by Sam Jones
It should be no surprise that the state of our financial and economic worlds are approaching perfect symmetry with the mid 70’s.
In 1974, we saw unfathomable federal bailouts, massive bank failures (many more than today), nationalization of the Savings and Loan institutions that were "too big to fail", the final phase of a losing war in Vietnam, historically low interest rates and yes the bottom of a prolonged and painful period in stock market history dating back to 1965. At the depth of despair, we also had Watergate and Nixon’s resignation. The Economist ran a headline in the Fall of 1974, "US Stock Market Going to Hell." Within one week, the markets bottomed and moved higher for 25 years.
For this discussion, I want to focus on the period between 1974 and 1982. Financial market academics know this period was one of the very deepest and toughest economic cycles next to the Great Depression in US history. During this period, hopeless indices were created like the Misery Index – which simply added the unemployment rate to the inflation rate.
Here’s a list of several major events that marked extremes. Pay special attention to their timing and sequence because I’m going to map out a speculative investment plan accordingly.
1974: US stocks finally bottomed after peaking 9 years earlier in 1965; US bond prices fall; interest rates of all maturities rise steadily; gold and commodities embark on a long term uptrend; the economy continues to weaken. Real estate prices peaked in 1972 and are beginning to accelerate to the downside.
1975: Unemployment peaks at 9% but inflation begins to really accelerate, gold moves even higher, bonds begin to accelerate to the downside. Real estate prices fall another 10%. Misery index rises dramatically in 12 months, hitting 17%.
1976 – 1979: Unemployment rate declines slowly as federal programs attempt to put people back to work. Inflation is running very hot, breaking above 10% a year. Gold and commodities continue higher, bonds and real estate are in a steady decline.
1980: Misery index peaks at 20, 76% of which comes from inflation and the rest from unemployment. This is a dark moment in US economic history. Bond prices hit their lows, interest rates in double digits, gold hits a high, Real estate prices in a death spiral.
1982: Unemployment hits another peak as the economy buckles under massive inflation. Inflation finally begins to fall under Reagan. Remarkably, the S&P 500 is now 54% higher than at its ultimate low 8 years earlier in 1974. 1982 marks the beginning of the most robust period of economic growth and financial market appreciation ever recorded
The key points during this period are:
Stocks bottomed 8 years before the economy began to recover. Bonds and real estate suffered terribly losing 30-40%. Inflation ran wild as did commodity prices. If we are to repeat the past even marginally, I fear for the great many investors who are still clinging to real estate and bond investments as well as those who have recently divested completely from stocks and are likely to miss a very large portion of what gains are made out of these lows. Unemployment was high for American standards as well but remember, at its worst, 90% of our country was still employed in 1982. Today, 92% of our country is still employed.
The Utility Trade
As I begin to understand the magnitude of "trillions" in dollar terms and the amount of US dollars in circulation, we must begin to entertain the possibility that wealth in the next several decades will be measured not in one’s account balance but in hard tangible assets. After all, dollars when measured in trillions are not of value anymore than a blade of grass or seashells.
Tangible assets can be held in raw form, like a yard full of steel beams. Or, more practically, we can buy the equivalent amount of raw steel in the commodity markets through exchange traded funds (ETFs) that own the metal, like the Van Eck Steel ETF (SLX). Clearly, we witnessed the first round of the "inflation trade" from 2004 – 2007 in the form of gold and oil price appreciation. And the evil twins may run again in the context of another complete commodity wave.
However, I am entertaining the possibility that this was just a warning shot of bigger things to come. A more comprehensive "inflation trade" if you will that includes all things tangible and useful from food to timber, water to steel, titanium to agricultural land. The next phase of inflation will be on a 70’s scale with growth in the developing world driving prices for natural resources even higher than we saw in June of last year.
But instead of the inflation trade of the past 4 years, I believe we will see more of a "Utility Trade". Not in the traditional sense of power utilities, but the concept of investing in things that have intrinsic utility, like land, steel, copper, titanium, water, wind and solar power. As I said, Oil may remain in the hunt but isn’t likely to be the great leader of the wave that it was earlier this decade. I think the same goes for gold on the simple basis that gold doesn’t offer us much utility beyond jewelry.
The trends I see developing are different and somewhat at odds with modern financial market theory but we are filtering these trends into all of our strategies now.
The trends are as follows:
Water: Water will become a growth industry as filtration, access, delivery and disposal of waste water are priced according to real demand. I have added a complete universe of Water stocks to my watch and monitor lists and have begun establishing core positions in several names, especially through our New Power strategy.
Base Metals: Demand for base metals (steel, copper, etc) has continued despite a 60% drop in prices. This appears to be a massive pricing anomaly as investors indiscriminately sold any and all commodities last summer. Base metals do not include precious metals like gold and silver which are still trading close to their all time highs. I’m OK with silver but can’t find anything good to say about gold. In our All Season strategy I have taken an early position in Powershares Base Metals (DBB) and have recently taken profits in our Silver position (SLV) selling it back to cash.
Renewable Energy, Smart Grid and Efficiency: The renewable energy sector is down an astounding 78% from the highs in January of 2008. Simply put, this sector is oversold and grossly undervalued given the backdrop of new technologies, political support, new demand and competitive pricing coming down the pipeline. Beyond 2009, renewable energy and clean technology sectors will grow exponentially faster than traditional oil and gas companies.
As the clock ticks forward, I am rebuilding our New Power portfolio to own the leaders of this new mega trend. Every recessionary cycle of this magnitude generates a whole new fleet of companies that become the blue chips of the next decade. Microsoft, Fed Ex, Hewlett Packard, and many others were established in the pit of despair in the mid 70’s. I am quite confident that the next two decades will be led by Green Chips not Blue chips.
Technology: one of the greatest benefits of technology is its ability to offer more for less. I’m talking about efficiency, productivity, service, and customization. The Technology sector is growing larger and larger, and it’s something we "manufacture" and can export to others. Technology saves money and time and therefore offers a great deal of utility to everyone, recession or not. I know at least a dozen people who lost their jobs in the last year but found enough cash to buy a $400 I-Phone!
The Technology sector is also one of the most deeply discounted in the market place now. It is lean and mean and ready to get back in gear as a leading sector. We are building our technology exposure in all strategies now after almost 8 years of sitting on the back burner.
These are the big and obvious players in the new Utility Trade. But I am also open to oil service companies, investments in country funds that are heavy in raw materials like Brazil, Russia, Australia and Canada (BRAC countries). Today, we bought the Brazil exchange traded fund (EWZ) in our All Season strategy and we own the Australian Dollar ETF (FXA) in our High Income model which pays 6.5% interest.
The whole point of this lengthy update is to get you thinking about what’s next. Instead of hyperventilating into a paper bag after reading the current media headlines, think about finding the opportunity that will allow you to recover quickly.
2009 is a transition year as we move from what seems like a hopeless situation to one that offers great opportunity for investors. Those who recognize value and have cash to spend, will do very well in the next 5 years. Those who yield to their emotions and sell everything at these levels will deeply regret that decision. The trick is to ride the fine balance of risk management and opportunity.
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Sam Jones is Senior Portfolio Manager of the New Power Fund and President, All Season Financial Advisors, Inc.
He is a monthly columnist in Progressive Investor, guiding subscribers toward green investments and helping them understand and react to market conditions.
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