THE GLOOM, BOOM & DOOM REPORT

iSSN 1017-1371

A PUBLICATION OF MARC FABER LIMITED

JANUARY 31, 2011 FEBRUARY 2011 REPORT

It May be Wise to Question Some Things We Have Long Taken for Granted

"One of the tests of leadership is the ability to recognize a problem before it becomes an emergency."

Arnold H. Glasgow

"The disappearance of a sense of responsibility is the most far-reaching consequence of submission to authority."

Stanley Milgram

"We have the Bill of Rights. What we need isa Bill of Responsibilities. "

Bill Maher

"No snowflake in an avalanche ever feels responsible."

Stanislaw Lee

"If you can put the question, 'Am I or am I not responsible for my acts?', then you are responsible."

Fyodor Dostoevsky

"We all know that Prime Ministers are wedded to the truth, but like other married couples they sometimes live apart."

Hector Hugh Munro (better known by his pen name Saki)

INTRODUCTION

Recently, Financial Times management columnist Lucy Kellaway discussed the full spectrum of office life - from extreme managerial uptightness, where command and control extends to lipsticks, to extreme hang-looseness, where all attempts by managers to impose order merely hamper the inner creativity of the workforce (Financial Times, December 20,

2010). Kellaway cites the 40-page dress code enforced at Swiss bank UBS (men must wear ties to match the bone structure in their faces, and women must wear flesh-coloured underwear) as an example of managerial uptightness. At the other end of the spectrum, she discusses the views of Jason Fried (who typically dresses in jeans and a black Tshtrr), co-founder of 37signals - a privately held and successful web application company whose commercial applications include Basecamp, Backpack, Campfire, and Highrise. According to Fried, the office is the worst place for doing work. Ms. Kellaway opines;

Mr. Fried's anti office tirade might seem the more germane. He says the problem with offices is the endless interruptions, which mainly come in the form of meetings and managers. These interruptions are a disaster because, work, he says, is like sleep. If you get interrupted you can't go back to where you

were .... He also has logic on his side. The office has been quite pointless for many years now. It used to make sense in the age of paper and filing cabinets and canvou-take-dictatlon-Ms. Green? But now there is no point to it at all. It is jolly expensive and inefficient and a ludicrous waste of effort, especially when vou think of all that commuting, But in practice Mr. Fried is utterly wrong - about offices, about the nature of interruptions and about what to wear when giving a speech. Companies are groups of people and in order to thrive they

need to spend an inordinately large amount of time holed up together. Which means by far the most sensible thing is to herd everyone into offices. Mr. Fried argues that the office is a hostile environment in which to work because interruptions are imposed by others, whereas at home any interruptions tend to be by choice and are therefore benign.

(I suppose Mr. Fried isn't married or has no children.)

Kellaway then goes on to explain that she is governed by "an internal time-wasting law that says that the amount of time wasted in any day is constant. If others aren't wasting my time, then I find ways of wasting my own. The difference is that at home time-wasting is low grade - Boggle benefits no one - while at work it is more sociable and sometimes a good idea materializes as a by-product." Kellaway, who wrote her column from home, then concludes that she now feels like skipping off to the office perfectly groomed in a type of UBS uniform that gets her in the right frame of mind for working, "in an environment where interruptions are imposed by others, leaving it up to me to engage in a little light work in the spaces between".

My regular readers will know that I have more sympathy for the views of Mr. Fried than for the UBS dress code. Still, I recognise that in certain types of organisations proper attire is advisable - especially for the sales force. Possibly, I am badly conditioned or old-fashioned, But if a UBS or JPMorgan Chase client relationship manager came to my office for the first rime, I would expect him to wear a tie. In London or New York, I think I would be somewhat taken aback if a salesperson showed up for our first meeting in jeans and flip-flops. Conversely, if a portfolio manager or dorcom geek came by, the way he dressed would be irrelevant. I should add that in tropical climates I wouldn't expect anyone to wear a coat and tie, However, how people should dress isn't the reason I have quoted Ms. Kellaway.

