My Thoughts on Toronto Financial AdvisorsIt was the most expensive lesson I’d ever learned – the equivalent of a University education. This lesson was much different from the material taught at school. There were no classes or lectures to attend, no books to buy, and no exams to write. Despite this lack of commitment, each day got increasingly more difficult. I felt helpless as my dreams were disappearing before my very eyes. Losing money sucks. In 1997 I began investing proceeds from my online business ventures into financial investments. Technology was what I knew, and I felt comfortable investing my money in these companies. My portfolio grew at an amazing pace as “investors” bid up the share prices of these companies to nose-bleed levels. For three years I thought I was the smartest man alive and that I’d never have to work a day in my life.
I was brought back to reality in 2001 when I finally
sold my remaining financial investment for only a fraction of what they were
once worth. My portfolio suffered a loss greater than eighty
percent. I was the perfect “average investor” – buying at the top
and selling at the bottom. Individual investors will do this
because they don’t trade with logic; they trade using their
emotions. I (along with millions of others) made irrational
decisions while trading. I bought because stocks were going up, not
for fundamental reasons. I sold because stocks were going down, not
for fundamental reasons. The majority of the financial investment community will disagree with me, but in order to make educated decisions, the decision maker should hear both sides of the story. In investing there are two sides – the bulls and the bears. Which am I you ask? Well, it all depends on the asset class. The “perma-bulls” showcased in the media through the likes of CNBC and The Wall Street Journal will only give you one side of the story. Over the next few pages, I will attempt to provide insight as to where the financial markets may be headed over the short, intermediate and long-term using fundamentals as my basis, and not Wall Street / Bay Street hype.hype. I will begin by making a case for why financial investments will not provide the returns which investors have grown accustomed to. I will support my case by examining the state of the U.S. economy, the effect that fiscal and monetary stimuli has on asset prices and fiat currencies. Now, I’m not all doom and gloom. In fact, I am extremely bullish on one particular asset class – the Rodney Dangerfield or asset classes – commodities! I know what you’re thinking, you think I’m crazy. Well guess what – we’re both right, but at least I’ll be crazy and rich. After reading this essay I hope that you have a greater understanding of what will unfold in the next few years and maybe even have the courage to implement some of my suggestions. I understand that most investors are in for the long haul, buy and hold type investors – and not speculators. Therefore, I will tailor my suggestions such that they can be implemented by your average investor using a Toronto financial advisor. Before I begin, just remember that free advice is worth what you pay for it.
Past Performance is Not Indicative of the Future Most western investors only care about returns; “What was the one year return, the 5 year return, etc.” What they tend to not focus on is risk. Risk can be examined by looking at the fundamentals. Fundamentals are the reasons why equities SHOULD go up or down. What are the fundamentals saying now? They are saying that equities should not perform well. The stock market has a history of alternating between secular bull markets and secular bear markets. By secular, I mean long periods that generally last about 15 years. In the year 2000, the longest secular bull market in history ran out of steam after an impressive 18 year run. We are now in the 5th year of the current secular bear market. Yes, the stock market has performed well the last two years, but this is only a “cyclical” bull market operating inside of a larger secular bear market. Equities will experience downside pressure over the next few years after this cyclical bull market tops out. What causes market cycles? Investor psychology. In 1982, stocks were very cheap and nobody wanted to own them. Nobody realized that the biggest bull market in history was about to begin. By the 1990’s, your average investor had mustered enough courage to enter the market. Extreme optimism marked the end of this bull market in 2000, and the Nasdaq proceeded to lose 85% of its market value. Over the next decade, investors will slowly lose confidence in the stock market until most have sworn off the market for good. It is investor confidence that drives markets. Tops are seen when we have extreme levels of confidence, bottoms are seen when we have extreme levels of pessimism. Currently, investors are still optimistic after achieving returns in the area of 15% per year throughout the 1990’s. They make the mistake of extrapolating past returns into the future. Ask these investors how much money they’ve made in the past 5 years since this secular bear market began. Most will say zero, although if they took inflation into account, they’re looking at a loss. Since you really just can’t take my word for it, I guess I’ll have to provide some proof. Given the space constraints, I will focus on the most popular measure of value – the Price Earnings Ratio (P/E Ratio):
”From 1982 to 2000, earnings increased by 120% and stock prices rose six-fold in inflation-adjusted terms. Valuations were pushed up to a level not seen in more than 100 years. In the chart above, we see that valuations have come down significantly over the past several years but still sit at the high end of their historic range. It is doubtful that the rally from October of 2002 marks the beginning of the next secular bull market. It would be an unprecedented development if it were indeed the case.” (Zyblock)
Anyone can see that stock valuations today are higher than in 1929 when the Dow suffered its infamous decline! How can any reasonable person expect the market to continue going up? Well, company earnings could double, but as I will show you later, this situation is extremely unlikely. According to John Mauldin, the 10 year real return (return after inflation) has historically been zero with P/E’s at the levels we have today.
