Be wary of buy and Hold

Those receiving conventional buy-and-hold advice from their brokers and advisors should be leery. We referenced Barton Biggs', former Chief Global Strategist with Morgan Stanley, book Hedgehogging in our April 2006 issue, Losers: Why We Invest with Them.

"Secular cycles, both in markets and sectors of the market, make a big investment management firm a very conflicting enterprise to manage if you are a businessperson, because the rational things to do to maximize short-term profitability are exactly the wrong things from both an investment and a long-term profitability point of view. For example, during 2000, even as the bubble was bursting, Morgan Stanley Investment Management, which has a business-dominated management, acted like businessmen: they heavily promoted the underwriting of technology and aggressive growth stock funds because those were the funds the salespeople could sell and that the public would buy. Management was not evil; they were doing what they thought was right. Large amounts of public money were being raised and very quickly lost. Short-term sales profits were collected at the expense of, not only the public, but the firm's long-term credibility and profitability."

Those who are looking for warnings from our "trusted" government officials should consider their track record. On July 12th of this year, U.S. Treasury Secretary Paulson declared, "This is far and away the strongest business economy that I have seen in my lifetime." Several days prior, on July 2nd, he stated, "In terms of housing, most of us believe that we are at or near the bottom."

If the truth is not already obvious to us, history can be instructive. With the help of Dr. Mark Thornton, of the Ludwig Von Mises Institute, one needn't look far to find examples of misleading statements at major market and economic turning points. Paul Warburg, an early advocate of the Federal Reserve, was on the Federal Reserve Board when he made this statement in January of 1930.

"Happily, we have now turned our backs upon the events of this unfortunate event."

Even more incredulously, on November 22nd of 1929, William Green, President of the American Federation of Labor, stated:

"All the factors which make for a quick and speedy industrial and economic recovery are present and evident. The Federal Reserve System is operating, serving as a barrier against financial demoralization. Within a few months industrial conditions will become normal, confidence and stabilization in industry and finance will be restored."

As a final word of warning, we leave you with the words of Dr. Carroll Quigley, a noted historian, former professor of history at Georgetown University, and consultant to the U.S. Defense Department, the Smithsonian Institute, and NASA. His tome, Tragedy and Hope: A History of the World in Our Time was used as a resource in our December 2006 issue: Mind Games.

"All past history shows that espionage has been generally successful and intelligence has been generally a failure. By this I mean that no country had much success in keeping secrets, in the twentieth as in all earlier centuries,but neither has any other country had much success in evaluating or in interpreting the secrets it obtained. The so-called 'surprises' of history have emerged not because other countries did not have the information, but because they refused to believe it. The date of Hitler's attack on the West in May 1940 had been given to the Netherlands by the German Counterintelligence Office as soon as it was decided; the Western countries refused to believe it. The same was true of every one of Hitler's surprises. Stalin was given the date of the German attack on the Soviet Union by a number of informants, including the United States Department of State, but he refused to believe. Both the Germans and Russians had the date of D-Day, but ignored it. The United States had available all the Japanese coded messages, knew that war was about to begin, and that a Japanese fleet with at least four large carriers was loose (and lost) in the Pacific, yet Pearl Harbor was a total surprise."

While the evidence of trouble has just begun to surface in U.S. equity prices, the love affair with credit, as demonstrated by record profits in the banking and brokerage industries, has only made investors, especially large institutional investors, more attached to this bullish run than ever. But, with the continuing contraction in the housing sector, and its impact on borrowing, the early warning signals are blowing.

The following is an excerpt from the email we sent our subscribers last Thursday, July 19th, regarding our latest issue of The Investor's Mind:

"We are releasing this month's Investor's Mind early because a variety of technical indicators are pointing to an end to the bull market run that began in the fall of 2002. I thought it important to release this piece on three high-level financial meetings that have taken place over the last few months, which I believe make it clear that those at the top of the money game have known for some time that the end of this period will bring massive shifts to the global capital markets."

Doug Wakefield

Systemic fallout dead ahead?

The Tip of the Iceberg?: "The near-collapse of two big Bear Stearns hedge funds heavily invested in highly-speculative packages of subprime mortgages indicates that the severe housing recession is spreading to the financial arena and is threatening the occurrence of systemic fallout. It is estimated that various institutions own about $6 trillion of mortgage-backed securities of which about $800 billion are subprime. About 13% of subprime mortgages are currently in default, and foreclosure rates on these loans are soaring.



In addition about $2 trillion of mortgage securities are backed by adjustable rate loans (ARMS) that have been or will soon be reset at higher rates. An estimated 29% of all mortgages issued in the last three years were ARMS. Home buyers who took out ARMS in 2004 have already seen their rates rise by about 40%, adding about $290 a month in additional payments on a $300,000 mortgage. Many of these buyers will not be able to refinance at fixed rates as a result of higher mortgage rates and stricter regulations that will disqualify would-be borrowers."

