Review of 2005, and Summary of 2006

Heading into 2005, we were concerned that there were a lot of risks on the horizon, but when we looked at the values in evidence, it struck us very much as if things were going to work out for investors, they were going to work because of the tremendous value in the commodities sectors, most notably energy and mines. We were concerned about the value of the US dollar, and the strong possibility that in a commodity market, an industrial type of market would not respond well. Hence our investment stance strongly favoured investing in the Canadian market and most notably in the commodities sectors. Both forecasts have worked out well for our clients.

We suspect that the early part of 2006 may be more or less a continuation of trends set in motion in 2005 but that if the 4-year stock market cycle has any efficacy, the markets are becoming increasingly risky and prone to reversal. In other words, while our hands are on a parachute, we are still aloft.

2006: “A Bubble Floating in a World of Pins“

"I don't know whether change [in the financial status of the US] will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than policy foresight that will force change."

- Paul Volker, Former Chairman of the Federal Reserve Board

Aberrant behaviour can go on longer than any reasonable person might think, but it cannot become a permanent way of life. There is no doubt that the current US economic paradigm is that we can spend our way to perpetual prosperity, and the proof of the pudding is definitely in the numbers that have been coming out of the US in particular. We hold up as proof of this statement that fact that all US deficits, household, governmental, and trade, have been cheerfully surging during the past year and show no sign of respite. Their very continuance has been imbedded in the expectations of economists, the markets, both stock and bond, as well as investors, yet objectively speaking, it is likely to be very dangerous to think that this can be anything but essentially short-lived, even if the term “short-lived” is longer than we would think.

Last month, we showed this chart of the household deficit over and above personal disposable income and this month we update it to show the third quarter numbers which have surged yet again as the rate of borrowing accelerates [again]. There is of course nothing that says that it cannot grow even larger from here – why not, given the gains in the value of housing real estate which is driving the “feeling of wealth”? – except that continuous leveraging of ones’ assets to maintain a spending lifestyle which is inconsistent with ones’ income is one of those trends which, in the final analysis, cannot be sustained forever because it is not built on productive wealth generation but rather asset price inflation, which has had an historical and nasty tendency to end. As “leverage” means ”debt”, we keep coming back to the proposition that in the end, the US consumer will be left with lots of debt and little asset. As this strikes us as a formula which will require lots of balance sheet rebuilding to resolve, we struggle with the need to balance the desire of our clients to maximize their investment returns against the rising risks entailed in doing so. As one commenter observed recently, all of us, whether we are Americans or not, are living in “bubble floating in a world of pins”. The health of the global economy is dependent on one massive economy, the United States, which is puffed up with debt but which is offering less and less to global productiveness and more and more to consumption as its contribution to the overall global expansion.

It would be nice to think that this state of affairs can be sustained under the watchful eye of the US Federal Reserve Board (the Fed). Many feel that it has done a masterful job over the past few years in beating down the normal effects of the business cycle. However, charts such as the one above show the Law of Unintended Consequences at work. If one bends ones’ efforts to take all of the apparent risks out of an activity, then that activity will continue to expand until even greater risks finally overwhelm those efforts. What would lead anyone to think that human nature has changed? Our challenge is to identify when those risks finally gain ascendancy over the opportunities and remove our clients from the path of destruction that must follow – only do it the week before.

In terms of the timing at which “something will happen” to change the current state of affairs from one of borrowing and spending to one of retrenchment and balance sheet rebuilding, in all fairness we have to observe that it is no ones’ interest to do so. As investment writer John Mauldin observes in a recent market note, “gradual is what everyone is hoping for. It is the best of all possible worlds. Asia and China in particular need time to build up their own consumer classes while we adjust to saving more and a gradually falling dollar. No sudden shocks, other than the normal ups and downs of the business cycle, is what governments, central bankers, business, investors and consumers all want to see happen”.

