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When Something Doesn't Add Up!

by Dr. Marc Faber

"To a very large extent, the bull markets of the last 18 years, the monetary and credit growth, the explosive expansion of the derivatives markets, and the decline in interest rates have exploited the potential of financial assets and, in fact, created an environment in which the global financial system is sitting on a gigantic powder keg that could explode at any time."

[Dr. Marc Faber is a sought after speaker and commentator whose views are often controversial but never taken lightly. He says, as the Financial Times puts it, "things that nobody wants to hear, and more often than not, he is proven right." After correctly anticipating the 1987 stock market crash and the so-called Asian Contagion of the late 1990s, Dr. Faber more recently distinguished himself by forecasting the bursting of the U.S. technology bubble. He is a regular contributor to the Financial Times and Forbes Magazine as well as publisher of his own "Gloom, Boom & Doom Report" from which this article is extracted. Dr. Faber is always a trenchant, provocative and engaging writer, whose byline is a welcome addition here at the Gilded Opinion.-- Editor, The Gilded Opinion]

It should be obvious to.anyone involved in the financial markets that today's financial scene doesn't offer the same kinds of potential returns on such a broad scale as we have experienced in the last 20 years or so. In the case of the US, the S&P 500 still sells at around 25 times earnings and the stock market capitalization as a percentage of GDP is still at around 14% (compared to 35% in 1982). It is clear, therefore, that the upside potential is far more limited with these kinds of valuations than it was in the early 1980s.

This observation applies particularly for the NASDAQ, whose P/E still exceeds 150 (as earnings have tumbled). Even the NASDAQ 100, which is more heavily weighted by the successful and large high-tech companies, has a P/E of 75! To make money from these valuations is extremely difficult, as investors who bought into Japan in the late 1980s ought to know. According to Bridgewater Associates, even if NASDAQ earnings were to grow over the next five years by 30% each year (totally unrealistic) and the NASDAQ were then to sell for 30 times earnings, capital losses would be incurred, as the high earnings growth would be more than offset by the reduction in the P/E.

In addition, I continue to maintain that corporate earnings will continue to disappoint, as we outlined in the Gloom, Boom and Doom Report of March 14, 2001, entitled "The Darkening Outlook for Corporate Profits". However, aside from stock valuations, there is an issue with interest rates. The bull markets in the last 18 years were accompanied by a downtrend in interest rates. But how much lower will interest rates go? Maybe long term treasuries will reach the 4-5% level the bond optimists are talking about, but only if we have a deep recession, which would depress corporate earnings far more.

Alternatively, if the stock optimists are right, and the economy soon recovers, I cannot see how bonds would rally, as inflationary pressures (given the still tight labour market) and the demand for funds would push bond prices down and yields up. So, in the one case (bond rally), the stock market would have to cope with continuous earnings disappointments; while in the other case (economic recovery), the stock market would certainly not benefit from lower rates, and may actually suffer from rising rates.

Then there is the issue of private-sector debt to GDP and the saving rate. Corporate debt alone, which stood at 30% of GDP back in 1982, has now risen to 45% of GDP. (Total debt stands at about 270% of GDP or US$27 trillion. ) Thus, if interest rates no longer decline, the high debt level will constrain rapid earnings growth. And while there is some debate about the true level of the US savings rate, the fact remains that its decline in the 1990s added to consumption and earnings growth. So, unless the savings rate continues to decline, economic as well as earnings growth will be more moderate in future. And if consumers did decide to save more, as they did in Japan after 1990, a recession would be almost a certainty.

