Try imagining a place
Where it's always safe and warm
Come in she said I'll give you
Shelter from the storm

I recall from a celebrity interview magazine article, that Bob Dylan does have a significant portfolio of US stocks and mutual funds, but I’m not sure the current economic conditions were exactly what he had in mind when he wrote the lyrics above. Sadly there are all too few people out there who realize the extent of the storm that might be about to break.

At the end of 1999 MBMG published articles citing that the levels of the US markets, particularly the NASDAQ were way too high, because individual stocks were being traded at prices that bore no relation to their performance, using any recognizable criteria of measuring value. They promptly fell.

At the end of 2000, despite all the optimism exuded on CNBC, we said that we saw no reason for markets to go up, looking at stock prices and prevailing economic conditions. They fell again.

As 2001 drew to its conclusion, we recommended either a zero allocation to the US or a short position (and we told clients to put their money into Thailand which is now up by over 50% from that point). Our concerns were that the reported numbers in the US were in many cases completely disparate from the apparent realities. The US indices fell again, and the wave of accounting scandals broke

In 2002 we published our first Stormy Times article, which asked the question - “Are we out of the recession or is this just an optimistic blip”?

We quoted the philosopher Santayana, who said, “Those who cannot remember the past are condemned to repeat it” and compared the US in the mid 1970’s to current market conditions:

A constant stream of bad news

A war overseas

A major scandal in the US

Over two years of falling stock prices.

In the 70s the DJ30 suddenly jumped by more than 40% in six months. People scrambled to join the bandwagon only to get completely stuffed by massive hikes in oil prices whilst at the same time inflation and interest rates rose at alarming rates. The DJ30 then basically did nothing for seven years. It did not lose people much money but it did them no favours either. It was not until 1982 that the bull market of the 1980’s began.

A year ago our main concerns were that stocks were still very expensive - even after three years of recession the DJ30 was still only 10% off its all time high. A well-known research company had calculated that the S&P 500 would have had to fall a further 29% to return to its median P/E ratio which is 17. No bull market in history has started with P/E ratios this high.

Our oft repeated view was that 2003 would start with negative momentum, but a positive outcome to the war in Iraq, continued low interest returns, tax incentives and government inspired massive liquidity in the equity markets would lead to a rally that would dominate the latter half of 2003.

So far this has happened almost exactly as if we had orchestrated it.

Our view going forwards remains that this is purely a liquidity driven bubble and the drying up of that liquidity might lead to a re-assessment of the relative risks of property, equities and cash with the first 2 sectors correcting to levels much more in keeping with their real inherent values (i.e. a 20-25% crash for equities and something much more severe for property – all of course in US$ terms; these numbers will be much worse for international investors once the Dollar scales the peak of its current short term spike and falls back to levels that are far more sustainable (expect to see Dollar : Euro rate break 1.20, Dollar : Sterling go well past 1.75 and the AUD back above 70 Cents.

It’s not just a case of people having been badly burned over the last couple of years – especially those who had invested heavily in technology. In the mid to late Seventies it took a long time for investors to get back into the market. It’s not just a case of reckless policy by the Fed and Treasury Secretary (remember stagflation; all those college grad analysts who’ve been reading up on deflation for the last year would be as well advised to check stagflation in their history books too), it’s not just a case of asset values being totally out of kilter with reality. It’s also the case that the growth at any price mentality that caused the bubble of ’99 still holds sway. Almost 93% of S&P500 companies outdid economists and analysts forecasts for Q2. So, why is that a problem?

One of the main reasons for this is that ‘accounting semantics’ seem to be making a comeback. It is really how corporate accounting methods act on amortisation of capital expenditure. There is no law stating that anything bought must be written off over a set period. A company is allowed to write off a purchase over whatever length of time it wants to. So, when a company is looking to reduce costs and increase profits they can increase the amortisation time and keep things going beyond their normal accounting life. According to Merrill Lynch, lower depreciation costs accounted for 25% of the improvement in Q2. To put it another way, earnings have been shown to have increased tremendously without any significant rise in better business conditions. In fact, it can be argued that it is detrimental to improving things in the long run. Since companies are stretching the life of any capital equipment it means that they can delay making any important investment decisions. Whilst this may be good in the short term and for the company accounts it is not for business spending which is vital for GDP growth. Merrill Lynch has also concluded that the weaker US Dollar has been another major factor in improved profits. US companies with international business interests will have had their profits increase by up to five per cent. This is not coming from leaner, meaner operations but just from the currency exchanges. Admittedly there could be a lot more of that to come, but for a currency to remain low, in such a competitive environment, demands levels of structural weakness that even the Dollar under George W’s misguidance might struggle to maintain.

The final major concern is that again, as we reported in 2001, it is becoming far too easy to alter reported earnings. Impartial analysts actually prefer to look at corporate profits as stated in the national accounts rather than listen to what the CEO or CFO has said. This is because no company wants to pay more in taxes than it has to, so its taxed profits are, to some extent, a better indication than its manipulated profits. This is revisiting the same territory as before. A graph taken over the last eight years would show that S&P profits and the national account profits start off mapping pretty much the same course. However in between 1998 and 2001 there was a sudden leap up the chart with the former that the latter just did not match. This is because companies such as Enron were manipulating their accounts to make the figures look better than they actually were. The divergence of the figures came back to almost match each other in the aftermath of the Enron and WorldCom scandals and when the bear markets were reaching their depths. However, over the last nine months the gap has again started to increase. Basically, S&P companies are showing an increase in operating profits whilst the national account profits have really remained flat. This is not a good sign. For long term optimism to return they have to converge again and remain in the same ball park – not in different states. If they do not improve over the next few quarters earnings then it will be interpreted as a sign that dubious accounting methods have returned to haunt us. It is early days yet but in an inflated market, within a mis-managed economy, at the top of the latest bubble, it is a cause for concern. Investors, mind the bulge!

