GloomBoomDoom Feb 07

THE GLOOM, BOOM & DOOM REPORTISSN 1017-1371 A PUBLICATION OF MARC FABER LIMITED FEBRUARY 5, 2007

Perpetual Debt Super-cycle, or Apocalypse Now?

Figure 1 S&P 500, 1994–2006 with Bollinger Bands

Source: www.hussmanfunds.com

INTRODUCTION

My attention was caught recently bysome comments made by JohnHussman, along with the figure below(www.hussmanfunds.com), whichdisplays a monthly chart of the S&PIndex going back to 1994 with a setof “Bollinger bands” that form anenvelope around the 20-monthmoving average. In his December 18,2006 weekly market comment,Hussman noted that “over the last 10weeks or so, the market has reflectedovervalued, overbought, andoverbullish conditions (acombination that has historicallybeen associated with market returnsbelow Treasury bill yields, on average— though not in every instance)”.Commenting on Figure 1, he admitsthat Bollinger bands don’t providevery useful buy or sell signals.However, he thinks that there is an“important regularity that shouldn’tbe missed”.

Once the market has enjoyed amature advance (not just an initialrally from a low, but an extendedadvance that has continued forsome time, even if it turns out tohave further to go), a move to theupper Bollinger band is almostinvariably followed at a later dateby a consolidation or a decline toa lower level… Stated simply, it’snever a good idea to buy the upperband in a mature market advance(which is where we are now). Themarket seldom “runs away” forlong, and you generally have abetter entry opportunity later.That tendency is behind therelative poor short-term marketreturns that emerge, on average,from the combination ofovervalued, overbought, and

overbullish market conditions[emphasis added].

As can be seen from Figure 1,each time the stock market advancematured, which began in 1994, the20-month moving average wastouched. This occurred in 1998 andagain in 1999 before the market’s topin March 2000. Also, since 2005, themoving average was touched threetimes (in April and October 2005,and in June 2006). Now, considerthree points. The current bull marketis one of the longest on record andthe second longest on record withouta 10% correction. As Steve Leuthold(www.leutholdgroup.com) shows, the

current bull market, which began inOctober 2002, has already exceededthe post-World War II norm by 12months (see Figure 2). Moreover, thecurrent bull market’s magnitudematches the post-World War IImedian (see Figure 3). So, bothmagnitude and length would supportHussman’s contention that theadvance is rather mature. (Theeconomic recovery that began inNovember 2001 — now more thanfive years old — would also seem tobe rather mature by historicalstandards.) Finally, the S&P 500hasn’t experienced a 2% correctionsince July 13, 2006, when the latestrally got under way. According to Jim

2 The Gloom, Boom & Doom Report February 2007

Bianco, this is the second-longestrallying period without a 2%correction since 1964; only in 1995did we have a longer rally without a2% correction. However, it should benoted that the 1995 rally came from arather depressed level (the S&P 500touched the lower envelope of theBollinger band, whereas the currentadvance since July 13, 2006originated from the 20-monthmoving average and not from thelower envelope of the Bollinger band— see Figure 1).

In a more recent market comment(December 26, 2006), John Hussmanelaborated on the “overbullish”condition of the market. Accordingto him, the quarterly poll of moneymanagers by the Russell InvestmentGroup, which was published inDecember, showed “a fairly stunning86% of advisors bullish for thecoming year”. About 13% of moneymanagers polled expected a flatmarket or a decline of less than 10%,and just 1% expected a decline ofmore than 10%. Hussman wrote:

…in the latest poll of 80 analystsby Business Week, 89% of theanalysts are bullish (18% of whichexpect positive returns but belowthe prevailing T-bill yield), 8%are slightly bearish — expecting adecline of less than 10%, and just

3 of the analysts expect a declineof 10% or greater. Evidently,there’s not a lot of “buyingpower” available from convertingthat tiny pool of remaining bears,but there’s a lot of roomavailable in the bearish columnin order to populate a moretypical divergence of opinion.The last time we saw this muchbullishness was at the start of2001, which preceded an awful2-year period for stocks [emphasisadded].

The prevailing extremely positivesentiment for equities is also evidentfrom the polling of clients at theGlobal Insight Day, held by MorganStanley in Europe in early January.Gerard Minack, the Morgan Stanleyeconomist based in Sydney, notedthat “one of the concerns I have forfinancial markets this year is simplythat the consensus seems so solidlypositioned for a Goldilocks world”.Figure 4 shows the preferred assets for2007; not surprisingly, equities werethe overwhelming favourite. (Notethe low reading for bonds.)

In mid-November 2006, I metwith Robert Prechter (Elliott WaveFinancial Forecast) in New Orleans.He told me that his sentimentreadings were then, from a contrarianpoint of view, more bearish than just

before the crash in 1987. A chartshowing the 60-day moving averageof bears, as reported by the DailySentiment Index Survey, revealedjust 12% bears; whereas readings forthis gauge, going back to before the1987 crash, showed that such a lowreading was unprecedented. Figuresnear 20% bears were the mostextreme ever recorded. Therefore, hisview was that, from a contrarianinterpretation, a very seriouscorrection or crash should beexpected.

Well, since then, the stockmarket has continued to rally andmay continue to do so for a whilelonger. But, combining the matureadvance of the bull market both interms of duration and magnitude (seeFigures 2 and 3), the presentoverbought condition of the market(indicated by the S&P touching theupper envelope of the Bollingerband), investors’ extremely bullishsentiment, and the recent heavyinsider selling, it would seem to methat a more favourable entry pointthan we have currently will shortlypresent itself. Since the upperenvelope of the Bollinger band nowstands at 1435, and the movingaverage (the middle line, which isperiodically touched) at 1327 (whilethe lower band is at just 1207), amore meaningful correction of at

Figure 2 Already an Extended Bull Market: Duration

Source: Steve Leuthold, www.leutholdgroup.com

Figure 3 Already an Extended Bull Market: Magnitude

Source: Steve Leuthold, www.leutholdgroup.com

February 2007 The Gloom, Boom & Doom Report 3

least 5–10% could get under way atany time. The bigger issue in mymind, however, is whether thecoming correction should be boughtaggressively (which is what investorsshould have done last June/July) orwhether it will be the harbinger ofworse to come.