“Here's a study done by Jeremy Grantham, where he breaks up the years from 1925-2001 by looking at the average price to earnings level for the year. He then groups the years based on this valuation into 5 different buckets. The highest price to earnings years was labeled the "most expensive 20% of history"; the lowest price to earnings years was labeled the "cheapest 20% of history." What he found is that over the next 10 years the cheapest or second cheapest quintiles had an average compound return of 11%.“ (Mauldin)
Mr. Grantham’s study proves (should history be a reliable indicator) that at today’s P/E levels, the 10 year real return for the market should be zero. Now what should we expect for the duration of this secular bear market? Well, the stock market could fall 50%, bringing it inline with historical valuations. Or, corporate earnings could double. Both of these situations are highly unlikely. What is more likely is that we will experience periods of upward and downward volatility, but the stock market will not really move any one way for extended periods of time. Corporate earnings will eventually catch up with equity valuations and inflation will slowly eat away at investor’s portfolios. When this secular bear market is over (which will be marked by extreme investor pessimism) most portfolios will be at the same nominal value as today, only their purchasing power will be much lower because of the toll inflation has took over the last decade. In order to make money in this market, we will have to focus on absolute returns instead of relative returns. Therefore, our benchmark will not be the S&P TSX or S&P 500, but simply cash! The investor who loses the least amount of money will be the winner. I’ll end this section with some advice: buy stocks and mutual funds about a decade from now when everyone has sworn them off and financial publications are declaring the death of equities. Don’t buy them now, it violates the first rule of investing – buy low and sell high.
The Recent Economic Recovery is a Sham Yes, the stock market has posted some pretty decent gains in the last few years. In order to be an intelligent investor, we can’t look at price action alone to determine the future direction of the markets. We need to understand why the market has performed well over the last few years. First, you’ll need a little history lesson: The U.S. economy was a powerhouse in the 1990s. Foreign direct investment was at an all time high and everyone wanted to invest in the U.S. The increased demand for U.S. assets drove up the value of the U.S. dollar. The appreciation of the dollar, coupled with globalization, allowed Americans to cheaply purchase imported goods and raw materials. This, and other factors, gave the U.S. Government the ability to run the economy red hot without inducing inflation. The U.S. Federal Reserve tried to cool things down, but received a lot of criticism because they were taking the proverbial punch bowl away from the party. But can you blame them? Who wants to be responsible for ruining such a good thing? Basically, too much capacity was built up in the 1990s, and these excesses had to be worked off. The U.S. economy entered a recession in 2001. If the Government and Federal Reserve had let market forces take their toll, the U.S. (and probably the rest of the world) would have experienced a deflationary depression worse than the great depression. Deflation is an economy’s worst enemy, and the U.S. did not want its economy to contract like Japan’s economy after their 1989 market crash. In an attempt to stimulate the economy, the Bush Administration cut taxes, introduced accelerated capital expenditure write-offs for business, and increased government spending by starting a war in Iraq. The Federal Reserve dropped the overnight rate from 6% to 1% - the lowest in 45 years. As interest rates fell, more and more people refinanced their homes at lower rates, and took out their equity to spend on consumer goods. The combination of tax cuts, increased government spending and the refinance boom allowed Americans to keep on spending and support the economy.
