Dr Faber's views on 2004 -- Economic Commentary by Marc Faber

Dr Marc Faber's book 'Tomorrow's Gold' published just over a year ago was spectacularly correct in its predictions for 2003. This article updates his thoughts after another year in the financial markets.

I remain convinced that the present 'strong' recovery phase in the US economy won't last for long, as it is totally artificial.

There are simply too many imbalances in the system, as reflected by a record low national saving rate, record household debts, and record trade and current account deficits, for this recovery to lead to sustainable strong growth that would justify the present stock valuations.

I have quoted Joseph Schumpeter in previous reports, but for the benefit of some of our new readers, I quote him here once again regarding the subject of economic recoveries, that are purely a consequence of fiscal and monetary stimulus.

Schumpeter writes: 'Our analysis leads us to believe that recovery is sound only if it does come from itself. For any revival which is merely due to artificial stimulus leaves part of the work of depression undone and adds, to an undigested remnant of maladjustments, new maladjustments of its own' (emphasis added).

A few years ago, I met Peter Bernstein, the author of several best-selling books as well as the excellent economic newsletter entitled (Economics and Portfolio Strategy www.peterlbernsteininc.com).

Peter is a deep thinker, an intellectual, and a realist, but is certainly not a gloom-and-doomster. In fact, I shall always remember that, in the course of a discussion that took place in the late 1990s, he noted that I was 'very negative' about the economic outlook.

I am mentioning this because his latest newsletter also sounded 'very negative' for someone who has a relatively balanced and moderate view of the world - certainly compared to myself. Peter analyzed in his recent reports the interrelationship of the twin deficits in detail.

According to him, the attitude among US citizens regarding these deficits is 'a combination of hope, indifference, or even puzzlement'. In his view, 'though there may be moments of passing improvement in the data, the evidence and analysis we offer here demonstrates with overwhelming power that neither of these problems is going to disappear any time soon. There is no basis for being light-hearted about these matters: they will continue to haunt our economic vistas indefinitely, casting a shadow over everything the future holds' (emphasis added).

Bernstein correctly points out the complexity of the issues involved: 'Private sector saving, private sector investment, household consumption, government spending, government revenues, capital flows, and trade balance all react upon one another - often in surprising fashion.

We live in a complex system: each piece tends to function as both symptom and cause.' And while I cannot discuss here Bernstein's entire analysis of economic data, which he himself admits is 'confusing', I just want to point out that he is 'certain' that 'current trends are not sustainable'.

'The imbalances are now enormous, far more glaring than at any point in the past. Furthermore, the linkage of the parts are so tightly knit into the whole that reducing any one imbalance to zero, or even compressing them all to a more manageable level, appears to be impossible without a major upheaval. A hitch here or a tuck there has little chance of success. When it hits, and whichever sector takes the first blows, the restoration of balance will be a compelling force roaring through the entire economy globally in all likelihood. The breeze will not be gentle. Hurricane may be the more appropriate metaphor.' (Emphasis added.)

In particular Peter is concerned about the long-term decline in the US national saving rate as a percentage of GDP. (The national saving rate includes household saving, corporate cash flows, and the government's budget surplus or deficit.) There was an improvement in the national saving rate between 1993 and 2000 due to higher taxes and a swing in the federal budget towards surplus, but thereafter the national saving rate plunged.

Over the same time period, real personal consumption expenditures as a percentage of GDP declined modestly between 1988 and 1998, but soared between 2000 and 2003 to a record. Now, in past recessionary periods (1973/74, 1981/82, and 1990), the tendency has been for real personal consumption expenditures as a percentage of GDP to decline modestly and, in the process, to create 'pent-up' demand, which then leads to sustainable growth during the recovery phase.

But, at present, given the low national saving rate and record real personal consumption expenditures as a percentage of real GDP, there seems little room for consumers to boost their expenditures significantly, unless households increase their indebtedness much more, or households' net worth or income rises substantially.

Noteworthy is that US consumers have increased their spending for an unprecedented 47 quarters in a row (the last downturn was in the fourth quarter of 1991) and more recently, consumer spending rose largely as a result of higher borrowings.

As a result, US household sector debt to net worth is at an all-time high, having expanded very rapidly since 2000, when the economic expansion started to stall. And while it is true that the cost of servicing the debt isn't excessive, this is only due to the sharp decline in interest rates we have had since the early 1980s and especially after 2001.