Footnote on the US Dollar

The US Dollar (USD), over the last year and a half had been getting steadily weaker against most major currencies but especially the Euro and the Yen. However, over the last three months it has risen 9% against the Euro. Some analysts (generally CNBC and in this instance definitely far more ANAL than YST) even think it might reach parity again. Both sets of USD swings can be seen as a false statistic though as between early 2002 and May 2003 the USD fell by nearly 30%, however, in trade weighted terms it only came down by 15%. Similarly, it has only gained 4% since May in trade weighted terms.

One reason for the reversal is the illusory information coming from the US suggesting that the worst is behind them. The outstanding Q2 figures highlighted above have led forecasters to predict GDP growth being almost 4% for H2. Against this the reports from Euroland have shown negative growth. If there is no growth then there are lesser returns on investment which makes Euro assets less attractive to foreign investors. On top of this the USD has also been supported by movements in relative bond yields. Three months ago US ten year Treasury bonds gave 0.3% less than their German equivalents. Now they give 0.25% more. So, having said all this why hasn’t the USD fallen more against the Yen, especially in light of the increased recent optimism about the Japanese economy? This is because Japan is the world’s largest holder of American Treasuries with 12% of the TOTAL stock. Also, the Bank of Japan has bought over USD80 billion of USD assets this year in an attempt to hold down the Yen and so support Japan’s fragile recovery. There is still wide disagreement among the so called experts as to how the USD will fare over the next year or so. Citigroup believe that the USD will remain at roughly the same levels as now over the next year or so. However, HSBC believe that by the end of 2004 the Euro will be worth USD1.35 and there will be 105 Yen to USD1.00.

The main reason to believe that the USD will soon go into decline again is America’s huge current account deficit. A USD rally driven by stronger American growth is not sustainable in the medium term. Imports are over 50% larger than exports. If America continues to be the powerhouse for the world’s economy for the foreseeable future then this figure will only grow. If the current account deficit is to come down then either growth must reduce in the US or the USD must decline to improve the competitiveness of US companies. HSBC economists, using figures from the Federal Reserve, reckon that US domestic demand will outstrip that of the other G7 economies by more than at any time since the early Nineties. The current account deficit could grow to USD800 billion (Annualised basis) or 7% of GDP in 2004.

Naturally, there is an alternative point of view that states that a current account deficit does not really matter. It just shows how successful the US is. Faster growth gives higher rates of return which therefore attracts more investors – both from the US and overseas. This can thus be interpreted as overseas investment actually driving the current account deficit and not the other way round. Unfortunately growth spirals have never yet continued indefinitely – usually because as in this case they create unmanageable debt burdens. It is true that the US did attract large investment from abroad a few years ago because everyone was optimistic about good returns. However, UBS has now revealed that institutions have been large sellers of American equities this year as they grow more and more reluctant to buy even more USD assets. Interestingly, it is the central banks, largely in Asia, that financed more than half of the current account deficit in Q2 of 2003. They now hold a larger proportion of the total stock of Treasuries than at any time in the last 25 years. To put it another way, America’s deficit is now being financed mainly by foreign governments – not by private investors. If these central banks got cold feet (and as we recently reported both Australia and New Zealand have now implemented a policy of managing their reserves for their own benefit rather than that of the US) then US bond yields would rise and the USD would fall. In the 1960s the US worried about the domino effect of Communist contagion throughout Asia. Their greater concern now should be the new domino of smarter financial and treasury secretaries in the region – which in small part explains the importance attached to the recent negotiations in China (although our take is that both parties exited the meeting thinking that very different commitments had been reached.) It’s not surprising therefore that there has been many a rumour that a number of Asian central banks will diversify from the USD to the Euro. Also, European central banks no longer have to keep such large reserves of the USD to defend their own (now extinct) currencies. None of this does the USD any favours.

Another nail in the Greenback coffin is that savings (as opposed to investment opportunity) is at an all time low in the US. This has also certainly not helped the current account deficit which basically means the gap between domestic saving and investment. Morgan Stanley reckon that US net national saving (i.e. private saving net of capital depreciation plus government dissaving, in the shape of the budget deficit) is likely to turn negative for the first time in peacetime history. This can be taken that the US is asking foreign investors not only to subsidise its investment but also to foot the bill for its consumption. Despite all of the above it has to be said that economists and analysts have been sounding the death knell about the US current account deficit for years and Uncle Sam is still alive and kicking. However, the longer the deficit is allowed to grow then it has to be said that the US Dollar will start to plunge.

Above all let’s put the recent rally into perspective. The last time the USD fell by a reasonable amount was in 1985 and 1986. In this time there were three periods when the USD rallied by as much as 10%, it then continued its long term decline falling by a total of 50% against the Deutschmark in just two years. Ring a bell? Expect the slide to continue. HSBC are likely to much closer to the right forecast than Citigroup