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Storm Watch: The Next Big Thing
(April 5, 2002)

by James J. Puplava / Financial Sense Online

 

Standing at The Crossroads

There are decisive moments in an individual's life. These epiphanies become turning points or doorways into the future. They are the fork in the road -- a crossroad where decisions become life-altering experiences. We can probably count these moments on one hand, but they likely determine our life's successes or failures. In my fifty-plus years, I have faced five of them.

The first crossroad I faced was during the Vietnam War. I made a decision after leaving the army to go to college and pursue a degree rather than pursue a trade. The second fork in the road came when I met Mary. As a recent college graduate, I had two full scholarships to graduate school: one to Patterson School of Diplomacy in Kentucky and the other to Thunderbird (American Graduate School of International Management) close to home. I chose Thunderbird (accounting and business) over Patterson (politics and diplomacy) to be closer to my future wife -- a decision I've never regretted.

The other forks in the road were along my career path. In 1979 I left the corporate world and decided to enter into the new field of financial planning. In 1985 I made another key decision to move into money management. Also at this time, I made a personal decision to return to my faith. The last turning point came when I made a decision to publish a newsletter for my clients on the Internet. I had no idea at the time that our web site and my radio show would become what they are today. I started publishing my newsletter on the web as a way to stay in touch with my clients. Since then, I've made numerous, faceless connections around the world. They have become not only good friends, but also resources of information that I can tap into when I need answers to questions I have about the financial markets. I've also taken on clients from different states and foreign countries through their exposure to my site. Internet technology still amazes me to this day.

In 1992 a friend of mine had a great interest in the Internet. We experimented with a site and actually produced a stock market report on the web back in 1993. But I doubt anyone was listening. Hardly anyone owned a personal computer at the time. It was a bit cumbersome and I decided to concentrate on other things. I abandoned the Internet for television and daily radio. Back in 1992 I thought that the Internet was too techy and would never amount to much. Was I ever wrong! But my friend persisted. When he developed a software for template websites, he asked me to be a beta test site in 1997. His software program became the original genesis of Financial Sense Online. From that point forward, our site has grown as a result of thought-filled days on my sailboat and my wife's imagination and creativity. My Storm Series was the result of an actual storm that scared the living daylights out me. As we were trying to make it back safely into port, I had a lot to think about -- my life being one of them. Although my life was probably never in any real danger, it seemed so at the time. It was, however, an experience that gave me pause for reflection, especially on what was going to happen to the financial markets. The result was my Perfect Financial Storm Series that has been read around the world. What happened to my friend and his software company? He sold his company for millions at the peak of the dot com craze and lives on a quiet island off the coast of Florida.

Investment Crossroads

You may wonder why I'm telling you all of this. Perhaps you too have found yourself in similar situations -- crossroads in your life -- where a decision you made altered the course of your life. There are similar crucial intersections in the investment markets. This similarity caught my attention when I recently read Marc Faber's The Gloom, Boom & Doom Report. In his February 28th newsletter, Marc wrote, " an investor could have done very well over the last 30 years with just a handful of investment decisions. In 1970, a long-term investor should have bought gold, silver, and oil (commodities); in 1980, he should have sold his gold and oil and bought Japanese stocks; then, in 1989, he should have switched out of Japanese stocks into the S&P 500 or, ideally, into the Nasdaq, which he should have sold at the beginning of 2000." 1

Faber succinctly expressed what I have found to be true: market leadership changes over time. As wise King Solomon wrote, there is a time and season for everything. Once a long-term trend is broken, it is replaced by another trend. Faber continues, "At such milestones in financial history, the rules of the investment game are altered; but alas, the vast majority of investors continue to play by the old rules and therefore either lose money or miss out on the substantial capital gains which the new opportunity or leadership brings about I suppose that one reason the road to ruin is broad, is to accommodate the great amount of travel in that direction The key to successful investing is to understand that, with nearly 100% certainty, the bursting of a bubble leads to a permanent change in leadership." 2 Faber believes that commodities may be the investment markets next leader, especially gold and silver. I concur.

A Review of the 50's Bull Market

In my humble opinion, natural resources will become "The Next Big Thing." In a moment I'll explain why. But first, it is important to look at the evidence of what Faber purports in his February newsletter. The first graph below depicts the bull market that began during the 1950's. Since the great stock market crash of 1929, it took the Dow Industrials 25 years to regain its former high reached in the fall of 1929. The 50's bull market reached its climax in the mid-60's. From that point forward, the stock market went through a series of highs and lows that culminated in the 1973-74 bear market. As the second graph of the Dow illustrates, the stock market would go virtually nowhere for 16 years. In fact, during 1970-72 period, the only stocks that did well were the Nifty-Fifty stocks. These were the must-own stocks like Polaroid, Xerox, Disney, IBM, and McDonalds. The rest of the markets, other than a few select blue chips, did poorly after the mid-60's.