THE BULLISH CASE

In my opinion, the most compellingcase for asset markets to continue todo well (corrections aside) is laid outby the Bank Credit Analyst (BCA) inits special year-end issue entitled“OUTLOOK 2007 — Another Yearof Riding the Liquidity Wave”(www.BCAresearch.com). In thisissue, the editors of the BCA focus on“global excess liquidity” and the“debt supercycle”, arguing that thereis “no sign that we have reached thelimits of domestic indebtedness in theU.S., or by extension, othereconomies” (see also below).

The weakest case for the US stockmarket to continue to do well restson the belief that record profitmargins are here to stay, thatvaluations are low, and that the US isa knowledge-based economy. As Ipointed out in last month’s report(see GBD report of January 3, 2007,entitled “Irreparable Cracks in theFinancial System”), the energy andfinancial sectors provided 50% of therecent profit growth and, because oftheir low P/Es, these sectors pulleddown the S&P 500 Index P/E morethan is usually perceived. I may addthat profit margins in the materialsand energy sectors have increasedsince 2002 by far more than the S&P500 Industrial Composite’s profitmargins (see Figure 5). Obviously,these two sectors have little to dowith a knowledge-based economy orthe outsourcing of production andservices. That aside, countries such asFinland, Sweden, Denmark,Germany, France, Switzerland, Japan,Singapore, and so on, are just asmuch knowledge-based economies asis the US (if not more). Moreover, asI have discussed in the past, one ofthe reasons US corporate profits havesoared is that wages as a share ofcorporate revenues have declined

Figure 4 Best Asset Class for 2007

Source: Gerard Minack, Morgan Stanley

Figure 5 Relative Profit Margins: S&P 500 Sectors, 1995–2006

Source: Ed Yardeni, www.yardeni.com

Figure 6 Corporate Profits and Wages, 1990–2007

Source: Bridgewater Associates

US Corp. Profits

Wages as Share of USCorp. Revenues


sharply since 2001 (see Figure 6)along with interest rates — thusreducing the cost of capital.

Concerning the current corporateearnings boom and record profitmargins, I should like to introduce aheretic thought! Security analysiscourses will emphasise the carefulanalysis of corporations andindustries with the view that risingcorporate profits will drivecompanies’ shares higher. But verylittle analysis has gone into theimpact of rising stock and other assetmarkets on corporate profits. In anincreasingly “financial economy”driven by the debt super-cycle, Isuppose that “excess liquidity”leading to rising stock prices is similarto an aphrodisiac and turbo-chargedprofits. In any event, it will beinteresting to see how corporateprofits behave once asset marketsdecline. If recent weakness in thehousing market is any guidance, theS&P 500 record profit margins couldshrink much faster than the bullishcamp expects!

But, as indicated above, there aregrounds for being positive if onebelieves that the “debt super-cycle”will continue to expand. However,there are numerous issues to consider

when discussing the “debt super-cycle”. The first and most obviousone is at what point the limits ofindebtedness are reached. They werecertainly not reached at 200% of USGDP and may still be manageable at330% of GDP. But who knowswhether these limits will be reachedat 350% — or 1000% — of GDP?

One point needs to be clear. Justas copper prices were hitting all-timehighs in April 2006, GaveKalResearch, which then called for adrop in copper prices, made a validpoint: the higher an asset marketmoves, the more money is required tosustain its advance. In other words, ifa debt super-cycle drives assetmarkets and the economy, creditmust expand at an accelerating rate(see also under “The Bearish Case”,below). Barry Bannister, an analystand historian at Stifel Nicolaus, whohas been right on the mark with hisrecent positive call on grain prices([email protected]), publishedin early 2003 a report entitled “ZeroHour 2015: Diminishing Returnsfrom New Debt, and the Inevitabilityof a U.S. Inflation Cycle” in whichhe produced a figure showing thediminishing returns from each $1 ofnew debt in the US economy (see

Figure 7). At the time, Barry notedthat “incremental debt is steadilylosing its ability to generate newGDP, and reaches zero in the year2015”, and that the inevitability ofhigher inflation rates would benefithard asset companies and companiesserving the commodity industriessuch as machinery, engineering firms,and oil servicing companies. I mightadd that just because the trend-linepoints to 2015 as the “zero hour”,that hour could approach muchsooner (see also “The Bearish Case”).

A second issue that is importantto understand is that, whereas thedebt super-cycle is highly conduciveto asset bubbles, there is acontinuous rotation of assets thatare inflating and those that aredeflating. Easy money andcontinuous debt growth didn’tprevent the Florida land boom of the1920s collapsing in 1926. Nor couldthe Fed’s ultra-expansionarymonetary policies, which have led toextremely rapid credit growth overthe last six years, prevent the high-tech debacle. So, even if we give thebenefit of the doubt to the debtsuper-cycle protagonists, who willargue that “there are no signs that wehave reached the limits of domestic

Figure 7 The Diminishing Impact of Debt Growth on the Economy, 1966–2015

Source: Barry B. Bannister, Stifel Nocolaus


indebtedness in the US, or byextension, in other economies”, theselection of the correct asset classwill still be crucial in order tocapitalise on the debt super-cycle (apoint that the Bank Credit Analystalso makes). If a particular marketbecomes glutted, even rapidmonetary expansion and creditgrowth won’t prevent prices in thatmarket from deflating — at least inreal terms. Huge price increases forcommodities in the 1970s led tooverproduction. Therefore, even asthe debt super-cycle gainedmomentum in the 1980s and 1990s,commodity prices trended down after1980 in nominal terms (see Figure 8)and in real terms after 1974 (seeFigure 9). However, it should benoted that had the debt super-cyclenot been in place in the 1980s and1990s, commodity prices in nominalterms would have deflated far morethan they did (see Figure 10). In fact,I suppose that without the

Figure 8 Reuters/CRB Continuous Futures Index, 1956–2006

Source: Ron Griess, www.thechartstore.com

“inflationary” impact of total debtexpanding from 140% of GDP in1980 to 260% in 2000, commoditieswould have declined by about asmuch as they did in real terms —down 80% (see Figure 10). Also, Isuppose that without this colossaldebt expansion, from 1980 the worldwould have been not just in a dis-inflationary environment, but in adeflationary one (declining CPI).The point is simply this: if the debtsuper-cycle continues to accelerate,the conclusion that all asset priceswill increase is far from certain. Evenfar less certain is that all asset classes(stocks, bonds, commodities, realestate, etc.) will increase in realterms. (“Real terms” would have tobe defined, since core CPI figuresdon’t seem to reflect the reality ofpaper money’s loss of purchasingpower.)

