In the "huge brothel" of the financial services industry, writes Dr. Marc Faber, wealth is not created, consciences are not followed, and though clients may be temporarily satisfied, the good times cannot last forever.

TOO MANY TREASURE HUNTERS By Marc Faber

The investment management industry has become a huge sector of the economy in most industrialized countries, and the money that is sloshing around the world now dwarfs the real economy by an unprecedented margin. Just consider that in the United States, manufacturing employment has declined to its lowest level since the 1950s, while debt-to-GDP is at a record high and continues to rise, and stock market capitalization as a percentage of the GDP is near a record.

Put simply, we seem to be producing less in the way of goods as a percentage of the economy, but an increasing amount of paper money at a faster and faster clip. These trends lead to the disproportionate growth of the financial markets compared to the real economy. If they persist, which I doubt they can do forever, eventually the Western industrialized nations will produce very little (as a percentage of GDP), but instead an ever-growing army of investment wizards will spend their days trading financial instruments, including stocks, bonds, mortgages, currencies, options, derivatives, and so on!

How sustainable is such a trend when, in fact, financial markets by themselves don't create wealth, but are a byproduct of wealth creation in the real economy? This may be a controversial question, but let us compare two economies for a moment. In the first economy, people work in factories and the services sector and invest their savings to boost the output of goods and services. In this economy, the financial economy only serves as a conduit for channeling savings into investments. In the second economy, the entire population has largely given up on working and instead trades financial instruments 24 hours a day.

It is easy to see that both economies could have full employment and "growth" - provided, however, that the monetary authorities continuously expand the quantity of money in the economy where the entire population is engaged in the financial market. But, real wealth would only be created in the economy that produces goods and provides services and annually channels its savings into net new investments (capital spending exceeding depreciation charges); the purely financial market economy would only produce paper or imaginary wealth, which would not be sustainable in the long run.

To put it another way, the economy producing goods and services builds wealth based on its investments in new technologies and structures (net new investments), whereas the purely financial economy builds its "wealth" on financial asset inflation, which at some point inevitably spills over into hard asset inflation as well (real estate, art, commodities, etc.), but which does not produce any new "real" investments.

Now, I am not suggesting that the United States has already reached this hypothetical stage of economic development - after all, it is not unusual that, with fewer workers in the manufacturing sector, more goods can be produced through improved productivity - but we are steadily getting closer to this situation. (Productivity gains aside, one should not forget that more and more retirees are being supported by fewer and fewer workers.) According to The King Report, which is an excellent daily economic and financial newsletter, 350,000 General Motors retirees are supported by 118,000 GM workers, half of whom, according to GM, are due to retire over the next five years. Therefore, there will soon be more than 400,000 retirees supported by fewer than 100,000 workers!

One of the symptoms of an economy that creates "artificial wealth" through asset inflation is the weakening trend of its currency, as the asset inflation makes its price level relatively expensive for the production of goods and tradable services, when compared to countries whose price increases are contained by an increase in the supply of goods and services as a result of real capital formation. In other words, the longer the Fed attempts to kick-start the U.S. economy through asset inflation with ultra-easy monetary policies, the longer the U.S. dollar bear market can be expected to last.

But that aside, there is another angle to the financial markets and the financial services industry becoming so huge when compared to the real economy that I wish to address. (In the first nine months of 2003, global capital market debt issuance surged 22% to US$3.72 trillion compared to 2002.) For an analyst, a fund manager, or a strategist, the analysis of companies and macroeconomic fundamentals begins to take a back seat. Of more importance is their analysis of what their peers in the financial industry are thinking, how they are currently positioned, and in what way they might change their positions in the future.

In other words, in terms of one's performance, what one thinks of a stock, a sector, or a country is less important than what other fund managers and investors might think about the same assets. Therefore, as silly as it may sound, an analyst attending a company presentation at a conference should actually pay less attention to what the company has to say than to the reactions of the other fund managers about what the company is presenting. If the company's presentation is well received, the other fund managers will immediately place buy orders for shares of that company; whereas if the presentation disappoints the fund management community, sell orders will follow.

Now, I am not suggesting that this "momentum" investing style will yield substantial returns in the long run, but in many cases stocks can have large moves for totally wrong reasons. A good example of this would be the sharp gains Eastman Kodak shares had in the late 1990s, when digital photography was just beginning to proliferate.

