Dennis C. Butler, President
Centre Street Cambridge Corporation
Private Investment Counsel
of all guest columns written by Dennis C. Butler, CFA
Just when you thought you had seen it all, along comes something to remind you never to be complacent, especially when it concerns money. Take this remark, for instance: "Everyone is buying, and you get very protectionist, and you don't sell anything," said the manager of $300 million of other people's money. "The trick is to know when enough is enough. ...When to start selling before everyone else does." The concept of the "Greater Fool" has always seemed a little farfetched to us: certainly no investment professional would jeopardize a client's capital simply because they expected to unload the risk at a profit on someone with no sophistication. Such behavior would be pure speculation, and to see in print (in our leading financial journal, no less) a statement like this attributed to an individual who is presumably knowledgeable about investments is disturbing indeed. Conceivably, these sentiments represent exceptions to the rule, but we suspect that such reasoning is not uncommon in our great money management institutions where, unfortunately, investment principles too often play second fiddle to fear of what the competition is doing. What really astonishes us is the amount of money some people are paid to do essentially the same thing that suckers of all eras have done for nothing. Sloppy habits of thought, once learned, come to be seen as normal after a while.
As with most things on Wall Street, even fools can seem sophisticated for a while when the trend is their friend, and the markets have not been unkind to participants of all stripes over the past year. Despite a lackluster first quarter of 2004 which left the major averages little changed, the past twelve months have been quite good for financial assets across the board. From major Blue Chip stocks to long-dormant commodities, the gains have been remarkably widespread and, lately, uniform. Only four of the S&P 500's 114 market sectors declined in 2003, and over the last several months the range of differences in returns among the various sectors has seldom been narrower. Unsurprisingly, stocks have become quite expensive as well. Recent market statistics show that 75% of non-technology stocks in the S&P 500 are above their prices at the top of the bubble in 2000. Some long-established and strongly-entrenched companies sell at valuations above those of the bubble days. Even utilities offer meager yields compared to those of four years ago. A sign of the times: the best gains have occurred in the most speculative areas, such as junk bonds, emerging markets, and the stocks of iffy companies. As the Financial Times so astutely put it, there has been a "Flight to Garbage" by money chasing yield, without regard for the hazards that most certainly exist in these areas. The inflation of asset prices has left us with a marketplace that insufficiently differentiates among risks. As far as the availability of good investment opportunities is concerned, the landscape appears about as desiccated and dusty as the plains of Mars.
One of the distinctive features of the current era is the emergence of China as a major factor in the markets for real and financial assets. Due to the prolonged boom in the Chinese economy (which its government, for reasons of stability, has diligently encouraged), the country has been a magnet for commodities of every description, from oil, steel and other industrial metals, to soybeans. Its demand has pushed up the prices of commodities sharply -- the first bull market in some basic materials (such as lead, for example) in many years. Commodity price indexes have hit their highest levels in over twenty years. The effects have been felt world-wide. Ask the management of almost any American industrial company these days and they will point to Chinese imports as the force behind rising prices for inputs ranging from scrap metals to foodstuffs. (Despite the increases in the prices of basic materials, energy and property, measured inflation in the U.S. remains subdued — a fact that may seem puzzling to anyone who has purchased real estate or buys their own groceries.) Owing to its large trade surpluses, China has also become a growing source of capital for the U.S., helping the latter to fund its various deficits while keeping interest rates at unusually low levels.
The Chinese economic boom and trade with America have had a beneficial impact on Asian economies in general, helping the latter recover from the crises of the late 1990s. Not surprisingly, interest among portfolio investors in the region's markets has been rekindled and Asian stock markets have been among the world's sharpest gainers during the last year (or perhaps it is the other way around). Against this backdrop it is interesting to note that the idea of investing in foreign markets has found strong support among investment theorists. For many years academic finance and the investment Establishment have touted the benefits of investing money abroad as a way of reducing the volatility of a portfolio's returns (or "risk," as it is defined in academic circles). The basic idea is that because financial markets around the world are subject to different influences and thus do not move in lockstep with each other, market fluctuations cancel each other out, thereby smoothing returns — diversification on a global scale, in other words. "Correlation" is the operative term used to describe these inter-market relationships; a low correlation indicates two markets are less likely to move together, and vice versa. At the same time they reduce volatility risk, foreign commitments might even enhance returns due to the stronger growth rates that may prevail in some overseas economies at any given time. Of course, this only works as long as the correlation between different markets remains low.