In previous reports, I have advised

my readers that, for security reasons, they should own a remote place in the countryside. Obviously, living in the countryside would involve working from home - at least partially. Some readers will naturally be concerned that if they work from home, rather than being in the office every day, they might miss out on certain career opportunities. However, as Fried explains, the office is the worst place for working, especially if the type of work you are doing requires peace of mind and involves a high degree of creativity and concentration. In addition, I don't see why a portfolio manager, securities analyst, or strategist would need to go to an office every day. On most days, such people could perform their duties perfectly well from home and shouldn't need to go to the office more than once or twice every ten days or so. (At home they could wear jeans, and before going to the office they could stop by a costume agency and rent the perfect UBS uniform for the day.)

I concede that executives

involved in the management of people and organisations may need to spend more time in their offices than purely creative people (writers, composers, artists, designers, etc.), However, even these executives may find that working from home a few days a week could significantly boost their productivity and lead them to take better decisions. As an example, the Chinese practice of {eng shui isn't just about how to place furniture in your office; it's also about "time"; you should only take important decisions at the "right place" and the "right time". The "right place" is obviously not at an airport or in the New York subway, but someplace where you feel comfortable and at ease. The "right time" isn't when you are sick, nervous, distracted, annoyed, pressed for time between meetings, or irritated, but when you are feeling calm, at peace with yourself and your surroundings, and well rested. Therefore, I think it really makes a lot of sense to work several days a week from a home in the countryside. Ideally, your home should include a detached office, which allows you a

2 The Gloom, Boom & Doom Report

February 2011

better separation between work and home. The comedian George Burns described happiness as "having a large, loving, caring, close-knit family in another city". However, if this is not possible, then, in my opinion, it is desirable at least to separate one's family from one's work.

I was further prompted to write about owning a house in the countryside by an email sent me by a reader of mine, Raymond French (raymondfrench@yahoo.com) . French brought to my attention some historical facts about the decline of the Roman Empire of which I had not been fully aware. According to French, The Fall of Rome and the End of Civilization, by historian Bryan Ward- Perkins,

.. . really stands out as superbly researched and written. He details the scale of the collapse in living standards that followed the fall of the empire and how those living standards did not regain their former level for another thousand years. He also details well the sophistication of the economy of the Roman Empire, concluding that the level of labour specialisation and mass

production that it had achieved was a major contributing factor to the scale of the collapse of living standards by making its economy more - not less ~ fragile. Once the system of production and distribution had collapsed, citizens were left in local communities that had no ability to

produce many essential goods that had been mass produced in. faraway places and brought to them by sophisticated distribution systems when the empire had existed. This caused a massive reversal of the gains in living standards that the empire had produced over centuries.

According to Professor WardPerkins,

The end of the ancient economy, and the timing of its collapse, were closely linked to the demise of the Roman empire. However,

to understand the full and unexpected scale of the declineturning sophisticated regions into underdeveloped backwaters - we need to appreciate that economic sophistication has a negative side. If the ancient economy had consisted of a series of simple and essentially autonomous local units, with little specialization of labour within them and very little exchange between them, then parts of it would certainly have survived the troubles of post Roman times - dented perhaps, but essentially in recognizable form. However, because the ancient economy was in fact a complicated and interlocked system, its very sophistication rendered it fragile and less adaptable to change .

For bulk, high-quality production to flourish in the way that it did in Roman times, a very large number of people had to be involved, in more-or-less specialized capacities. First, there had to be the skilled manufacturers, able to make goods to a high standard, and in sufficient quantity to ensure a low unit cost. Secondly, a sophisticated network of transport and commerce had to exist, in order to distribute these goods efficiently and widely. Finally, a large (and therefore generally scattered) market of consumers was essential, with cash to spend and an inclination to spend it. Furthermore, all this complexity depended on the labour of the hundreds of other people who oiled the wheels of manufacture and commerce by maintaining an infrastructure of coins, roads, boats, wagons, wayside hostelries, and so on.

