If you think
the "Lost Decade" Japan endured during the 1990s was deep and painful,
stick around: As the global financial crisis that was jump-started by the
meltdown of the subprime mortgage market continues to unwind, the U.S. economy
is headed for a financial Ice Age that will make Japan’s 10 wasted years
seem like a single chilly night.
The two meltdowns
started in much the same way - with busted stock-and- real-estate bubbles.
With both the United States and Japan, the market manias were ignited by laughably
loose credit policies, smoldered under a lack of oversight from government
regulators, market analysts or such private-sector sentinels as credit-rating
agencies, and were finally fanned into a frenzied financial conflagration
by the promise of easy profits.
Americans are
already getting financial frostbite. Unemployment is 20% higher than it was
a year ago. Zooming meat, dairy and gasoline prices are eviscerating household
budgets, meaning that the "real" rate of inflation is probably double
or triple what the federal government would have us believe. Mortgage defaults
are at their highest level in 30 years. Home prices have fallen so much that
they’ve wiped out all the gains of the past four years. And U.S. stocks
have eradicated a decade’s worth of profits.
That’s all bad, of course. In fact, it’s downright awful. But here’s
the problem. It’s going to get worse. Much worse. And here’s why.
Anatomy of a Lost Decade: Japan
Just look at
what happened in Japan. Success in the export markets - coupled with a strong
tariff policy that protected the home market from imports - pumped up the
yen and led to a massive buildup of cash in both Japan’s corporate coffers
and among its consumers. That spawned an era of easy credit, and that fueled
a frenzy of stock-and-real estate speculation unrivaled since the U.S. Great
Depression.
Almost overnight,
the newly wealthy Japanese were viewed with fear. Americans talked about the
invincible "Japanese superman," an unstoppable juggernaut who never
made mistakes. Japanese cars filled American roadways, Japanese cars filled
American roadways, and Japanese-owned companies treated the U.S. market like
it was a private rummage sale. Suddenly, Universal studios, Columbia Records,
Rockefeller Center and the Pebble Beach golf course (with its lonely cypress
tree) all had new ownership.
U.S. lawmakers
sounded the alarm. And so did the news and entertainment media. Fortune magazine
carried a piece entitled "Where Will Japan Strike Next?" And author
Michael Crichton’s alarmist book, "Rising Sun," was made into
an equally alarmist - but no less fun to watch - feature film that starred
Sean Connery and Wesley Snipes.
At the height
of the insanity, Japan boosters regularly claimed that the land beneath the
Imperial Palace in Tokyo dwarfed the value of the entire state of California
- an argument that defied reason, and yet could be substantiated mathematically
with actual market values. In 1989, in Tokyo’s Ginza district, prime
office space was going for $139,000 a square foot.
On Dec. 29 of
that year, the Nikkei 225 Index topped out at 38,957.44, before closing at
38,915.87. By the following September, it had nearly been halved - and there
was still much more bloodletting to go (despite several subsequent rallies
up over the 20,000 threshold, the Nikkei ultimately bottomed at 7,830 in April
2003. It closed yesterday - Wednesday - at 12,760.80, still down 67% from
its trading high 19 years ago).
The fallout
from that meltdown was incredible. By early 2004, houses were selling at 1/10th
their peak value, and commercial real estate was selling for less than 1/100th
of its peak-market value. All told, an estimated $20 trillion in stock market
and real-estate wealth had been vaporized (although one could easily argue
that the peak values weren’t real to start with).
As horrific
as the damage Japan suffered through that damage sounds, here’s the thing:
The U.S. financial crisis is much, much bigger, and the resultant "Lost
Decade" is arguably going to take much longer to work through.
What’s
the holdup, you ask? Believe it or not, we expect any recovery to be long
and needlessly drawn out largely because of the U.S. Federal Reserve, which
is the very same culprit that created much of this mess in the first place.
The Lost Decade - American Style
A dangerously
inflationary monetary policy by the Fed fueled two massive U.S. asset bubbles
-- stocks in the latter half of the last decade, and housing in the first
half of this one. If you argue that the beginning of the looming Lost Decade
for the United States was very different than Japan’s, we’ll counter
and say that you’re wrong.
You see, both
were spawned by a massive overflow of liquidity. True, Japan’s was created
naturally, with a mass of cash from savings that lead to a period of easy
credit. And we all know that U.S consumers are lousy savers, meaning that
couldn’t be the catalyst here. But that’s okay. Under Messrs. Alan
Greenspan and Ben S. Bernanke, the Fed did that for us artificially - holding
rates at ridiculously low levels, even as it continued to stoke the money
supply. Despite the different routes the two markets took, the result is essentially
the same.