The last point that a responsiblecitizen should consider is that thelonger the debt super-cycle remains

in place, the worse the eventualoutcome will be. If we define a debtsuper-cycle as a long period duringwhich credit growth far exceedsnominal GDP growth (see Figure 10)and Barry Bannister’s “zero hour”, itshould be clear that there is a pointat which easy monetary policies anddebt growth becomes totallyineffective (see Figure 7). When thatpoint is reached, all the world’sprinting presses cannot lift realeconomic activity. Hyperinflation,accompanied by economicdepression, social unrest, and war,then follows. It’s not exactly a verydesirable option, but it would seem tome that it is one that marketparticipants are perfectly happy toaccept.

As has been the case for the lastfew years, in a moment of weaknessAlan Abelson, the author of thescathing “Up and Down Wall Street”column in Barron’s, invited me toparticipate in this year’s Barron’s


Figure 9 Reuters/CRB Continuous Futures Index (adjusted for inflation using the Consumer Price Index –all items), 1956–2006

Source: Ron Griess, www.thechartstore.com

Figure 10 Total Debt-to-GDP, 1960–2006

Source: Bridgewater Associates


Roundtable, which took place inearly January. The participants are allvery successful investment managers,analysts, and strategists, and some ofthem are worth over a billion dollars.But do you think that any one of theAmerican participants touched on —even just en passant — the problem ofcredit growing far more rapidly thanGDP, and of the resulting assetbubbles? That issue, and thedeepening problems in the MiddleEast, weren’t even mentioned.

THE BEARISH CASE

The bullish case based on the debtsuper-cycle is easy to explain and easyto understand. The central bankpursues expansionary monetarypolicies, credit grows, and asset pricesincrease. Consumer price inflationstays low because of globalisation andproductivity improvements. AGoldilocks economic scenario is inplace! The Goldilocks scenario is infact so “obvious” that, as I haveshown above, it is widely accepted bythe investment community. Thebullish sentiment among investors(see above), low volatility, tight yieldspreads, and the willingness to usehigh leverage are all symptoms of theacceptance of the mantra that “thegood times for asset markets will rollon” — if not forever, then at least in2007.

The widespread optimism amongindividual and institutional investorsis that much more surprising giventhe fact that the high-tech-loadedNasdaq 100, where most investorswere positioned in 2000, is still downby 61% from its high, and that theS&P measured in Euros is, as of thisJanuary, down by 37% in Euros andby more than 50% against gold. Butto the average American, a dollar is adollar; the concept of dollar weaknessoffsetting the gains on his dollarassets is incomprehensible. The smartpeople in the professional financialcommunity are well aware of thisrelationship, but they don’t caremuch because their performance ismeasured in US dollars or against aUS dollar benchmark. Moreover, foras long as they can benefit frominvesting in foreign equities, bonds,

properties, and currencies, they willremain complacent and optimisticabout the future of asset markets. So,the bearish case, as opined by peoplesuch as Kurt Richebächer, isdismissed because “so what, themarkets are rising”!

My friend Jim Walker, the HongKong-based chief economist at CLSA(www.clsa.com), recently published areport entitled “Apocalypse Now”. Imet Jim in the 1990s and, in myview, he is one of the mostaccomplished economists I know. Heis also a likable Scotsman, a good andconsiderate friend, and a person Ienjoy going out with at night fromtime to time. He also happens to beone of the more courageous people Iknow in the investment business, inthat he dares to take career risks bymaking unpopular calls that runagainst the consensus. Prior to the1997 Asian crisis, he was — alongwith Andrew Sharpe (now atRedburn Partners, an independentresearch broker in London —[email protected]) — oneof the very few economists whowarned of the impending crisis. Theyears preceding the Asian crisis —and particularly in Hong Kong —were very similar to the currentenvironment in the US: growingcurrent account deficits, wildproperty and stock marketspeculation, enormous optimism(although most Asian stock marketswere well below their 1990 or 1994peaks), and the endless saga abouthow the business cycle had beeneliminated. At that time it took greatcourage, as it would still today, for aneconomist at CLSA who was (andstill is) surrounded by a pack ofhungry and short-term-orientedsalespeople to express a negative viewabout Asia. But Jim was able todefend his negative views and waseventually proved to have been 100%on the mark (although, like me at thetime, he may have underestimatedthe severity of the crisis). So, whenJim Walker, who certainly cannot belabelled as a “perma-bear”, takes avery negative stance on the economicprospects of the world, and inparticular of China, I take notice.This in particular because he himself

admits to having been wrong aboutthe prospects in 2006, which mayaccount for the fact that his views arenow largely ignored by the bullishcrowd who are self-contentedlysleeping the slumber of confidence.

“Apocalypse Now” is a 52-pagedocument and, therefore, I shall onlybe able to touch very superficially onits, at times, difficult-to-understandcontent and Jim’s rather gloomypredictions. Jim Walker’s principalreason for recommending caution is“the strange pattern of behaviour insectors and markets that permeatetoday’s global economy. ThroughAustrian eyes markets appear to beat one of their most dangerousjunctures in recent financialhistory. Global monetarymanagement is at the heart of ourconcerns.” (By Austrian eyes, hemeans based on the Austrian Schoolof Economists.)

What concerns Jim in particular isthat “confidence in global centralbanks has never been stronger normore misplaced. The Greenspan–Bernanke Fed has achieved almostthe impossible: the death of risk.Investors express bearish concernsbut they are 100% invested (in manyinstances 200–500% invested). Theirfaith in the Fed and its guarantee thatliquidity will flow regardless is at alltime highs — emerging market andjunk bond spreads are testament tothis fact. It has become unfashionableto be negative, especially on China.We are confident that these are thebest late-cycle indicators of all.”

To validate his “Austrian” views,Jim explains that the AustrianSchool of Economists has had a muchbetter record of forecasting businesscycle problems than any other schoolof economists. So, whereas JohnMaynard Keynes believed in 1927that “we will not have any morecrashes in our time”, and IrvingFisher thought a few days before theOctober crash in 1929 that “stockshad reached what looks like apermanent plateau”, Austrians suchas Friedrich Hayek and Ludwig VanMises warned of impending seriousproblems. According to Jim, LudwigVan Mises exclaimed in 1929, onbeing offered a senior post at the then


largest Austrian bank, CreditAnstalt: “A great crash is coming,and I do not want my name in anyway connected with it.” (Two yearslater, Credit Anstalt failed along withthousands of other financialinstitutions in the Great Depression.)