     

The 70's Market

This next series of graphs depict what happened to the price of gold, silver, and oil during this period. The 1970's was an investment era dominated by the commodity markets. Investors had lost faith in paper assets. The Fed was inflating the money supply, the dollar was no longer backed by gold, and inflation was heading towards the double-digit level (a product of the debasement of the U.S. currency). During the 1970's the price of gold was liberated from the control of governments. In the late 60's, governments were trying to curtail the price of gold as they are today. Back then the London Gold Pool kept gold prices suppressed. The U.S. government began running a deficit. The Federal Reserve convinced the leading central banks of the world to form a selling consortium. They supplied gold to the pool. This pool was used to prevent gold prices from exceeding $35.20 an ounce. The manager of the pool was the Bank of England. The London Gold Pool collapsed in 1968. France withdrew from the consortium and began exchanging its dollars for gold. Eventually, as other foreign governments exchanged their dollars for gold, there was a run on U.S. gold reserves. This forced President Nixon to sever the link between gold and the dollar in August 1971. From that point forward, the U.S. government and other governments around the globe were free to inflate their currencies and run perpetual budget deficits. The era of deficit spending had begun and it continues today.

During the 70's the U.S. experienced a loss of confidence in government and in financial paper. The period was characterized by a series of policy failures that directly contributed to a rise in inflation. Investors preferred to put their money in tangibles rather than intangibles. These graphs of gold, silver, and oil show the tremendous price rise of key commodities during this time. Other commodities such as grains, cotton, and base metals also rose in value. Everything tangible from gold, oil, real estate, and rare art to collectables rose in value. The stock markets languished during this same period as reflected in the previous graphs of the Dow Industrials. If you made money in stocks, it was mainly in small cap companies or the commodity producers.

S & P 500 Ten Biggest Stocks
(Index Weight)

1970's
 IBM

 4.3%

 AT&T

 3.8%

 Exxon

 3.8%

 Standard Oil Indiana

 2.5%

 Schlumberger

 2.4%

 Shell Oil

 1.9%

 Mobil

 1.9%

 Standard Oil California

 1.8%

 Arco

 1.6%

 GE

 1.5%

Source: WSJ 8/27/99 and Bloomberg   

The table of the top 10 capitalized companies within the S&P 500 shows that seven out of the top companies were oil related.

The Bull Market's Return Beginning with Japan

As the next graphs show, by the time the investment public began selling their silverware and jewelry, with silver at $50 an ounce and gold over $800, the era was ending. The next big thing was about to begin. It wasn't gold, silver, or oil. It was Japan. The bull market in equities was about to begin again and its epicenter was Japan. The Japanese stock market began a bull run that took the Nikkei from a low of 6475 in March of 1980 to a high of 38,274 in January of 1990 or a gain of 491%. The financial press eulogized the Japanese business model. Government officials talked about emulating the Japanese style of intervention, control of the economy, and industrial enterprise.

The era for investing in Japanese stocks came to an end when Japan's Central Bank decided to puncture the bubble by raising interest rates. The Nikkei has never recovered. As of today's Storm Update, it closed at 11,335 -- down over 70% from its peak. Since its zenith, Japan's economy has been mired in several recessions. Their once dominant banking institutions are now on the verge of bankruptcy. Prime ministers come and go with the people of Japan no longer having faith in their government or their financial institutions. They are now buying gold.

The U.S. Market's Glory Days

Source: Federal Reserve

As Japan's stock market reached its pinnacle, the U.S. equity markets were ready to take its place. The U.S. stock market had risen steadily throughout the 80's, but not to the same degree as Japan's stock market. That would change during the inflationary monetary policies of the Clinton Administration. A series of crises beginning with U.S. banks and S&L's in the late 80's and early 90's would begin a period of monetary and credit inflation, the likes of which we have never seen in history. The 90's were followed by one financial brushfire after another. It began with the bailout of the S&L's and continues to this day.

