Peter Grandich on Stocks, Gold, & Silver
Part - I
I thought you might be interested in reading my interview in the May 1997 issue of Moneychanger and the June 1997 issue of Universal Coin & Bullion Investor's Profit Advisory.
Is the stock market turning down?
The bull market in stocks has three main ingredients: interest rates, corporate profits, & colossal money flows into mutual funds. That last item never existed in previous bull markets. Interest rates, as we all know, were dramatically lowered over several years. The long bond sank below 6%. The Federal Reserve was doing two things at once. First, they bailed out the commercial banking system & avoided a paper bailout like the savings & loan crisis. What was the Fed's magic? By lowering short term interest rates, the Fed allowed commercial banks to borrow at a rate cheaper than the rate they received on the government securities they bought with that borrowed money. That quickly turned around banks' liquidity & profits. Then the banks raised capital by offering new equity rather than issuing new debt. They could easily sell new shares because a bull stock market was grateful to buy anything waved in front of its face. The Federal Reserve had accomplished all this by mid- to late-1993 or early 1994. At that point, for the first time in history, banks owned more government paper than outstanding industrial & commercial loans.
What has happened to the bond market since then?
It has remained in a neutral to bearish mode. In 1994, the last time we saw rate hikes, we had the worst bond market in seventy years. The bond bulls say, "Well, 1994 was unique because Fed funds started at 3% when they began hiking & now they are at 5-1/4%." The problem with the bullish argument is that the inflation equation has changed since 1994. Back then wage inflation was less than 2%, where now it is 4% year over year. Another factor that has led the Fed to tighten again, & will lead to continuing tightness, is the record percentage of population in the labor force. Every indicator that has always led to Fed tightening continues to rise: hours worked per week up, unit labor costs up, & now record low business inventories. On top of that, throw in a trade gap of about $150 billion. Why should that cause concern? It's not that both imports & exports are dropping while imports are dropping more slowly. No, sir, imports are rising. That flashes a signal to the Fed that a strong economy is running wild in the US. If one interest rate hike caused a 10% stock market correction, what will two or three more hikes do? The interest rate element of the bull stock market equation is no longer bullish & hasn't been since 1994.
WHAT ABOUT CORPORATE PROFITS?
With corporate profits, too, the game is changing. From 1992 through 1996, profits grew 300% faster than revenues. How was that possible? First, lower interest rates allowed corporate America to refinance at lower rates & then offer equity instead of new debt. Next came an unbroken stream of restructuring lay-offs; one person now does the work of nearly two. Technological improvements also led to big productivity gains. And don't forget the "creative bookkeeping" which Barron's & others have written about. Companies have used creative bookkeeping to make their earnings look far better than they really are. But they have a problem now. That's all behind us.
Now the strength of the US dollar is coming back to haunt the big Fortune 500 companies. (These illusory gains explain why little companies have under-performed big ones for so long.) These are multinational corporations, & their overseas operations are now hurting a lot of them. One question stares us in the face. Do corporate profits slow down to match revenue growth, or does revenue growth speed up to catch corporate profits? Corporate profits have grown three times faster than revenues. Something has to give.
With Greenspan talking
the way he has, I don't
think it makes sense to
stay bullish on stocks.
But there's a hitch. In a higher interest rate environment, in a clearly late cycle end of an expansion, one can fully anticipate that corporate profits will slow down. Apparently that's the other thing that the market is digesting, because for the first time we saw surprisingly good earnings in the most recent announcements but stocks failed to rally strongly. That clearly shows that the market has already priced in these good earnings. It rallied in anticipation of these earnings, & now it's beginning to doubt.
Maybe corporate earnings can't keep up their phenomenal growth, especially with interest rates headed higher. Therefore the market is starting to roll over.
LOOKING UPSIDE DOWN
Americans (much more than Europeans) have forgotten the purpose of owning stocks. Enthralled & bewitched by the bull market, investors have forgotten that it goes back to simple ownership of companies. As a part owner, you are anticipating that someday somebody will pay more for that right than you did.
Government bonds are returning 7% & stock dividends are only yielding 1.75%. Doesn't that argue that investors are not buying stocks for return, but for capital gain?
From the money management standpoint, bonds now offer better value than equities. Even the bulls won't say equities are cheap, they just give the reasons why they are the only game in town, etc. But in the long term, competition from higher interest rates always hurts the stock market. Margins within these companies are clearly starting to show the difficulty of passing on costs which will hurt earnings as well. In the usual business expansion, rising costs can be passed on to customers, but this expansion has a different twist. Pricing power remains weak. Companies have not been able to lift prices since tight labor markets started to boost costs. In this past fourth quarter, profit margins for non-financial corporations actually fell.
It's important to look at non-financial corporations because there has been a boom within financial businesses. A lot of people argue that inflation has all gone into financial assets. Corporations profiting from the goods & services they provide (rather than the paper they hold or sell) saw profit margins decline this past fourth quarter. That's unusual, & spells trouble for corporate profits for the next 12 to 24 months. Meanwhile the Fed's prophet, Greenspan, has said in his speeches that he wants to see a slow down, even making that well-known remark about "exuberance" last December. The last time a Federal Reserve Chairman publicly commented about stocks being overvalued was in the 1960s, & the market went into a 15 year trading range. With Greenspan talking the way he has, I don't think it makes sense to stay bullish on stocks.