Economic complexity made mass-produced goods available, but it also made people dependent on specialists or semi-specialists - sometimes working hundreds of miles away - for many commercial needs. This worked very well in stable times, but it rendered consumers extremely vulnerable if for any reason the

networks of production and distribution were disrupted, or if they themselves could no longer afford to purchase from a specialist. If specialized production failed it was not possible to fall back immediately on effective self-help.

Comparison with the contemporary western world is obvious and important. Admittedly, the ancient economy was nowhere near as intricate as that of the developed world in the twenty-first century. We sit in

tiny pigeon holes, making our minute and highly specialized contributions to the global economy ... and we are wholly dependent for our needs on thousands, indeed hundreds of thousands, of other people spread around the globe, each doing their own little thing. We would be quite incapable of meeting our needs locally, even in an emergency ....

The enormity of the economic disintegration that occurred at the end of the empire was almost certainly a direct result of this specialization. The post-Roman world reverted to levels of economic simplicity, lower even than those of immediately preRoman times, with little movement of goods, poor housing, and only the most basic manufactured items. The sophistication of the Roman period, by spreading high-quality goods widely in society, had destroyed the local skills and local networks that, in pre-Roman times, had provided lower level economic complexity. It took centuries for people in the former empire to reacquire the skills and the regional networks that would take them back to these pre-Roman levels of sophistication [emphasis added].

I am bringing this up because it would seem to me that our economic and social systems today are far more vulnerable than was the case at the time of the Roman Empire. In my opinion, investors, and in particular

February 2011

The Gloom, Boom & Doom Report 3

people employed in the financial sector, are either completely overlooking the present vulnerability of the system or are extremely complacent about it. (Just a quick look at Detroit would suffice to expose the vulnerability of a system that is dependent on a high degree of specialisation.) Nowadays, any meaningful interruption in the international flow of manufactured goods, commodities, or funds (money, oil, and food, in particular)

could wreak havoc with the global economy. Or consider what wouLd happen should a cyber-attack be successful at some future time (which is not exactly on my wish-list, since I depend on the Internet and transportation systems). However, it would be naive to think that a cyberattack may never succeed. It is surely more realistic to assume that, at some time in the future, a cyber-attack will succeed in paralysing the world's power, communication, and

transportation systems, as well as the entire mechanism of government. In fact, I am convinced that the day will come when planes will be unable to take off, cards won't work, and funds won't be electronically transferable. (Brink's will be very busy on that dav.)

I am extremely grateful to William Leavitt of Leavitt Capital Management for having penned the following thoughts and observations on the threat of a cyber-war.

Cyber Security

William Leavitt, Leavitt Capital Management

3000 Dundee Road, Suite 101, Northbrook, IL 60062, USA

Tel: (847) 205-1300; Fax: (847) 205-1350; E-mail: wleavitt@leavittcapital.com; Website: www.leaviucapital.com

'" am often asked what keeps me up at night. Number One is the cyber threat."

Deputy Defense Secretary William]. Lynn III, January 2010

When Bosnian Serb Gavrilo Pricip assassinated Archduke Franz Ferdinand, in Sarajevo, in June 1914, he set in motion The Great War (before they started numbering them). As with the armies of Napoleon's wars over one hundred years before, and the U.S. Civil War, sixty-five years earlier, millions of personnel and supplies were marched or railed to sites hundreds or thousands of miles away. In 1914, the Germans marched for three weeks, to the Western front, through Belgium, with 84,000 horses.' After World War II, the cold war, global civil wars and skirmishes, and expenditures of trillions of dollars on conventional and unconventional weapons, a new threat has emerged, which can be waged from almost any location, by many different participants - cyber

warfare. Current and future wars will largely be fought with computers, rather than armies.

