For years it was known as the “New Paradigm” economy. We now know that the “New Era” economy never existed. What we experienced in the 1990’s was nothing more than an asset bubble fueled by an ample supply of credit. That asset bubble popped in March of 2000. The Nasdaq over the next three years would lose more than 70 percent of its value. The economy went into recession and the Fed embarked on an aggressive policy to reinflate the economy. In the Fed’s mind the way to fight an asset bubble is with more credit. The Fed never saw an abundance of credit as reason for the problem. Even though Mr. Greenspan first identified the market’s reaction to that credit as “irrational exuberance,” he later for political reasons abandoned that train of thought injecting more credit into the system. It was this abundance of credit that gave us asset bubbles in the economy and malinvestments in telecomm and in technology. Another problem that was created by excess credit is that America’s trade imbalances helped to fuel credit expansion, excess capacity and asset bubbles globally. The result is that there is excess capacity in just about everything around the globe.
The efforts by the Fed to lower rates and expand credit have created additional bubbles in the bond market, mortgages and housing, and lastly consumption. By lowering interest rates to record low levels here in the U.S. it became attractive for consumers to take on more debt. Lower rates enabled debt accumulation which enabled consumers to maintain their spending habits. So while businesses spending and activity contracted giving us a recession, the contraction in was offset by additional spending on the part of consumers. A strong housing market and strong consumer spending gave us a mild recession. There never was much pain in the economy because consumer spending helped to take up the slack from a retrenchment on part of business. However, this spending could only be maintained as long as rates kept falling and housing prices kept rising, something we know can’t continue forever. In fact there are signs now that higher interest rates are taking their toll on housing as mortgage demand has fallen to a 3-month low. The American Mortgage Bankers Association reports that home loans fell 5.4 percent last week to the lowest level since early May. Refinance applications have fallen by 7.2 percent. Home buyers are now resorting to variable rate mortgages in order to purchase a home. Over the last month mortgage rates have backed up almost one full percentage point.
Relying on consumers to maintain spending and hold up the economy may be coming to an end. For these reasons the Fed may now be turning its attention to a moribund business sector. Since business spending and investment has been anemic and shows no visible signs of turning around the Fed needs to stimulate the business sector. Lower rates have allowed many companies to refinance debt, which is a positive thing if you look at the degree of bond defaults and bankruptcies have lessened. But lower interest rates and plenty of credit is a two-edge sword for business. Lower interest rates have allowed many marginal companies to stay alive through the issuance of additional debt and the ability to refinance existing debt. However, companies are using lower rates not to build new plant and equipment and make new investments, but are instead using lower rates to repair their balance sheet. The negative side of this is that many companies whom would not exist today without access to cheap credit are kept functioning. Therefore the malinvestments of the credit boom are never allowed to be liquidated leaving the economy with excess capacity. It is only common sense when there is so much excess capacity and underutilized plant and equipment in the economy that business would be reluctant to spend even more money to add more capacity.
It is this excess capacity that is depressing prices leaving business with little pricing power. It is cutting into profit margins so businesses are looking for more ways to cut costs to offset declining profit margins. This means more payroll reductions. Moreover, in addition to slashing payrolls many businesses are moving service and manufacturing operations overseas. Of the 2.5 million jobs lost since 2000 many of those jobs have now been exported overseas. This means they are not coming back. According to Gartner Inc. by 2004 more than 80 percent of U.S. executives will have discussed offshore sourcing with about 40 percent of U.S. companies to have completed some kind overseas outsourcing project. Companies have been moving manufacturing facilities overseas for decades now. What’s new today is that many high level service functions are also leaving our border. The New York Times reported yesterday that execs at IBM are now looking at plans to accelerate its outsourcing effort. Outsourcing is particularly strong within the tech industry where companies from Intel, Dell, Cisco and now IBM are moving service operations to India, China, Russia and the Philippines. Technology companies are leading the way in the exodus of high paid service jobs to overseas.
As more jobs are lost the consumer consumption bubble could come to an abrupt end, especially if interest rates continue to rise as they are now. In all of the policy debates about a new boom and recovery I have yet to hear a clear argument other than wishful thinking how unemployed workers can support America’s economy through debt based consumption. It is one reason why this has been a jobless recovery. There have been no useful measures proposed that would solve this dilemma. The problem for the U.S. is that we have substituted consumption for production in our political and economic polices. The result is that we have become a debt based malinvested economy. The American economy now runs on debt, consumption and paper asset bubbles financed by foreign debt. These imbalances will eventually be corrected either through a change in policy, or more likely by the discipline of the markets.
