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US Economy Still on Life Support

Peter Schiff, Why It's Time To Dump Most US Stocks

Stock-Markets / Stocks Bear Market Sep 14, 2010 - 08:46 AM GMT

By: Peter_Schiff

Stock-Markets

Best Financial Markets Analysis ArticleStocks are widely believed to provide inflation protection since factories, equipment and inventories rise in value as prices generally increase. Historically, stocks have in fact tended to rise with inflation rates, but too much inflation has caused volatility and raised a question as to whether stocks really are a reliable inflation hedge.


Stocks in certain sectors have similarly earned a reputation as recession protection. Stocks designated as “defensive” are those in industries that make stuff we've simply got to have, such as food and drugs, or items in the category of “sin,” referring to things we may not need but will kill to get – traditionally tobacco and alcohol, and perhaps other things to newer generations.

Such rules of thumb are based on common sense and will always be valid, although whether they result in gains, simply lower losses, or neither, depends on the severity of the recession, the urgency of the demand and a lot of other factors that change as a downturn proceeds.

Of course, we are not talking here about mild inflation or a minor recession except as early or late stages of the main event. The situation we are facing is of a magnitude comparable to the Great Depression of the 1930s and the next-worst bear market, the stagflation period of the 1970s. There are parallels to both cases, but also ways in which the current crisis differs significantly.

THE 1930s

There is a very real possibility that the current recession will deepen into a repeat of the Great Depression of the 1930s, only with consumer prices rising, not falling.

In the 1930s, the problem was not inflation, but deflation. Cash grew in value, as did bonds held to maturity. Stocks went both down and up, and ended the decade down. Stocks that bucked the downtrends were generally the defensive and countercyclical issues. But hedging inflation was not a factor. Interestingly, price inflation was minimal during the bull market from 1921 to 1929.

The collapse that ensued bottomed out in 1930, with the Dow Jones Industrial Average down 89% from its 1929 peak. But it gave way to a bull market that lasted until 1937, when prices fell again until a few months after Pearl Harbor.

In 1930, every stock in the Dow declined except three. Those that gained slightly were Liggett & Myers [Tobacco Co.], General Foods [Corp.] and Borden Co. – one tobacco company and two food producers. In 1931, every Dow stock was down, and the same was true in 1937. In 1933, 1935, 1936 and 1938, 80% to 90% of the Dow stocks showed gains. Of course, the fortunes lost in the stock market of the 1930s were lost because so much stock was bought on margin, meaning that when prices tumbled, margin calls meant putting up more money. Holding for prices to come back was not an option for many people, and those who did hold waited until the 1950s for the Dow to recover.

But the 1930s proved that food and tobacco, traditional defensive stocks, bucked the trend during the worst stock market crash in history. Gold-mining shares, of course, were in a stratosphere of their own.

It also proved that markets don't like extreme deflation any more than they like extreme inflation. As I stated, though, deflation (at least as it leads to falling consumer prices) – which is getting increasing publicity as a present threat – is one “problem” we won't be facing this time. Sure, as the credit bubble deflates, asset prices will fall relative to goods prices, but the Federal Reserve stands ready to replenish the money lost with freshly printed bills. However, this new money will not reinflate the busted asset bubbles but simply drive goods prices even higher.

Of course, we will see, and are already seeing, instances where prices are declining. But inflation is now so pervasive that despite any trade-offs, the net effect will have to be rising prices.

THE 1970s

Very much like present times, the 1970s combined stagnation and inflation, notably in skyrocketing gas prices, giving rise to the term “stagflation.” What was different about the 1970s, though, is that government and consumer debt were relatively moderate, with both government and mortgage debt locked in over long time periods.

This gave the Fed the option of countering inflation with aggressive interest rate hikes when it reached double digits. Today, it doesn't have the option of raising rates significantly without triggering consumer debt defaults and mortgage foreclosures that would bring the economy to its knees.

Also, back then, any new government borrowing was financed internally. Interest paid by the government was offset by interest earned by American savers. The net effect was not a net drain on national income, though there were certainly social effects of a domestic transfer of purchasing power from the less to the more affluent. Now, however, approximately half of our national debt in public hands is held abroad, and an even larger share of new issues is sold abroad. As a result, significantly higher interest rates would result in meaningful drains on our national income. Furthermore, as the outstanding debt is now very short-term, higher rates would affect the total of what the government owed, not merely new borrowing. In other words, American taxpayers have been committed to the mother of all adjustable-rate mortgages!