Whether we acquiesce or not, our lives are determined by technology and computer systems. Our electric grids, nuclear systems, water supplies, financial institutions, fuel systems, communication systems, as well as our governments, are directed by technological systems, which are subject to attack or disruption. The recent WikiLeaks disclosures indicate that low-level security clearance can access and cause the dissemination of highly sensitive, classified information. Rogue actors, whether individuals, states, or criminals, have successfully launched many cyber attacks against governments, institutions, corporations, and individuals.

The U.S. Department of Defense classified military computer networks were attacked in 2008. At a military base in the Middle East, an infected flash drive was inserted into a U.S. military laptop, presumably by a foreign intelligence agency.' The code uploaded itself to a network run by the U.S. Central Command, spreading undetected in classified and unclassified systems, creating a digital

source from which data could be transferred to computer systems under foreign control. The worst fears of the military (or any institution) had been realized: undetected, a rogue program could deliver operational plans into the intelligence networks of unknown adversaries.

Exponentially, the number and sophistication of intrusions into military, civilian, and financial systems has increased. U.S. Congressional estimates were that U.S. governmental agencies suffered eight million cyber attacks in 2008; by March 2010, the number had risen to an average of 1.8 billion per month.' In May 2007, Estonia's government and financial institutions were overwhelmed by cyber communications, causing a shutdown. CD incidentally, the attacks coincided with a dispute with Russian authorities. In August 2008, as combat raged between Georgian and Russian forces, Georgian government internet services were attacked and rendered useless. During the fall of 2008, the height of the presidential campaign, the headquarters of both John McCain and Barack Obama were penetrated by sources attributed

1 Ni,,11 Ferguson, The War of the \\7orld (2006).

2 William J. Lynn Ill, Ll.S. Deputy Director of Defense, "The Pcnragon's Cvber Straregv", Foreign Affairs, V,,1. 89, N(>. S. 3 "Cybcr Attacks Explode in Congress", Politico, March 3,2010.

4 The Gloom, Boom & Doom Report

February 2011

Figure 1

Cyber Incidents Reported to US·CERT in 2006-2008, estimates 2009-2010

40,000

3.5,000

30,000 •.

20,000

-------- .. _. __ . __ . __ --,

l~,OOO ~ ------------

10,000 I

5,000 r

o

2006

200'

Source: "Cyber Security Incidents 011 Rise", Cyber Security Market, May 29, 2009

2008

2009

2010

to China. In July of 2009, South Korean and U.S. government and financial institutions were attacked by cyber perpetrators linked to North Korea (see Figure 1),4

The U.K. designated the threat to its "Smart Grid" national infrastructure as a "tier one" threat in a recent study on security. Over the next five years, over 70% of U.K. energy companies are expected to deploy "Smart Grid" applications to defend against cyber attacks, according to an October 2009 report by Oracle Utilities. Even with "Smart Grid", defenders are rushing to keep pace with attackers. During the summer of 2010, Norway discovered computer attacks directed against its electric and water infrastructure, although no damage was reported. A former mathematician at the U,S. National Security Agency calculated that, given $100 million, 750 people, and two years of preparation, a rogue state or perpetrator could launch a devastating attack on the EU, which could disable electric grids,

communications systems, air, rail, and train systems, as well as stock exchanges, financial institutions, government, and military networks.'

Particularly disturbing is the asymmetric nature of cvber war. Nations with little military capability, commercially motivated gangs, and, of course, terrorists and rogue states, can inflict horrific damage on military and economic super-powers, as well as any other nations or institutions. Often, it is difficult to identify the attacker, as an attack can be launched from remote computers and servers, making redress or retaliation problematic. For example, it has been determined that, using a $26 off-the-shelf software item, Iraqi insurgents have the capability to hack into the live U.S. satellite feeds, providing them information necessary to evade U,S, drone attacks.