The list of major differences between the early 1980s, or even the early 1990s, and today could go on and on, but let me just mention two more important points. In the early 1980s, the US dollar was depressed and embarking on a bull market, while the US trade balance was negligibly negative. Today, however, the US dollar is high and the trade as well as current account deficit is very wide. Thus, more than ever before, the US is dependent on foreign capital flows. Now, these foreign capital flows may continue forever, but obviously vulnerability exists should they be reduced or reverse altogether. Also, whereas in the early 1980s and early l990s we came out of recessions, today we are, since the economy is still expanding (at least this is what the government's statistics suggest), in the longest economic expansion ever. Thus, even if Greenspan's monetary injection and the tax cuts work, you can be sure that a recession will occur at some point in the future, especially given the imbalances referred to above.

Let's now turn briefly to the emerging markets in Asia, which as we have recently repeatedly explained, are depressed (see also GDB report of May 16, 2001 entitled "Emerging Markets: An Unpopular but Depressed Asset Class"), and which to some extent tempt my appetite. There are, however, several important fundamental differences between the merits of these markets in the mid-1980s and today.

In the mid-1980s, the world stood at the beginning of a business expansion, which led to annual export growth in the Asian economies in excess of 30%. At the same time, this business expansion in the 1980s was accompanied by falling interest rates (in 1986 the deposit rates were cut in Thailand from 14% to 6%), low leverage in the corporate sector, and small foreign debts as a percentage of the economy. Also, in the 1980s the vibrant Japanese economy was a driver of growth, and politically, Asia was then a far more stable region than it is today. And finally and most importantly, until the late 1980s, the Chinese economy was not a major competitor, as its industrial and commercial infrastructure had not yet been fully developed. In addition, until the 1990s, China did not attract the bulk of foreign direct investments flowing to Asia. Thus, all these factors contributed to what I call the golden age of Asian growth ex China in the period from 1985 to about 1990.

But what about today? Will this golden age of economic growth ever return in Asia outside China? For as long as there is no major social or political disruption on the mainland, China will go from strength to strength in terms of industrial production and I very much doubt that any of the other Asian countries will be able to avoid being squeezed badly by the competition from China, which will only intensify. This not only applies to the less developed Asian countries, but also to Japan, Taiwan, and South Korea, whose labour costs are a multiple of what they are in China and who therefore, inevitably, will have to continue to shift their production capacities to China. And while this may be good for some of the companies involved, it may not be good for these countries' economies, as we have recently seen in Taiwan, which grew in the first quarter of 2001 at the slowest rate in 26 years. In fact, I think the most important issue economists are missing in the discussion of Japan's structural problems is the fact that Japan's industrial production is being increasingly squeezed by China and that unless it lets its domestic price level decline far more (through deflation, but not through monetization, a measure advocated by American economists, which would weaken the Yen but lead to inflation and other problems such as rapidly rising interest rates) in order to regain competitiveness, this problem simply won't go away. Thus, while I see relatively good values at present in the Asian stock markets, I am not as wildly optimistic as I was in the mid 1980s. Naturally, some sectors in Asia will benefit from China's growth (notably tourism and the producers of commodities), but on balance the opening of China will be as negative for the industrial sectors of its Asian neighbors as the opening of the American West, with its vast territories, was in the 19th century for European agriculture.

However, in terms of the US and Asia, I have so far discussed only what I consider to be relatively "minor" issues when compared to what I am most concerned about, which relates to an ever-increasing systematic risk. Let me explain.


We live through some memorable moments in the course of our lives -- moments which we never forget and which permanently shape some of our behavior and thoughts. In my case, and as far as the financial markets are concerned, I have had a few unforgettable experiences, two of which I wish to write about here.

In the late 1970s, in the midst of the oil boom, I frequently traveled to Kuwait. There I met a bright local stockbroker, Farouk Sultan, who in 1979 told me that he thought the Kuwait stock market, then in the midst of a spectacular boom, was headed for a crash like Wall Street in 1929. (At its peak in 1980, the stock market capitalization of Kuwait exceeded that of Germany.) Farouk asked me to get him some books about the American stock market boom and crash in the late 1920s, which I did. On another visit to Kuwait, I was curious to know if the books I had given Farouk, as well as my advice to get out of Kuwaiti stocks as quickly as possible, had had any impact on him, and so I asked him whether he had sold out and gone into cash.Farouk, who was now somewhat less convinced that Kuwait was the kind of bubble I was talking about, replied that he was fully hedged and that he would make some money if the market continued to rise and not lose any if the market declined.

