Is Another 2008 Imminent for Global Equities?
By: Jim Nelson, Portfolio Manager

Given the dramatic market volatility we have seen over the past few months, we thought it wise to provide our investors with our take on what is driving the turbulence, especially in light of the short term surge in the US dollar and the declines in commodity related investments, which may be falling heavily on Euro Pacific Capital portfolios.

We believe the trend downward since June has been primarily driven by slower expectations for world-wide economic growth, and growing skepticism that monetary and fiscal stimulus will be able to address the problem.  Adding to the volatility have been key events such as the Japanese earthquake, the US debt ceiling debate, the US debt rating downgrade, fear over inflationary pressures in Asia, and ongoing concerns that China will crash after a period of rapid credit expansion. But perhaps the most significant event is the ongoing debt crisis in Europe which has stoked widespread fears of a European banking crisis that may even threaten the existence of the euro itself.

The market has long concluded that Greece will default, however larger nations such as Italy and Spain have been an uncertainty. While policy makers suggest one plan after another, with little progress in the way of action, the market grows increasingly impatient. When economic growth slows, the market grows even more concerned. A solvency crisis for large nations in the Eurozone would have significant negative implications for the global economy; first for the banking sector, then spreading to other sectors of the economy as global liquidity tightens. The impacts would be felt world-wide, and the difficulty in seeing past the crisis is reflected by current global stock valuations. Sentiment is extremely low, and cumulative short interest on major US exchanges has recently hit 2009 highs.

Despite the fear, Euro Pacific Capital has not abandoned our long-term, value-oriented approach to global markets. We continue to maintain our exposure to high quality, dividend paying companies, with solid balance sheets and minimal exposure to Europe, Japan, the UK, and the US. In our managed accounts, we are currently taking opportunities to add to these positions. We also increased our precious metal exposure early in the year.  We have maintained our overweight allocation to non-cyclical sectors such as consumer staples and utilities.

Clearly over the past few months, our global strategy has underperformed the broad US markets. This is largely due to the correction in precious metals, a breakdown in some of our key currencies, and a lack of liquidity in some of our key markets such as Norway and Singapore. Moving forward, we look for liquidity pressures to abate and precious metals and currencies to rally, which would be a tailwind for our strategy. We feel the lack of liquidity in some markets was a key differentiator in September, but will have less influence moving forward. Additionally, we think a lot of the selling in our markets has been flushed out and that there’s still some distance on the downside to cover in developed markets.

Country Fundamentals and Performance as of 10/3/2011:

Source: Bloomberg, 2011.

Country Fundamentals

Source: IMF, Bloomberg, 2011 & 2010.

In our opinion, given the data in the above charts, the recent strength in the US dollar and US Treasury bonds is unwarranted. While many explain the rally as an understandably defensive ”flight to quality” in the face of what many believe to be increasingly likely deflation, we find this scenario to be extremely unlikely. From the Federal Reserve’s perspective, deflation is public-enemy number one, and it will do anything to prevent such an outcome. As a result, we believe additional stimulus will follow before austerity. Each day that the market ticks down increases the likelihood of Fed action. And even if the Fed were to resist its instincts, we believe that a deflationary scenario could place politically unbearable pressure on public finances.

We think a more likely scenario is a two to three year game of “monetary whack-a-mole” where markets trend sideways with increased volatility as policy makers whack away at each crisis created by a market that is trying to correct the excesses of the past decade of unsustainable credit growth and malinvestment. But the long-term implications of our view appear to be clear: developed deficit nations will continue to stimulate, devaluing their currencies and increasing the value of commodities over the long-run. In contrast, we continue to believe that the countries we focus on are in fairly good shape and have more conventional policy tools at their disposal.

In our view market, valuations at their recent lows make little sense. The 10-year T-note has dipped to a low of 1.7% and is currently holding at the lowest levels in more than 60 years. This comes at a time when CPI is increasing 3.9% annually. In contrast, equities in some world markets are now trading near 7x earnings with 5% dividend yields. Many equities and market sectors are now approaching 2008 lows, even though corporate balance sheets are much stronger than they were at that time.

These conditions suggest to us that markets will correct to reflect these underlying realities over the long-run. While we can’t predict what might happen over the short-term, we believe it makes sense for investors to maintain some exposure to equities and foreign currencies in order to stay diversified. Over the long-run, we remain confident in our strategy. 