The Austrian economists(including Kurt Richebächer) are,according to Jim, the most pessimisticcommentators today because of theway they define “inflation” and how“inflation” affects relative priceswithin the economy: “Inflation is notabout rises in core consumer prices,the metric on which markets andmost central bankers today arefocused. Rather, inflation is aboutthe increase in money and creditaggregates (since credit in its myriadforms is the final determinant ofmalinvestments Austrians havetended to focus on it and the rolethat fractional reserve banking playsin its creation as the source offluctuations in the real economy).”In other words, as the Austrianswould do, Jim takes no comfort fromthe fact that core inflation in the lastfew years has been benign. Hebelieves that excessive money andcredit growth will lead to a“malinvestment crisis”, particularly inChina and the US. He then quotesWilliam White BIS Working PaperNo. 2005, April 2006, entitled “IsPrice Stability Enough?” to explain apoint that I have tried to make onnumerous occasions in the past.Consumer prices stability is noguarantee whatsoever of theavoidance of economic crises.Moreover, in the end, asset inflationperiods are far more destructive thanconsumer price inflation periods.White writes:

The historical record providesstark evidence that a precedingperiod of price stability is notsufficient to avoid seriousmacroeconomic downturns.Perhaps, the most telling exampleis that of the Great Depression inthe United States in the 1930s…The crucial point is that theoutturn was not preceded by anynoticeable inflation… Rather,the period was characterized by

rapid technological innovation,rising productivity, rapidincreases in the prices of equityand real estate and strong fixedinvestments… Still morerecently, attention could bedrawn to the financial crisis inSouth East Asia in the late1990s… Similar to the US andJapanese cases, these difficultieswere not preceded by anyinflationary excesses but ratherby sharp increases in credit,asset prices and fixedinvestment.

As an aside, I should mentionthat at its peak in 1929, the US stockmarket sold for just 13 times earnings.

Jim Walker is particularlyconcerned about three different, butin my opinion rather closelycorrelated, issues: excessive debtgrowth in the US, which led tomalinvestments in the US (first theNasdaq bubble and then the housingboom); malinvestments in China;and finally, the failure of the Bank ofJapan to move swiftly to normaliseinterest rates.

Concerning the excessive creditgrowth in the US, Jim expressessimilar views to ours (see thediscussion of the debt super-cycle) byquoting Friedrich Hayek’s “A Tale bythe Tail”:

If the current level of output andemployment is made to depend oninflation [As explained above,inflation, as defined by theAustrians, is about the increase inmoney and credit aggregates —ed. note], a slowing-down in thepace of inflation will producerecessionary symptoms. Moreover,as the economy becomes adjustedto a particular rate of inflation,the rate must itself becontinuously increased ifsymptoms of a depression are tobe avoided: to inflate is to have “atiger by the tail”. (In the US,financial and non-financial creditexpanded by $2.8 trillion in 2004,when the first interest rateincreases took place. In the thirdquarter of 2006, total credit grewat an annual rate of $4.4 trillion.)

This is a very important point. Inorder for an “inflating” economy tojust maintain its altitude, the rate ofmoney and credit growth needs tobe continuously expanded. Thisphenomenon is clearly visible fromFigure 7 on page 4. The momentcredit growth no longer expands or,worse, decelerates, asset prices stall,decline, or more likely collapse and arecession becomes unavoidable.

Jim believes that because newtechnologies (Nasdaq) and housingare played out as bubble sectors —even if the Fed were “to start relaxingpolicy and pushing households andbusinesses to take on more debt thereis no obvious sector for the bubble tomove into (except private equity,M&A activity and even biggerbubbles overseas perhaps?). In orderto do so, interest rates would probablyhave to be reduced towards theprevious low as well.”

According to Jim Walker, the2007 China malinvestment crisis willcome about because China’s depressedexchange rate attracts too muchcapital most of which is speculative —hoping to benefit from anappreciation of the currency. But atthe same time it is “distorting: it addsto domestic demand, particularlyinvestment, when it is the mostdangerous to do so”. The danger Jimsees is that corporate profit growth inChina is slowing down at a time whenexcessive money and credit growth(inflation) has, throughmalinvestments, produced excessivecapacities in capital goods industriessuch as steel, base metal refining, cars,etc. In fact, Jim explains that profitsare likely to be overstated because ofincreasing domestic competition andlikely waning productivity growth.Moreover, “to suggest that Chineseprofitability is improving in the face ofrapidly rising commodity prices andrapidly rising labour cost, neither ofwhich are in dispute, makes no sense”.Jim also notes that malinvestmentsare exacerbated when public sectoragencies play a significant role in theinvestment process: “indeed, historyhas shown that the public sectorexcels at malinvesting”. (This seemsto be particularly true with respect towarfare.)


Concerning Chinese monetarypolicies, Jim anticipates that 2007will bring about a much tightermonetary environment than was thecase at the beginning of 2006: “theslower growth in monetaryaggregates already built in to thesystem will produce a surprisingdegree of business failures and baddebts in the Chinese banking systemover the next 2–3 quarters.”

I must stress that Jim Walkerdoesn’t expect Chinese GDP growthto turn negative in 2007. But, basedon his rather negative views aboutthe US economy (he expects GDPgrowth of 1% in both 2007 and2008), he forecasts growth to slowdown considerably:

Our view of the US economy withits direct (export) and indirect(capital flow) effects are nowcritical elements in our 5–7%forecast for China in 2007…China suffers the same policyfailings as every other country andit will suffer the same cyclicalfluctuations as any othercapitalistic economy although, inthe early stages of transition toindustrialization, when capitalinvestment plays a lead role, thefluctuations are likely to be moresevere than in more matureeconomies.

In fact, Jim favours Japan’sindustrialisation roadmap as a proxyfor the kind of violent cyclicaleconomic swings one should expectin China (see Figure 11). As can beseen from this figure, Japan didn’texperience negative GDP growthbetween the 1940s and the 1970s, butit certainly didn’t feel good whengrowth was halved, as happened fourtimes over this period. Jim alsoexpects the Chinese Yuan to weakenonce Chinese GDP growth slows toless than 7%.

