Read an Excerpt
The Bull Hunter
By Dan Denning
John Wiley & SonsISBN: 0-471-71983-8
Chapter OneDEBT, DEFICITS, AND THE DOLLAR: AMERICA'S KILLER Ds AND WHY THE OLD INVESTMENT STRATEGIES DON'T WORK
People for the most part stood their ground, but the ground itself gave way beneath them. -Joseph Schumpeter
Take a good look at the world around you. Oil prices are at record highs. The dollar has been globally battered. Interest rates are rising. America is clearly in the economic street fight of its life.
Why? Globalization has made the brave new investment world much more competitive. With offshoring and outsourcing showing no signs of slowing down, no job is clearly safe anymore. The automobile and aerospace industries, which America used to dominate, now face fierce competition from Japan and Europe. Even U.S. stocks and bonds and the dollar itself are not as universally popular as they were just three years ago. It's as if investors suddenly realized that there is more to the investment world than mutual funds.
But there's more than just a change in investment fashions. The old answers to basic investment questions just don't work anymore. Mutual funds are too big and slow to profit from the rapid tidal shifts in markets that are now happening. (In Chapter 2, I'll give you a specific example of the rapid shifts I'm talking about, and tell you how to survive them and profit.) Most important for investors, being good at just one style of investing-value investing,growth investing, market timing-isn't enough to guarantee you'll make money in the market.
Terrorism, politics, energy prices-all of these factors affect stock values. The world is networked and complicated, and markets never sleep. Investors need new tools to keep up. The old ones clearly haven't.
But there are solutions, and they are both exciting and dynamic. Whether you use them depends on your willingness to take a fresh look at the investment world. And it is a world, not just a stock, a sector, or even an individual country. The wonder child of twentieth-century investing-the growth mutual fund-will not meet your needs in the coming years. Look at the predictions by some of the world's most respected investors. These are men who made money in the old world. They know that things are different now.
Bill Gross, the best fixed-income manager in the country and head of the nation's largest mutual fund, the Pimco Total Return Fund, says that bonds will outperform U.S. stocks over the next decade-and that bonds will yield only low, single-digit returns. Warren Buffett, who turned every $10,000 he invested in Berkshire Hathaway 35 years ago into more than $18.6 million, says the Standard & Poor's 500 (S&P 500) will be lucky to eke out a 5 to 6 percent annual return over the next decade. Sir John Templeton, founder of Templeton Funds, recently said: "Over the next century you should expect your share prices to average 6% (return) a year. Over the next five years, ten years, I think you'll be lucky to come out even."
These are gloomy forecasts for investors reluctant to use new tools. But there is no escaping reality. Mutual funds are set up to fail because of the restrictive and conservative assumptions by which managers run their funds. For the most part, fund management is out of touch with both fundamental analysis and market realities. Fund managers use diversification formulas that largely ignore the risks of buying into particular sectors and stocks, in the belief that their job is to spread risk and not necessarily to avoid it.
Ironically, this changes the playing field, the rules, and even the shape of the ball. If you are using a full-commission brokerage firm's advice and investing in the traditional manner of the twentieth century, you may want to lower your expectations. We face a crisis and a challenge. In fact, this challenge is the biggest that U.S. investors have had to face for the past 75 years. Traditional forms of diversification are bankrupt.
The average U.S. money market fund pays less than 3 percent. Government bond yields are coming off the lowest level in 42 years and don't promise savers much in the way of passive income that outpaces inflation. And U.S. stocks are still expensive by any fundamental measure. Then there are the intangibles: war, growing government deficits, sluggish job growth, and international outsourcing-all on top of the highest level of consumer debt and the lowest savings rates in history.
With all this going on-and the economy mired in a perpetual "recovery"-U.S. stock investments won't give you the kind of return you need to send your kids through college or finance your retirement. Yet despite this being one of the toughest investment periods in U.S. history, one fact continues to ring true to this day: There is always a bull market going on in some corner of the world that will make investors very rich.