Not all attacks are directed against the U,S_ or its allies. In 2010, a virus known as Stuxnet, probably the first "cyber missile" or "cyber

super weapon", was inserted into

han's nuclear facilities, sabotaging them. The computer worm could set back Iran's nuclear efforts for almost two years, according to some estimates, Although no nation or group claimed responsibility, Iran blamed Israel for the attack, Israel has created, within its military forces, an elite intelligence group (Unit 8200), which is trained to develop offensive and defensive cyber warfare capabilities, as well as satellite and communications systems penetration and interception. It should be noted that Russia, China, and North Korea also have extensive cyber capabilities and have been blamed for attacks

(see above). Of course, the U.S. has extensive cyber capabilities as well, It is expected that with a cumulative market valued at $55 billion, the

U.S. Federal Cyber Security market will increase at a compounded rate of 9.1 % over the next five vears." U.S. federal cyber spending is expected to reach $13.3 billion by 2015, in response to an estimated 445% increase in security incidents over the last four years."

Stuxnet changed the perceptions of cyber security and the responses to it. The virus targets servers and systems which control electric transmission, nuclear and chemical plants, pipelines, communications networks, and other critical infrastructure." In the Iranian attack, Stuxnet sabotaged special power supplies used primarily in nuclear fuel-refining centrifuge systems. Its lise, in this instance, was designed to destroy a very specific target." However, variants of the virus could be used to launch a large-scale attack against the U.S. or any other nation, damaging crucial water, power, transportation, financial, and other services, according to a report issued by the U.S. Congressional Service (CRS) on December 9,2010.10 A shortage of qualified security

4 Center for Strategic and International Studies, Significant C-yber Events Since 2006. 5 Econotwi.st, August 30, 2010.

6 Market research media, "U.S. Federal Cyber Security Forecast 2010--2015", Mal' 25, 2009. 7 SecuritylnfoWatch.com, December J, 2010.

8 Ibid, November 22,2010.

9 "How Stunt Cyber Weapon Targeted Iran Nudear Plant", Chri,rian Science MOlli!(lr, November 16,2010. )0 Ibid.

February 2011

The Gloom, Boom & Doom Report 5

professionals required to staff the increase in cyber security activities presents a problem for the U.S.

Not all cyber activity is directed toward attacks. Many cvber systems are utilized for data gathering and analysis. Banks, airports, hotels, and other institutions not only monitor data for facial and pattern

recognition, but also collect data to monitor our purchasing, travel, and other activities. Much of our beloved spam and junk mail is derived from data collection cyber activity. As recently as August 2010, over 200 billion sparn messages per day were sent." Approximately 40% of the spam results from the Rustocl< Borner. Botnets infect computers belonging

to unaware internet users, evading many anti-virus software systems.

The computer then comes under the control of cyber rogues, who may direct the computer to perform tasks such as sending out spam messages to other computers (a single computer may be directed to send out as many as 25,000 spam messages per day) or combine with other infected computers to overwhelm websites, causing them to crash. Millions of computers are infected. More effective anti-virus systems have been developed to reduce botnets (down to less than 50 billion per day by Christmas Day ofIOIO), but there is evidence that spam is again on the rise (see Figure 2).

Of course, government, military, corrections, and police authorities use the data for other purposes. Some airports use eye scanning technology either to expedite the flow of prescreened passengers, or to detect and intercept unwanted travelers. Virtually every e-mail, fax, instant message, wire transfer, text, and phone call is subject to interception by some group. Think you can remove pictures of an evening doing tequila shots, posted on a social network site? Think again. The virtual world does not erase.