Cheap money
drove the Internet boom-and-bust. Cheap money fueled the run-up in housing
prices - and induced the U.S. banking system to create "subprime"
mortgages so it could reach a bigger pool of potential "customers,"
and boost its potential profits. All those extra customers flogged home prices,
which drew in an even greater number of potential buyers, this time in a group
interested in buying second homes as "an investment." Of course,
that pushed home prices up even higher.
All the money
flowing in from these mortgage payments (many of them the "no money down"/interest-only
variety) forced Wall Street to create all sorts of new asset-backed securities,
snipping the mortgages into pieces much like a coupon-clipping consumer used
to cut up the Sunday newspaper.
We’ve already
talked about how the financial-crisis fallout has pounded U.S investors and
consumers in guise of plummeting asset values and spiraling prices (inflation)
in the face of a stagnant - or even stagflationary - economy (rising unemployment
and rising inflation).
Just as we’ve
been predicting since Money Morning’s earliest issues last year, the
financial crisis is already transforming the United States into the World’s
Biggest Garage Sale. Japan faced a similar ordeal, having to dump off virtually
all the trophies it had grabbed during its artificially created salad days.
Foreign-government-controlled
sovereign wealth funds already are investing billions in some of our choice
companies. And they’re making their moves with an almost-surgical shrewdness:
They’re snapping up financial firms that possess key competencies, are
buying into such strategically positioned ventures as stock exchanges, and
in some cases are clearly willing to send good money after bad to learn the
art of financial deal making that America once dominated - because we were
once so good at it.
Dubai just spent
$800 million for a 90% stake in New York’s vaunted Chrysler Building
- the first in what figures to be a long line of "trophy" purchases
by foreign buyers. Trust me when I say you’ll be able to watch as the
sovereign- wealth heavyweights from emerging Asia and Europe, the Middle East
- or cash-laden China, with its $1.68 trillion in foreign reserves - begin
to snap up high-profile U.S. properties.
But when you’re
the United States - and are constantly spending more than you make in the
form of the twin deficits of budget and trade - you have to finance your shortfall
somehow. And you do that by selling off your best assets to your overseas
creditors.
The 'Lost Decade' vs. A 'Lost Coupla Years'
Here’s
a little secret. Just as Japan didn’t have to waste the better part of
15 years in the financial equivalent of a locked-room mystery that can’t
be solved, the United States doesn’t have to endure 10 years of wasted
time, missed opportunities, and watching countries such as China, India, Brazil
and others start to put some real distance between us.
But it’ll probably happen anyway. In fact, the longer we wait to take
action, the more inevitable it becomes.
Look at it this
way. Back in the late 1980s and early 1990s, the United States went through
a savings-and-loan crisis right about the same time Japan endured the beginning
of its banking-and-stock-market crisis. Today, however, the S&L crisis
is hardly a blip on U.S. memories, while Japan’s Lost Decade is now part
of global financial lore. The reason for this big disparity is simple: We
attacked the S&L industry with great energy, shuttered or sold off ailing
thrifts, and decisively enacted new guidelines to avoid such problems as under-funded
state insurance pools, lousy capital requirements, and major regulatory loopholes.
Japan did nothing.
It refused to acknowledge the breadth and depth of its problems, partly because
banks are part of complex, societal cross-linking arrangements known as keiretsus.
And because taking action would force it to admit it had handled this sector
poorly. By the time Japan finally realized it had to take action, the problem
was so ingrained and the losses had ballooned so much that it was too late
for decisive action - only time and long-term policy changes could bring about
the desired conclusion.
This time around
in the United States, the Fed opted for the "prop it up" pathway
instead of the decisive route. Think about it. When the subprime crisis broke,
instead of permitting the free markets to fix the problem, the Fed embarked
upon on of its most aggressive rate-cutting campaigns ever, and slashed borrowing
costs at a time when it probably should have been raising them.
Then it set
a dangerous precedent when it intervened in The Bear Stearns Cos. (BSC) case,
setting up a bailout-and-sale deal with JPMorgan Chase & Co. (JPM). When
Fannie Mae (FNM) and Freddie Mac (FRE) came around, the Fed was almost obligated
by that precedent to bail these two mortgage giants out - not necessarily
the best position to be in when additional failures (such as the Federal Housing
Administration, or FHA) are in the offing. Indeed, investing guru Jim Rogers
calls the Fannie-Freddie bailout an "unmitigated disaster."