In the meantime the Fed seems to have readjusted its focus to recreating another asset bubble in the financial markets, especially the stock market. It may have directly intervened in the markets at key support levels to support the markets and put a floor directly underneath it. There has been talk about the “Greenspan put” referring to lower interest rates as keeping a floor underneath the market. However, the resilience of the market over these last four months given anemic earnings and economic news may show signs that the Fed is taking a more direct interest in the outcome of the stock market. Reinflating a stock market bubble may be part of the Fed’s new policy to resurrect a moribund business sector. Resurrecting a stock market bubble could accomplish temporarily several key political and economic objectives as follows:
* Reignite the merger and takeover game * Rekindle the IPO market * Reboot stock options and turn those options into consumption * Increase tax revenues for government through capital gain taxes * Keep consumer confidence and consumption high
The mortgage and real estate bubble helped to offset the weakness in the economy from the last recession. Real estate has accounted for nearly half of our economic growth through one form or another over the last three years. In fact, as stock prices fell consumers were able to monetize the value of their homes more easily than they could their stock portfolios since many households have their equity portfolios tied up in pension accounts. As the mortgage-real estate-consumption bubble comes to an end it is becoming obvious to Fed policy makers that another bubble is needed to take its place. By alerting the financial markets as it does almost on a weekly basis that it is willing to keep interest rates low indefinitely and flood the markets with liquidity, it is doing all it can to resurrect the equity bubble by encouraging speculation in the financial markets. So far it has been successful in doing this. The following points support evidence that we are now back in another bubble.
Credit spreads have narrowed to 500 basis points
Low quality companies out-performing blue chip stocks
Internet stocks back to bubble-like valuations
Mergers and buyouts picking up again
IPO calendar full of new issues
Day trading and margin debt back on the rise
Public coming back into the market through mutual funds
P/E multiples and all fundamental yardsticks of value at extremes
The list above is not inclusive of all aspects of this new bubble in the equities market. Certainly there has not been anything fundamental on the horizon, past, present or future that would justify today’s euphoria in the financial markets globally, especially here in the U.S. Earnings have improved year-over-year as a result of cost cutting (job layoffs) but not enough to justify today’s sky high valuations that make 1929, 1966, and 1987 look like bargains. What the Fed in effect has done is to encourage asset speculation whether in junk bonds or lower quality debt and in the equities markets. The massive expansion of liquidity the Fed has created and the U.S. has exported through its trade deficits have created an enormous pool of money sloshing around the globe. This is “hot” spec money looking for easy returns. At a time that risk-free returns are almost zero the speculative environment is flourishing. This is evidenced by the out-performance of companies that are struggling financially and the narrowing of credit spreads around the globe. The Fed through its massive reflation efforts has put a significant amount of hot air back into the equity bubble. Paper money is chasing paper globally looking for anywhere to land.
What you now have is everyone from retired investors looking for income, pension plans trying to fund future retirement liabilities, to the spec community chasing and looking for the “Next Big Thing.” U.S. investors have been pouring billions into high-yield (junk) funds. Close to $20 billion has flown into this sector alone this year. The general public has also been flooding bond mutual funds with money just as interest rates have hit bottom. Pension plans and well heeled investors also desperate for returns are investing in junk paper, placing money with hedge funds, mezzanine funds and other illiquid assets. This search for higher yields and returns has forced investors and institutions alike to take on larger risks than they realize. Troubled companies with balance sheet problems and over-leveraged companies with low debt ratings have those ratings for a reason. They pose a greater investment risk. It is the risk part that most investors don’t understand. Risk is no longer defined in terms of leverage. The risk most investors are familiar with today is volatility, not the risk of too much debt. The financial institutions that originate and issue most of this debt, the securities market that syndicates the debt to the institutions and individual investors who end up investing in this debt may not be fully aware or prepared for any fallout that could occur as a result of some unforeseen event.
The existence of this much credit and speculation can not go on without some kind of mishap taking place that could unravel the whole financial system. The spec community and the financial community are snug in a comfort zone feeling that if a problem erupts the Fed stands ready to bail them out. After all, each past crisis like those that occurred in 1994 with the peso and derivatives, Asia in 1997, LTCM and Russia in 1998 were met with a large injection of credit by the Fed that fueled additional asset bubbles in the stock market. There is a false sense of calm or delusion on the part of investors that if such a crisis erupts the Fed will be there to save them. How short are our memories? The Fed couldn’t prevent the Nasdaq from deflating nor could it prevent the U.S. economy from going into a recession. The markets are bigger than any central bank and it is the markets that will be the final arbiter of its actions.