Keep the positive in mind ... because right now, we need to confront something very negative-what I call America's Killer Ds: debt, the dollar, and the deficits. You may have heard of them. If you haven't, let me introduce you to
Chronic federal deficits ($477 billion in 2004) and a monstrous federal debt ($7 trillion) A $600 billion annual trade deficit Household debt of $9 trillion, including $2 trillion in credit card debt A currency, the dollar, weakened by all that debt and the enormous trade gap
The total debt picture in America is both gruesome and appalling. There is no polite way of putting it. We are a nation that cannot stop spending, even if it's money we don't have, even if it means the death of currency as a trusted source of stable value, even if it ruins our current economic prospects and dooms our children to paying off our spending sprees. See Table 1.1 for more detail on America's increasing debt.
While some of the economic relationships are complex, anyone with a sense of decency understands the problem clearly:
You cannot spend more than you earn and get rich. You cannot consume more than you produce and accumulate wealth. You cannot borrow today and force other generations to pay without ushering in a day of reckoning.
That day is coming. The United States must import $1.8 billion in capital each day to keep the dollar from falling even more. It's been said that a weaker dollar, in economic theory, should make some American exporters more competitive by lowering prices for American goods overseas. But what will the Chinese buy from the United States that they can't get at a lower price from a Chinese producer? In what industry does a 30 percent decline in the dollar suddenly make American manufactured goods price-competitive with goods produced in Asia?
These are critical questions that I'll address in later chapters, where I tell you what I saw in China when I visited and what the Chinese themselves are saying. For one, I think big multinational firms may have the advantage in surviving a falling dollar. Critics of the falling dollar point out that the dollar has to fall against something, namely, another currency. That, of course, is exactly what the dollar has been doing. "But can Europe afford a stronger euro?" they ask. Maybe not. A stronger euro puts pressure on euro zone exporters.
The answer may lie in this argument: The dollar will fall against real assets. Chapter 2, examines what we expect to see for the dollar, the Dow, and U.S. bonds from here.
NEW REALITY, NEW STRATEGY
It is important to keep in mind that there are solutions. It's just that buying stocks automatically is not one of them. At times it helps to ask simple questions: What's out there that could move stock prices up this month? If I can't answer that question simply and sensibly, I usually don't buy. Are stocks cheap? Are earnings growing? Has the geopolitical situation changed in a way that moves a roadblock out of the way of higher stock prices? Or am I just hoping stocks go higher because I'm impatient?
To use the language of the Federal Reserve, I'd say the balance of risks in today's market-for U.S. stocks, that is-is negative. Stocks are still valued above historical norms. Instead of finding a reason to defend or explain this away (and buy stocks), I take it for what it's worth.
This epic bear market began in 2000. Yet the average investor has never really thrown in the towel on tech stocks. Stocks like Yahoo, Cisco, Lucent, and Microsoft are still the most actively traded stocks on the market. That's why you haven't yet seen the rock-bottom valuations that would trigger a buy signal. What could cause investors to pay even more for earnings than they do now? Expectations that earnings in coming fiscal quarters will be even stronger? GDP growth of 5 percent? Better growth in profits?
Maybe. But if you ask me, this is a market that's already priced as if good things were going to happen in the economy and that rising interest rates were good for economic growth. In other words, stocks continuously discount a positive economic scenario-well ahead of that scenario actually materializing. Yet on the other side of the ledger there are plenty of risks:
The extra boost to consumers of tax cuts and low interest rates has run out of steam. Rising interest rates and oil prices will drag consumer spending down. Home equity withdrawals and cash-out refinancing will wane as mortgage rates rise.
These are all big risks to the American consumer. But the biggest risk of all is that America's entire economy has become more financial and less tangible. Or, if you will, more fictitious and less real. This is one of the reasons I'm so excited about opportunities elsewhere. And even here, in America's "asset economy" as Morgan Stanley analyst Steven Roach has called it, there are opportunities. But to understand the nature of the opportunities, you have to first understand the nature of the asset beast and what created it.
WHAT'S A FINANCIAL ECONOMY?
You may have heard some people claim that as an economy matures, it becomes less industrial and more service-oriented. It naturally adds more jobs in services and fewer jobs in manufacturing. This is what some people call a postindustrial economy. In the Introduction, I showed you that there's nothing wrong-and indeed a lot right!-about the "old" industrial economy. After all, it's how most great nations have become rich.