Still, according to Merrill Lynch's chief North American economist, David Rosenberg, 'the amount of leverage relative to the size of the consumer balance sheets has never been as large as it is today. While the asset side has been given a lift from the rebound in equity prices and the continuous strength in house values, the reality is that the aggregate liabilities in the household sector have risen by almost 12% in the past year, outpacing asset growth by a factor of nearly three. The 14% jump in mortgage balances over the past year has also nearly doubled the pace of real estate appreciation as home equity was gutted during the latest refinancing boom and easy credit standard nurtured a wave of high loan/value ratio loans for new entrants to the housing market. So far in this nascent two-year old 'recovery' households have added more than 15% to their outstanding indebtedness and yet net worth has barely budged.'

Before explaining what this all means, let us also take a look at households' income where the trend is worrisome. Hourly earnings increases have been declining sharply since late 2002 - most likely because of the accelerating trend to manufacture in low-cost countries and outsource services to countries such as India.

In fact, since 2001, real wages and salaries have declined (they declined by 0.2% in the 12 months ended September 2003), and while some recovery in real wages is possible, given the low level of hourly earnings increases, the fading impact of the tax cuts after January 2004, and lower refinancing activity, consumption is unlikely to receive much of a boost from the households' income.

I may add that the decline in real wages and salaries was far worse than official figures would suggest, because the US government has been purposely understating inflation figures by a wide margin.

Moreover, I believe that real wages won't increase, but could actually decline further, as overseas competition for manufacturing and increasingly higher paying service jobs is here to stay and inflation may actually pick up.

So where does all that leave us? Consumption could also be increased, if not through income growth, then through a further decline in the national saving rate (see above) and additional consumer borrowings. But for households' borrowings to keep on expanding at their recent strong pace, asset prices, including housing and equities, must continue to appreciate or interest rates will have to decline much further!

In other words, rising asset prices, which supported additional borrowings, have been largely the driver of the US recovery. (The government also made a small contribution by boosting spending.) This is particularly true of the housing sector, where rising home prices allowed households to increase their mortgage and provided them with additional spending power.

I hope the reader appreciates the precarious nature of this state of affairs. The entire US economy is depending on high 'asset inflation' in order to stay afloat! Only if asset prices continue to rise at high rates can consumers maintain their borrowing binge. But trouble seems to be brewing in the American wonderland. First of all, it would appear that the housing sector is slowing down.

The Merrill Lynch Housing Index has declined sharply since August and the growth rate in real estate loans has slowed to an 11.5% year-over-year growth rate, down from this summer's 18% growth rate. Refinancing activity is down by 70% from its summer peak, and real estate loans at banks have begun to contract. But why worry?

Most recently, the tireless and imaginative American consumer offset slower real estate loan growth with a sharp jump in consumer loans, which, however, carry far higher interest rate!

The question that arises is, of course, how sustainable is an economic recovery that is driven by a declining saving rate and strongly rising additional borrowings, which in turn depend on rising home and equity prices, especially since the combination of these factors has led to a sharp deterioration in the US trade and current account deficit, and hence, as we pointed out in earlier comments, to a weakening dollar?

This highly artificial recovery is, in our opinion, not sustainable for very much longer, although we should all realize that the Fed is fully aware that asset prices must, under no circumstances, be allowed to decline.

In fact, the Fed will try to make them appreciate even further through highly expansionary monetary policies, as stagnating home prices alone would endanger the recovery, while declining prices would be altogether unbearable for the highly leveraged household sector, whose debt to net worth would obviously soar in an environment of declining asset prices.

So, we are in a situation where the imbalances are likely to worsen further until something gives. At some point, the American consumer will be forced to retrench through a rapid loss of the US dollar's purchasing power, which will lead rising inflation rates and inevitably also to higher interest rates.

Accelerating inflation will most likely also bring about falling real household income, as wage increases would unlikely match the rate of inflation, due to the overseas competition for jobs we referred to above. Therefore, a voluntary or involuntary consumer retrenchment could badly derail the Fed's inflationary monetary policies.

I am not sure exactly how the present imbalances will play themselves out, but I am certain that Peter Bernstein will be proved right when he writes (see above) that the breeze that will accompany the restoration of balance won't be 'gentle' but will likely take the form of a financial and economic hurricane.

In fact, trouble may have already started. All measures of money supply have turned negative, and MZM has declined at an annual rate of 7% in the 13 weeks ended November 10 while M3 is growing at its slowest pace since 1993.

The bulls will, of course, point out that there is nothing to worry about in regards to the decline in money supply, which, they argue, has to do with an increased preference for equities over cash by investors. But the steep deceleration in money supply growth is more likely to be due to the collapse in home refinancing activity and was, incidentally, accompanied by first a deceleration in the growth rate and more recently by a decline in total bank credit.