For some perspective,
consider this: This bailout adds $6 trillion to the U.S. debt load - a liability
that’s equal to nearly half the value of the output from the U.S. economy
for an entire year.
(In his recent
"Inside Wall Street" column, Money Morning Contributing Editor R.
Shah Gilani makes an excellent argument that the bailouts of Fannie and Freddie,
though as undesirable as we say, still were probably necessary and certainly
were the only valid exceptions to the "no-bailouts" argument. He
details the FHA predicament in another "Inside Wall Street" report).
By slashing
rates, pumping up the money supply and rescuing poorly managed enterprises,
Fed Chairman Bernanke has essentially thumbed his nose at the free-market
system, as if to say the central bank can do it better. Financial markets
are remarkably resilient. If financial ventures are so poorly run that they’re
poised to fail, the free-market doctrine says to let them do so. The pain
will be deep, and will certainly have a broad ripple effect, but in the end
the marketplace will have flushed the poorly run venture away, freeing up
capital that well-run, opportunistically rich companies can use to grow and
create jobs.
Instead, Bernanke
and Co. have stepped into the fray in such a way that the virtually assures
the United States of a Lost Decade of its own. The artificially low interest
rates the Fed has employed to avoid the financial pain from the crisis will
continue to put an intense downward pressure on the U.S. greenback. And that,
in turn, will fuel additional run-ups in food and energy prices - inflationary
pressures that will prolong the U.S. economic malaise for months or even years
to come.
Just how long will it last? Opinions vary.
Buyout specialist Theodore "Ted" Forstmann, the chairman of IMG
who was one of the players in the "Barbarians at the Gate"/RJR-Nabisco
saga, recently told The Wall Street Journal that this financial crisis still
has a fair distance to run.
"We are
in a crisis the likes of which I’ve never seen in my lifetime,"
Forstmann said. "The credit problems in this country are considerably
worse than people have said or know. It’s hard for me to believe that
it gets fixed without an upheaval in the financial system. Things are going
to fail. Enterprises are going to fail. The economy is going to slow …
I think we are about in the second inning of this."
In response
to that prediction, noted Contrarian Investing columnist Bill Fleckenstein
recently related the prediction of a trusted industry source that he refers
to as "The Lord of the Dark Matter," who admitted
that he didn’t know what inning the financial crisis was in - although
he was certain it was going to be a double-header.
We couldn’t agree more.
A "Lost
Decade" doesn’t have to translate into lost profit opportunities.
As the global financial crisis continues to escalate, the United States is
increasingly facing the prospect of a long malaise that could easily eclipse
Japan’s Lost Decade of the 1990s in both duration and depth.
And history
shows that such periods can be the worst for investors to navigate - especially
when they follow a record stock-market run, such as the all-time-highs that
U.S. share prices reached last fall.
In the United States, for instance, the Dow Jones Industrial Average hit 381
on Sept. 3, 1929, a record pinnacle achieved in advance of both the Great
Crash and the Great Depression that followed -- and a level that wouldn’t
be eclipsed again until November 1954 - more than 25 years later.
From the Great
Crash, fast-forward 60 years, to 1989 Japan. On Dec. 29 of that year, the
Nikkei 225 Index topped out at 38,957.44, before closing at 38,915.87. By
the following September, stock prices had nearly been halved - and there was
still much more bloodletting to go. (Despite several subsequent rallies up
over the 20,000 threshold, the Nikkei ultimately bottomed at 7,830 in April
2003. It closed yesterday - Thursday - at 12,887.95, still down 67% from its
trading high 19 years ago).
The fallout
from Japan’s slow motion, stock-and-real-estate-market meltdowns was
incredible. By early 2004, Japanese houses were selling at 1/10th their
peak value, and commercial real estate was selling for less than 1/100th
of its record highs. All told, an estimated $20 trillion in stock and real
estate wealth was vaporized (although one could easily argue that the peak
values weren’t real to start with).
That’s
scary stuff, especially because many experts fear the U.S. version of the
Lost Decade that’s to follow could be much worse. After all, the U.S.
financial crisis is much, much bigger, and the resultant malaise is arguably
going to take much longer to work through.
Let’s look
at some of the some of the profit plays that will allow investors to sidestep
a long U.S. slumber - and profit just the same.