Throughout the decade, flooding the financial markets with money became the standard remedy for putting out fires in the financial system. It didn't matter whether it was Mexico and derivatives in 1994, Asia in 1997, Russia and Long term Capital Management in 1998, Y2K in 1999, or the recession and Trade Center attack of 2001. The standard prescription for any crisis was and is to flood the system with money and credit. The result is that the outlet of much of that money creation moved into the financial markets beginning in 1995. From 1995 to 1999, the stock market experienced back-to-back years of double-digit returns not seen since the mid 1920's. It was also a period that the public came back to the stock market. Lured by double-digit returns and a quick way to wealth, the small investor bought into the stock market thereby contributing to the final stages of the bull market. This is clearly shown in the graph of mutual fund assets, which grew disproportionately during the final years of the decade. Up until the mid 90's, most investors had their money in fixed income investments like GICs in their 401(k) plans, Treasury and corporate bonds, or bank CDs. With fixed investments offering double-digit returns throughout the 80's and high single-digit returns in the early 90's, investor preference was for safety.

Investor preference changed with the monetary inflation and credit expansion that became the hallmark of the Clinton Presidency and the strong dollar policy of Robert Rubin's Treasury. Administration policy created the greatest monetary and credit expansion the world has ever seen. The outlet for much of this credit creation found its way into the stock market. As the graphs of M-3 and the Nasdaq show, the stock market -- especially the Nasdaq and technology stocks -- became the magnet for much of that money creation. The public was fed a constant diet from the new financial media and Wall Street about a new era for American companies. The constant hype, combined with the flow of easy money, created the market myths and shibboleths of the period. This era ended during the first quarter of 2000.

Trends are Never Permanent

The big question going forward is did the bubble like conditions of the stock market end in 2000 or was it simply a change in leadership within the stock market from technology to other sectors? Since the major markets hit their peak, only the Nasdaq has suffered major losses. The Dow and the S&P 500 have both lost money, but not to the same extent as the Nasdaq. As Marc Faber makes clear in his February newsletter, " if there was a complete stock market bubble, as had been the case in 1929 and in Japan in 1989, then obviously a new leadership in an asset class other than the U.S. stock market should be expectedIf we can be sure that in 2000 a major U.S. stock market mania reached a climatic peak, then it is futile for the average investor even to try to play bear market rallies". 3

 

At this point, it can be safe to draw some conclusions from the above charts. Trends in financial markets are never permanent no matter the market. The 1990's bull market was characterized by oversized returns that were fed by easy money and credit. The unprecedented investment mania that produced these returns means that lower returns will probably follow. The bust of the 30's followed the boom of the 20's. The 50's and 60's bull markets were followed by the commodity bull markets of the 70's. As commodity prices peaked, another bull market in financial assets replaced it beginning first in Japan and then in the U.S. In the case of the U.S., the boom fed into an investment mania, which has only begun to unravel. This unraveling is now working its way through the accounting scandals that are so prevalent in today's headlines. The earnings manipulations that are now being discovered  have shattered the "new era" earnings phenomenon. The earnings myth was a result of creative accounting more than it was a new era in earnings productivity.

Debt Fuel

Everything about the late 90's was a myth disguised to cover up the greatest monetary and credit expansion in U.S. history. What made the 90's boom so unique is that government, private households, and businesses embarked on a spending and borrowing spree never before seen in history or in any other nation. Government continued to borrow and spend as never before. The budget surpluses were the figment of imagination of government bureaucrats and a powerful White House spin machine. The government debt ceiling was increased by half a trillion dollars back in 1997. Now, five years later, the U.S. finds itself in a position of having to increase the national debt ceiling by another $750 billion. How can you have a balanced budget with annual surpluses and have the national debt growing by half a trillion dollars?

During this same period, while government debt and spending was growing, debt was piled up at the consumer and business level. Consumers borrowed to pay for consumption and speculate in the financial markets. The escalation in consumption and debt accumulation resulted in the actual disappearance of personal savings. Private sector savings dropped dramatically and at one point turned negative.

Business debt also increased during this period, but not for reasons that would have increased productivity, profitability or increased economic activity. Instead, businesses borrowed to buy back their shares and drive up earnings per share and consequently company stock prices. Debt was also used in mergers and acquisitions of other companies. Capital investment during this period actually fell to postwar lows. The much heralded technology boom was another figment of the statisticians. Actual business spending on computers during the last half of the 90's increased by only $23.2 billion to $87.8 billion. The use of hedonic pricing turned that small investment into an increase of $240 billion. The only problem with the $240 billion number was that those dollars were never spent or received by anyone.