Stocks to correct 15% by year end

If there is a single salient truth about the U.S. stock market, it
is that 2007 is a record setting year from almost every aspect.
While there are a few rare exceptions that place either 1929 or 2000
in the spotlight instead, our overall impression is that the mania
for stocks appears to be at least as emphatic now as it has ever
been. We have repeatedly illustrated margin debt extremes and the
historically low mutual fund cash-to-assets ratio as evidence, but
the best picture of the continuing mania for stocks remains the
sheer volume of trading. Not only is the volume of trading at a
historic high, the velocity of transactions have exceeded the
previous highs with such ease that one's only choice is the
assumption that a veritable mania is still in progress, and in fact,
never really ended. Apparently, the collapse and bear market that
endured from March 2000 to March 2003 was only a corrective phase to
the greatest stock market mania of all time.
We make the distinction of a "corrective phase" rather than a bear
market due to the observable fact that we cannot find one instance
of back-to-back stock manias in the past. Perhaps the semantics and
definitions do not work for some, but nevertheless, we find it
extremely difficult to dispute that the mania never really ended.
Even at the nadir in 2002, Dollar Trading Volume was still at a
level that equated to a 18.3% rate of growth in velocity from 1995,
when we posit the mania actually commenced. This seven year path
would have been extraordinary sans the final manic peak and
subsequent collapse!

As it now stands, DTV has grown 18.1% from last year's record total
and exceeds the fateful year of 2000 by 28.1%. Compared with Gross
domestic Product and total stock market capitalization, we are close
enough to record extremes to posit the possibility that a similar
outcome to 1929 and 2000 should eventually be at hand.
DTV is more than three times the size of GDP
for only the second time in history.
DTV versus market capitalization is 223%, only nominally lower than
the 228% registered in the Roaring Twenties.
If there is only one salient truth about the stock market today, it
is that the mania remains largely unrecognized by professionals and
the public, who blithely continue without concern, taking larger
risks with greater exposures than ever before, while denying
investments in favor of trading, per se.

We define Speculative Fervor as the one-year differential in DTV
compared with the level of GDP. A market that trades an additional
$2 trillion while GDP rises by 3% is more speculative than a market
that trades an additional $1 trillion while GDP rises the same 3%.
Although Speculative Fervor has not reached the levels registered in
1999 and 2000, this indicator has remained at "Roaring Twenties"
levels for four full years. It is easy to posit that recent high
levels have reinforced the notion that stocks can do no wrong, hence
the game is still played to the hilt. We believe it is imperative
to note that Speculative Fervor remained between +15% to -10% for a
stretch of 64 years (!!!) from 1933 to 1996, equating to the
historic norm. A return to these levels will result in a huge
dénouement for traders and investors. In our view, this outcome is
inevitable. We do not expect an identical collapse such as occurred
from 2000 to 2003, but an initial shock followed by a consistent and
steady disenchantment with the inability of stocks to recover over
the long term.

Stocks are overowned and clearly, overtraded.

China – An Historian’s View

The China story is one of the most amazing tales of our time. From the incredible turmoil of civil war and war with Japan arose a Marxist State that bemused boomers like myself as we pondered the “Great Leap Forward” and the famine that followed, the happy smiles of contented workers on model farms and iconic images of millions of Chinese waiving the “little red book” on the television.
Real GDP per capita grew 17% in the Sixties, 70% in the Seventies, 63% in the turbulent Eighties and 175% in the Nineties. While this development has been concentrated in the coastal and southern provinces, efforts have been made in recent years to expand the prosperity to the inner provinces and the industrial North East.
Since the start of the “China story” we often hear how it will all end badly in civil disorder or economic collapse, whereas, Jim Rogers, the commodity guru has argued that the next big correction in China will be a massive buying opportunity, for both commodities and Chinese equities.
Well then, what’s the real deal on China?
Perhaps it might be useful to consult an historian and I found a strong opinion was held by a great one, a man who was awarded the Pulitzer Prize for literature and the highest award granted by the United States government to civilians, the Presidential Medal of Freedom. (President Ford in 1977).

William James Durant (November 5, 1885–November 7, 1981) was an American philosopher, historian, and writer. He is best known for his authorship (and co-authorship with his wife Ariel Durant in the later volumes) of “The Story of Civilization”.

Will Durant received his doctorate in 1917 and worked as an instructor at Columbia University.
The Story of Philosophy was published in 1926 by Simon & Schuster and became a bestseller, giving the Durant’s the means to travel the world several times and allowing Will Durant to spend four decades writing the eleven volume opus “The Story of Civilization.”

This is what Durant wrote sometime in the 1920’s as he concluded his history of China and reflected on its future. (the emphasis is mine).

This nation, after three thousand years of grandeur and decay, of repeated deaths and resurrections exhibits today all the physical and mental vitality that we find in its most creative periods.

There are no people in the world more vigorous or more intelligent. No other people so adaptable to circumstance, so resistant to disease, so resilient after disaster and suffering, so trained by history to calm endurance and patient recovery. Imagination cannot describe the possibilities of a civilization mingling the physical, labor and mental resources of such a people with the technological equipment of modern industry. Very probably such wealth will be produced in China as even America has never known and once again, as so often in the past, China will lead the world in luxury and the art of life.

No victory of arms or tyranny of alien finance can long suppress a nation so rich in resources and vitality…… Within a century China will have absorbed and civilised its conquerors and will have learnt all the techniques of … industry..

Roads and communications will give her unity, economy and thrift will give her funds and a strong government will give her order and peace. Every chaos is a transition. In the end disorder cures and balances itself with dictatorship. Old obstacles are roughly cleared away and fresh growth is freed. Revolution, like death and style, is the removal of rubbish, the surgery of the superfluous; it comes only when there are many things ready to die. China has died many times before and many times she has been reborn.

The History of Civilisation: Our Oriental Heritage Volume One Will Durant

I conclude, therefore, that only a fool would bet against China at this point and we can therefore surmise that Rogers is correct, driven by huge structural change in the global economy – in this case the strong growth and industrialisation of China, the current boom is part of a supercycle that will last for years to come.

I unconditionally recommend Will Durant’s work to readers and await the next major China correction to establish a position.