Investors can take advantage of this precarious situation. A few public companies exist which

11 IT Secu,ic)' s Nerll'ork New.l, januarv 11, ZOl. I,

Figure 2 Spam Volume: Global Projections

250,000,000,000 .. - .--~-.-------. ------.~ - ------- .--- -_._ ----- .---~-.-.-

150,000.000.000

100,000.000,000

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11/14

121'5

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22,6

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HIOM

100""

6 The Gloom, Boom & Doom Report

8/22

10/3

10/24

Source: Symantec

Figure 3 Symantec, 2003-2011

17.52 +0.13 -0,7 ... 1/14111

lISA J 004 A J OG5A J 000 A

Source: www.decisionpoint.com

specifically focus on cyber threats. Symantec (SYMC: US) (see

Figure 3) has developed systems to protect against botnets and other malicious computer viruses. Check Point Software Technologies (NASDAQ: CHKP) (see Figure 4), an Israeli company which recently

acquired Nokia's Security Appliances Division, is one of the premier companies in the field. Most of the cutting-edge companies are private or small public companies which have been acquired by larger groups, eager to gain a foothold in the space or expand their platforms. Fraud

February 2011

Figure 4 Check Point Software Technology, 1999-2011

48.20 .1.02 +2.3 .... 1/14111

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10

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Source: www.decisionpoint.com

Sciences, an Israeli company created by former members of Israel's elite intelligence group Unit 8200, was acquired by eBay in 2008; another Israeli company, Riverhead, a provider of cyber protection services, also founded by former members of Unite 8200, was acquired in 2004 by Cisco; and McAfee, the U.S. antivirus software company, was acquired by Intel this past summer.

We continue to search for public and private opportunities in this burgeoning area. The threats posed

by cyber attacks will continue to provide involuntary buyers, which is a theme upon which we focus (like water). Technologies which do not exist today, or which are still in the incubation stage, will be on our "radar". Perhaps U.S. Deputy Defense Secretary Lynn is correct in staying up nights worrying about cyber security. While we sleep, someone is indeed watching over us.

INVESTMENT OBSERVATIONS

I am not suggesting that investors should structure their entire portfolios, and corporate executives should take all their business decisions, based on the possibility (or the likelihood) of some shocks causing major disruptions in global trade, communication, and financial flows. However, since people insure themselves against all kinds of damage arising from adverse events, I strongly suggest that my readers take out some form of insurance against a systemic failure. I am not suggesting that a fully paid house in the countryside, in the mountains, on a remote island, or on a farm will be the best investment people can make. However, under certain adverse conditions, such a piece of property in the middle of nowhere could be one of the very few assets that will provide you with security and the basic commodities for survival, as well as with a relatively comfortable lifestyle. As Professor Ward-Perkins pointed out, we are "wholly dependent for our needs on

thousands, indeed hundreds of thousands, of other people spread around the globe, each doing their own little thing. We would he quite incapable of meeting our needs locally, even in an emergency." This would certainly apply to people living in large urban agglomerations. Conversely, people living in the countryside would be capable and more likely of meeting their needs locally. In a systemic failure, the living standards of the rural population would certainly also decline because people might not get paid (barter will immediately come into play) or they may be unable to ship their produce (energy shortages), or to communicate and get spare parts for their machines, etc. But my point is that they would be in a better position to survive, and under far better living conditions, than citydwellers whose every necessity needs to be shipped into the city on a daily basis and where looting and crime will inevitably proliferate. Therefore, my first piece of advice is for

investors to shift some of their financial assets into rural properties

- not necessarily because of their capital gain potential, but because of security concerns.

In a systemic collapse, countries like the US, Australia, New Zealand, Canada, Brazil, Argentina, Thailand, Russia, Ukraine, etc., would be in a relatively favourable position because these countries could feed

themselves. In fact, I would argue that a global systemic collapse

would in relative terms benefit the US. If an external shock interrupted trade flows, the US trade deficit would shrink and previously outsourced production would come back to the US. Standards of living would decline, but less so than in economies that depend heavily on trade flows or exports. Therefore, in a horror scenario, US equities would likely outperform emerging market equities (see Figure 5). In fact, already in 2011 we could see the US stock market outperforming emerging markets because in the current environment (symptoms of inflation showing up in food and energy prices) money printing is less damaging in high-per-capita-income

February 2011

The Gloom, Boom & Doom Report 7

countries than in low-per-capitaincome countries, where spending on food and energy accounts for a larger percentage of personal incomes than in high-income countries,

