s half-a-mile high. Call it conspicuous construction. The Burj Dubai holds the dubious record for something else -- the biggest contrarian indicator in history.
What Do You Do?
Back to the illicit poker party. If you hear sirens in the distance, what do you do? There’s no point waiting for them to kick the door down. In late 2007 we sold off our entire Tech portfolio. The bubble needed just one final pin-prick to burst. That came in 2008, with the collapse of Bear Stearns. As in all speculative episodes, the unraveling proceeds at great speed. In September 2008, we wrote about how to prepare for the inevitable bear market. The reckoning came within weeks of the column’s publication.
Even with advance warning, the collapse was stunning in shock and severity. The Dow fell 51% from its high. The TSX experienced a record one-day drop. Oil prices collapsed, falling 70% from their high. Automobile sales imploded and bankruptcy for the Big Three automakers cannot yet be ruled out. The Canadian dollar, flying high earlier in the year, declined precipitously, losing almost 20% against US currency. Chaos roiled markets all around the world.
These events confirm the historical observation that the bigger the bubble, the worse the subsequent collapse. (The $50 billion dollar Madoff investment fraud is just one more testament to speculative excess that shatters all previous historic experience).
As I write this in mid-January, the markets have recovered somewhat but the reprieve is probably temporary. The TSX is at 9400, up from its November low of 7600 and the Dow is at 9000, up from 7400. The market is in an Eerie Zone. (As they say in bad movies: “Things are quiet. Too quiet”). Investors are putting on a brave face on deteriorating fundamentals. But if there is anything to learn from the great bear markets of the past, it is that the majority of wealth is not lost in the initial selloff wave but in the subsequent continual liquidation. The investors during the 1920s did not lose their fortunes during the Great Crash of 1929. They lost them by piling back into the market in 1930. They were conditioned by “buying-the-dip”. And they were crushed by a two-year bear market that knocked prices down by almost ninety percent.
I would have more faith in the market’s current levels if I thought that this downturn is just another “vanilla” recession. One that could be fixed with a simple interest rate cut. Alas what worked in the past will fizzle this time around. Any successful economic policy contains the seeds of its own demise. The old rate-cut playbook won’t do because it’s landed us in a mess:
- Consumers are drowning in debt after a decade of overspending. Tragically millions of homeowners with deadweight mortgages are going to get wiped out.
- Companies are equally stretched. Corporate defaults will reach record highs this year.
- Lenders can no longer pass their problems to others through CDOs and the like. Instead, banks are clamping down on anyone suspected of credit risk.
And while residential real-estate was ground zero for the credit crisis last year, this year the big story will be the devastating collateral damage to employment..
The unemployment rate in the U.S. was 5.7% just last June, but by December it had skyrocketed to 7.2%, a sixteen year high. This is a terrible development because it means that we’re entering a decline vortex. More unemployment means more real-esate defaults and foreclosures which in turn means more pain for the banks, tightened borrowing, drops in consumer spending, sharp falls in corporate profits…which spawns yet more unemployment. As if that wasn’t bad enough, we’re seeing this vortex effect right around the world. Subprime default may have sparked the conflagration last year, but the underlying credit bubble is a global one.
We won’t hit bottom until much of the toxic debt has been purged from the system. Unfortunately this will take a long time because not only are we talking about consumer mortgages, credit cards and student loans but also commercial real-estate loans, and piles of corporate junk bonds. The worse news is that the burden of bad debts will rise as the economy contracts.
We in Canada have yet to feel the brunt of the impact. We’re living in our own Eerie Zone. But as I’ve written before complacency is not a substitute for prudence. I expect that news of mortgage foreclosures in Canada for example will start hitting the headlines in about six to eight months. I expect a 60 percent chance that the TSX will fall below 6000 this year. In the U.S. I expect a 50 percent chance of the Dow hitting 5000. It would be wise to build cash reserves heading into the storm.
Perhaps the main reason we’re in the Eerie Zone is that many investors think stocks look cheap. Lots of companies are sporting single digit P/E ratios. Our old friend Intel is yielding over 4%! But looking cheap is different from being cheap. If you are intent on buying, my advice is to compare your stock’s current price to the price it held in 2004 before the bubble began in earnest. If it’s considerably lower then it’s worth a nibble. If not, I would be wary. Above all, restrict any investment to companies with little or no debt (i.e. low debt-to-equity ratios) and preferably to those with a solid dividend. And like Oliver Cromwell said, keep your powder dry. Hold some funds in reserve for the eventuality that cheap will get cheaper.
Market Bottom?
When will we know when the worst is over? How do you recognize the market bottom? One myth is the saying that the bear market ends when all the news is bad. This is the converse of the equally invalid myth that bull markets end when all the news is good. We’ve already seen in our Businessweek example given above, that the bull market ended when bad news was in plain sight. Similarly, the bear market will likely end when good news is in plain sight but people don’t see or believe it. Leading indicators would include: a solid rise in automobile sales, and a spirited increase in sales of PCs and other consumer electronics. Still, picking market lows is notoriously tricky. For those who’ve had experience with the abysmal track record of economic prediction, it may be better to be an agnostic and employ a pyramiding strategy as outlined in our September 2008 column. I have opened a tiny position in Intel, for example. It trades at $13-14(nibble), but I have buy points set at $10 (buy) and $5 (load up!). (Incidentally for those who are active investors, the current volatility provides good trading opportunities. I usually have a rule against short-term trading and I believe it should not be the core of an investment program but if there’s a time to consider bending the rule, it’s when the prices of good companies can swing up to twenty percent in weeks).
How bad can things get? The two worst possible scenarios would be either hyper-deflation or hyper-inflation. The chances of either happening are less than ten percent in my opinion. Of the two, I think the former more likely than the latter. In either case, having a small percentage of assets (5-10%) in gold stocks would be advisable. In hyper-deflation, many companies and some countries would default on their debt and former safe havens (e.g. the U.S. dollar) would be abandoned in favor of gold. In hyper-inflation, prices skyrocket as governments try to get themselves out of debt by printing money. Again, gold would become the asset of choice. I favor mining stocks rather than the metal itself because mining companies pay dividends. Think of it as an insurance policy that pays you premiums. I am not a mining expert so my approach is to buy four or five senior gold producers. Buying Canadian has an additional payoff in the dividend tax credit.
We are living in unusual times. The only certainty is surprise. They don’t call them bubbles for nothing. When they pop, much of the conventional “wisdom” of the day gets blown away. In October 2006 I wrote that oil prices were going to be closer to US$30 a barrel than to US$100. In a blackly humorous twist I was correct but only after prices had soared to $140 in the interim. Surprise, noise, confusion, and negative circumstance-- this is the new normal.
A final note: what about the conventional wisdom of “buying and holding” stocks. I think the best days of holding are past. And the best days of buying are still ahead.
Wynn Quon is chief investment analyst at Legado Associates. You can send e-mail to me at wynn_quon@hotmail.com