My response to this was very simple. l told him that, given the "post-dated cheque" business in Kuwait (stock purchases were paid for with post-dated cheques), l was convinced that if the market crashed, there was no way these cheques would ever he honoured and that everybody, including the fully hedged investors, would therefore be totally wiped out. And this is precisely what happened when the market collapsed after 1980.

Then in the 1980s I became quite friendly with Tracy Cheng, who was in charge of operations at the Taiwan Stock Exchange, including its computer systems. Thanks to a very sophisticated trading system, which my friend had created, the Taiwan Stock Exchange could handle in a morning trading session of three hours an almost unlimited amount of transactions. In fact, on several days in 1990, at the height of the Taiwan stock casino, the volume on the Taiwan Stock Exchange exceeded the daily volume of the NYSE. Well, at about that time, Tracy told me that he had almost created a miracle in terms of the sophistication of his computerised order-handling system, but he also remarked that he had let the genie out of the bottle and that, unfortunately, it had grown into a monster that would sooner or later come to haunt its creator.

In effect, he had created a system that not only facilitated, but also encouraged, one of history's greatest speculative orgies. (Even the Japanese stock market speculation in the late 1980s paled by comparison.) Indeed, shortly thereafter, in 1990, the Taiwan market began to tank and within 18 months it had declined 80% from its peak. (Since then the Taiwan stock market has never made a new high, and today, 11 years later, it is still down by more than 50% from its 1990 high -- to some extent, because of the increased competition from China, referred to above.)

Now consider the following. Every major invention or innovation leads first to a boom, as businesses want to capitalise on the profits the new invention promises (railroads, autos, radios, the Internet, and so on). The boom then leads inevitably to speculative excesses and over capacities, which then lead to a vicious downturn for the revolutionary new sector.

So, why should this well-established pattern of boom and bust only apply to industrial inventions and new technologies in the manufacturing sector and not also to financial innovations?

Moreover, if you were to spend some time analyzing the history of infectious diseases and plagues, the common pattern that emerges is that, over time, viruses mutate and develop immunity against the agents that have been created to fight them. In other words, in health care there is an ongoing fight between the newer and more effective drugs developed to destroy viruses and bacteria, and those viruses and bacteria, which are extremely creative at inventing defense mechanisms against the new drugs. Now, why should life in economics be any different than in nature? Governments, government sponsored organisations such as the IMF and the World Bank, financial institutions, corporations, etc., all try to invent new "drugs" with which to fight the "recession and crisis viruses", but at the same time these "viruses" also continuously mutate and reinvent themselves in order to launch renewed attacks on an economy's "immune system".

Lastly, consider that globalisation -- in particular modern transportation (airplanes, ships, and trains) -- has also led to viruses and bacteria spreading around the world at a far more rapid rate than ever before in history. In turn, the growth in international trade, the increasing division of labour, and the global capital market we have today, have all led to a far more complicated and interconnected marketplace, which in turn greatly facilitates the transmission of economic viruses which attack the system. For all these reasons, it would therefore be a grave error to think that a serious disruption to the system could be prevented by a bunch of central bankers who first allowed the Japanese bubble to occur, then watched and encouraged the speculation that led to the Asian crisis, and more recently created history's biggest hot air balloon on the NASDAQ.