"During the four years 2000-04, personal consumption captured 87.1% of U.S. real GDP growth, as against a longer-term average of 67%. At the same time, net national savings plunged from 5.8% to less than 1% of GDP." (Richebacher) Basically, this recovery really isn’t a real recovery – it’s just Americans spending more and more money and digging themselves deeper and deeper into debt. “Across this “recovery” wage and salary gains have accounted for just 23% of real income growth. Over the average of the last 7 Post WWII recoveries the average was 49%.” (Wolf)
So, where are Americans getting all this money? Well, from the insane amount of credit expansion caused by lowering interest rates to 1% and the Federal Reserve running the printing presses night and day.
“Credit expanded by $10 trillion between 2000 and 2004, compared to nominal GDP growth of only $1.9 trillion. During the period, 2000-2004, consumer spending on durables and housing, plus government spending, equaled 123% of real GDP growth. Other parts of the economy - notably, business investment - went down. What the nation was doing was shifting from production to consumption. Its leading business was shifting from GM to Wal-Mart - that is, from making vehicles to selling paraphernalia from China. And its citizens were shifting too - from making things that they could sell to others...to selling houses to each other.” (Richebacher)
Yes, 10 Trillion dollars of credit was created by the U.S. Federal Reserve. In the past, that would show up in the Consumer Price Index as inflation. But, with globalization, the dollars have entered other country’s economies and caused a world-wide housing boom.
"In no other two-year period since 1975 has liquidity increased by
so much. America's easy-money policy of recent years has spilled
abroad. Low American interest rates have encouraged large inflows
of capital into emerging economies, especially in Asia, as investors
have sought higher returns. Central banks have then tried to resist
the consequent upward pressure on their currencies by buying foreign
exchange, mainly dollars. When a central bank does this, it credits
domestic commercial banks with deposits (i.e. the monetary base
expands), encouraging banks to lend more. Central banks are
supposedly the guardians of money. Yet between them, they may have
created the biggest liquidity bubble in history."
(The Economist)
“Courtesy of an extraordinary shift to
monetary accommodation, the pendulum of asset depreciation quickly
swung into property markets; US house-price inflation has since
surged to a 25-year high. To the extent that equity extraction from
ever-rising property appreciation was viewed as a substitute for
organic sources of labor income generation, hard-pressed consumers
went deeply into debt to monetize the windfall. As a result,
household sector indebtedness surged to nearly 90% of US GDP -- an
all-time record and up over 20 percentage points from levels in the
mid-1990s when the Asset Economy was born.”
(Roach) “In other words, there is tremendous inflationary pressure at work, but it has impacted the economy and the price system very unevenly. The credit deluge has three obvious main outlets: imports, housing and the carry trade in bonds. On the other hand, the absence of strong consumer price inflation is taken as evidence that inflationary pressures are generally absent. Everybody feels comfortable with this (mis)judgment.” (Richebacher) “Today’s bubble market, just like those in the past, is fraught with peril. As housing prices increase the equity in one’s home, homeowners have cashed out this equity at a record pace. During the years 2001 through 2003, homeowners with conventional loans took out a total of $341 billion. The next highest level over a three year period was $103 billion from 1998 through 2000. The use of one’s home as an ATM spurred economic growth, but at the cost of increasing household debt to potentially unstable levels.” (Pollock) Let’s just sum everything up. Basically, U.S. consumer demand is completely artificial. Rising home prices give Americans money to increase their consumer spending. This is why the U.S. has such a massive current account deficit – Americans simply spend too much! And they are running out of money quickly, as illustrated by the following exhibit courtesy of the Rude Awakening:
“Starting in 1999, and continuing through 2004, households' cash outlays on goods, services and tangible assets have exceeded their cash incomes. From 1952, the beginning of these data series, through 1998, this phenomenon of households spending more than they were taking in had never occurred.” (Mayer) The U.S. Dollar Must (And Will) Fall Even though the U.S. dollar has fallen a great amount over the last few years, we’ve only seen the beginning. The Asian Central Banks are artificially supporting the dollar to allow Americans to buy imported goods. Who doesn’t like cheap imported goods? Americans love to buy them, and the Asians love to sell them. Let me explain why the dollar should fall: When Asian manufacturers receive U.S. dollars as payment for their exports, the manufacturer exchanges the dollars for the local currency. The foreign central bank will then sell the U.S. dollars in the open market. An increase in the supply of U.S. dollars will lower its value, making imports more expensive, and after some time, the current account deficit will work itself out. But, instead of selling dollars on the open market, the Asian Central Banks are buying U.S. Treasury Bills. Asian Central banks give the U.S. Federal Reserve dollars, and the U.S. gives the Asians T-bills. The value of the U.S. dollar does not drop, and Americans can continue buying cheap imported goods. So in essence, the Asian savers are financing the U.S. consumption binge. This relationship can’t last forever, but I have no idea how long it can continue. The U.S. dollar will have to fall eventually. The dollar will also fall due to accelerating inflation pressures. The 10 Trillion dollars that the Federal Reserve created will find its way into consumer prices eventually, but for now the main outlet has been increasing home prices and a large current account deficit. Basically, countries that experience high levels of inflation will see their currencies depreciate.
