Accentuating the similarities, ignoring the differences

According to David Dreman, portfolio manager of Kemper-Dreman High Return Equity Fund and Kemper-Dreman Financial Services Fund and author of Contrarian Investment Strategies: The Next Generation, there is a natural human tendency to draw analogies and see identical situations where none exist. Example: Comparing the 1987 share market crash with the 1929 share market crash (because the performance of the stock market during the August-October period of 1987 was very similar to that of August-October 1929 many people jumped to the conclusion, in October 1987, that another economic depression was about to occur). Another example (one that is dear to our heart): Concluding that the good performance of gold during the deflation of the early-1930s means that gold will prove to be a good investment should we now experience a period of deflation (this conclusion ignores the critical fact that gold was a hedge against deflation during the 1930s by virtue of the fact that it was officially linked to the Dollar, whereas it is now a hedge against inflation).

This natural tendency of people to focus on the similarities, whilst ignoring the differences, can lead to forecasting errors and prevent investors from recognising opportunities. A current example is the assumption that because interest rate reductions were of little help during the early-1930s in the US and the early-1990s in Japan, they will have minimal impact on today's US economy. However, the critical difference being ignored by those who make this argument is that money-supply growth plunged during the post-bubble environments of 1930s' US and 1990s' Japan, whereas money-supply growth has accelerated higher during the recent US experience. In fact, it makes no sense to say that lower interest rates will not have a substantial effect since they have already had a substantial effect. To borrow an analogy from Sean Corrigan, it seems that the Fed is not so much 'pushing on a string' as reeling a kite out into a gale.

The ability of falling interest rates to stimulate a surge in the money-supply growth rate over the past several months is, of course, symptomatic of the fact that the US bubble is yet to burst. Even in the stock market, one particular bubble has certainly burst (the speculative mania in technology and internet stocks) while other sectors continue to bubble away. The major structure that has supported various asset price bubbles in the US over the past few years - the credit bubble - is also very much in tact. Until the US credit bubble bursts, an event that will be signaled by a substantial decline in the year-over-year M3 growth rate, it makes no sense to draw comparisons between the situation in the US today and the situation following either the bursting of the Japanese bubble in 1990 or the US bubble in 1929.

Bond Market Update

We were bullish on bonds for much of last year and then turned medium-term bearish in early-January 2001. Our thinking was, and still is, that aggressive easing by the Fed and an explosion in the supply of money would prompt bond-buyers (lenders) to demand compensation for the on-going inflation. If you think that money will be worth less in the future than it is today, you will demand a higher interest rate on any long-term loans you make to compensate you for the likelihood that the loan will be repaid in depreciated currency. We would not be surprised to see a bond rally soon, but see no reason to change our forecast that bond yields are headed much higher over the coming 12 months. On the contrary, the fact that the US Fed is proclaiming that inflation is contained is a reason to be even more bearish on bonds beyond the short-term. There is no reason for us to stop believing in an inflationary future until the Fed starts believing in an inflationary future. The first step in solving a problem is to admit that you have a problem, so the Fed and most financial pundits are yet to take that first step.

But what about the US Government budget surplus? Won't the projected surplus lead to a reduction in the supply of T-Bonds (since part of the surplus will be used to re-purchase debt) and, therefore, higher bond prices (lower long-term interest rates)? The problem with that argument is two-fold. Firstly, the projected surplus will almost certainly not materialise because it is based on invalid assumptions regarding future economic growth and capital gains tax revenue. Secondly, the only means by which tax revenue can be elevated sufficiently to produce the projected surpluses is through inflation. In other words, depreciation of the currency is necessary in order for the surpluses to eventuate. In this situation, will bond buyers really be happy to accept a rate of interest that does not adequately compensate them for the depreciation of the Dollar just because there might be less government bonds on the market? We think not.

The Dow/Gold Ratio

Below is a long-term chart of the Dow/Gold ratio. The source of the chart is Fred's Intelligent Bear Site (http://freeweb.pdq.net/filskov/)

There are a couple of things worth noting with regard to this chart. Firstly, the ratio moves in a well-defined channel (although it did overshoot on the downside in 1980). Secondly, each of the prior two occasions on which the channel top was reached was followed by a decline to the channel bottom. If the same thing happens this time, the Dow/Gold ratio will drop to about 5:1 over the next several years.

The chart doesn't tell us anything about the next 12 months, but does strongly suggest that July-1999 represented a long-term high in the Dow/Gold ratio (July of 1999 most likely gave us the secular peak for the Dow in terms of hard money, although it went on to achieve higher levels in terms of US Dollars). This means that the major trend has most likely reversed lower and that gold bulls, having spent 20 years on the wrong side of a major trend, are now on the right side.

Steve Saville
Hong Kong

21 May 2001

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