Mauldin cites game theorist, John Nash (the Nobel laureate in mathematics featured in the movie "A Beautiful Mind") who hypothesized the Nash Equilibrium, a kind of optimal strategy for games involving two or more players, whereby the players reach an outcome to mutual advantage. If there is a set of strategies for a game with the property that no player can benefit by changing his strategy while the other players keep their strategies unchanged, then that set of strategies and the corresponding payoffs constitute a Nash equilibrium. The problem with the current status quo is that it is not sustainable because it requires increasingly large transfers of “savings” from the rest of the world to the US, as we discuss in detail below.

Mauldin adds that “while the game can go on for much longer than reason would dictate, there will be an end to it. Will it be the soft landing with nations agreeing to work together to find a sort of new Nash equilibrium; or the hard landing where the "vacuous rhetoric of globalization" (to quote Stephen Roach) masks the reality of each nation going its own way, in a kind of "devil take the hindmost" world?”

Can it happen? Can things go that smoothly? He replies, “Sadly, probably not. There will probably be, as economist Peter Bernstein notes (and Paul Volker fears), an economic storm. Something will push somewhere on the disequilibrium and the stability that we now sees shifts. The world will try to find a new Nash equilibrium moment, where all the players begin to adjust and try to secure their own optimum situation.”

After all, that is the nature both of markets and the global information village. As long as no one moves suddenly, then everyone is okay. But we already know that markets tend to react with lightning speed to untoward events, and our work at SAC suggests that we may be moving towards one of those “untoward events.

The US Dollar and the Insolvency of the US Economy

With a nod to Dr. Kurt Richebächer who provided the background data, it is clear that the US would appear to be heading into some sort of currency crisis down the road. Using as a proxy for our solvency ratio, the GDP to Total Debt Ratio of the US, we find that the ratio currently stands at approximately .33, a short stone’s throw from what we term a “Second-Order Insolvency” which occurs at .289. 25 years ago, the ratio stood at roughly .7, the same level around which it had stood since the early 1920s, and also the level of maximum balance sheet (economic) efficiency within Dr. Atrill’s analytical framework (Note: Dr. Atrill was the founder of SAC and the theoretician who developed the mathematics which drives our work). Since then, the ratio has continuously fallen to its current level, and shows no sign of reversal. If anything, it shows signs of deepening. Within our corporate analysis, once a balance sheet falls to this level, the share price collapses and the company must sell assets, encumbered as they are, as that is all that is left.

Once an entire economy as a whole falls to – and below, if that is possible – .289, then all bets are off as to what will occur next. Dr. Atrill used to observe that an insolvency can be perpetuated as long as a banker (lender) can be found who was willing to accommodate it. Once one has reached the condition in which one’s insolvency cannot be accommodated, then the game is over. Without the data to prove conclusively that passing .289 results in a drastic change of modality, first of the bankers who had accommodated it and second by those who have reached a second order insolvency, we cannot answer the question, “now what?” with any conviction. Getting good data, let alone any data, from countries whose currencies have fallen drastically, from Germany in the Weimar Republic to Mexico a few years ago is virtually impossible, but we believe from our analytical framework that .289 must mark a key turning point. The US of course has one banker more than willing to accommodate it, the US Federal Reserve Board. And indeed, within the Nash Equilibrium conditions, there is a powerful incentive for all (global) bankers to accommodate the US as to do otherwise could push us all into a state of economic dislocation.

However, we would have to hypothesize that eventually that will not be enough. The US has been described as a “Ponzi Economy” in that not only does it have to borrow to repay the principal amount of its existing debts, but also it now has to borrow to pay the interest on those debts as well, interest which is compounding steadily and rapidly. This is not a shock when we recall that in Dr. Atrill’s terms, a second-order insolvent is “one that has sold everything on the shelf and now must sell the shelf itself in order to meet its cash requirements”.

