It is no secret that I believe that the United States suffers from horrible debt dynamics, a dysfunctional and delusional government, a fragile economy, an oppressive tax code, and an irresponsible central bank that is creating asset bubbles across the financial spectrum. My long-term investment prescription to deal with these realities has been to overweight exposure to non-dollar investments, particularly in those countries that have strong growth, pro-business governments, high dividends and positive fiscal attributes like low-debt, positive trade balances, and relatively high interest rates. But the past four years or so have been extremely frustrating for investors who have structured their investments around these principles. Since the beginning of 2011, currency-adjusted U.S.-based equity investment returns, as reflected in major indices, have easily led the world. In fact, we have seen the greatest differential in recent memory of relative performance of the U.S. vs. many foreign markets.
This outcome has bred a great deal of confidence among investors that the trend will continue. Despite our own unresolved problems, trouble brewing in Europe and Asia has convinced many that America remains "the cleanest dirty shirt" in the investment hamper. Non-U.S. markets are considered perennially riskier, to be sampled in smaller doses, and only during periods of extreme confidence.
Although past performance is no guarantee of future results, a casual look back at how the U.S. out-performance trend played out the last time it had occurred should call these assumptions into question and give investors much to think about.
In many ways the four years from the end of 1996 to the end of 2000 provide a good parallel to the four years from the end of 2010 to the end of 2014. During the earlier period, the Dow Jones Industrial Average rallied 67% and, in the second period, the Dow rallied 54%. In addition to these similar market results, both periods showed similarities in monetary policy and in America's perceived dominance as an investment destination.
The late 1990s was the original "Goldilocks" era of U.S. economic history, one in which all the inputs seemed to offer investors the best of all possible worlds. The Clinton Administration and the first Republican-controlled Congress in a generation had implemented policies that lowered taxes, eased business conditions, and encouraged business investment. But, more importantly, the Federal Reserve, under then Chairman Alan Greenspan, had pursued an extremely expansive monetary policy (at least what was then considered expansive...by today's standards it would be considered absolutely draconian) that caused confidence on Wall Street to swell significantly. His efforts to orchestrate smooth sailing for investors led many on Wall Street to dub Mr. Greenspan "The Maestro."
Greenspan took office 2 months before the Stock Market Crash of 1987, and perhaps as a result of this trauma he developed a reflexive reaction to cut interest rates whenever anything seemed to threaten the economy or the markets. This protectionism ultimately became known as the "Greenspan Put." (a reference to strategies used by stock traders to protect themselves from losses.)
Towards the end of the 1990's, Greenspan worked hard to insulate the markets from some of the more negative developments in global finance. These included the Asian Debt Crisis of 1997 (in which lack of foreign exchange reserves led to huge devaluations of overly extended Asian economies) and the Russian debt default of 1998, and the concern around the Y2K phenomenon (the fear that the world economy would grind to a halt because of the inability of computer programs to distinguish between the year 2000 and the year 1900).
But the most telling policy move of the Greenspan Fed in the late 1990's was its response to the rapid demise of hedge fund Long term Capital Management (LTCM), whose strategy of heavily leveraged arbitrage backfired spectacularly in 1998. LTCM had placed large trades with nearly every major firm on Wall Street, and many believed that its bankruptcy could spark a full-blown financial crisis. To prevent such an outcome, Greenspan engineered a $3.6 billion bailout and forced sale of LTCM to a consortium of Wall Street firms. This direct engagement with the market took the Fed to territories beyond anything previously conducted by the central bank. The intervention was an enormous relief to LTCM shareholders but, more importantly, it provided a precedent that the Fed had Wall Street's back.
Not surprisingly, the 1990s became one of the longest sustained bull markets on record. But in the latter part of the decade the markets really started to climb in an unprecedented trajectory. While most people like to explain away the dotcom mania as a purely psychological creation (brought about by the intoxicating effects of new and seemingly magical technologies that promised to rewrite the rules of finance), in reality the bubble had much to do with an extremely supportive Fed. As the bubble began inflating in earnest in 1998, and market analysts began uttering classic remarks such as "earnings don't matter," Greenspan did nothing to prevent it from expanding wildly. This reluctance was contrary to the maxim, popularized by William McChensney Martin, one of Greenspan's predecessors, that the Fed's job was to remove the punch bowl before the party got out of hand. As he had demonstrated with LTCM, Greenspan decided that it was not the Fed's job to prevent bubbles from forming, but simply to clean up the mess after they burst.