Where Is The Next Bull Market? As I stated earlier, commodities will be where it’s at. Now, think back and remember our discussion concerning secular bull and bear markets. Commodities also move in secular bull and bear markets. In fact, commodities and equities have a negative correlation. When equities are in a secular bear market (like now), commodities will be in a secular bull market (like now). Equities and commodities alternate their leadership roles. Why are commodities in a secular bull market? Well because of three factors: 1) Commodities rise as equities fall. This is demonstrated throughout history and there are no exceptions. 2) The intensity of this cycle will be compounded by the growth of emerging economies. 3) The unprecedented increase in the money supply of the last few years will lead to a depreciation in all world currencies (starting with the U.S. dollar). Commodities are hard assets which retain their value, and will rise in price as currencies lose their value. Commodities go up when stocks go down – it’s that simple. Remember what I said about psychology driving markets? As people become more pessimistic with equities, they will become optimistic about commodities. This bull market will run until it has reached an extreme level of optimism, much like the year 2000 for technology stocks. Your neighbour will be bragging about the fortune he made in soy bean futures. This will set off a warning light indicating that a top is near. As for emerging economies, China and India combined make up almost half of the world’s population. These countries are growing at very high rates as they shift from central planning and protectionist policies to operating as more of a market economy, much like the west. Every year, tens of millions of people are entering the middle class in those counties. Soon they will enjoy all the amenities that you and I enjoy. The amount of resources that will be consumed is enormous. In just a few years a Chinese peasant could go from living on a farm with a dirt floor, to living in an apartment, driving a car to his/her factory job, consuming KFC and drinking Starbucks coffee.
“The developed countries have gone from about 33% of world population in 1950 to the 18% range right now. The current developed countries will be 12% of the population in 45 years. The underdeveloped countries are going to grow to roughly 87%. That's a huge demographic shift. AND WILL REQUIRE A HUGE AMOUNT OF RESOURCES.” (Mauldin)
If not for any other reason, it is just smart to own commodities as an inflation hedge. When the money supply grows faster than the economy, you have more money chasing a finite number of goods – this is inflation. Commodities are real things and will retain their value relatively well.
“My investment management firm monitors 61 foreign countries that report regularly on money supply statistics. In the last 12 months these 61 foreign countries have increased their basic money supplies by an average of 15.2%. Most people with savings in these countries will try and protect themselves from inflation that is surely looming and will most likely be buying gold. The Chinese basic money supply from 1998 has averaged an annual increase of 13% for 7 solid years. Inflation is coming to China - and that means plenty of gold buying.” (Gerbino)
Commodities are cheap right now! That’s the first rule of investing – buy low and sell high. Why someone would buy expensive stocks and not cheap commodities is beyond me. Let me give you some figures to see how inexpensive commodities are when adjusted for inflation:
“How high could gold and other commodities go in this cycle? Some people think I’m trying to be controversial when I talk about $1,000 gold, but to my mind, that’s a conservative estimate. Gold’s peak at $850 in January of 1980 would correspond to $1948.60 today. $50 silver then would be $114.62 silver today. $42 uranium then would be $96.28 now. $1.44 copper would be $3.30. And $38 crude would be $87.11.” (Casey)
In order to take advantage of this trend, I don’t recommend buying actual commodity futures. Instead, the average investor can take advantage of the commodity boom by purchasing equities whose business is the underlying commodity: Gold and metals miners, oil companies, fertilizer companies, etc. Now, some of you may be confused. I’ve been telling you not to buy equities this whole time, but now I’m telling you it’s OK. Well let me clarify – the only stocks or mutual funds you should buy are those dealing with commodities. They will not appreciate as much as the actual commodity futures, but you will greatly outperform investors who don’t hold such equities.