Thus, what concerns me today far more than ever before is the risk to the system. The financial markets worldwide have become, as my friend in Taiwan feared in 1990, a monster with the debt and derivative market being the most vulnerable to any sort of future attack. According to the Bank for International Settlements (BIS), total derivative positions currently exceed US$95 trillion (world GDP is about US$30 trillion), and according to my friend Doug Noland (www.prudentbear.com), "The Office of the Comptroller of the Currency reported $33 trillion of total commercial bank interest rate derivatives at the end of the year, compared to the $7.2 trillion going into the 1994 credit market dislocation. Interest rate derivatives have jumped almost $13 trillion, or 64% since the second half of 1998. Interest rate swaps of $22 trillion have doubled since the second half of 1998 and are up 6-fold since the end of 1993. J.P Morgan Chase has a swap book of a staggering $14.2 trillion, comprising a majority of its more than $24.5 trillion of notional derivative positions at year-end."

It may be that, as was the case in the 1990s, the global financial system can continue to expand and that whenever glitches occur -- such as the S&L crisis, the Mexican crisis, the Asian crisis, and the LTCM debacle -- the authorities can solve the problems temporarily by putting fresh paint on the cracks through easing monetary conditions and letting credit grow at an ever faster pace. But it ought to he clear that at some time in the future (maybe sooner than expected), something will go awry.

Then what? The outstanding derivatives positions will then be unlikely to be settled, in the same way that the post-dated cheques which my friend Farouk Sultan held, in the hope of being fully hedged, could never be honoured. This outcome is, in my opinion, a certainty. At this point I am in no position to tell our readers when this calamity will occur, but given the complacency and the intellect of the central bankers, it is a question of when and not if.


I have tried to show above that there are only very few really great value plays around in the financial markets. To a very large extent, the bull markets of the last 18 years, the monetary and credit growth, the explosive expansion of the derivatives markets, and the decline in interest rates have exploited the potential of financial assets and in fact created an environment in which the global financial system is sitting on a gigantic powder keg that could explode at any time.

Thus, a few trading opportunities aside (selected Asian emerging equities, Turkey, possibly some bombed-out high-tech stocks), I can see only two great bargains. The Russian stock market is quite independent of and uncorrelated to the rest of the world, and is inexpensive. So if, as I believe is possible, Mr. Putin can clean up the system (the way Pinochet cleaned up Chile in the 1970s, and Lee Kwan Yew overhauled Singapore in the 1960s and 1970s), this is the market with the highest appreciation potential in the next five to ten years. Needless to say, in an environment of rising commodity prices (which we anticipate), Russia would be the prime beneficiary.

In the case of the developed markets of the US and Europe, we see at best a trading range in the next few years, but lower stock prices will at some time in the future create bargains such as we found in 1974, 1982, and 1990. As far as Asia is concerned, stocks are by and large reasonably priced, but with interest rates unlikely to go much lower and with competition from China intensifying, their upside potential is far from what it was in the 1985-1990 period. Still, I expect from here on a relative outperformance of Asian equities compared to the S&P 500.

Russia aside, I see only one asset class that has the upside potential of US stocks after 1982, Asia in the late 1980s, and Latin America after 1988. I am referring here to gold mining companies, physical gold, and other commodities such as grains. The gold bear market is more than 20 years old and has either already ended or is at least approaching its end, as more and more investors will come to share my view that something simply doesn't add up in the present monetary system (which isn't really a system) and that one day the ownership of a store of value that is totally uncorrelated to financial assets will be a highly rewarding investment.

Thus, I urge our readers to gradually accumulate physical gold and gold shares. In fact, our readers should follow my advice but also hope that I am wrong, because if gold really does take off the way I think it will, then obviously something else will go badly wrong and destroy wealth on a massive scale. Thus, I recommend gold as the only perfect hedge against the systematic risk I was referring to above.

by Dr. Marc Faber
August 22, 2001

Marc Faber is author and publisher of the "Gloom, Boom & Doom Report", a monthly publication which highlights unusual investment opportunities. Interested readers will soon find more about Dr. Faber and his services at his website, www.gloomboomdoom.com .

Copyright © 2001 by Marc Faber. All Rights Reserved.

Reprinted by USAGOLD with permission of Dr. Faber. No further reproduction without permission.

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