The recent decline in money supply and bank credit doesn't bode well for either the economy or the stock market. In fact, if we look at the recent performance of consumer-sensitive shares such as airlines and retailers, one has to wonder about the wildly optimistic economic forecasts.

Sears and Best Buy have broken their up-trend; Home Depot and Lowe's look like they have topped out; Southwest Airlines and Jetblue have collapsed, and Delta Airlines is no higher than it was at the beginning of the year.

The price of Wal-Mart is weakening despite all the brouhaha about the strength of the economy and is now barely higher than a year ago. Even the recently super-strong Philadelphia Semiconductor Index (SOX), whose components are very economic-sensitive, is no longer leading the market and is breaking down. In addition, most recently, housing stocks also took a beating, possibly confirming the weakness in the Merrill Lynch Housing Index.

In sum, the stock market seems either to have had second thoughts about the sustainability of the present economic recovery, or it may already have fully discounted the recovery. In fact, in the past a high level of ISM orders, such as we had recently, has always been a reliable sell stock indicator! In short, US equities offer limited up-side potential but entail, in my opinion, high risk and should best be avoided.

You can listen to a recent interview with Dr. Faber here --

Jim Puplava Interviews Dr. Marc Faber

Other interesting and related articles --

The Outlook for the Housing Market -- Economic Commentary by John Mauldin

Don’t believe the hype

The Joyless Recovery

Remarks by Chairman Alan Greenspan -- Jan 3, 2004

Richard W.

Rank	Location	Receipts	Donors/Avg	Freepers/Avg	Monthlies
49	Vermont	10.00	1	10.00	29	0.34	49.00	5

"There are simply too many imbalances in the system, as reflected by a record low national saving rate..."

The "national savings rate" figures come from the U.S. government, which still uses their 1930 era formula of *EXCLUDING* all stock market investments, including retirement accounts like IRA's and 401k's from their figures.

Using a more modern "savings rate" formula that includes such retirement accounts, most Americans have far more wealth saved today than at any other time. Doubly so if home equity is included (the government stats ignore that wealth, too).

In fact, any time that the stock market goes up, that means that Americans have invested *MORE* of their money/savings into it. So when the Market goes up, so too does the "national savings rate" go up.

It's just that U.S. Government statistics won't reflect that increase in savings.

"There are simply too many imbalances in the system, as reflected by a record low national saving rate, record household debts, and record trade and current account deficits..."

That's redundant. If you have a record trade imbalance then you will likewise have a record current account deficit. Moreover, our trade imbalance is artificial.

Our trade imbalance is due to foreign governments artificially altering the Market by purchasing vast amounts of circulating U.S. Dollars. This has the effect of driving UP the Dollar while driving DOWN their currencies (e.g. Chinese Yuan, Indian Rupee, Euro, Yen, Taiwanese Dollar, Thai Baht, etc.).

As the Dollar declines in foreign exchange value, this artificial imbalance will self-correct itself. As this currency imbalance corrects itself, our trade imbalance and current account deficit will self-correct in harmony.

"I remain convinced that the present 'strong' recovery phase in the US economy won't last for long, as it is totally artificial."

Not true. Not even close. Our fundamentals are strong, in fact.

Unemployment is historically low. Average Wages are now at an all-time national high. Interest rates are low. Inflation is dead. Credit is easy. The speed of money is increasing. Productivity is at or near its all time high, too. Our infrastructure (both physical and data) is in great overall shape (speaking commercially) and we don't have a labor shortage. Our federal income taxes are down to some of their lowest historical levels, too.

In other words, our economy has *never* before been better positioned.

Drop the value of the Dollar against most foreign currencies by another 20%, drop the price of oil down below $25 per barrel, and you've got yourself positioned for the largest economic boom in world history.

"Americans have far more wealth saved today than at any other time. Doubly so if home equity is included (the government stats ignore that wealth, too).

Well with all due respect, that is not quite so. The saving is what occurs first. If you had savings and no stock market or personal use real estate at all, you will still have a savings increase. The stock market and the personal use real estate are the other side of the entry--the savings were employed by purchases of common stock and homes. No saving and no more savings because the stock market or real estate market goes up; until the stock or the house is sold and the profit is saved. And more important, no increase in the capital stock of productive assets achieved when savings are employed to buy public common shares or personal use real estate.

