I Wish I Could Be Bearish
By Dr. Marc Faber
January 27, 2007

When I worked for Drexel Burnham Lambert between 1978 and 1990, "the king of junk bonds", Mike Milken, theorized that a diversified portfolio of junk bonds would offer a higher yield and lower risks than AAA-rated bonds, since the latter would eventually be downgraded.

In the late 1970s and early 1980s, this argument struck a chord with me and
I was one of the first foreign buyers of high-yield US bonds. At the time, I was managing a number of tax-exempt accounts, such as churches and charitable institutions.

(Foreigners were still paying a 30% withholding tax on US bonds' interest payments.)

But by the mid-1980s, I noticed that the quality of junk bonds had declined markedly as a result of the LBO boom, while at the same time the arrogance of the Drexel junk bond traders had exploded as a result of their trading department's enormous profitability.

I therefore began to share with my clients my negative opinion of the junk bond market and advised that they avoid junk bonds. This almost cost me my job, but since my office in Hong Kong was the only profitable foreign office at Drexel, I was left alone and Drexel's management dismissed my views as those of an ignorant but nice "permabear".

In the meantime, Abby Cohen, who was then Drexel's chief strategist, remained bullish about the US stock market (and, with the exception of the 40% drop between August and October 1987, rightly so). But she failed to foresee the demise of the "king of junk bonds" and her own employer, which is not an inconsiderable mistake in the life of a strategist...

Lower-quality bonds and structured products are a wonderful investment in an economic expansion and when asset prices increase. However, excessive liquidity (read: a lot of stupid money) in the end always leads to imprudent lending. Eventually, default rates soar and the weaker lenders are forced to the wall.

Reading the recent research published by Wall Street and articles in the financial press, I am struck by how positive the underlying tone is. "Soft landing", "Goldilocks economy", and "excess liquidity" have become household terms, and, based on favorable economic statistics (or at least, they are being interpreted favorably), S&P earnings are expected to continue to grow next year while interest rates will remain low.

We are in the midst of a synchronized, powerful global economic expansion. In the developed world, unemployment has just hit a 25-year low. And, due to their current account surpluses, the economic and financial outlooks of the emerging economies have rarely looked more promising.

Moreover, at the Fed we have Mr. Bernanke, who has clearly and unmistakably assured the world that should asset prices ever decline, extraordinary monetary policy measures would be used to prevent the occurrence of a deflationary recession. It's not surprising, therefore, that none of the nine Wall Street strategists recently polled by Barron's (see Barron's of December 9, 2006) is forecasting a decline in the stock market in 2007.

A well-respected independent economist and strategist with a bearish trait told me recently that he wished he could be bearish, but that he couldn't find anything that he thought would disturb the asset markets and the global economy in the foreseeable future.

Looking at the "real" global economy and at what people produce in terms of manufactured goods and services (ex-financial services), I would have to agree.

Comparing the current global economic expansion, which began in the US in November 2001, with previous economic expansions, it seems to me that the "real economy" isn't showing any signs of the overheating that, in the past, led to aggressive central bank monetary tightening.

So, I am, like my strategist friend with the bearish trait, also impressed by the prospects for the global economy.

However, I am increasingly concerned about the inflated asset markets around the world, and about the almost unanimous belief that nothing will ever come between the "Goldilocks" economic conditions and the Fed, in conjunction with the US Treasury standing ready to support markets should they decline meaningfully and disturb the current heavenly asset market conditions.