With respect to Japan, Jimbelieves that “in order to secure therecovery the Bank of Japan mustraise rates”. His reasoning goes asfollows. Japan, the world’s second-richest economy, has effective cashholdings equivalent to almost 76% ofGDP compared to the US where

immediate cash holdings are less than11% of GDP (see Figure 12).According to Jim, “the lower theratio the higher the confidence in thefuture and the system’s financialinstitutions (ie, the lowerprecautionary cash balances)… TheJapanese ratio, following 15 years ofgrim deflation, is three times largerthan it was at the beginning of the1990s.”

Jim believes that, in order torestore confidence among consumersin the system, interest rates musttherefore be increased. I have aslightly different take on this. If theBank of Japan were to increaseinterest rates meaningfully, it wouldat the same time kill the Japanesebond market and the carry trade, andincrease consumers’ interest income.At one stroke, this would achieve the

following: move money out of cashdeposits and bonds into equities,boost confidence, and repatriatemoney that was invested overseasinto Japanese equities and properties(since the bond market would bedeclining). However, as Jim believes— and I agree with him — boldactions by the Bank of Japan areunlikely to happen. Therefore, theJapanese carry trade could one dayunwind for other reasons than boldinterest rate increases in Japan (seealso below).

The most important investmentimplications Jim sees if his“Apocalypse Now” scenario comes topass in 2007 are as follows. If, inJapan, interest rates were to increasesignificantly, this would diminish theattractiveness of the carry trade.Since the carry trade “is one of the

Figure 12 Effective Cash Holdings as Percentage of GDP, 1990–2006

Source: Jim Walker, CLSA

Figure 11 Japan’s Real GDP Growth, 1946–1973

Source: Jim Walker, CLSA


largest sources of excess capital in theglobal system today” and has been“instrumental in supplying leveragedfunds for bets on high yieldcurrencies, commodities, emergingmarket debt and fashionable stockmarkets”, all these assets woulddecline significantly in value. At thesame time, Jim expects the Yen andJapanese asset prices to increase. Hetherefore advises, “sell high yieldcurrencies, commodity funds,emerging market debt and fad andfashion stocks, eg, Chinese banks”.

The expected Chinamalinvestment crisis will slow theeconomy significantly (to a GDPgrowth rate of 5–7%), and “any signthat the economy is slowing below a7% growth rate would put the skidsunder the renminbi… We wouldexpect the renminbi to move backabove Rmb 8/US$1 perhaps towardsthe Rmb 8.2/US$1 mark by the endof 2008. Commodity prices,especially for base metals and oil,would fall sharply… There will be acooling in the notion that Chinaconstitutes a ‘core holding’ ininternational portfolios.”

The blow-up of the US super-boom, which Jim believes is morelikely to happen in 2007 “than at anytime in the last fifteen years”, wouldhave “the most serious consequencesfor the region”. Capital flows to Asiaand elsewhere would be cut through“the twin effects of a decliningcurrent account deficit and the ‘homebias’ that occurs when a largedomestic economy runs into trouble.The easy money that seems to bewilling to increasingly buy emergingmarket and commodity assets woulddry up immediately (just as it did inMay and June 2006).”

Lower capital flows to Chinawould exacerbate the effect of theexpected China malinvestment crisis,lower the demand for commodities,and diminish risk appetite. USinterest rates would decline, but partof the interest rate decline in the USwould be offset by risk premiumincreases. “But much moreimportant, compared to interest rates,nothing destroys liquidity like arecession. When companies begin togo bust and non-performing loans rise

in the system banks curtail credit. Inturn, the constant increase in capitalflow that is required to make marketsgo up is not forthcoming. Equitymarkets fall, even when rates arefalling.”

PERSONAL THOUGHTS

Both the Bank Credit Analyst’s“Another Year of Riding theLiquidity Wave” (see “The BullishCase”, above) and Jim Walker’scontrarian “Apocalypse Now” reportsare well-thought-out analyses of thecurrent global economic andfinancial environment. The BCAstudy outlines the more likelyoutcome in the near future, theApocalypse report the certaineventuality at some point in thefuture. But when — this year, nextyear, or in five to ten years?Moreover, unlike Jim Walker, I doubtthat in the event of the apocalypticscenario, US GDP growth willremain at 1% and Chinese growth at5–7% per annum. If one really thinksthrough the combination of risinginterest rates in Japan, the end of thecarry trade, the US economy blowingup, a Chinese malinvestment crisis,and collapsing commodity and stockprices, the perfect cocktail of eventsshould be in place to bring about aterrific deflationary depressionaround the world where, with theexception of the highest-qualitybonds (but where are they?) and,possibly, precious metals, every typeof asset should be avoided.

Depending on one’s investmentstrategy, the debt super-cycle or theapocalypse will make or break one’swealth. Under the economicapocalypse scenario, bonds will dowell in absolute terms (declininginterest rates) and fantastically wellin relative terms (as all other assetprices collapse, with the possibleexception of precious metals andfarmland).

Under the debt super-cyclescenario, the worst investments willbe cash and bonds, because papermoney will continue to lose itspurchasing power compared to assetprices such as real estate,commodities, stocks, and art at an

accelerating rate, although, as theBCA pointed out, asset priceinflation will rotate.

There is one point that JimWalker makes that I haven’tmentioned, but which may yieldsome clues as to what an investorshould do. According to Jim “one ofthe most worrying features in globalcentral banking today” is that centralbankers don’t want to takeresponsibility: “when the US FederalReserve, ECB and Bank of Japan talkabout appropriate monetary policiesthey do so in a national context. TheFed has stopped raising rates becauseof the US housing market slump; theECB has been slow to raise ratesbecause of sluggish EU growth; andthe Bank of Japan has dragged outthe process of interest ratenormalisation because of the lack ofinflation in Japan.”

But, as Jim explains, in a worldwhere globalisation is acknowledgedin every speech a central bankermakes, “there is no attempt torecognise — because that wouldmean taking responsibility — theeffects of their national monetarypolicies on economies, commodities,and assets around the world. This iswhat makes the current state offinancial markets possibly the mostdangerous in history” (emphasisadded).

But what are the implications ofthe unwillingness (and, in somecases, the inability) of centralbankers to assume responsibility?Quite simply, it means that if the UScuts interest rates and takes“extraordinary measures” in order tosupport the housing market andconsumption, the other centralbankers will all, to a larger or smallerextent, do the same thing and printmoney.