Even a relatively superficial analysis would have shown that a company whose profits depend largely on selling nonreusable films and developing them could only lose from the new digital photo technology, which is bound, over time, to make non-reusable films obsolete. But the momentum players were at it and drove the shares to their highest level ever, dead ahead of the worst disaster in the company's history - the loss of a fantastic franchise and the duopoly in the photo industry it had shared for the last 20 or so years with Fuji Photo.

I have mentioned this because of the recent strong rebound and significant outperformance of the old high-tech favorites of the 1998-2000 bull market. In the same way that many of the "nifty fifty" stocks in the 1970s, including Kodak and Xerox, broke down in 1978 below their 1974 lows, we could also see, after the current rebound runs its course, new lows in Nasdaq stocks sometime in the next few years. In addition, we can see that Eastman Kodak and, I might add, the entire "nifty fifty" sector of the early 1970s weren't good investments after 1973. For most of the 1980s and early 1990s, Kodak and Xerox (as well as Polaroid, which went bust last year) were lower than in the early 1970s and, inflation-adjusted (in real terms), never actually made new highs above their peaks in 1973!

Kodak is an interesting example of a "high-quality" company that fell on hard times for no other reason than "creative destruction" as a result of a new technology, and one has to wonder how many of today's favorite momentum stocks, such as Cisco, Intel, Microsoft, Oracle, Sun, etc., will eventually encounter a similar fate. In fact, Hewlett-Packard would seem to have many similarities to Eastman Kodak, since sales of cartridges and toners for printers subsidize the entire company.

Stocks do not always go up in the long run. The reality is that most companies go out of business in the long term, and investors must continuously look for new companies, regions, sectors, and asset classes within the investment universe. After a bubble bursts, there is always a change in leadership, a fact which investors must also take into account.

In today's investment climate, those fund managers who share my concerns about the U.S. economy have only two choices when confronted with a rising market. Either they can stick to their defensive strategies (high cash position and ownership of low-volatility stocks) and risk their jobs, bonuses, and the loss of impatient clients, as they are bound to underperform the market for some time; or, despite being bearish at heart, they can go long the sectors with the strongest momentum and, often, also the weakest long-term fundamentals and highest valuations (high-tech stocks over the last six months) and perform admirably well.

The reader will easily be able to see which choice most fund managers will take. In fact, I feel sorry that some of my friends who are first-class thinkers and analysts are forced to take investment decisions based on market momentum, in order to perform and keep their jobs and their clients, but which run totally contrary to their own fundamental analysis and judgment.

It may sound harsh, but the entire financial service industry is like a huge brothel. The brokers push stocks they know nothing about, but which move and, therefore, can be turned over quickly, thus generating commissions. The analysts recommend stocks not necessarily based on sound fundamentals, but because they are showing signs of rising momentum as other analysts are also recommending them. And the fund managers are forced by the brothel's owners to perform by buying sectors that they don't really like but which will, as they soar, give full satisfaction to the brothel's clients. In the meantime, newsletter writers and financial advisors like myself are also actively prostituting them, as our clients also expect - aside from just sound financial advice - some moneymaking ideas.

I wish to stress that while I am critical of the financial system and the gargantuan financial service industry, which forces its professionals to invest increasingly according to momentum (excessive liquidity), I am not critical of most of the very brilliant fund managers, strategists, and analysts I come across. In fact, I am stunned again and again by the quality of analysis, breadth of knowledge, and fine personalities of the people I meet in the financial service industry, but sadly, the relentless supply of new paper money created by the Fed forces all of us to act in a way that doesn't always conform to our own beliefs.

For my taste, the Western financial markets are too large compared to the real economy and will have to be deflated at some point much further than has already happened since 2000. There are also too many smart people and treasure hunters involved in the financial service industry, which makes it more difficult for the average investor to perform well.

Valuations remain extremely high and the renewed leadership of the old favorites is more of a symptom that the recent strength is a powerful bear market rally within a long-term downtrend, which is once again likely to fool the majority, than the beginning of a new bull market. The old leaders and current momentum plays are likely to disappoint at some point, in the same way that Eastman Kodak, Polaroid, and Xerox performed poorly after the 1973 bubble peak in the "nifty fifty" stocks.

In fact, I don't believe that the current environment presents excellent entry points for most financial assets. If the correction does not come now, it is likely to be far more severe later and, therefore, investors will be in a position to buy most financial assets cheaper sometime within the next 12-18 months.

Regards,

Marc Faber for the Daily Reckoning

Editor's note: Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report, as well as a frequent contributor to Strategic Investment. Headquartered in Hong Kong for the past 20 years, Dr. Faber has specialized in Asian markets and advised major clients seeking down-and-out bargains with deep hidden value, unknown to the average investing public.