That the US has become a sort of giant vacuum sweeper for the worlds’ “savings” is not a surprise from a (SAC) solvency point of view. What this does not mean is that there is any such thing as a “global surplus of savings” which is being “efficiently” recycled into the US, as Greenspan (and some others) maintain. That sucking sound is simply the modality under which any entity, be it company, person, or country, must operate who is deeply insolvent and who is not called to account!

[GRAPHIC]

As the graphic above shows, the cost of what Dr. Atrill termed “Maintaining State” – that is, financing one’s fiscal requirements – escalates rapidly once insolvency has begun. A small entity, like your ne’er do well son-in-law, may carry on from hand to mouth with loans from those who can’t bear to see their daughter suffer, but his condition is plain for all to see (and suffer). Increasingly, you are ‘out’ when he comes to visit and friends cross the street when they see him walking along. In the case of the US, being ‘out’ is not an option. Either other central banks accommodate the US by lending their foreign exchange earnings back to the US so it can pay its interest bills, or they face a potential business slowdown with the attendant employment problem at home. The failure to understand the macro-mechanics of a sovereign insolvency the size of the United States means that increasingly large and growing global resources must be misallocated to the US, resources which could be better and more efficiently used to generate healthy (solvent) growth elsewhere.

The question is less one of ‘if’ but rather of ‘when’ the US will have to face the inevitable outcome of its own insolvency, particularly as it shows no desire or will power to do a thing about it. There is, of course, a certain sang froid that comes with being the world’s number one military and economic power at the same time. Who, after all, is about to challenge the US directly? The only ‘thing’ in the world which is able to confront and stare down the US is the market itself, a reality which has been repeated time after time throughout history when others (including Great Britain early in the 20th century) have thought themselves above reprisal. The market is ultimately bigger than anyone and everyone. Even so, it is taking the market a long time to confront the US and, to date, the US has even continued to win. And small wonder that this has been the case. No one (other government or central bank) really wants the sort of correction (recession) which would be necessary to ‘cure’ the current problems of the US insolvency, even though in the longer run, it would free up a lot of resources for faster (and more healthy growth) in all parts of the globe, probably including the US as well.

This past year was certainly one in which, if anyone could be said to have won, it was the US. It is true that Canada with its resource-based economy and improving Federal government balance sheet, made some modest yardage against the US dollar and our stock market certainly performed brilliantly, but there was no catastrophe as the US dollar bears had been expecting for some time.

As Paul Volker stated a little while ago, "I don't know whether change [in the financial status of the US] will come with a bang or a whimper, whether sooner or later. But as things stand now, it is more likely than not that it will be a financial crisis rather than policy foresight that will force change." At SAC, we have followed a policy of avoiding the US markets and the US dollar and will continue to do so. Where clients seek or cannot avoid exposure, we therefore recommend hedging the US dollar with the Canadian currency. It is very cheap and easy to do so while nothing is happening as it is now, and may be impossible or very expensive to do if, as and when it is needed.

Investing In Gold

Since the Fall, gold bullion has put on an excellent show, and even gold stocks did not fare too badly overall, although year over year they lagged the SPTSX Index by about 1/3, the SPTSGD Index being up a little over 14% versus 23% for the main index. The Streettracks Gold Trust (symbol GLD), effectively an ETF for gold bullion, did have a nice year, however, although it fell back almost 8% in the dying moments of the year.

When people ask us about “gold”, we find that invariably the real question is not about gold bullion, but the gold stocks themselves. The problem with the gold companies on the TSX is that they are quite fairly fully valued as there are so many investors who “believe in” gold (and hence gold stocks). It is therefore necessary for bullion to keep rising in order to be able to justify the current prices being paid for the stocks. That means that investing in gold shares is essentially speculative in nature and harder to justify from a purely investment quality point of view (and much more so, if one happens to get it wrong).

Since our solvency analysis strongly suggests that the US dollar [eventually] must fall, we have considerable sympathy with the sentiments of the so-called Gold Bugs, but have a harder time identifying good values in the stocks themselves. We do, however, have to give some consideration to the probability that a possible recession would speed the development of a US insolvency along, as a recession will slow the generation of additional GDP but speed the generation of new debt to support the increasingly flimsy current debt structure of the US.