So, for one, my view would bethat, at least for now, a mildapocalyptic scenario may occur in the“real economy”, but that the “asseteconomy” could continue to inflate— albeit interrupted by severecorrections and with fewer assetclasses participating (that is, withouthousing and industrial commodities).Under this scenario (some kind ofstagflation), the worst investments


would be long-dated bonds (seeFigure 13). Inevitably, the assetinflation will in time also lead tomore consumer price inflation,because if the debt super-cycleremains in full force and creditcontinues to expand at anaccelerating rate, commodity priceswill have nowhere else to go but up!(The supply of commodities willdecline relative to the supply ofmoney and credit.)

Therefore, in a mild apocalypticscenario for the real economy, a farmore desirable alternative to long-term bonds would be to buy short-dated, high-quality bonds andTreasury bills. But should investors goshort long-dated US bonds? As asecular long-term bet, T bonds shouldbe an excellent short, but in the nearterm yields may not rise much as theUS dollar could strengthen somewhatmore and because of the very lowbullish consensus about bonds (seeFigure 4).

I have one further observationabout long-dated bonds. Investorswho either sold or avoided bonds in1982, when 30-year T bonds wereyielding more than 15%, were totallymisguided, as they were discountingconsumer price increases to eitheraccelerate or remain around 13% perannum (providing a real yield ofabout 2% — see Figure 13). Now,investors who buy 30-year T bondsseem to expect inflation to average atmost 2.5% per annum for the next 30years — a bold assumption, indeed,given that, as Jim explained, “centralbankers do not want to takeresponsibility”.

I suppose that a mild apocalypticscenario would equate to stagflationfor the majority of households except,perhaps, the asset shufflers. However,that the latter would continue tothrive is far from certain. Why? Ifinterest rates were to rise and creditgrowth remained constant and failedto expand, not only the economycould remain stagnant but also mostasset markets. After all, Misespointed out that, “as the economybecomes adjusted to a particular rateof inflation [money and credit growth— ed. note], the rate must itself becontinuously increased if symptoms

of a depression are to be avoided.”In the December 2006 GBD

report, entitled “Irreparable Cracks inthe Financial System”, I suggestedthat some cracks had appeared in theUS sub-prime lending market, inhouseholds’ liquidity, and in theperformance of some of the assetshufflers and the collapse of theMiddle Eastern stock markets. But,now we can add to those cracks somenew ones. Since its early January highthe Venezuelan stock market is down33% within just a few days, and theThai stock market has dropped by15% since mid-December. It is highlyprobable that the emerging markets,which just recently began to stall ordecline (exceptions are Vietnam up30% so far in 2006, and China upbetween 5% and 27% depending onthe index), are the canary in the coalmine for global liquidity. ForeignOfficial Dollar Reserves (FRODOR),which is a reliable indicator ofinternational liquidity, is still growingat about 15% per annum, but growthis no longer accelerating. (As Imentioned above, the rate of moneyand credit growth must continuouslyincrease if recession is to be avoided.)

When FRODOR growth began todecelerate in late 2005, it gave a

warning signal that commoditieswere likely to peak out in 2006. Theprice of crude oil is down 34% fromits July 2006 high, and the CRBIndex is now down 21% from its May2006 peak (see Figure 14). (Pleasenote that the difference inperformance between the Ron GriessCRB Continuous Futures Index —Figure 8 — and Figure 14 is becauseFigure 14 is based on the RevisedReuters/Jefferies CRB Index, whichhas a higher energy weighting.)

Unless FRODOR reaccelerates, Iwould expect the following scenariofor the next three to six months.Equities globally will top out shortlyand decline in a sharp sell-off.Emerging markets will underperformthe US. The dollar rallies as USliquidity shrinks due to far worseconditions in the housing marketthan are perceived, which bringsabout further failures among sub-prime lenders.

Once the US stock marketdeclines by 5% from its peak, the Fedwill start to cut interest rates andembark once again on massiveliquidity creation in order to protectits friends on Wall Street. Whetherthe Fed succeeds at that time instabilising the markets will depend on

Figure 13 Thirty-year T-Bond Yield ($TYX), 1980–2007

Source: www.decisionpoint.com


a number of factors, includingwhether the Japanese Yen carry tradeavoids going into a massiveliquidation. And here I have aslightly different take on the situationthan Jim Walker. The Yen carry tradecan also end if foreign assets suddenlystart to decline or under-performJapanese assets — not just becauseJapanese interest rates increase. Sincemuch of the carry trade is invested in

risky assets, any decline in their valuecould violently reverse the trade andspread like a bushfire through theasset markets. Whether at that pointmassive liquidity creation by all thecentral banks (not only the US Fed)will bring about a strong recovery inequity prices remains to be seen!However, it is likely that preciousmetals will perform well during thisact of monetary desperation.

INVESTMENTCONSIDERATIONS

Given the over-bought and over-bullish position of most equitymarkets, my preferred investment fornow is US Treasury bills with amaturity of three to six months. AsJohn Hussman said, there is presentlynot much buying power left fromconverting a tiny pool of bears intobuying equities, but there is a lot ofroom available in the bearish columnin order to populate a more typicaldivergence of opinion.

While I remain very negativeabout the prospects of the US dollarfor the long term, based on FRODORnot growing at an accelerating rateand strong money supply growth inEurope as well, the dollar should holdat least for now and may evenstrengthen somewhat. The problemwith being overly negative about theUS dollar against other currencies isthat they are also fiat currencies. Idon’t agree with Jim Walker’snegative views concerning theChinese Renminbi and I continue tolike Asian currencies.

For investors who need — or wish— to own equities, I continue torecommend exposure to Singaporeand Malaysia. Thai stocks areinexpensive and are supported byhigh dividends, but they are unlikelyto perform well for now.

A friend of ours, Chris Roberts, atechnical analyst at CLSA, recentlypublished a figure showing that Asianequities have now broken out to newhighs (see Figure 15). Chris expects a25% correction to get under wayshortly, which will provide a “majorbuying opportunity”. From the 2007lows, the Asian markets should thenadvance by more than 100%. If Chrisis right and the BCA debt super-cyclecontinues unabated, it would seem tome that the risk of not owning Asianequities is higher than having toendure possibly an intermediate 25%correction. As a result, I am still longAsian stocks, although I havereduced my positions. In themeantime, Jim Walker thinks thatthe companies that will perform best

Figure 14 Reuters/Jefferies CRB Index ($CRB), 2001–2007


Figure 15 Asian Equities, 1988–2006

Sources: CLSA Asia-Pacific Markets and Chris Roberts


Figure 16 S&P 500 Relative to MSCI World, 1990–2006

Sources: CLSA Asia-Pacific Markets and Chris Roberts

Figure 17 Broker/Dealer Index – AMEX ($XBD), 2003–2007


through the next cyclical downturn“will be the true winners in Chinaand Asia. At this stage in the cyclethere is too much liquidity ‘noise’ tomake a reasonable assessment.”