Impact of the 401(a) retirement plan and 401(k) on savings is more complicated. I agree that marginal income deposited into a tax shelter savings vehicle is savings but I believe the government numbers also assume that--the investment side is not included but it does not count because it is not marginal savings; as to the employer contribution that is not counted because only current account marginal amounts are actually savings--amounts the employer puts in by contributing stock or by buying its own stock do not add to the national savings pool.

Bottom line on savings is that in a capital formation driven economy, you can't create additions to the national income stream without significantly greater savings invested in productive assets (not public common stocks) than we presently have--just that simple. However you calculate savings, we don't have enough or anywhere near enough to capitalize our productive plant. Reason why is simple--not much after tax return incentive to save money.

Bottom line on the good Dr. Faber: Not much here of any real surprise--current trends are unsustainable. And when the first bubble cracks, the drop will be swift and of significant economic consequences.

I am the simple one note Johnny--how do we protect ourselves? Dr. Faber's perscription of gold last year was correct. But does gold continue up in a deflationary liquidity challanged environment? If the ultimate casulty of the deflationary collapse is the dollar, people aren't going to take them any more for groceries or rent--so owners of T-Bills are not secure even if the government continues to print enough money to pay them (in the 1930's the government was solvent and so could continue to service its debt from tax revenues; in a 2004 deflation, tax revenues will continue their decline, and the government may not pay its bills with anything that is worth having).

On the other hand, in a traditional deflation, people sell everything to get liqudity to pay bills; including their gold stocks and gold. And legal tender liquidity is valuable indeed.

So which is it?

"more important, no increase in the capital stock of productive assets achieved when savings are employed to buy public common shares or personal use real estate."

Nonsense. You've got it precisely backwards.

In the real world, when you buy stocks you are supporting a company's ability to borrow money based upon their asset valuation as well as propping up their ability to purchase other companies outright with stock.

In contrast, putting your money into a bank's savings account forces the bank to pay you interest, a cost to the bank, and forces the bank to find some way to loan out your money (consumer, real estate, corporate) in order to recoup those interest expenses.

Even worse, if you just "save" you money under your mattress then absolutely no value is re-injected back into the Market. A "high" amount of that sort of "saving" would wreck an economy.

"Bottom line on the good Dr. Faber: Not much here of any real surprise--current trends are unsustainable. And when the first bubble cracks, the drop will be swift and of significant economic consequences."

Have you not paid even the slightest bit of attention to FUNDAMENTALS?!

In other words, our economy has *never* before been better positioned.

the investment side is not included but it does not count because it is not marginal savings

You will have to excuse my ingorance on this point, but I have never understood why "investing" in intruments of financial speculation would ever be considered as savings. If I put money into the latest hot stock pic on a gamble that I will turn a profit on it, is that savings or is it just a transfer from my saving account at the bank into an ether land and not counted until it is returned to the saving account at the bank? If I speculate in lotto tickets, is that savings? I don't think so and I would say that many shareholders at Enron and WorldCom would agree.

Richard W.

Part of the reason we have record levels of household debt is that every g%d d%%n thing you can buy today is JUNK!!

It seems I have to replace every appliance in my home every 4 or 5 years, and I'm not hard on my stuff. I work on my own cars to save money, and buy the best parts I can get, yet those end up needing to be replaced (even the lifetime warranty ones - had a brand new "lifetime" alternator go out after two months).

When you have to spend every dime you make just to stay even with what you own, plus some, no wonder there's a record level of household debt. Add in corporate marketers using every possible angle of psychology (and sometimes nearly coercion) to get us to buy that junk, and I do believe we are at record levels of debt.

Don't come back and hammer my knowledge of economics, either. I can argue free market theory with the best of them, and I'm definitely no leftist (check out my screen name).

If a record number of Americans owned their own businesses, it would be different. A home with a mortgage is not much different than a rental. If RE values inflate, owning has a plus. If RE values deflate, owning has a minus. Net neutral.

Home ownership does encourage a home-owner's investment in better repairs, better improvements than a rental unit. And more furnishings, as homes tend to have more rooms than rentals. But that investment does not produce income, unlike investment in a business.

And there are sociological questions that resolve economically about the "virtues" of widespread home ownership, especially when that ownership nearly always involves a massive debt burden. It's finances and reactions to times of financial distress that break many marriages. And we have a marriage problem today. Too many break. Is part of that due to too much over-burdened "ownership" of homes, rather than the more flexible and financially responsible renting? I think so, but that's my opinion. In general late stage fiat money corrupts everything it touches, and the great fountain of fiat wealth is home "equity" today.

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