An Inverted Yield Curve Ahead?

The yield on the two-year T-note is 4.41%, compared with the yield on the 10 year T-note which is 4.38%. Thus, the spread between the two is almost flat — a very modest .03% in favor of the 2 year T-note. Normally, that would be an indication of slowing business, something the Fed fears, given its need to keep business activity as high as possible to prevent a recession from beginning and possibly unraveling the debt structure of the US. It is important to note that while a yield curve inversion is a necessary precondition for recession (it is a leading indicator), it is not a sufficient condition for one. That is, it may point to slowdown but does not guarantee one, especially an inversion this minor.

With .03 basis points of spread now lying between the two and the ten-year notes, we have to wonder whether the Fed will have the courage to boost Fed Funds another quarter of a percent. Another boost in short funds could well send short rates well above longer rates, rendering the yield curve solidly “inverted” (short term rates are higher than long term rates). We suspect that it is highly doubtful that the Fed wants an inverted yield curve, although Mr. Greenspan, in anticipation that such an event may be unavoidable, has already told us that “as this time is different, people need not fear that the usual outcome following the curve inversion – namely a recession – will occur”.

Like other skeptics of this new-age hypothesis, we suspect that Greenspan probably believes such an inversion is the inevitable, but he is hoping that a preemptive verbal strike will calm the concerns of investors and traders alike when it actually occurs. This time is unlikely to be any different than in the past, and therefore if this one continues and even expands into 2006, we should be ready to increase our defensiveness towards the stock market (and probably the bond market as well) to a marked degree if/when it happens.

Assuming that such an event presages an economic slowdown, why would we not therefore become bullish rather than bearish on the longer term bond market? Surely a slowdown would be a precursor to lower interest rates as the US Fed reacts by becoming more stimulative. After all, that is most certainly what the bond market must be currently thinking, as we wrote in our December Market Letter.

The answer lies in the response of the market, not to the perception that a slowdown will lower rates, but to the perception that a slowdown will substantially increase the  risks in the economy. Referring back to the graphic above, anything which slows GDP while forcing the generation of additional debt makes the solvency of the US economy worse off, and hence increases the risks of investing in any US-denominated debt instruments. As we also reported last month, J.P. Morgan prepared an excellent piece on risks and yields in the US and concluded that there is a strong potential for long yields to increase by 1.5% in 2006 and another 2-3% in 2007, all due to the dawning realization that the Fed’s actions may have temporarily suppressed the normal risk premium in the long term bond market but the risks haven’t gone away. The Fed may be helpless to fend off the consequences of that change in perception as they themselves were the author of the suppression in the first place. As noted, the Law of Unintended Consequences may start to bite in 2006.

Will This Market Cycle End With Bang or a Whimper?

The definition of insanity: doing the same thing over and over in hopes of a different outcome.

- Old Adage

It seems that within our own memory over the past 40 years, every four years the stock market bulls enter the 4^th year of the long-established 4-year market cycle, confident that “this time is different”. The combination of ‘current business strength’ and ‘enlightened’ fiscal and monetary policy will see them through. Usually, in our experience, the market also reaches that stage in which it decides that the risks are modest enough and that an intervening recession will be so immaterial, that it is safe to remain fully invested throughout. In truth, it rarely is.

A 4^th year in which the market does not correct is rare but not unheard of. 1994 saw an essentially flat year for instance. Interest rates did their bit to wreak havoc as long rates doubled that year which would have ordinarily been enough to knock the markets for a loop, except that earnings for the Dow (for one index) doubled that year and rendered the year a wash. In many bear years, the decline may be swift and deep, but rebounds can hold market closes to fairly modest overall losses.