Unfortunately, big Wall Street ideas such as this tend to lose their relevance once they become widespread and popular. The original argument for international investing was based on sound historical data going back decades that effectively demonstrated the benefits. But the fundamental reason for going abroad — diversification — has been negated to a significant extent by the growth in global investment flows over the past ten to fifteen years, and the ever-tightening links between financial systems world-wide — increasing correlation. The potential impact of this linkage was seen during the Asian and Russian crises in 1997-1998 when markets worldwide declined sharply within the same time period. If anything, world markets are even more intertwined today. International investment and money flows rebounded after the late 1990s. Countries whose currencies are tied more or less tightly to the U.S. monetary unit have created a dollar region in which a vast recycling of dollars occurs owing to the large American trade deficits. Consequently, actions by the U.S. monetary and fiscal authorities now have a direct impact on areas far beyond our borders. It is to be expected that developments in these regions will also echo more loudly here.
Nowhere, perhaps, is the linkage more evident than in the case of China. Owing to a strong currency link in the form of a relatively fixed exchange rate enforced by the Chinese monetary authorities, and efforts by the corresponding American authorities to stimulate the U.S. economy, trade between the two countries has exploded, but at a huge deficit for the U.S. (The link has also created a political storm due to the movement of U.S. industrial production to China, a low-labor-cost country.) On the Chinese side the trade imbalance creates a flood of dollars which has to be invested, and much of this money finds its way into U.S. treasury securities. Thus, Chinese and Americans have developed a kind of interdependency: China relies on the U.S. to provide a ready market for its goods; the U.S. depends on China, to an increasing extent, as a source of capital to fund its deficits.
The nature of this relationship has been widely discussed in the media, especially when dealing with the jobs issue. Less well understood, perhaps, is the impact of U.S. monetary policy on countries such as China. The latter's currency link exposes it to U.S. monetary policies in a more direct fashion than countries with less direct ties to the U.S. economy, or whose currencies float in value versus the dollar. Actions taken by U.S. monetary authorities to re-inflate the U.S. economy and foster growth "leak" abroad via the increased imports that the currency ties encourage. Hence, greater stimulation is necessary to inflate the American economy into a job-creating mode than previously was the case. Such efforts, in addition to producing what are arguably asset bubbles in the U.S., are having a bubble-inducing effect in China and other parts of Asia as well.
The problem with these economic booms and their accompanying bubbles is that they are fun while they last, but usually end badly. Businesses such as steel, which suffer from chronically low returns on investment, are suddenly making gobs of money. New capacity suddenly seems feasible. China, for example, is planning lots of new steel-making infrastructure to meet its seemingly infinite need for materials for buildings, highways and so on (capacity additions are not confined to ferrous metals — a Chinese group recently announced plans to spend nearly $1 billion on alumina capacity, the raw material for aluminum). As previously mentioned, market investors, too, have been doing well, and not just overseas. The stocks of American companies in producing industries such as steel and non-ferrous metals are some of the more obvious beneficiaries of Chinese demand. One could even argue that the entire U.S. stock market has been pumped-up because of the Asian factor; the recycling of dollars has kept U.S. interest rates unusually low, putting upward pressure on equity valuations.
In our view, the developments in China, and the excitement they have produced in the financial and commodity markets, pose a significant risk for investors because there is much in the international economic picture that is simply not sustainable. In low return and high capital businesses such as metals, more capacity usually leads to a price implosion. China's fixed currency rate versus the dollar (as well as Japan's managed floating rate) will become more difficult to maintain as trade imbalances continue to grow. U.S. trade (and budget) deficits cannot continue on their current paths indefinitely. Growing U.S. debt levels represent a systemic risk. Increasing demand for energy and commodities has already impacted input costs for a wide range of industries. Finally, none of these factors seems compatible, long-term, with the high stock and bond valuations and low interest rates that we are now experiencing. There is much room for mischief.
As investors, it is not our business to "know when enough is enough . ... When to start selling before everyone else does." Our obligation is to weigh risks and potential rewards and preserve capital. The imperative to "invest with an eye to calamity" seems more appropriate now than at any time in the recent past. When the market is not discriminating among risks, it is usually a good idea for the investor to wait until it does.
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 23 years and has been published in Barron's. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at www.businessforum.com/cscc.html. To correspond with him directly and /or to obtain a reprint of his featured articles, "Gold Coffin?" in Barron's (March 23, 1998, Volume LXXVIII, No. 12, page 62) or "What Speculation?" in Barron's (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
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