Moreover, if trade flows were interrupted for one reason or another, it is likely that oil shipments would be interrupted as well, which would obviously hurt large oil importers

such as the US and China. However, in the case of the US, large natural gas reserves would be available and could at least partially substitute for reduced oil supplies. In fact, I believe that investors should overweight energy-related equities for two reasons. If the global economy surprises on the upside, it is a near certainty that oil demand would pick up (see Figure 6). As can be seen from Figure 6, oil demand in nonOECD countries continued to grow throughout the global economic contraction, whereas energy consumption in the more developed countries declined. However, over the last few months, oil demand in the more developed economies has picked up and is now driving global oil consumption to new highs (see Figure 7). Therefore, amidst an optimistic economic scenario, energy-related issues should perform well. Conversely, a systemic failure would likely lead to geopolitical tensions, which would, as I have explained in earlier reports, drive lip commodity prices - including energy prices. This would particularly apply to the price of natural gas, which would benefit companies such

Figure 5 S&P 500 Compared to Emerging Markets, 2009-2011

Source: www.decisionpoint.com

Figure 6 Crude on Demand is Picking up!

Nov

50

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CRUDE OIL DElvlAND

(million barrels per day '12-montll average)

8 The Gloom, Boom & Doom Report

so

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February 2011

Figure 7 World Oil Demand, 1987-2010

CRUDE OIL DEMAND

86 (million barrels per day, 12-month average)

Source: Ed Yardeni, www.yardeni.com. Oil Market intelligence

84

82

80

78

76

74

70

68

66

62

as Apache (APA) and Chesapeake Energy (CHK - see Figure 8).

I should like to make another, quite controversial point about the US. The Fed is printing money and, as I have explained on numerous previous occasions, it will keep real short-term interest rates negative for

a very long time. The symptoms of this monetary inflation will show up in all asset classes, but at different times and with different intensities.

In the late 1990s, the symptoms of inflation were evident in the NASDAQ. Inflation in home prices followed between 2000 and 2007. Later, between September 2007 and July 2008, we had a boom in commodity prices. Last year, inflation showed up in emerging economies and in agricultural prices. The maliciousness of monetary inflation is that it touches different sectors of the economy and asset classes unevenly and at different times. The problem is that it is practically impossible for the common man or the average investor to take advantage of the rapidity with which different sectors of the economy are affected by the symptoms of inflation brought about by excess liquidity (inflation followed

by deflation). This is especially true in an environment where the policy makers will bail out large market participants ("too big to fail" corporations) when they make horrendous mistakes, but bankrupt

the unsophisticated and gullible public for trying to protect its purchasing power by investing in appreciating assets.

Put yourself in the shoes of a decent family man in 2005. You are

figure 8 Chesapeake Energy

Source: www.decisionpoint.com

February 2011

The Gloom, Boom & Doom Report 9

living in a rental apartment, but your intention is to eventually own your own home. Your real (inflationadjusted) compensation is not increasing (because you are not working for the government) and your savings provide you with a 4% yield. However, you notice how your friends and neighbours' homes are appreciating by 15% per annum and, therefore (and rightly so) you conclude that the longer you defer the purchase of a house the less affordable it will become. Sure, you heard from some pundits that real estate is a bubble. However, since you also watch CNBC, where the highly educated Mr. Greenspan and Mr. Bernanke maintain that all is well in the property market and claim that they cannot identify bubbles (so how could you?), you are almost

compelled to buy a property. Therefore, you purchase a house, only to see it subsequently decline by 30% in value. Unless you financed the house well (low debts), you find yourself without a house and without any money.

I am aware that speculators also drove the housing market boom, but the point is that many decent people

were misled (and are still being misled), by expansionary monetary policies and artificially low interest rates, into putting their money in inflated assets for fear of losing their savings' purchasing power by keeping their money in cash. I cannot sufficiently emphasise the destructive impact of monetary inflation on the average person (the median household). Tragically, I doubt that either Mr. Greenspan or Mr. Bernanke ever look in a mirror and ask themselves just how many decent people they have bankrupted and how much misery they have caused to countless families.