I might add that Chris Robertsbelieves in a secular de-rating of theUS stock market compared to therest of the world (see Figure 16). Asmentioned above, if a sharpcorrection gets under way, I wouldexpect US equities to outperform theworld for a while by declining lessthan other stock markets. Regularreaders of this report will know that Ihave been very negative about sub-prime lenders such as AccreditedHome Lenders (LEND) and NewHomes Financial (NEW). I continueto maintain this negative view. Inaddition, I believe in a highervulnerability of brokerage companies.Buying puts or selling short brokeragestocks in the period directly aheadshould be considered (see Figure 17).

Kenneth Ng, who has anaccounting background and whom Imet in the mid-1990s when he was asenior analyst and head of research atBaring Securities in Bangkok (helater worked at MacquarieSecurities), now runs an Asian microcap value fund, NTAsian DiscoveryFund ([email protected]), inwhich I have invested some money(the minimum investment isUS$100,000). Kenneth has providedthe following comments aboutopportunities in very smallcompanies in Asia.


Frontier Investing in our BackyardKenneth Ng, CEO, NTAssetNTAsian Discovery Fund (Bloomberg code: NTASIAN KY Equity)Tel: +662 343 1771; Fax: +662 343 1774; Email: [email protected]; www.ntasset.com

How much would you pay for acompany that is effectively a holdingcompany of some of the top brandnames in Asia with earnings growthof 42% and 16% in 2007 and 2008,respectively, a debt to equity ratio of20%, and generating an ROE of 24%?Throw in a healthy dividend also! Ifan analyst were to write a researchreport on this company, it might looksomething like this:

It is noteworthy that the market isonly valuing this portfolio ofcompanies at 9x FY07 earnings and1.8x PBV. That would put thedividend yield also at 4%. Themanagement of these companies are acollection of some of the bestentrepreneurs that Asia can offertoday. Against average Asian marketvaluations of 15x FY07 earnings andEPS growth of 11%, you can’t get

deeper value than that. So, what’s thecatch? No catch, except the fact thatmost institutional investors areunlikely to have heard of thesecompanies, nor is it worth their whileto risk going so far off thebenchmark, because their marketcapitalisation is just too small for alarge fund to invest in.

When anyone mentions frontierinvesting, three different types come


to mind: investing in (1) new assetclasses; (2) new markets; or (3) stocksthat most investors haven’t heard of.Investors invest in frontier marketsfor one reason alone: better returns,because there are fewer bidders forthat particular asset class. Fewerbuyers = less bids = lower pricing.Some fund managers excel in newasset classes; others love exploringnew countries and emergingeconomies. We like looking a littlecloser to home. However, theinvestment philosophy remains thesame, look to seek “value” and investwhere others aren’t looking, for allthe reasons explained in the previousparagraph. Is it higher risk? Only ifyou get it wrong. That would seemobvious, but because there are fewerbidders, if you get it wrong, you oftenhave no option but to ride it all theway down. That’s the main risk inthis game.

However, if you do get it right,the returns can be rewarding. Anarticle in the Financial Times recentlyconcluded that “value” investing

Figure 18 Twelve-month Rolling Returns, January 2001 – October 2006

Source: Hedgefund.net, a division of Channel Capital Group Inc.

strategies, made popular by BenjaminGraham, have now outperformed themarket for seven years in a row acrossthe developed world and forcompanies of all sizes. According toMSCI, its world value index grew22.2% in 2006 while its growth indexgrew by 13.8%. Figure 18 illustrateshow rewarding the returns for small/micro cap funds have been over thepast six years when measured againstaggregate hedge fund returns as wellas the Russell 2000 index, one of themost widely recognised indexes forsmall cap stocks.

If we break down the performancefor small/micro cap funds, we findthat emerging markets small capfunds continue to be the mostrewarding, returning more than 2–5times the returns offered by small/micro cap funds in the US, Europe, orJapan over the past six years (seeFigure 19).

What is the explanation? In orderto see how we can find value inrelatively “mature” (and I’m usingthis sparingly) emerging markets, we

have to analyse the structure of theindustry between the sell side and thebuy side.

There is no denying that marketsin Asia are better covered now thanthey were 20 years ago; on the otherhand, if we compare the number ofgood-quality analysts now and tenyears ago (pre-crisis), especially postthe consolidation of foreign marketplayers, there are probably fewertoday. In addition, the structure ofthe research industry has changedsignificantly, with fewer analystscatering to a larger number of funds.Inevitably, with pressure frommanagement for sell-side analysts tofocus on “tier 1” clients, pitching aUS$100 million marketcapitalisation stock to a US$3 billionindex relative fund is probably notgoing to be much value added,meaning coverage will continue tofocus on large market cap stocks.

To put some numbers to this, wecollected some data on the level ofcoverage in Asia of the top 30 marketcap stocks against the level of

Jan-

20

01

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-20

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Table 1 Level of Coverage for Large and Small Cap Stocks in Asia

Big caps Small cap (≤ US$100m)*

Country % of top 30 stks Avg. no. of % of total % of 30 small Avg. no. of % of totalwith coverage analysts/stock mkt cap caps w/coverage analysts/stock mkt cap

Hong Kong 100 19 59 0 0 0

China 90 7 80 7 1 0

India 100 9 86 33 1 0

Indonesia 93 11 79 27 2 2

Korea 93 6 63 13 3 0

Malaysia 100 16 79 50 1 1

Philippines 93 5 76 17 1 3

Singapore 97 11 81 47 1 1

Taiwan 100 9 57 10 1 1

Thailand 100 16 69 70 2 2

#1 #2 #3 #1 #2 #3

* — 30 small caps starting from US$100m market capitalisation and lower were used#1 — denotes how many of the top 30 stocks have minimum of 1 analyst covering#2 — denotes average number of analysts covering a top/small cap stock#3 — denotes how much of total market capitalisation the top 30 capitalised/30 small capstock accounts forSource: Bloomberg

Figure 19 Cumulative Returns for Small/Micro Cap Hedge Funds by Regions in Which They Invest,January 2001 – October 2006

Source: Hedgefund.net, a division of Channel Capital Group Inc.