Recommendations for the Future By now you probably know that I am bearish on the stock market, the U.S. economy, and the U.S. dollar. I am by no means even close to being a professional, so take my views with a grain of salt. Knowing what you do now, it may be wise to lighten up on equities and allocate more of your portfolio to money market. It is not a good idea to hold any U.S. equities. The U.S. market will probably top out this year, and over the next two years will fall below its 2002 low. I talk about the U.S. market because all other markets have a high correlation to it, and when the U.S. market sneezes, everyone else catches a cold. The long-term outlook for the U.S. dollar is bearish, although I am expecting a rally through this year. As the Federal Reserve raises interest rates, the flow of capital to emerging market economies will slow, and investors will race to safety by purchasing U.S. assets. Don’t buy it, it’s just a bull trap. Now that I’ve told you what not to buy, let’s focus on making some money. First of all, just living in Canada is a start. Our country has a very large amount of natural resources. During the last commodity bull market, our dollar went to par with the U.S. So, by just being Canadian, we’re already making money. Our stock market is blessed by the fact that there are quite a large number of commodity related equities, so playing the bull market run in commodities should be easy. My number one recommendation is to buy gold producers. Gold should appreciate with other commodities, but more importantly, it is a great store of value. As the U.S. dollar falls, gold will appreciate. Look to buy sometime this year as the U.S. dollar rallies. This will give you an excellent entry point. My number two recommendation is oil. Lets face it, demand is increasing and supply is not. OPEC members are also lying about the amount of reserves they have. In the 1980s when OPEC was formed, they based production quotas on the amount of reserves a country had. Overnight, many middle-eastern country’s reserves doubled or tripled; hmmmm. Fortunately, the Tar Sands in Alberta hold more oil than Saudi Arabia. With oil over $50, it is finally profitable to extract this oil from the gooey mess of clay, water and other junk. The oil sector has had a pretty good run up recently, so look to accumulate companies in the oil sector on weakness, especially the ones that deal with the Tar Sands. Other recommendations include buying China related mutual funds because this is where the growth will be in the future. I wouldn’t recommend this anytime soon because the global money supply is shrinking as the U.S. Federal Reserve raises interested rates. China’s economy will experience a hard landing as there is just too much overcapacity built up right now. I also recommend buying metal producers and mining companies. Again, now is not the best time as they are cyclical, and any downturn in the global economy will send their share prices lower. These equities should be accumulated on weakness over the next few years. The most important recommendation is just to stick to your guns. If you know the fundamentals you know what will happen. The most difficult aspect is knowing when it will happen. Invest for the long-term, buy when others are selling, and sell when others are buying. Works Cited
Mauldin ,
John. “The More Things Change” Richebacher,
Kurt. “The Wall Street
Fandango” Wolff, Max Fraad. “Failing the Soft Constraint” Prudent Bear.com The Economist "The World's Giant Money Printing Press" Richebacher
,Kurt. “Ahead of the Herd” Roach, Stephen. “Original Sin” Richebächer, Kurt. “The Great Wealth Deception” Prudent Bear.com
Mayer , Chris. “The New Leisure Class” Rude Awakening
Pollock, Darren. “Irrational Exuberance Moves Home”
Casey, Doug. “VOLUME XXVI, ISSUE 3” International Speculator
Gerbino, Ken.
“What We Know”
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