What we know now is that the miracle productivity and investment boom of the last decade was more fiction than reality. A healthy economy grows on a sound basis with savings, investment, and profits that produce the income. An economy needs to grow in order to create enduring wealth. Just the opposite occurred. Capital was consumed, savings fell, profits were sub par, and income was supplemented by debt. These are all the hallmarks of a bubble economy not a miracle economy. It is one reason that the current economic recovery will be shallow and short lived. In fact, the current recovery could also turn out to be nothing more than a recessionary rally. Just as bear markets have occasional rallies, so do long lasting recessions and depressions. The U.S. economy during the depression years of the 1930's and Japan in the 1990's and today are perfect examples of this phenomenon. Contrary to popular opinion, investment and not consumption leads and gives economic recoveries their real strength. It is one reason Mr. Greenspan hedges his speeches about economic recovery by saying " growth of activity will be short-lived unless sustained increases in final demand kick in before the positive effects of the swing from inventory liquidation dissipates".

Where will this sustained final demand come from? Will it come from consumers going even deeper into debt or businesses leveraging up their balance sheets? In the case of business, just the opposite is true. Many major corporations are now in the process of shedding plant, equipment and employees, and liquefying their balance sheet. From a macro sense, this reflects a contraction in the economy not an expansion. The other aspect that makes a compelling argument against another stock market or economic boom is the self-cleansing process that normally takes place in recessionary periods. It hasn't happened this go-round. Just the opposite is true. Instead of debt being liquidated, it actually increased by trillions of dollars. Savings fell as consumers continued to go deeper into debt in order to maintain living standards. According to The Wall Street Journal, unlike the last recession in 1990 where consumers cut debt by $410, this time average household debt increased by $1,420. Mortgage debt also increased as households extracted more equity out of their homes, which fed into consumption throughout the recession.

So if an economic recovery and another bull market takes place, it will be completely based on the continuation of debt accumulation by businesses and consumers and deficit spending by government. It will also take the willingness of foreigners to finance America's huge trade and investment deficits. It is for these reasons that I believe that the bull market ended during the first quarter of 2000. The stock market may rally, but I believe these brief upward blips will be bear market rallies and nothing more. With government help, the markets could go through a similar period as shown by the late 60's and 70's, with short rallies punctuating a long bear market.

Basic Needs and Population

My observations lead me to believe the next big move will be in commodities. I believe it will be driven by supply and demand factors aided and abetted by a growing world population. Food, water, and energy are necessities. These items aren't optional, but are considered basic necessities of life. Without them, civilization would perish. At the end of the last century, world population was estimated to be 6 billion. By the year, 2020 global organizations from the World Bank to the UN estimate the human population on this earth will grow to 9 billion people, a fifty percent increase from where we are today. This population growth will become the primary driver of the demand for commodities of all kinds, will special emphasis on clean water, energy, and food. This demand for basics will take place regardless of the condition of the economy be it inflationary of deflationary.

Price Suppression

Another factor that will drive the next boom in commodities is the suppression of their price by financial instruments known as derivatives. Currently the paper markets control the physical markets for basic commodities. Look at low prices for any basic commodity. Chances are that large short positions enhanced by leveraged derivative contracts have driven down their price. Once the world's monetary system became decoupled from gold, credit expansion took on a new dimension.

During the 1980's governments turned to central banks to help them out of an inflationary spiral. The answer was to expand credit and transfer it outside the basic banking system. In essence, the mechanism for creating credit was the financial system and it became the central driving force behind monetary expansion. The inflationary impact of credit expansion manifested itself most directly through the financial system through debt instruments such as collateralized mortgages and the securities markets. This giant credit creating mechanism enabled the explosion of fixed plant and equipment on a global basis that has created the glut in manufacturing that we now see globally in just about every industry but basic commodities. The error in this policy was not to recognize the inflationary impact of these policies. Instead of showing up in the inflationary figures, they showed up in the financial markets and the excess capacity of all manufactured goods.

Resolving Crises Through Monetization

In order to maintain and keep this new system functioning, it became necessary for central banks to keep the financial system liquefied. That is why central bankers move expeditiously to contain any financial fire whether it is Mexico, Asia, Russia, or LTCM. Since we now operate on a debt-based system, it is necessary to keep the system fully liquid by additional injections to keep the system from imploding or contracting. Since debt represents borrowed money, when it is destroyed or disappears through bankruptcy or default, it is replaced by additional infusions of money into the system.

In order to maintain confidence, the system must constantly be fed with new money to keep the system from contracting or imploding. For close to a decade, it has become necessary for central bankers and especially the U.S. Fed to keep the credit doors constantly open. If the bond market was to collapse from defaults or credit was to dry up, the system would fall from its own weight. This support has become an absolute necessity in order to maintain the credit mechanism functioning. The stock market also plays a key role in keeping the household sector afloat. Like collateral for a loan, rising housing and equity prices provide the collateral and the cushion that allows for even more borrowing.