While the 1960s, called then the Soaring '60s, will be remembered for its go-go mutual funds, its conglomerates and concept stocks – like Four Seasons Nursing Centers of America [Inc.] (bankrupt by 1970) and Performance Systems [Inc.], a franchiser of fried-chicken restaurants, all of which came to grief by decade's end – the 1970s became famous for the Nifty 50. These were a group of high-capitalization growth companies that big mutual funds and institutional investors, by then a dominant force in the market, could buy and never worry about again. Also called “one-decision” stocks and “all-weather” stocks, these big household names by 1971 were selling at 100 times earnings (when they had earnings), despite a general market decline led by everything else.

When the bear market of 1973–74 settled in, 27 of the Nifty 50 dropped an average of 84% from their 1971–72 highs. The Dow, which closed 1972 at 1,929.02, closed 1973 at 850.86 and 1974 at 616.24 before beginning its recovery the following year. In 1973, only six of the Dow stocks rose significantly, and in 1974, only five – and with one exception, they were different stocks.

But here's what's interesting: All six of the 1973 gainers were basic-raw-materials companies, consistent with a pattern whereby commodities and financial markets go in opposite directions.

Not only that, but their returns were strong, led by Allied Chemical [Corp.]'s total return of 73.4%, Alcoa [Inc.]'s 40.6% and Bethlehem Steel [Corp.]'s 18%.

In 1974, stagflation had begun, with unemployment over 7% and inflation over 10%. The Arab oil embargo was in full swing, causing fuel shortages and plant closings. Two companies benefiting from the oil crisis led the Dow in 1974: Johns Manville Corp., which sold fuel-saving insulation materials, and United Aircraft [Corp.], whose fuel-efficient jet engines were in demand from the aircraft industry.

In 1975, the market picked up again, this time led by cyclical stocks. Profiting from what was termed “a new era of pricing power,” the basic industries such as steel, chemicals, aluminum, paper and copper enjoyed a short-lived revival.

By the end of the 1970s, the cyclicals were back in a slump, and leaders were the energy issues and related technology stocks, small biotech issues and defense/aerospace stocks, reacting to the Iran hostage crisis and anticipating a Republican administration. On another tier, small-capitalization stocks did prove their worth as an inflation hedge, outperforming inflation and registering a positive return over the decade. In a global economy where the action is abroad, however, it is hard to imagine that small-caps, which would generally have minimal, if any, international exposure, would outperform in today's market.

With that exception, the 1970s proved that in extreme inflation, stocks in general do not hold up as well as an inflation hedge. Gold, of course, is in its own world; gold-mining stocks were off the charts. The 1970s experience proved something else of great and relevant importance: The inverse market relationship of commodities (including basic materials, agriculture, energy and metals) to stocks in general gains validity the more serious economic problems become. It's financial paper versus tangible stuff.

So what to do with your U.S. stock investments now? My basic recommendation is to restructure your domestic stock portfolio with conservative, dividend-paying foreign stocks that will produce currency appreciation and keep you out of the collapsing dollar and immune from any desperate measures or political gambits that the U.S. government might resort to as the economic predicament worsens.

Some domestic stocks are worth holding on to, such as mining companies and producers of basic materials, energy and agricultural commodities that trade worldwide in dollars and will benefit from a commodities boom. I would hold the major oil producers, but be prepared for an excess-profits tax. A better bet would probably be oil service companies, which benefit more directly from a strong oil market and are unlikely to be hit with excess-profits taxes. Makers of farm equipment or fertilizer companies are proven as a way of participating in the agricultural boom. Exporters and multinationals with good foreign exposure should also do well.

The most important part of any U.S. allocation would be to avoid like the plague any stocks largely dependent on American consumers, especially when it comes to discretionary purchases or repaying their debts. That includes financials, retailers, home builders and consumer discretionary. I would also avoid any high-multiple stocks, which excludes most technology or biotechnology companies.

Another thought: Any U.S. company not adversely affected by inflation and producing a good global earnings stream is a possible target for acquisition by a sovereign-wealth fund – or private foreign buyer. That's bad news for the American economy but potentially good news for some American shareholders. Witness Anheuser-Busch Cos. Inc.

Click here for a description of Peter Schiff's best-selling, just-released book, How an Economy Grows and Why It Crashes.

Regards,
Peter Schiff

Euro Pacific Capital
http://www.europac.net/

More importantly make sure to protect your wealth and preserve your purchasing power before it's too late. Discover the best way to buy gold at www.goldyoucanfold.com , download my free research report on the powerful case for investing in foreign equities available at www.researchreportone.com , and subscribe to my free, on-line investment newsletter at http://www.europac.net/newsletter/newsletter.asp

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