However, the point I am driving at is that whereas it was a bad time to buy a home in 2005/2006, now that the market has deflated and the real estate news is distinctly negative, it may be a good time to re-enter the market. I am not suggesting that US residential real estate prices will increase much in the near future, but rather that the downside is now limited compared to financial assets and commodities. Housing starts, which are running currently at a 50- year low, will rebound sometime in the future (see Figure 9). On any

rebound - or in anticipation of a rebound - in housing starts, I would expect homebuilders to perform well compared to other asset classes (see Figure 10).

The deflationists will naturally argue that home prices win decline by another 30%, while commodities, precious metals, and equities will deflate by 80%. This is a possibility we cannot dismiss entirely; but even in this horror scenario, homebuilders would be relatively attractive. A much more likely scenario is, however, that on any renewed weakness in asset prices, the Fed will proceed with further rnonerisation. First, additional monetisation will depress bond prices (rising long-term interest rates). However, at some point, investors will become jittery about equities and increasingly concerned about the value of any paper assets in a systemic failure. At that point, people will want to cash out of paper assets (cash, bonds, and equities) and wHI conclude that in a financial meltdown it might be a better idea to have some land and a roof over their heads, financed with little or no leverage, than owning paper assets. (They might also finally

Figure 9 US Housing Starts, 1959-2010

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HOUSING STARTS

(million units. saar)

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19

1.7

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II

.9

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Source: Ed Yardeni, www.yardenLcom

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10 The Gloom, Boom & Doom Report

February 2011

buy some precious metals.) Above, I explained that, in a housing bubble when prices trend strongly upward, people can't resist purchasing a home.

However, when the bubble bursts, sentiment turns extremely negative (Pigou's "error of pessimism") and no one wants to enter the market (or

Figure 10 Philadelphia Housing Index Compared to Gold, 2002-2011

No lttott,Ffnf: 6,b f., $HOX'$OOLD

PMO 3.57 t ~q.~ hit :; 1·~, t

o "

Source: www.declsionpoint.com

Figure 11 KB Home, 2002-2011

Source: www.decisionpoint.com

people cannot enter the market because of lack of funds). This condition then creates an undervaluation. Therefore, I believe that now may be a good time for those of my readers who don't yet own their own property to purchase a home (ideally in a rural area, and which they can enjoy), and that equity investors should consider the gradual accumulation of hornebuilding companies (see Figure 11 - strong support for KBH exists at $10).

In the December 2010 GBD report, I expressed some caution about emerging markets. After their stellar performance since March 2009, the Philippine, Thai, Indian, Malaysian, and Indonesian stock markets all appear to be rolling over (see Figures 12 and 13). I don't know whether the recent weakness in emerging markets will lead only to a brief correction or to a more serious (20-30%) decline. However, as I have mentioned before, I am concerned about excessive credit growth in China and the rather disturbing inflationary pressures in most emerging economies. The Guangdong Provincial People's Congress recently approved plans to "step up wage rises" as part of the province's five-year plan. The move is aimed at boosting living standards and creating "happy livelihoods". The chairman of the Hong Kong Small and Medium Enterprises Association expects Guangdong's wages to jump 25-30% this year as a combined result of worker shortages, the need to retrain people, appreciation of the Yuan, and more requirements for workers' social welfare and insurance.

I should emphasise that when a market turns down, it is not possible to reliably forecast if, following a short-term downside correction, the uptrend will resume or if the weakness signals a major change in the trend from up to down. However, it is common for the initial decline to be followed by a rebound, and it is from the technical strength of this rebound that more reliable conclusions about the marker's future trend can be made, If the rebound is weak (only few stocks participate and

February 2011

The Gloom, Boom & Doom Report 1.1.

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