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More Important Questions for Economic Survival in the 21st Century

(May 25, 2006)

Dear Subscribers and Readers,

I hope all our subscribers are doing well – and I hope all our American-based subscribers are going to enjoy a great Memorial Day weekend!  Since this weekend will be a long weekend, our upcoming commentary may be slightly more delayed than usual.  At some point, even this author needs a vacation!

For readers who have been with us for awhile, you may recall that we discussed three overarching themes for “economic survival in the 21st century” in a “special report” slightly less than two years ago.  Those three overarching themes were:

1) The combination of an aging population, globalization and the rise of China and India– an inevitable trend that will continue to snowball and affect more aspects of our lives.  This is an old saw – but given our consumer culture, labor flexibility and geographic mobility, and Americans' continuing quest for innovation, I believe most Americans will ultimately benefit by working together with both the Chinese and Indians to develop more efficient production lines and better products.  While future productivity increases and better medical technologies may well cushion a significant part of the impact of an aging population, there is no doubt there will be a change of lifestyle for future retirees down the road – mostly due to the significant under-funding (current and future) of our social security and Medicare systems, as well as significant under-funding of both pension and healthcare liabilities in U.S. corporations.  Going forward, many Americans will need to defer retirement or simply work on a part-time basis once they have “officially retired” – but I don't believe this will be the “end of the world,” so to speak.  Recent comments by Bill Gross suggesting that GM may simply be a microcosm of the U.S. economy is definitely overblown – and is only valid when one compares GM and Ford's pension and healthcare obligations to social security and welfare.  The following chart courtesy of Goldman Sachs shows that GM and Ford alone make up 28% of the total gross obligations and under-funded liabilities in retiree healthcare – suggesting that the under-funding problem is mostly concentrated in the auto sector as well as other unionized industries (such as airlines, steel, etc.):

Retiree healthcare bigger issue than pensions - Underfunding highly concentrated in unionized companies

Moreover – and this may be regarded as more of a cop-out – many Western European countries and Japan are in a more dire situation than we are, as the population in those countries are aging significantly faster than the American population.  At the same time, many of these countries have made much more social promises than we have. If one was a young, talented, and smart Western European, where would you work going forward?  If you are anywhere close to being an entrepreneur, there is still no doubt you will opt for America.  Despite recent grumblings, America is still a haven for immigrants – and given our huge consumer market and the ease of access to capital, this country will continue to attract the young, talented, and smart individuals.  This is what will continue to give us “our edge” going forward.

2) The end of the era of cheap energy – which I discussed when oil was still “only” at $40 a barrel and when natural gas was at $5/MMBtu.  In that “special report,” I wrote: There are currently three factors at work which should contribute to a continued increase in the world oil price - the maturing of supply, growing demand, and the lack of a cushion in refining capacity and low inventories.  The "culprit" has usually been labeled as China, but it is interesting to note that the United States has had virtually no domestic energy policy (in terms of conservation and encouraging the development of alternative fuels) for the last twenty-something years.  China demand, however, has soared over the last few years.  It is now the second biggest oil consumer, having just surpassed Japan for the title.  Demand for oil in China has more than doubled over the last 10 years (to today's 6 million barrels per day), and this amazing increase is projected to continue, especially given the fact that oil demand in China is still a lowly 2 barrels per person per year (compared to 25 barrels per person here in the United States).  Furthermore, it is interesting to note that the number of cars in China only totaled 700,000 as late as 1993 and 1.8 million as late as 2001.  Today, the number of cars in China totaled more than 7 million - and this number could potentially have been much higher if not for the Chinese government intervention in limiting the number of cars that could be sold and driven each year.  Now the most scary part: Current oil demand in India is only 0.7 barrels per person per year - given this fact, oil demand in India could potentially explode over the next decade - barring a huge worldwide economic recession or depression.