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SmCap EM

SmCap Global

SmCap US

SmCap Europe

SmCap Japan

coverage for 30 stocks with marketcapitalisation of US$100 million andlower (see Table 1).

The level of coverage for what Iwould consider “below institutionalinvestor radar” companies (a marketcapitalisation cut-off derived frommore than a decade of sell-sideexperience trying to pitch smaller capcompanies to buy-side fundmanagers) remains insignificantcompared to the top 30 capitalisedstocks. In addition, the analysts thatare looking at the small cap stockstend to be junior or recent graduates,coming from mainly local houses,implying little in-depth analysis orrelatively inaccurate forecast data.

As a result of this, there can besignificant differentials in pricingwith a stock that may have the samegrowth rate, but where the publicrelations machine isn’t working aswell in one company as in another.As such, a US$100 million companythat is growing at 15% p.a. and


trading on 5 times earnings couldpotentially be in a “value trap”.However, if it were trading at 10times earnings, implying a $200million market capitalisation, it issuddenly “more investable” and couldtrade up to even 12–15 times PER asit is now liquid enough to attractlarger funds. Of course, a valueinvestor is a patient investor, but alittle helping hand doesn’t do anyharm, and the management of suchfirms are often not that market savvyand need to be urged into action inorder to increase the profile of theircompanies. Quite often the key tounlocking the value in thesecompanies isn’t a question of thefundamentals of the company but,rather, of increasing marketawareness.

ANATOMY OF INVESTING INMICRO CAPS

Our criteria for selection ofinvestments aren’t significantlydifferent to investing in largercompanies; however, because anysuch investments tend to be lessdiversified and the ability to exit isquite often more limited, we exerciseextreme caution in pulling the triggeron any investments. Our science isfiltering the markets with ourvaluation screens for a list of cheapstocks with fast-growing prospects.Our art is selecting the ones mostlikely to re-rate over the foreseeablefuture. Our qualitative criteria helpto narrow down our selectionsfurther.

1) Management, management,management: Given the hands-on nature of most entrepreneurs,and given the size of thebusinesses we tend to invest in,this category is by far the singlemost important factor, and at aguess, its weighting probablyaccounts for around 60–70% ofour investment decision. Becausethis is so important for us, wedon’t undertake any investmentuntil we have, at the very least,talked with management, if notmet them eye to eye, or visitedthe factory. Quite often, the best

references are from competitors;so, where we can, we also tend tosniff around the competition inorder not only to get a betterunderstanding of the industry butalso to see how the company isseen by its competition.

Because of the above factor,we tend to do a great number ofcompany visits, as it is prettymuch the only way we are able togather information (given thelittle coverage from brokeragehouses). In fact, last year, weclocked up 269 company visits(most of which were face-to-facemeetings with senior or topmanagement), and given we heldaround 15 stocks in the portfolioat the end of the year, that’s a hitrate of 5–6% — lower if youconsider that this list was alreadyshortlisted from several hundredstocks screened using our

valuation filters (see Figure 20).

2) Branding: Whether it is B2B orB2C branding, we tend towardscompanies that have built a brandfor their products, if not throughaggressive advertising andmarketing expenditure, thenthrough longevity. As such,around 70% of the stocks the fundholds have strong brands if not intheir products, then in thecompany itself. Why the focus onbrand? Partly because Asianinvestors don’t tend to put muchvalue on brands (in the same waythat investors don’t put muchvalue on research anddevelopment expenditure,something which we consider tobe an essential component ofbuilding a good brand); as such,we feel that branded companies,or those with a strong brand, tend

Figure 20 Number of Company Meetings

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec0

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Subscriptions and enquiriesMARC FABER LTDUnit 3311–3313, 33/F Two International Finance Centre, 8 Finance Street, Central, Hong KongTel: (852) 2801 5410 / 2801 5411; Fax: (852) 2845 9192;E-mail: [email protected]; Website: www.gloomboomdoom.com

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Author & PublisherDR MARC FABER

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CopyeditorROBYN FLEMMINGE-mail: [email protected]

THE GLOOM, BOOM & DOOM REPORT© Marc Faber, 2007

DISCLAIMER: The information, tools and material presented herein are provided for informational purposes only and are not to be used orconsidered as an offer or a solicitation to sell or an offer or solicitation to buy or subscribe for securities, investment products or otherfinancial instruments, nor to constitute any advice or recommendation with respect to such securities, investment products or other financialinstruments. This research report is prepared for general circulation. It does not have regard to the specific investment objectives, financialsituation and the particular needs of any specific person who may receive this report. You should independently evaluate particular investmentsand consult an independent financial adviser before making any investments or entering into any transaction in relation to any securitiesmentioned in this report.

However, we do tend to find thatsocially responsible managementtend to practise better corporategovernance than their peers, sowe don’t focus on socialresponsibility just because it’s thetrend!

Finally, we find that if we look atthe fund as an investment company,it tends to focus our attention evenmore. Would we want to be in thisbusiness ourselves (assuming we hadthe expertise), or are we buying itbecause we think the share price willgo up? Putting some reality in ourinvestment decision, rather thanlooking at purely the share prices,forces us to consider how viable thelong-term prospects are. As such, weconsider ourselves a partner, rather avisitor, in all our investments.

to be undervalued in Asia. Inaddition, brands tend to be moreresilient in downturns. They tendto command higher margins,giving lower operating leverage,and therefore are better able towithstand a drop in volumes; theyhave a better ability to adjustpricing to reflect higher costs; andthey have more loyalty amongtheir customers.

3) Industry: Naturally, the industrysector, dynamics, competition,types of business, and so on, areall important considerations, butdynamics are significantlydifferent for different sectorsacross Asia, so it is difficult togeneralise for this criterion.However, earnings predictabilityand steady income is a prime focus

for us, given our value and steadyreturns orientation, which isprobably why more than 50% ofthe companies in the fund areconsumer-related businesses. Wehave found that even in the mostcompetitive of segments, if themanagement focus,determination, and expertise arethere, a company can thrive, sowe don’t tend to rule out anyindustry.

4) Corporate governance andsocial responsibility: Of course,this goes back to management.However, trying to determinewhether the management of asmall cap company will havecorporate governance issues is liketrying to forecast the direction ofthe market using astrology.

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