1. Miss the
Market Meltdown: The Dow closed at an all-time record high of 14,164.53
on Oct. 9 of last year. With yesterday’s 207-point rally, the Dow closed
at 11,446.66 - leaving the 30-stock blue-chip index down 19% from the October
record, leaving it right on the doorstep of a bear market.
But what if
things were to get much worse? For the Dow to match the Nikkei’s wrenching
decline of 67%, it would have to drop all the way down to 4,574.29 - an area
it hasn’t seen since the first half of the 1990s. Will the Dow drop that
much? Probably not.
But it doesn’t
hurt to hedge. That brings me to a key point: There’s a big difference
between "diversification," which most individual investors equate
with "protection," and actual "hedging," which is part
of an investment-protection package that professional traders employ. If we
believe a market poised for a real fall, we want to hedge and find an investment
that’s going to go up in value while everything else is going down.
For us, that
investment is the Rydex Inverse S&P 500 Strategy Fund (RYURX). RYDEX URSA
is a so-called "inverse fund" that’s designed to profit as
the Standard & Poor’s 500 Index declines in value. In that way, it
complements our other holdings by providing some portfolio stability.
As Money Morning
Investment Director Keith Fitz-Gerald says, hedging is such a compelling strategy
because financial studies demonstrate that "even though broad sections
of the markets may decline over time and our portfolios with it, we need only
have a small section permanently hedged at any given time. The reason is that,
by having a small portion of our assets (5%-10% or less) earning above-average
returns, our overall returns are far higher over time."
2. Gold Isn’t
Just for Hedging Anymore: Mention the word "stagflation" to
anyone who worked and invested during the 1970s, and I’ll bet you’ll
actually see that person physically shudder at the memory. Stagflation - the
double-whammy combination of stagnant economic growth and high inflation -
was thought to be an impossibility, until it showed up during that decade,
leaving ruin in its wake.
But for our
purposes, no matter whether we’re looking at stagflation or inflation,
one thing is clear - we’re looking at higher prices. And when prices
are on the upswing, gold is the one investment you certainly want to own.
Then there’s
also the whole "Lost Decade" outlook for the U.S. economy. In a
misguided attempt to slowly deflate the asset bubbles it created with a years
of overly expansive monetary policies, the U.S. Federal Reserve is now keeping
interest rates at artificially low levels - gambling it will still be able
to launch a successful counterattack on inflation later on. What’s more,
the central bank also has made the ill-fated decision to diversify into the
"bailout business" with its intervention in the Bear Stearns Cos.
(BSC) and Fannie Mae (FNM) and Freddie Mac (FRE) debacles.
The artificially
low interest rates will continue to punish the U.S. greenback, sending it
lower and causing inflation to accelerate. And the trillions in debt the U.S.
government’s balance sheet will take on from the Fannie and Freddie bailouts
certainly won’t help.
In addition
to the bleak-sounding inflation-case for gold, there’s also what I like
to call the "wealth case" for the "yellow metal." As the
consumer classes in China, India, Latin America and Emerging Europe grow in
both breadth and depth, their ability to buy luxury goods will finally intersect
with their desire. And gold will be a major beneficiary.
But how best
to play it? There are mining companies, bullion, coins and even jewelry. Everybody
has his or her preferences for gold investments, including us. We prefer the
SPDR Gold Trust Exchange Traded Fund (GLD). There’s no delivery risk,
it’s liquid, and you can buy and sell easily through any online brokerage.
Oxford Club
Investment Director Alexander Green prefers the Market Vectors Gold Miners
(GDX) ETF. Market Vectors is linked to the AMEX Gold Miners Index and owns
all of the world’s leading gold and silver mining companies. That means
you can capture the performance of the entire sector in a single, well-diversified
investment.
Finally, there’s
our favorite gold-mining stock: Barrick Gold Corp. (ABX). Barrick is a Toronto-based
company with mostly North American production, though it also has properties
in South America and Africa, and some copper and zinc add-ons. It has a $41.4
billion market capitalization, so there’s plenty of liquidity. By gold-mining
standards, this company has a substantial presence, is reasonably valued,
and has little political risk. The company also recently sent some very bullish
signals to the market and reasserted its confidence in meeting its 2008 output
target of up to 8.1 million ounces of gold.
3. Profit
From the New Trading Blocs: A decade ago, professional traders would tell
you that "when Wall Street sneezes, the rest of the world catches a cold."
There’s one major difference between the world today and the one that
existed back in the early 1990s when Japan skidded into its Lost Decade: Globalization
has today finally taken hold, and isn’t just some concept to be talked
or hypothesized about, as it was back when Japan’s overheated economy
threw a rod back in 1989.