Furthermore: I believe my readers should be made aware of the current energy supply/demand situation.  Given the above, what is the best course of action for the average American?  How about the best course of action if you were the head of a motor company like GM or an airline pilot employed by a legacy airline like Delta?  How about the best course of action for a mutual fund manager or a commodity fund manager?  Since there are no easy solutions, there should be no easy answers either.  In the short-run (three to five years), Americans will have to pay up if we want to drive gas-guzzling SUVs, and legacy airlines like Delta will have to continue to cut costs by probably further slashing labor costs as their first priority.  A further improvement in extraction technology should help, but the serious development of alternative fuels will have to start now.  I also believe that the next serious decline will be induced by a combination of an "oil shock" and a rise in interest rates.  Readers may recall the relative strength chart that I developed in my August 15th commentary showing the AMEX Oil Index vs. the S&P 500 and the huge potential inverse heads and shoulders pattern in that chart.  For now, the relative strength line should bounce around the neckline (the line drawn on that chart) - possibly even for a few years - but once the relative strength line convincingly breaks above the neckline, crude oil prices could rise to $80 or even $100 a barrel.  I sure hope that my readers would not be taken by surprise if gas prices at the pump soars to $4.00 a gallon five to six years from now.

In retrospect, the subsequent spike to $70 oil in August of 2005 surprised even this author – as I had not been looking for such a spike in so quick a timeframe.  However, it now looks like that the combination of a $70 oil price and higher interest rates is starting to do its job – given the recent weakness in the stock market and further signs that the U.S. economy is slowing down – which should subsequently help prices moderate over the next 12 to 18 months (possibly to even $50 a barrel or lower).  Over the long-term, however, there is no easy solution – and it is difficult to envision oil prices staying down as long as Americans don't modify their consumption habits.  In subsequent comments and postings on our discussion forum, I had stated that oil prices will not start coming down until we see a major bankruptcy (or two) in the airline industry and a significant drop in airline capacity.  While this is exactly what has transpired over the last nine months (with the bankruptcies of Delta, Northwest, and most recently, with the major airliners raising ticket prices) – there are many signs that consumers are still continuing to pay up for higher ticket prices and as load factors on airlines have continued to increase.  This is also being confirmed by the huge relative strength in the Dow Transports.  The $64 billion question is: No doubt that Delta or Northwest was the marginal consumer of crude oil in 2004 and 2005, but who is the marginal consumer of crude oil now?  The easy answer would be to say “the American consumer,” but which sub-group of the American consumer are we discussing?  This author would like to bet on the consumer that drives full-sized SUVs and pickup trucks – as there continues to be signs that SUV and pickup trucks sales are slowing down – even here in Texas (which is definitely telling you something since 1) Texans have always loved their trucks, and 2) the local economy is still booming, unlike Michigan, for example).  And since GM has recently bet their entire turnaround plans on their 2007 SUV lineup, my guess is that the next casualty of high oil prices is GM.  High oil prices have always come with a price – and the 2003 to 2006 spike in oil prices won't be any different.

3) The necessity of knowing one's own psychological make-up in navigating this secular bear market (and yes, I still believe we are in the midst of a secular bear market).  In our “special report,” I stated that: Investing or trading has always been dominated by emotions and always will be.  My thinking in starting has always been that that if I can get my readers to buy in now, it will be a much easier decision for them to sell and hold cash once the DJIA reaches 11,000 or 12,000 or so - as opposed to being in cash and staying out for the rest of this secular bear market.  99% of Americans are just not disciplined or dedicated enough to stay in cash during a secular bear market - not to mention staying in cash during the entirety of a secular bear market and buying and holding common stocks during the entirety of a subsequent secular bull market. The average human psyche is just not capable of doing this.  Because of this, I sincerely believe that success in the stock market (for most people) during the next five to ten years would involve catching the swings at the right or near-right times.