But while U.S. markets were taking off, the rest of the world was languishing, or worse. As shown in the chart below, some of the markets that are favored most heavily by Euro Pacific Capital, both then and now, experienced dismal returns. In fact, in the four years of the late 1990s, while the S&P 500 was up almost 80%, all world markets, excluding the U.S., were up only 12%, and an important emerging market index was down 30%. (Only the minor markets of Sweden and Switzerland managed to keep pace with the U.S.) The surging dollar also decimated gold and gold stocks, which were down 26% and 65%, respectively, over that time frame. The numbers tell the tale:
Created by EPC using data from Bloomberg
Based on this stunning performance, the belief in the "Goldilocks" economy and the continuous support of an accommodating Fed, many mainstream U.S. investment houses saw few reasons to believe that the dominance of American markets would ever end. Anyone who had put faith in non-dollar markets had been made to look like a fool.
But then a very funny thing happened. In March 2000, the music stopped and the dotcom bubble finally burst, sending the Nasdaq down nearly 50% by the end of the year, and a staggering 70% by September 2001.
Momentum often creates its own justification. When something moves in one direction long enough people may conclude that the movement is natural and inevitable. In such an environment, even some of the most followed investment analysts began to explain away the most glaring red flags. So during the dotcom era, fundamentals like value, profitability, sustainability, dividend yield, and debt management took a back seat to newer, more exciting, concepts such as "mindshare," "page views", and "disruption."
But when the music stopped, the belief in these new concepts stopped with it. When investors looked to get back into the market, their values had changed and they began dancing to a different tune. They began to favor those types of investments that had the characteristics that they had previously ignored. Having been burned by sky high valuations, they began looking for low valuations, real revenue growth, understandable business models, high dividends, and low debt. They came to find those features in the non-dollar investments that they had been avoiding.
An Era of Non-Dollar Domination
While the period is now almost completely forgotten to contemporary analysts, the seven-year run that began at the end of 2000 and lasted until the end of 2007, produced stunning returns overseas while the U.S. markets languished. Over that time, the Dow Jones managed just a cumulative 23% return over the entire seven-year period. The S&P 500 inched upwards by just 11%, for an average annual return of 1.6%. But the world index (which includes everything except the U.S.) was up 72%. The emerging markets, which had suffered the most during the four prior years, were up a staggering 273%. See table below:
Created by EPC using data from Bloomberg
Not surprisingly, the markets and asset classes that had been decimated by the Asian debt and currency crises, delivered stunning results. South Korea, which was only up 10% in the four years prior, was up 312% from 2001-2007. Brazil, which had fallen by 4%, notched a 407% return, and Indonesia, which had fallen by 50%, skyrocketed by 745%.
The period was also a great time for gold and gold stocks. The earlier four years had offered nothing but misery for investors like me who had been convinced that the Greenspan policies would undermine the dollar, shake confidence in fiat currency, and drive investors into gold. Instead, the dollar rallied by 23% (FRED, FRB St. Louis), while gold fell 26% (to a 20-year low), and shares of gold mining companies fell a stunning 65%.
But when the gold market turned, it turned hard. From 2001 - 2007, the dollar retreated by nearly 18% (FRED, FRB St. Louis) while gold was up 206%, and shares of gold miners surged 512%. As it turned out, we weren't wrong about the impact of the Fed's easy money, just early.
Obviously those investors who had the foresight to rotate out of U.S stocks in the first quarter of 2000 and into foreign stocks, energy, and gold must have achieved absolutely stunning performance over the entire 11-year period. But who really has that kind of a crystal ball? I would suspect that very few actually got that timing right, and those who had are likely living in blissful retirement. Many investors who enjoyed the meteoric rise of U.S. technology stocks, crashed and burned with it when the market went bust. Many not only lost their paper profits, but a good portion of their principal as well. Based on the fear of and disgust in a collapsing market, some percentage of investors may have even pulled out completely near the lows. Some may have migrated from one bubble in stocks, to a larger one in real estate, only to get burned again when that bubble burst.