That will make
a huge difference, for it means that global growth can continue - even if
the U.S. economy stalls and falls into decade-long slumber. One of the biggest
developments is the emergence of new trading blocs - that don’t include
the United States. At the center of most of them: China. The biggest of these
new blocs is undoubtedly China and Japan, an immensely powerful alliance that
might develop into the United States’ military equal, in addition to
its economic superior. It’s ironic that Japan - which suffered through
its own Lost Decade - would be one of the antidotes for investors seeking
to escape a looming U.S. downturn that has the potential to be equally as
devastating.
Investors will
want to uncover profit plays from this deepening relationship, and would do
well to look at major Japanese companies that already are shifting production
from their high-cost home market into lower-cost China. One such company is
Japanese heavyweight Toshiba Corp. (TOSBF.PK).
This major manufacturer
of computers, medical electronic equipment and telecommunications systems
has developed a highly integrated manufacturing capability in China, enabling
it to synergize its technical innovation with China’s highly skilled,
low-cost workforce. Toshiba’s shares are trading at about 22 times earnings,
reasonable for a high-tech company -- especially one that’s poised to
capitalize on such new-technology markets as flat-panel televisions and solar
power.
For investors,
one of the biggest profit opportunities will be with companies that are helping
China build out its still-archaic infrastructure and build up its consumer
sector, which is why such companies as solar-ceramics maker Kyocera Corp.
(ADR: KYO), and trading giant and independent power plant developer Mitsui
& Co. Ltd. (MITSY), are logical choices.
China also is establishing trading blocs with Africa and the Middle East.
For a broader exposure to the Chinese through a high-quality mutual fund,
investors should carefully consider the China Region Opportunity Fund [USCOX],
managed by the San Antonio, Tex.-based U.S. Global Investors (GROW), itself
not a bad stock to consider.
4. Invest
in the Global Infrastructure Boom: Global consultant Booz Allen Hamilton
recently estimated that the world’s water, power and transportation systems
would require an outlay of $40 trillion to bring them up to modern standards
- an amount equal to the value of all the world’s stock markets combined.
Some of our favorites plays in this area include raw-materials suppliers,
such as miners Rio Tinto PLC (ADR: RTP), BHP Billiton Ltd. PLC (ADR: BHP)
and Companhia Vale do Rio Doce, now referred to only as Vale (ADR: RIO).
One of the very
best plays may be ABB Ltd. (ADR: ABB), the Zurich-based giant that’s
a leading global provider of power-generation systems and components. With
a market value of roughly $63 billion, ABB is one of the real heavyweights
in a sector that includes such rivals as America’s General Electric Co.
(GE) and Germany’s Siemens AG (ADR: SI). Over the last several months,
for example, ABB has announced deals of $233 million in Korea, $74 million
in India, $170 million in the Sweden-Finland region, $53 million in Dubai,
and $70 million in China, to name just a few.
Of course, you
can also buy individual engineering and construction firms, or invest in the
broad holdings of the PowerShares Dynamic Building & Construction ETF
(PKB).
5. The Middle
East Isn’t Just About Oil Anymore: Indeed, thanks to the petro-gusher
dollars so many Middle Eastern countries were able to amass, and to the government-controlled
sovereign wealth funds that now control that capital, these same nations have
been able to transform themselves into major global financiers. There aren’t
a plethora of plays here, yet, but there will be. For right now, consider
the T. Rowe Price Africa & Middle East Fund [TRAMX], which carries a $2,500
minimum investment, and the SPDR Standard & Poor’s 500 Emerging Middle
East and Africa (GAF) ETF, which tries to closely match the performance of
the S&P®/Citigroup® BMI Middle East & Africa Index.
6. Head South
of the Border When You Consider the BRICS: An acronym for Brazil, Russia,
India and China, the BRICs are among the fastest-growing economies in the
world. We’ve covered China, but Brazil bears more than a mere mention.
The main play to look at here is Petroleo Brasilero SA (ADR: PBR). Latin America’s
appetite for energy is nothing short of ravenous. As of now, three-fourths
of the country’s electricity comes from hydroelectric power. That figure
will be higher in 2012, when the region’s largest hydroelectric project,
the Santo Antonio Dam, will begin producing electricity. Santo Antonio is
the first of three Amazon River dams the government hopes will decrease Brazil’s
need for fossil fuels. Until then, however, Brazil’s state-controlled
oil-and-gas company, Petrobras, will continue to meet the demand.
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