While many folks still don't have the patience for a “buy-and-hold” strategy in the three to four-year timeframe, this author believes that it is practically doable – as opposed to staying out of stocks for up to years at the time.  Sure, folks can always dabble in commodities or foreign currencies in the meantime, but over the very long-run, buying good managed companies with sustainable business models is still your best bet for long-term outsized investment returns.  Over the next five to ten years, this author believes that one will need to be a nimble investor to successfully navigate the U.S. stock market – and it is very difficult to do so if you don't even know what your own psychological make-up is when it comes to investing or trading.

At this point, this author would like to ask a couple of more questions that are central to “economic survival” in the 21st century – well, at least over the next few years anyway.  As both individual investors and market participants in the U.S. and global economy, one has to be very worried about the opaqueness of the hedge funds and the financial leverage in many of those funds today.  Derivative turnover continues to exponentially increase – as evident by surging volumes on many of the domestic and world derivative exchanges and as exemplified by the many deals that are being done by private equity firms.  Financial leverage isn't just restricted to finance professionals, as American households are also as leveraged as they have ever been since records have been kept.  As the following chart shows, the asset-to-liability ratio of American households has steadily declined from over 14 to merely 5.4 in the fourth quarter of 2005:

Households' Asset to Liability Ratio vs. Total Absolute Net Worth ($ Billions) (1Q 1952 to 4Q 2005) - 1) Even on a percentage basis, the decline in wealth during the 1973 to 1974 bear market was merely a blip on the radar screen... 2) In a highly-leveraged economy (a low asset-to-liability ratio), the last thing that the Fed wants is a declining level of net worth (assets minus liabilities). That is why Ben Bernanke was so fearful of a deflationary depression during the 2000 to 2002 period. 3) The greatest decline in households' net worth in post WWII history! 4) Over the span of slightly over 50 years, the asset to liability ratio of U.S. households has declined from a ratio of over 14 to merely 5.4 today...

We cannot be worried about what we cannot see (we can only make guesses) in the hedge fund industry – but the leverage in the private equity world is obvious – as these investment vehicles have taken advantage of low interest rates in the U.S., Europe, and in Japan over the last few years to leverage up their balance sheets and to use them to take public companies private – most recently at historically high valuations.  Make no mistake: The LBO and private equity binge has definitely given the U.S. stock market a significant amount of support over the last few years – as the number of shares that are available to trade has consistently declined during that time.  This is due to share repurchases, cash mergers, but more importantly, private equity buyouts, as shown by the following chart from Goldman Sachs:

Quarterly change in US shares - Billions of dollars, at annual rate

As shown on the above chart, both share repurchases and cash mergers only accounted for a minority part of the negative gross change in shares over the last few years.  The majority of the negative gross change in shares has been due mostly to the LBO and private equity binge, but now that the era of cheap money is effectively over (or as will be after the Bank of Japan starts to raise interest rates as well) a huge pillar of support for U.S. equity prices will start to disappear.

And finally, in our April 23, 2006 commentary (The Message of the Fed Cleveland Median CPI), we stated that there were signs of rising consumer inflation, and that the Fed may continue to raise rates that are above current expectations.  This danger still remains with us, given the relatively tight labor markets, the fact that corporate profits as a percentage of GDP is at 40-year highs, and signs of rising wages in both China and India.  As shown on the following chart (again from Goldman Sachs), unit labor costs are not only rising in the service sector, but in the domestic manufacturing sector as well:

Unit labor costs may begin to rise from low levels

From a secular standpoint, both China and India will continue to be a deflationary force on the world – given the immense potential productivity increases as their labor forces shift from the agricultural to either the industrial or the information sector.  But keep in mind that the transition will not be smooth.  In the meantime, there are signs of cyclical inflation, and moreover, there will need to be a continued investment in education in both China and India for this transition to smoothly occur.  At this point, we continue to remain optimistic in both these countries – as there are many signs that both China and India are continuing to pour money into their education sectors.

Signing off,

Henry K. To, CFA

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