Jim Nelson is Portfolio Manager with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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After clicking the ad above, you will leave the Euro Pacific Capital website and be directed to the website of Euro Pacific Precious Metals, LLC. Neither Euro Pacific Capital nor any of its affiliates are responsible for the content of such website. Peter Schiff is CEO of Euro Pacific Capital, Inc. and CEO of Euro Pacific Precious Metals, LLC.

Precious metals are volatile, speculative, and high-risk investments. Physical ownership will not yield income. As with all investments, an investor should carefully consider his investment objectives and risk tolerance as well as any fees and/or expenses associated with such an investment before investing. The value of the investment will fall and rise. Investing in precious metals may not be suitable for all investors.

Death by 1,000 Cuts
By: Neeraj Chaudhary, Investment Consultant

With the US stock market’s recent volatility, many investors may be wondering whether or not we are headed for another 2008-style crash where the market drops 30 to 40 percent within a few short weeks. Sensing that timing could be critical, many investors may be sitting on the sidelines waiting for a good entry point. But this dynamic misses that far bigger picture: Notwithstanding the bull and bear cycle over the past decade, the entire market has been slowly sinking. As a result, a well timed entry into US stocks may not be enough to deliver long term results.

The majority of investors who have been holding US stocks for the better part of a decade have seen their real wealth diminished. And even if the market does not collapse as it did in late 2008, US stock investors will likely continue to bleed away real wealth for the foreseeable future, as the dollar itself continues to shed value. As we dismantle our economy piece-by-piece, through seemingly unending bailouts and stimulus, real wealth – and real stock prices – will continue to flow abroad. 

Source: Yahoo Finance. S&P 500 from August 2000-October 2011.

To see this big picture, we must look back to August 2000. At that point the tech stock bubble had just started to pop, but its effects had not yet been felt in the wider economy. That month, with investors still flush with the optimism of the late 1990’s, the S&P 500 Index hit an all-time high of 1,461¹*. At the time, the cheerleaders predicted that the United States would lead the free world into a 21^st century capitalist dream, with a perpetually growing economy and permanently rising stock prices.

But then something funny happened on the way to the mall. For the next eleven years, US stocks went nowhere. While there was indeed much volatility in the decade (such as the crash of 2008, and the ensuing two-year rally that restored stock prices to their pre-crash levels), long term stock market returns were essentially non-existent. By May of this year the S&P 500 was at 1,338¹, about 8% below its nominal value in August 2000. While an 8% decline is no victory, it is not quite a tragedy either. The problem, however, is that these seemingly mild declines are greatly magnified by the falling dollar.

Using 2011 dollars as a yardstick, the August 2000 S&P 500 high would not have been 1,461¹, but actually 1,952¹. If adjusted for this inflation, the S&P 500 fell an astonishing 31% to May 2011. In other words, investors have lost nearly one-third of their real wealth since 2000. These losses did not only occur in the 2008 crash, as many market cheerleaders insist. They came cut-by-cut, over the past eleven years.

It is this expression of wealth – where a 31% loss of real wealth is represented as a more benign 8% loss of wealth – that is not recognized. The Federal Reserve can pump liquidity into the markets, causing nominal stock prices to rise, yet ignoring the lost purchasing power.

It is worth noting that all of the inflation numbers that Dr. Shiller used to calculate real stock values are based on US CPI as currently calculated by official sources. However, throughout the 1980s and 1990s, the US government made significant changes to the way CPI is calculated. These changes had the cumulative effect of dramatically reducing the rate of reported inflation. If CPI had been instead measured using the formula in use prior to 1980, inflation would have averaged at least 6% annually from 2000-2011. If these measurement techniques had been held in place, investor losses of real wealth to inflation would have been higher during this period.

The moribund market seems to have reduced confidence in the time tested “buy and hold” strategy. Instead investors hoping to actually make money may now be choosing risky market timing strategies or loading up on particular companies or sectors that they hope will outperform. Certainly, some have been successful. But a larger number are likely on  the losing end of those trades. But a falling equities market is a drag on the overall economy beyond Wall Street.

Looking ahead, if there is a repeat of the 2008 crash, Ben Bernanke himself has indicated that the Fed will rush in and pump the markets up again with liquidity². And, as they did in 2008, stock prices may once again rise to their pre-crash levels. But when the dust settles, investors may see another large bite taken out of their portfolios as a result of high inflation.