In this regard the Fed may already have a problem. Actions taken by numerous open mouth committees by Fed officials have seemed to backfire. Interest rates have headed up again and are now back to where they were at the beginning of the year. The dollar after a brief and short rally looks like it wants to return back to its true course which is south easterly. As the charts below of the dollar, 10-year note and 30-year bond indicate, the bond markets are now issuing judgment on Fed policy and may not be buying the deflation story. Interest rates have backed up over 100 basis points in little over a month. If the Fed was hoping to keep interest rates low, it apparently has backfired. This is the worst bond route since the bond market debacle of 1994.
The Fed keeps proclaiming that it has a full quiver of arrows left in which to fight a weak economy or deflating asset bubbles. Mr. Bubbles Bernanke was at it again today speaking to a university audience here in my backyard of San Diego. Bernanke told the audience the U.S. central bank was prepared to cut interest rates all the way to zero if necessary to prevent deflation from occurring. If that didn’t work the Fed would resort to unconventional methods of trying to resurrect and reinflate the economy and all of the asset bubbles created through its loose monetary policy.
In the Fed governor’s words, “Monetary ease appears to be indicated for a considerable time.” The message today from Bernanke was that we aren’t done yet. The message to the markets was there is going to be plenty of money and credit as the Fed burns the currency and floods the markets with cheap money. In monetary terms this means more inflation and depending on how far the Fed goes it could end up as hyperinflation.
If the Fed governor was hoping to calm the markets, it failed. Equity prices rallied back from losses earlier in the day. However, another picture emerged that is questioning the Fed’s wisdom. Gold prices surged 5.4 percent hitting a five week high at $358. Silver prices also soared 5.8 percent as the price of the precious metal closed above $5 at $5.08. Oil prices rose and the dollar fell. As the charts of gold, silver, oil, and natural gas show below, another bull market is forming and is just in its early stages. The prices of “things” are in a new decade-long bull market.
As the Fed and other central banks make the value of paper worthless the value of metals is soaring in response. If there is a message here it is that the Fed is embarking on an inflationary course. The Fed is the source of all inflation within our economy. Generally, this policy of inflating the financial system is disguised in economic babble. The difference today is that the Fed is openly admitting that is what they are trying to do. Owners of paper assets should be forewarned. The paper you now own is about to deflate in value making it worthless. The charts of interest rates above which show interest rates are rising again means that the value of bonds is falling. Investors have now lost more money in principal this year than they have gained in interest. Since June 13th the rate on a 10-year Treasury note has risen by 32 percent. The deflation trade that began with the Fed May 5th meeting is now being unwound.
The problem for the Fed going forward is that it is beginning to lose its creditability. Last week Greenspan was before Congress predicting economic growth of 3.75-4.75 % by next year. That was for the benefit of the stock market. At the same time the Fed is trying to talk down the inflation risks by constantly bringing up the deflation story. To anyone that understands monetary policy inflation is a monetary phenomenon. What the Fed is now saying through pronouncements from its Open Mouth Committees is that we are going to have plenty of it in the future. We are clearly heading into uncharted territory. Maybe that is why gold has held up so strongly this year despite another equity bubble. Got to own it in order to thrive and survive.
Today's Market
In today’s market action there was plenty of mixed messages on the earnings front. AOL and Schwab profits were up. Schwab reported a 29 percent jump in profits thanks to increased trading. Kodak reported a 60 percent drop in profits and announced that it would lay off 9 percent of its workforce. Lucent reported its 13th straight quarterly loss. Kimberly-Clark reported flat earnings an unveiled a new plan to fix its ailing business. Schering Plough warned its profits would not meet targets for the second half of the year. Broadcom reported bigger losses along with Boeing which lowered guidance for the rest of the year.
Markets fell at the opening bell but recovered late in the day. The rally took place across a wide spectrum of sectors from energy, drugs, technology, Internet to precious metals. Gold and silver stocks exploded to the upside as the price of bullion broke out explosively. Silver stocks were up as much as 12-15 percent. Gold shares were also up, especially the price of high quality juniors. Many junior mining companies are up 50-60 percent this year. In fact, the movement in high quality juniors continues to outperform just about every asset class except the bubble Internet stocks this year. This picture, in my opinion, is only going to get better as the Fed continues to inflate the financial markets and that giant pool of hot money looks for a safe haven in time of extreme volatility of paper asset classes.
Volume came in at 1.3 billion on the NYSE and 1.9 billion on the NASDAQ. Winners narrowly beat out losers on both exchanges. The VIX fell to 20.44 and the VXN dropped to 30.77.
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