The Fed addressed the importance of monetizing the financial markets in its July 1999 discussion paper # 641. In this paper, Fed analysts Karen Johnson, David Small, and Ralph Tryon make the case for propping up the stock market should monetary policy through money creation and interest rate reductions fail to resuscitate the economy. If monetary policy should fail or if the stock market was to collapse, the Fed would be facing its worst nightmare deflation. They have been fighting the inflationary battle not recognizing its new form in the financial system. As generals who always want to fight the last war, the Fed has been fighting inflation without recognizing that it is deflation that is knocking on its door. The deflation that is coming will affect those areas that were greatly impacted by credit. First among them is the financial system in both the stock and bond markets. Next it will be real estate.

Central Bankers' Two-Front War

For these reasons it has been necessary to maintain confidence in all things financial be it stocks, bonds or currencies. Central bankers are fighting a two-front war. One front is in the financial system that requires constant injections of liquidity to hold back the debt defaults and prevent the system from collapsing. The other battle is to prevent users inside the system from shifting their funds to an alternative medium such as gold, silver, oil or any other tangible good that would compete with paper and credit. It is a lot like a fork in the road. On one side is the credit and paper money system that makes up the world's financial system. On the other road are tangible goods such as base metals, oil, silver and gold. The war is a constant battle where the public must be corralled on the one side of the road. Therefore, in a crisis, the only alternative is to shift from one paper asset to another rather than exit the system for the other side of the road.

Control by Derivatives

The way the battle is waged is through the derivative markets. The use of leverage afforded by derivatives allows a relatively small amount of money (estimated to be approximately $200 billion) to control the world's commodity markets. You can see this very easily in the commitment of traders reports on any of the major commodity exchanges and zero in on the short positions. This is most visible in the energy markets, (refer to charts in Hubbert's Peak) and in the silver and gold markets. In each of these markets, a small leveraged short position through derivatives has kept prices suppressed. It is the main reason why despite growing worldwide demand for gold, silver, and oil, their prices have declined for the last two decades.

HUI Index (Amex Gold Bugs Index) as of 2/4/02
up 29% Year to Date up 72% 52 Week

HUI Index (Amex Gold Bugs Index) as of 3/25/02

This current system is very similar to the 1960's London Gold Pool, except it is done on a much wider scale. The central bankers are aided and abetted in this task by the world's investment banks who have become allies in waging this two-front war. In my estimation, this is one reason for the explosive growth in the derivative markets over these last few years. The derivative book of our seven (in reality three) top banks have grown by double digits each year as the graph of derivatives by type above illustrates. This is why there is a desperate battle going on now in the precious metals markets. Gold has been the world's strongest currency over the last two years. While the yen, Euro, and dollar have lost purchasing power, the price of gold has risen. In the financial markets as shown by these graphs of the HUI, gold and silver mining shares have risen substantially. That is why central bank gold sales, gold leasing, and short sales of silver have grown to such magnitude. This, I believe, is the more subtle message in the rise of the price of gold and silver mining shares. They are rising as a hedge against the systemic failure of the credit-based financial system and as an alternative to a breakdown in the stock market. You can also throw in geopolitical tensions of the war against terrorism and the violence in the Middle East.

These subjects will be addressed in much greater detail in forthcoming installments of Powershift. Reluctantly, I now believe that my Perfect Financial Storm thesis will become a reality. It will be the result of the central bankers' two-front war in the financial markets. Deflation will be the result for most of the economy because of the breakdown and contraction of credit. Concurrently, we will see inflation in the commodity markets because of their decade's long suppression. Study these charts of the financial markets, gold, silver, and oil again. I believe "The Next Big Thing" has already begun. Since 2000, energy, gold, silver, water, food, and most basic commodities have outperformed financial assets.

One final note. When I completed the Storm Series, I felt the need to continue to inform my visitors of potential storm clouds on our horizon. Since then, we have developed several resource pages of particular interest with the storm scenario. I would like to recommend that you occasionally visit Storm Watch, Precious Metals, Energy Resources, and Fed Watch. We include daily news stories, interesting graphs, articles and commentary by experts in the investment fields. We even archive the stories as there are many. You will find these resource pages tell a compelling story. Remember the old adage, "The trend is your friend." I hope that this site will help you discern the trend.  ~ JP

Endnotes
1  Faber, Marc, The Gloom, Boom & Doom Report, Marc Faber Limited, February 28, 2002, p. 5.
2  Ibid., p.5.
3  Ibid., p.5.


by James J. Puplava
April 5, 2002

Storm Watch Index

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Copyright © 2002 by James J. Puplava. All Rights Reserved.

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