THE MUTUAL FUND MANIA
The last factor is the mutual fund mania. When you mix that with the lack of experience among financial advisors, we have a problem. In 1990 there was only about $226 billion in mutual funds. Today, there is $1.3 trillion. You don't have to be Einstein to conclude that 80-85% of the money currently in mutual funds has entered the market since 1990. Until recently there had only been one correction since 1990, a 7% drop last July. Afterwards the Wall Street Journal polled 401K investors, with amazing results. These people who supposedly always claim, "We're in for the long haul" sold seven times as much as they did before the decline. When it rallied they re-entered the market as progressive buyers, but that's still a storm signal. It suggests that in a small correction, these people are already willing to forsake their buy & hold strategy. What will happen when a major bear market correction arrives?
MONEY MANAGERS ARE GREEN
My analysis of the next problem explains why I won't be invited to anymore brokerage firm parties: professional advisors lack true bear market experience. Morning Star studied Fidelity Funds, & found that out of the 28 managers who manage their growth funds, growth & income funds, & conservative stock equity funds, eleven had not left grammar school when the last bear market occurred. Twenty out of the 28 were not even managing money in 1987. This latter group supposedly manages $150 billion of Fidelity's $250 billion.
I am not picking on Fidelity, but this does point out that most advisors have no experience driving down two-way streets. Registered Representative magazine reported that close to two-thirds of all advisors have only been in the business since 1982. With only 15 years or less experience they can't imagine a day coming when people stop pouring money into their funds, & begin taking money out. I first got into the market professionally just in time for the 1980 gold spike. I was a gold bull & had to ride it down for years before I understood the deceitfulness of a bull market mindset. It conceptually blinds you to the hyperbolic curve in front of your eyes, screaming, "SELL! SELL!"Maybe a few people don't need to live through that experience to learn that markets both rise & fall. Maybe few can catch on from a book or somebody else's experience, but most people have to learn first hand how deceitful their own mind can be.
The unmistakable signal that the bubble had reached its peak was the great craze for tech stocks which have only now come down hard. Last year the NASDAQ composite really masked the overall weakness of over the counter stocks. That composite is heavily weighted toward the top tier of stocks like Intel, so the composite rose 23%. If the index had been unweighted, i.e., all the stocks had been equally represented, the index would only have risen 7%. The market cap for tech stocks tripled in the last two years while computer sales last year were cut in half from the year before. The last time that happened was 1983, but in 1983, the stock market had only just begun its bull market run. The market rising 5,000 points has crippled people's memory.
|Back then the hot stocks like today's Intel & Microsoft were names like Atari, Eagle Computer, Computer Vision, Commodore, & IBM. Only one of those companies still exists, but back in 1983 the brokerage reports were all bullish on those five companies.|
ARE STOCKS FINISHED? - DO YOU EXPECT MORE THAN A 10% CORRECTION?
I think it is the end of the bull run. Investing is like a pendulum, it always swings from side to side. In 1980 no one wanted to own stocks & people said equities were dead. Today everybody & his mother has bought stocks. Now envision that pendulum. If I am right, stocks won't just undergo a normal correction & return to fair value. No, stocks must become very unvalued again & undergo another cycle. Some argue that 5000 to 5500 would represent to fair to under-valuation. It wouldn't surprise me that stocks would lose half their current value & trade towards a 4000 Dow before they are undervalued again.
THEN YOU EXPECT THIS GRAND BULL TO END NOT WITH A CRASH, BUT WITH AN EROSION?
Right, whimping out. Like a party where everybody's excited & then a couple of people leave while the rest party on. Suddenly you look around & ask, "Where did everybody go?" You're left there holding the bag. We see that already by the rising number of people complaining that they have lost money while the market was rising. People who didn't own the top tier stocks, true blue chips, are down 20% already. What kills me is to turn on the TV & hear the experts say, "Well, that's good because that signals that the damage is already done." No, that's bad because those people have held on only because they've seen the top stocks still making news. If the Dow rolls over, they will only see bigger losses. The Dow won't drop 10 or 15% while those second tier stocks rally 20%. That's insane. Precisely why do you believe that the Dow would lose only 50% or less than 50%? In a typical bear cycle, markets lose 90-95% of their peak value. I think 50% will be enough. If, as Robert Prechter forecasts, the Dow drops to 400 or 600, the economic, political & social situations in the U.S. would be worse than ever before, including the Great Depression. To picture that one has to imagine all sorts of pandemonium, &, as much as I think the great game is over, I also don't want to imagine that that can occur. The key is, to get out of that market now & put money where one can survive even that remote chance of utter catastrophe.
Assume that events play themselves out somewhere between catastrophe & a major (30-40% down) correction. Who will be hurt the worst? Older people, the very ones who were not in the market 10 or 15 years ago. They used to hold CDs & other safe investments, & were forced out. The great majority of those in mutual funds are baby boomers from 50 to 65. They don't have 10 or 20 years to live through the decline & get even in the next bull market. There have been periods when it took 25 years to get even in the market. These people can't afford that risk.
|Forty-three percent of all American households are now investors in the stock market, against 10% before the Great Depression. I bet 70-80% are the older people. The 45 to 65 year olds are heavily in the market. All in all, I just can't find reasons to get enthusiastic. Past the day to day hype, the factors that really drive the long term are turning down. They are no longer bullish.|