Timing the markets is notoriously difficult, and I feel that it's better to invest in things that you believe in, and hold on through the good times and bad. From my perspective, when it comes to timing, investors are generally either too early or too late. One of the problems with being too early is that other investors think you're just wrong, pointing to their profits as proof. But the larger problem is when early investors begin to doubt the thesis themselves, it can cause them to capitulate at the wrong time. They may end up selling their contrarian positions near the lows or, worse, buying into the bubble stocks near the highs.
But that is the history of markets. They sometimes make it easy to do the wrong thing and difficult to do the right thing. Going with the crowd may get you instant validation and short-term paper profits. But figure something out that the crowd misses, and you may be punished with short-term paper losses. But if the mass delusion ends, paper profits can quickly turn into realized losses, and paper losses give way to actual gains.
The Long Haul
Looking at the entire 11-year period (the end of 1996 to the end of 2007) through the respective ups and downs, the performance of U.S. stocks was eclipsed by many markets around the world:
Created by EPC using data from Bloomberg
During that period the U.S. only managed to outperform a few of our favorite foreign markets, such as Singapore and Hong Kong.
2010 - 2014
In recent years, investors who have placed money with my firm have encountered many of the same frustrations that dogged my clients during the late 1990s. They have watched foreign markets, energy, and gold go nowhere while the dollar and U.S. markets surge as they did in 1997-2000. This time it may even be a little worse. Global stocks ex-US were flat from the end of 2010 to the end of 2014, whereas they were up 12% from the end of 1996 to the end of 2000. Energy stocks were down 1% in the last four years, whereas they were up 50% in the earlier period. Gold stocks were down 70% (more than the 65% in the earlier period).
Created by EPC using data from Bloomberg
Will it Happen Again?
It is said history may not repeat, but it often rhymes. There may be a financial sonnet brewing. There are reasons to believe that relative returns globally will turn around now much as they did back in 2000. Perhaps even more decisively.
Just as they had back in the late 1990's, investors appear to be ignoring flashing red flags. In its Business and Finance Outlook 2015, the Organization for Economic Cooperation and Development (OECD), a body that could not be characterized as a harbinger of doom, highlighted some of the issues that should be concerning the markets. Reuters provides this summary of the report's conclusions:
- Encouraged by years of central bank easing, investors are plowing too much cash into unproductive and increasingly speculative investments while shunning businesses building economic growth.
- There is a growing divergence between investors rushing into ever riskier assets while companies remain too risk-averse to make investments.
- Investors are rewarding corporate managers focused on share-buybacks, dividends, mergers and acquisitions rather than those CEOS betting on long-term investment in research and development.
While these trends have been occurring around the world, they have become most pronounced in the U.S., making valuations disproportionately high relative to other markets. As we mentioned in a prior newsletter
, looking at current valuations through a long term lens provides needed perspective. One of the best ways to do that is with the Cyclically-Adjusted-Price-to-Earnings (CAPE) ratio, which is also known as the Shiller Ratio (named after its developer, the Nobel prize-winning economist Robert Shiller).Using 2014 year-end CAPE ratios that average earnings over a trailing 10-year period, the global valuation imbalances become evident:
As of the end of 2014, the S&P 500 had a CAPE ratio of well over 27, at least 75% higher than the MSCI World Index of around 15. (High valuations are also on evidence in Japan, where similar monetary stimulus programs are underway). On a country by country basis, the U.S. has a CAPE that is at least 40% higher than Canada, 58% higher than Germany, 68% higher than Australia, 90% higher than New Zealand, Finland and Singapore, and well over 100% higher than South Korea and Norway. Yet these markets, despite the strong domestic economic fundamentals that we feel exist, are rarely mentioned as priority investment targets by the mainstream asset management firms.
In addition, U.S. stocks currently offer some of the lowest dividend yields to compensate investors for the higher valuations (see chart above). The current estimated 1.87% annual dividend yield for the S&P 500 is far below the current annual dividend yields of Australia, New Zealand, Finland and Norway.