But what do I mean when I use the term financial economy? Simple, it's an economy distorted by the easy availability of credit, credit made available by the policies of a nation's central bank. Let me quote analyst Dr. Marc Faber on the subject:
In a real economy, the debt and equity markets as a percentage of GDP are small and are principally designed to channel saving into investments. In a financial economy or "monetary driven" economy, the capital market is far larger than GDP and not only channels savings into investments but also continuously into colossal speculative bubbles.... In a financial economy ... investment manias and stock market bubbles are so large that, when they burst, considerable economic damage follows.
[I]n the financial economy (a disproportionately large capital market compared to the economy), the unlimited availability of credit leads to speculative bubbles, which get totally out of hand. In other words, whereas every bubble will create some "white elephant" investments (investments that don't make any economic sense under any circumstances), in financial economies' bubbles, the quantity and aggregate size of "white elephant" investments is of such a colossal magnitude that the economic benefits that arise from every investment boom ... can be more than offset by the money and wealth destruction that arises during the bust. This is so because, in a financial economy, far too much speculative and leveraged capital becomes immobilized in totally unproductive "white elephant" investments.
Those "white elephant" investments are the stocks, bonds, and mutual funds that have been bid up to incredible heights and bought with borrowed money. That is the financial economy. You can directly measure it in two ways: first, by how large its capital markets are relative to the total value of goods and services exchanged (GDP), and second, by the stock market capitalization-to-GDP ratio. In both cases, you're measuring real economic activity versus financial, or these days speculative, activity.
Let's look at the first, total credit market debt as a percentage of GDP. According to the Federal Reserve's Flow of Funds report from 2004, total credit market debt outstanding is $33.7 trillion. GDP, however, is $11.2 trillion. In plain math, the total credit market debt outstanding is three times larger than America's GDP. Households, businesses, and government ... everyone in America has borrowed heavily against the promise of the future.
The biggest borrowers are financial companies. Financial debt grew by 107 percent from 1997 to 2003, doubling from $5.5 trillion to $11.4 trillion. Wall Street was busy borrowing cheap and buying expensive stocks. See Table 1.2.
It's not much better once you get off Wall Street, however. Nonfinancial debt includes the federal government, state and local governments, businesses, and households-everyone who tries to make money buying stocks (instead of selling them).
The federal government, of course, is a big offender. The federal deficit (and the national debt) are dangerous because they divert savings away from real investment. The Britons who financed the Industrial Revolution in England didn't do it by loaning money to the king. They did it by loaning money to men like Thomas Newcomen so he could make a steam engine. The steam engine became the workhorse for the Industrial Revolution, until it was replaced by the internal combustion engine.
It's not just a historical point, either. In fact, it's as important a point as realizing the breadth and depth of your investment opportunities in the gobalized world. Loaning money to the government-especially the U.S. government, which could very well default on its debt-is a fool's bargain. Chapter 2 explains how to make a much more profitable bargain from the disaster that is the U.S. government's finances.
It's a much better deal than expecting "safe" returns from U.S. savings bonds. Those bonds cannot make you rich. In fact, the more of them there are, the worse it is for America. I know this goes against conventional investment thinking. So let's take a moment to see why.
HAYEK VERSUS KEYNES: A RECAP OF BASIC ECONOMICS
John Maynard Keynes is the famous economist who advised governments to spend money in order to create economic growth. Keynes gave his now famous advice during the Great Depression, when no one-business, individuals, or the government-had money to spend. But the government enjoys the legal privilege of spending money it doesn't have. And that's what Keynes recommended. To be fair to Keynes, he didn't recommend perpetual deficit spending. His view was that government should spend only to stimulate the economy when business and the private sector are unwilling and unable. Once the government gets the economy going again, the deficit spending ought to stop. Continued deficit spending with annual increases in government spending leads to a structural deficit.
Where this version veers off into the land of economic make-believe is that a government-any government-could spend just enough money to get the economy going without succumbing to the temptation of buying votes through chronic overspending. Politicians love spending money they don't have to get votes they desperately need. They've always done so and probably always will, if we let them get away with it.
Excerpted from The Bull Hunter by Dan Denning Excerpted by permission.
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