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June 30, 2015

Are You Prepared When The Music Stops?

By Peter Schiff, Euro Pacific Capital

It is no secret that I believe that the United States suffers from horrible debt dynamics, a dysfunctional and delusional government, a fragile economy, an oppressive tax code, and an irresponsible central bank that is creating asset bubbles across the financial spectrum. My long-term investment prescription to deal with these realities has been to overweight exposure to non-dollar investments, particularly in those countries that have strong growth, pro-business governments, high dividends and positive fiscal attributes like low-debt, positive trade balances, and relatively high interest rates. But the past four years or so have been extremely frustrating for investors who have structured their investments around these principles. Since the beginning of 2011, currency-adjusted U.S.-based equity investment returns, as reflected in major indices, have easily led the world. In fact, we have seen the greatest differential in recent memory of relative performance of the U.S. vs. many foreign markets.

This outcome has bred a great deal of confidence among investors that the trend will continue. Despite our own unresolved problems, trouble brewing in Europe and Asia has convinced many that America remains "the cleanest dirty shirt" in the investment hamper. Non-U.S. markets are considered perennially riskier, to be sampled in smaller doses, and only during periods of extreme confidence.

Although past performance is no guarantee of future results, a casual look back at how the U.S. out-performance trend played out the last time it had occurred should call these assumptions into question and give investors much to think about.

A Clear Parallel

In many ways the four years from the end of 1996 to the end of 2000 provide a good parallel to the four years from the end of 2010 to the end of 2014. During the earlier period, the Dow Jones Industrial Average rallied 67% and, in the second period, the Dow rallied 54%. In addition to these similar market results, both periods showed similarities in monetary policy and in America's perceived dominance as an investment destination.

The late 1990s was the original "Goldilocks" era of U.S. economic history, one in which all the inputs seemed to offer investors the best of all possible worlds. The Clinton Administration and the first Republican-controlled Congress in a generation had implemented policies that lowered taxes, eased business conditions, and encouraged business investment. But, more importantly, the Federal Reserve, under then Chairman Alan Greenspan, had pursued an extremely expansive monetary policy (at least what was then considered expansive...by today's standards it would be considered absolutely draconian) that caused confidence on Wall Street to swell significantly. His efforts to orchestrate smooth sailing for investors led many on Wall Street to dub Mr. Greenspan "The Maestro."

Greenspan took office 2 months before the Stock Market Crash of 1987, and perhaps as a result of this trauma he developed a reflexive reaction to cut interest rates whenever anything seemed to threaten the economy or the markets. This protectionism ultimately became known as the "Greenspan Put." (a reference to strategies used by stock traders to protect themselves from losses.)



Towards the end of the 1990's, Greenspan worked hard to insulate the markets from some of the more negative developments in global finance. These included the Asian Debt Crisis of 1997 (in which lack of foreign exchange reserves led to huge devaluations of overly extended Asian economies) and the Russian debt default of 1998, and the concern around the Y2K phenomenon (the fear that the world economy would grind to a halt because of the inability of computer programs to distinguish between the year 2000 and the year 1900).

But the most telling policy move of the Greenspan Fed in the late 1990's was its response to the rapid demise of hedge fund Long term Capital Management (LTCM), whose strategy of heavily leveraged arbitrage backfired spectacularly in 1998. LTCM had placed large trades with nearly every major firm on Wall Street, and many believed that its bankruptcy could spark a full-blown financial crisis. To prevent such an outcome, Greenspan engineered a $3.6 billion bailout and forced sale of LTCM to a consortium of Wall Street firms. This direct engagement with the market took the Fed to territories beyond anything previously conducted by the central bank. The intervention was an enormous relief to LTCM shareholders but, more importantly, it provided a precedent that the Fed had Wall Street's back.

A Bubble Forms

Not surprisingly, the 1990s became one of the longest sustained bull markets on record. But in the latter part of the decade the markets really started to climb in an unprecedented trajectory. While most people like to explain away the dotcom mania as a purely psychological creation (brought about by the intoxicating effects of new and seemingly magical technologies that promised to rewrite the rules of finance), in reality the bubble had much to do with an extremely supportive Fed. As the bubble began inflating in earnest in 1998, and market analysts began uttering classic remarks such as "earnings don't matter," Greenspan did nothing to prevent it from expanding wildly. This reluctance was contrary to the maxim, popularized by William McChensney Martin, one of Greenspan's predecessors, that the Fed's job was to remove the punch bowl before the party got out of hand. As he had demonstrated with LTCM, Greenspan decided that it was not the Fed's job to prevent bubbles from forming, but simply to clean up the mess after they burst.

But while U.S. markets were taking off, the rest of the world was languishing, or worse. As shown in the chart below, some of the markets that are favored most heavily by Euro Pacific Capital, both then and now, experienced dismal returns. In fact, in the four years of the late 1990s, while the S&P 500 was up almost 80%, all world markets, excluding the U.S., were up only 12%, and an important emerging market index was down 30%. (Only the minor markets of Sweden and Switzerland managed to keep pace with the U.S.) The surging dollar also decimated gold and gold stocks, which were down 26% and 65%, respectively, over that time frame. The numbers tell the tale:

Chart Created by EPC using data from Bloomberg

Based on this stunning performance, the belief in the "Goldilocks" economy and the continuous support of an accommodating Fed, many mainstream U.S. investment houses saw few reasons to believe that the dominance of American markets would ever end. Anyone who had put faith in non-dollar markets had been made to look like a fool.

But then a very funny thing happened. In March 2000, the music stopped and the dotcom bubble finally burst, sending the Nasdaq down nearly 50% by the end of the year, and a staggering 70% by September 2001.

Momentum often creates its own justification. When something moves in one direction long enough people may conclude that the movement is natural and inevitable. In such an environment, even some of the most followed investment analysts began to explain away the most glaring red flags. So during the dotcom era, fundamentals like value, profitability, sustainability, dividend yield, and debt management took a back seat to newer, more exciting, concepts such as "mindshare," "page views", and "disruption."

But when the music stopped, the belief in these new concepts stopped with it. When investors looked to get back into the market, their values had changed and they began dancing to a different tune. They began to favor those types of investments that had the characteristics that they had previously ignored. Having been burned by sky high valuations, they began looking for low valuations, real revenue growth, understandable business models, high dividends, and low debt. They came to find those features in the non-dollar investments that they had been avoiding.

Courtesy Peter Schiff, Euro Pacific Capital 

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle


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