If a dramatic shock occurs as it did in 2000, will investors again turn away from high leverage and high valuations to seek more modestly valued investments? Then, as now, we believe those types of assets can more readily be found in non-dollar markets.
The most important similarity between then and now, other than the relative investment returns, is the confidence investors have placed in the ability of the U.S. economy to deal with heightened debt levels, and the seeming unassailability of the U.S. economy, and the dollar itself.
Back in the late 1990s the extra tax revenue created by bubble-related capital gains and the wealth effect that rising stock prices had on consumption caused some to believe the Federal budget surpluses then being realized would continue indefinitely.There was actually concern about how financial markets would be affected if the entire national debt were repaid and the government no longer issued Treasury debt.
In Dec. 2000, the official national debt stood at just $5.6 Trillion. It's now a staggering $18.1 Trillion. At this point, no one worries that we will run out of Treasury debt. Not only did the expected surpluses disappear, but we eventually ran Federal deficits that exceeded $1 trillion annually, a sum that exceeds the entire national debt as late as 1981.
Looking forward, we can see nothing but enormous Federal deficits. While we have backed off the $1 trillion dollar figure for now, helped by the current asset bubbles, even the Congressional Budget Office acknowledges that the red ink will spike severely by 2020 and beyond.
I had expected, at the time, that those late 1990's budget surpluses would vanish as soon as the stock bubble burst and a recession ensued. But as the Nasdaq took off, my contrarian story was a hard one to sell. But those who bought into it, positioned themselves for the profits that other investors missed from early 2000 through the end of 2007.
Another similarity between then and now is the propensity to confuse an asset bubble for genuine economic growth. The dotcom craze of the 1990s painted a false picture of prosperity that was doomed to end badly once market forces corrected for the mal-investments. When that did occur,
and stock prices fell sharply, the Fed responded by blowing up an even bigger bubble in real estate. When that larger bubble burst in 2008, the result was not just recession, but the largest financial crisis since the Great Depression.
The dollar has also reigned supreme in both eras. Back then it rose largely on the back of the "strong dollar policy," which mainly consisted then in Treasury Secretary Robert Rubin repeatedly saying "a strong dollar is in the national interest." Although this policy lacked any substance, it was enough to convince investors that the U.S. dollar could not fall if Washington didn't want it to. The strong dollar caused global investors to buy even more dollars to get in on the action, making the dollar even stronger. It was a virtuous cycle that turned vicious once the music stopped playing.
The current narrative is that seven years of zero percent interest rates and three rounds of Quantitative Easing have finally produced the long-awaited recovery, making a return to higher interest rates and a smaller Fed balance sheet possible. Investors believe that U.S. tightening will be occurring while other central banks are easing. Such a scenario, were it to occur, would be bullish for the dollar.
But once again investors have mistaken a bubble for a recovery, only this time the bubble is much larger and the "recovery" much smaller. The middling 2% GDP growth we are currently experiencing is approximately half of what we saw in the late 1990s. In reality, the Fed has prevented market forces from solving acute structural problems while producing the mother of all bubbles in stocks, bonds, and real estate. A return to monetary normalcy is impossible without pricking those bubbles. Soon the markets will be faced with the unpleasant reality that the U.S. economy may now be so addicted to monetary heroine that another round of quantitative easing will be necessary to keep the bubble from deflating.
The current rally in U.S. stocks has gone on for nearly four full years without a 10% correction. Given that high asset prices are one of the pillars that support this weak economy, it is likely that the Fed will unleash another round of QE as soon as the market starts to fall in earnest. This realization should seal the dollar's fate. Once the dollar turns, a process that in my opinion began in April of this year, so too should the fortunes of U.S. markets relative to foreign markets. If I am right, to which all the objective evidence still points, we may be about to embark on what could become the single most substantial period of out-performance of foreign verses domestic markets.
While the party in the 1990s ended badly, the festivities currently underway may end in outright disaster. The party-goers may not just awaken with hangovers, but with missing teeth, no memories, and Mike Tyson's tiger in their hotel room.