So let the cheerleaders soft pedal the dips, celebrate the rallies. At the end of the day, the US market appears to be just chasing its tail. However, we believe the buy and hold strategy is still in effect in many world markets, where robust real gains have been delivered over the past decade.

¹ http://www.econ.yale.edu/~shiller/data.htm

* In order to provide a data series that may be used in conjunction with US CPI data, Dr. Shiller uses average values for each month of his S&P 500 data.

Neeraj Chaudhary is an Investment Consultant with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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Spain’s Infrastructure Spending: A Flight to Nowhere
By: Andrew Schiff, Director of Communications & Marketing

Recently there’s been much talk about how infrastructure spending can be a viable solution to our country’s current economic woes. President Obama’s proposed $447 billion dollar jobs bill contains, among other things, investment in infrastructure projects like road construction. Many progressive economists have called for much more, with some even saying that the utility of such programs is secondary to the short term economic stimulation that would result from hiring unemployed workers. In other words, it doesn’t matter what is built, as long as the government creates jobs. But even if the projects are widely regarded as needed, will the benefits justify the costs? Oftentimes the answer is no, as the actions of the Spanish government over the last two decades suggest.

Spain covers an area about the size of Utah and Arizona combined, and is home to a little more than 46 million people. Although it is neither the largest, most populous, or most prosperous country in Europe, over the past two decades it has nevertheless built the largest high-speed rail network on the continent, covering 2000 kilometers. The same is true of its aggressive highway construction program which has added 5,000 kilometers of new roads over the same time frame.  But the most ambitious element of its plan was the construction of 48 airports, 43 of which were international.

In June, the New York Times ran an article that quoted Spain’s industry minister Jose Blanco accusing the government of “bad planning and excessive spending.” This is nowhere more obvious than in its disastrous airport construction policies.

A perfect, and highly publicized, example is the Castellon airport, which cost the Spanish government nearly 150 million euros ($213 million). Although Castellon was finished in March of this year, it has yet to welcome a single flight. In fact, it doesn’t even have an airport license. Originally, the airport was supposed to ride the wave of Spain’s booming tourism industry and bring money and jobs into the local economy. But central economic planners in Madrid misread the market and failed to recognize a growing bubble. The airport now stands as one of many expensive white elephants that dot the Spanish landscape.

In Spain, the larger airports are run by regional governments and only 11 turn a profit. The government is currently considering selling concessions to run the two biggest – Madrid Barajas and El Prat in Barcelona. Even some of Spain’s more successful regionals are in the red. A recent piece in Spain’s El Pais newspaper revealed the practice of paying discount airlines to land in regional airports. For example, Girona airport, located about two hours outside of Barcelona, paid Ireland’s Ryanair around seven million euros a year to continue operating (largely empty) flights to the airport.

While recent austerity measures have reduced this practice, subsidies to discount airlines is common among many of Spain’s regional airports. These payments allow Ryanair and other discount airlines to play Spain’s many regional airports against one another, demanding higher subsidies and lower fees.  The existence of this market would evidence that Spain has built out these facilities well beyond the point of economic sense. But as with all politically motivated spending, economic necessity is never a high priority.

In the past few years, the country seems to have doubled down on its infrastructure investment in spite, or perhaps because of the global financial crisis. For example, a November 2008 stimulus initiative focused heavily on infrastructure projects. The stimulus cost eleven billion euros (1.1% of Spain’s GDP), eight billion (73%) of which went to public works projects. An April 2010 report by the US Department of Labor called the program a relative success but acknowledged the difficulty in calculating the number of full-time jobs that resulted. It highlighted how some of the jobs lasted only a few hours. 

After the dust settled from these projects, it has slowly become clear that the employment didn’t last and all that remained were unneeded facilities and unsustainable debt. Meanwhile, according to the same report, despite the spending, Spain’s GDP contracted an estimated 3.6% in 2009 and unemployment now stands at 21%.

There are of course, significant differences between infrastructure projects in Spain and in the United States that make it difficult to compare the two. We may not build airports but choose to focus on high speed rail. But, when it comes to the efficient allocation of scarce economic resources, why should we expect our government planners to be wiser than their Spanish counterparts?

Andrew Schiff is Director of Communications & Marketing with Euro Pacific Capital. Opinions expressed are those of the writer and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.

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Mortgage Crisis Goes Primetime
By: John Downs, Vice President