If you want to send a roomful of 100 wealth managers into an icy chill, have Russell Napier address them. This is exactly what happened at Citywire’s Smart Beta retreat at the Four Seasons Hotel in Hampshire recently.
Napier’s presentation, “Deflation in an Age of Fiat Currency,” is thought-provoking, and the precise polar opposite of investing as usual. A wry and picaresque speaker, he starts with some conclusions. Among them:
- To reach record lows [akin to those on offer in 1921, 1932, 1949 and 1982], US equities will have to fall by more than 60%.
- Central banks are straining to produce inflation, and developments in emerging markets (i.e. China) suggest a deflation shock is now likely.
- The capital exodus from China is disrupting the creation of inflation.
- In the search for yield, cash is trash ‚ so now is the time to own cash. (This is an example of his dry contrarianism.)
- US Treasuries could repeat their 83% price decline of 1946-1981.
US stock markets aren’t cheap, not by a long chalk. Napier, like us, favors the 10-year cyclically adjusted price / earnings ratio, or CAPE, as the best metric to assess the affordability of the market. Unlike the traditional P/E ratio, CAPE smooths the near-term volatility by taking a 10-year average.
At around 21, the US market’s CAPE is near the top end of its historic range. The S&P 500 stock index currently trades at a level of around 1400. Napier believes it will reach its bear market nadir at around 450, driven by a loss of faith in US Treasury bonds, and in the dollar, by foreigners.
The growth of the Treasury bond market coincided with Baby-Boomers, Medicare and Social Security. Its death will be triggered by falling demand for Treasuries from emerging economies.
And it seems this rollover in the US Treasury market is already under way. Foreign central bank purchases of US treasuries have been in decline since 2009:
As Napier points out, this coincides with a disturbing decline in the growth rate of China’s foreign reserves.
In our view, investors’ fortunes will depend on how they survive the bear markets to come. I use the term ‘bear markets’ in the plural because it strikes us as almost a certainty that a grotesque bear market in western government debt is approaching. (If we knew the precise timing we’d already be on the beach.)
And if western government debt craters (pick your poison: US, UK, euro zone, Japan…they all look appalling), stock markets will not be far behind. It is inconceivable to us that equity markets could simply ignore a savage sell-off in the <cough, cough> risk-free markets of the world.
Remember, though, bear markets are not necessarily to be feared. Provided one can survive them, they bring opportunities to create significant wealth. But this is not automatically a rapid process.
As Marc Faber writes in his introduction to Napier’s excellent book, Anatomy of the Bear: Lessons from Wall Street’s Four Great Bottoms:
“Conventional wisdom has it that great market bottoms, which offer lifetime buying opportunities, occur quite soon after devastating market crashes. But . . . great bear markets have long life-spans. . . At its 1921 low, the Dow Jones Industrial Average was no higher than it had been in 1899, 22 years earlier…”
Sobering stuff indeed.