In truth, we do not know what the profile of the coming (assumed) bear market will be or even when it may start in earnest. We at SAC have – as yet – not received anything like a definitive bear market signal from our analytical methodology, and therefore remain cautiously optimistic at least for the quite short term. We do observe that the markets, especially south of the border, have become fairly narrow – few leaders, many laggards these past couple of months – and what certainly appears to be a slowing in both housing and auto sales may well be the precursor of a general slowing economy in the year ahead. If the yield curve holds and expands that inversion as well, then that should be the end of the market advance of the past 3 years or so. We also see that the TSX may well be staging a breakout into higher ground, and therefore it may well be too early to run to cash.

We expect the market’s demise to be slow and reluctant at the outset mainly because the Fed has inculcated investors with a touching confidence that whatever happens, the Fed will bail them out. A stealth bear is more likely to steal up on investors rather than one which announces itself loudly and clearly, at least as clearly as bear markets ever do.

Previously, we have shown clients the picture of the bear market of 1974, a market which also came on the heels of a strong commodities move. The market began to slip in early 1974, oozing downwards, then slowly picked up steam as it went. The markets were well into their decline before it even became apparent that anything was amiss. In other words, it is our suspicion that any bear market in 2006 may be the sneaky kind as investors find out belatedly that even the Fed cannot cure everything every time.

Finally, if, as, and when the bear comes to Bay and Wall, it may come against an apparent background of not unreasonable values. Again harking back to the 1974 bear market following the commodity boom then, the market started off with values (low PE ratios in that year) which became progressively “cheaper” as time progressed. In retrospect, it turned out that many of the expected profits were phantom and never did materialize. We observe the values in the S&P 500 Index and note that the current earnings forecasts for the consumer sector in particular produce current Fair Market Values which are very high. That the market is not paying up for those values now suggests that the market already suspects that they are unlikely to actually appear – and in all probability, if the consumer is on as wobbly a footing as we think, they will not.

The TSX: Possible Upside Break Out?

On the general theory that one picture is worth a thousand words, here is the TSX Index in minute detail for the past year. The index has put on a beautiful show for 2005, far outperforming the American indices. At the close of the year, the TSX retested its Growth (G) Price and as of the time of writing, it very much appears as if the TSX is attempting a breakout over its Growth (G) Price. If that breakout holds, then there will be further gains (at least early in the year), and an overly bearish stance may be premature. Note that this would also imply strength in the S&P 500, with a target of 1380-1400, the MG Price.

As you can readily see, some sort of answer is close at hand!

Comment on Group Potential

There has been little change month over month in the group potentials and even the overall upside potential has barely budged (+72.3% this month versus +73% last). And still the consumer groups continue to maintain the greatest representation in that august group of groups with a 60% weighting. Clearly, among US analysts, there is no still concern of any consumer slowdown on the horizon at all despite evidence to the contrary in both the auto and housing markets. However, reviewing the market letter commentary, we would have to guess for further consumer strength to occur that the US consumer is going to be borrowing upwards of a trillion dollars to maintain both the growth of the economy and the growth of his lifestyle. It’s possible. Just not likely.

In Canada, the Energy and Mines & Metals sectors continue to lead in terms of upside potential in terms of heavily weighted groups, although forward earnings in 2007 remain generally below those for 2006, a circumstance that we can only imagine would be likely under a recession scenario. If so, then there are equally large risks elsewhere, but they are not identified as such by other analysts.

Gold stocks are still in last place, and need bullion to carry on upwards in order not to really fall back. We do see further estimate improvements in the group. Without significant US dollar weakness, the group is still very speculative. We still prefer black gold to the yellow stuff for the time being.

We continue to expect that the period ahead will be characterized by the emergence of what we call the “late bloomers”, those stocks which usually have higher highs by the end of bull markets than they enjoy now. We noted last month that “stocks such as Canadian Tire, Biovail, the Oils, as well as some of the Mining stocks such as Teck Cominco may not be done as of yet” – and they weren’t! If we get a further decent rally that lasts 2-3 months, we continue to think that a number of stocks could do very well even in a plodding market.