Today's Market WrapUp 03.26.2003 Mon Tue Wed Thu Fri Puplava Archive
The
Road to Perdition
BY
JAMES J. PUPLAVA, CFP
Students
of economic history are familiar with the boom and bust cycles that
punctuate most of US economic history throughout the 20th
century. These boom and bust cycles are the result of the expansion
and contraction of credit engineered by the central bank, in this case
the Federal Reserve. In a typical cycle, the Fed expands credit, which
causes interest rates to fall, stimulating demand and consumption
within the economy. As credit expands the economy picks up, business
revenues rise along with profits. Expanding profits translate into a
boom in financial markets as investors are willing to pay more for
equities whose profits are rising. However, at some point in the
business cycle, the boom no longer becomes sustainable. The expansion
of credit creates above-normal demand for goods and services that
leads to higher prices. The economy heats up and financial markets
become grossly over-valued as investors bid up prices to extraordinary
levels believing the boom will last into perpetuity. The economy and
the markets are in danger of contracting and crashing. At this point,
the Fed steps in and raises interest rates in order to cool off demand
and speculation in the markets. The inevitable correction begins, the
markets fall and the economy contracts. During this period of
correction excess inventory is worked off, manufacturing slows down,
and the stock market corrects from over valued levels to more normal
valuations reflective of actual business conditions.
The Business Cycle
Once all of the excesses, which include all malinvestments of the previous boom, are liquidated and excess inventory levels are eliminated, another cycle of renewal begins. The Fed lowers interest rates and another credit expansion and business cycle begins. This has been the typical pattern of business cycles repeated with regularity in the past century. However, there are certain business cycles that are carried to extremes. They become super booms, a period of above-average economic growth and above-average stock market returns. A distinguishing feature of these booms is that they are fueled by massive amounts of credit. The large injections of credit into the economy fuel above-normal demand as a result of abundant credit and lower interest rates. This leads to large-scale demand in the economy and widespread speculation in the financial markets. These booms are also associated with technological advances giving rise to the “new era” myth that is used to justify market valuations and the belief in a perpetual boom. Such was the case of the 1920s. The advancement in technology, the economic boom, and the rising markets that followed led many to believe they were living in extraordinary times. What was not as widely recognized during this period of the extraordinary boom was the product of an aggressive monetary expansion by the Federal Reserve. In the aftermath of the 1929 stock market crash, what should have been a short-lived recession and short painful adjustment turned into a prolonged and deepening depression as the direct result of government interference with market. The cleansing mechanism of the market in liquidating malinvestments was interfered with through price and wage supports, and government taxation and spending were substituted for private sector investment. It would take a world war to bring us out of depression.
From the 1930s forward the US economy, although freer than most, no longer operated under true market conditions. Government interference and regulation played a more important role in the economy. In the latter half of the 20th century, government fiscal policy and monetary policy became a tool of politicians to influence the outcome of the economy and the financial markets for political gain. A prosperous economy and financial markets made for happy constituents. Happy constituents reelected their political leaders and unhappy voters threw them out of office. Because of this direct interference with the economic process of markets and the economy, the post-war period has been punctuated by periodic boom and bust cycles that have become longer and more severe in their duration. The policy goal--as elusive as it sounds--has been the complete elimination of the business cycle. At any sign of weakness or disruption in the economy or financial markets, either monetary policy or fiscal policy has been brought to bear in an effort to prevent a downturn. The goal has been perpetual prosperity. No politician wants to see the economy or the financial markets decline because voters will blame them for the outcome.
The
result is that we have a politicized economy and market that is no
longer in equilibrium. Fundamentals are no longer in line with market
forces, but instead are altered by government intervention. This has
led to increasing imbalances in our markets and in our economy that
periodically leads to acute crises. These crises are increasing in
frequency as continuous intervention must be brought to bear in order
to avoid an economic collapse or stock market crash. Metaphorically
speaking, the economy and the markets are prevented from drying out
and instead are fed a constant supply of credit in order to keep them
in a constant state of intoxication. This is no more evident than the
boom period of the 1990s that began with a conscious effort by the
Clinton Administration and the Fed to expand the rate of credit in the
economy and stimulate an artificial boom. This can be seen in the
graph of the money supply that begins to expand parabolically in 1995.
This giant leap in
credit gave way to a booming market and economy that was often
referred to as the “new era” economy. The “new era” economy
ended in March of 2000 with the stock market. The economy followed
suit in 2001 when the US economy entered into a recession. Instead of
allowing the credit excesses and the malinvestments of the previous
boom to correct themselves, the Fed chose to interfere in the
cleansing process by moving aggressively to expand credit and lower
interest rates. Beginning in 2001 the US economy came under the
influence of the most aggressive monetary expansion in US history. As
the chart of the money supply above and the chart of interest rate
cuts on the right indicate the Fed kept and continues to keep its foot on the
monetary pedal until it has created another boom to take its place.
While equity prices contracted, another bubble was created in the
mortgage, real estate, and consumer sector to replace the downturn in
business and the stock market.
Monetary policy has proven to be a failure in both preventing a recession and in reigniting the stock market. Now the asset bubble in the mortgage market, the boom in housing, and the bubble in consumption is in danger of contracting and sending the economy back into recession. Furthermore, the stock market was in danger of slipping further into the abyss beginning last July, October, and then again in February and in March.
It
now appears that intervention in the financial markets is becoming
every bit as important to Fed policy in an effort to avoid a market
crash and reignite another business cycle. With growing evidence that
the consumer is now starting to retrench on spending plans and with
the real estate boom starting to soften, the economy is now in danger
of slipping back into recession. This time officials have to be
worrying over what will reignite the business cycle. It appears that
the consumer is tapped out. Therefore, unless another refinancing wave
can begin by engineering interest rates even lower, there is nothing
on the horizon outside massive government fiscal policy to keep the
economy afloat, that is unless a stock market boom can be
reengineered.
If stock prices could boom again, this could alter business behavior. Rising stock prices could stimulate another round of merger activity that could in drive earnings higher. Higher earnings could then help to perpetuate another boom in stocks as higher earnings could be used to sell a business and market recovery. Higher stock prices might also alter business activity and help initiate a trend towards capital investment. It has been the contraction in capital spending and the downturn in manufacturing that led us in to the last recession. By reigniting a stock market boom, it may be the desire of government officials to reignite a capex-spending boom. Government economists and Wall Street analysts have been predicting a second half recovery boom for four years now based on an improvement in business conditions. The improvement or the capex spending have never materialized. The reason is business recoveries are predicated on the complete purging of all past malinvestments of the previous boom. This purging process entails bankruptcies and defaults as these malinvestments are liquidated and the economy is cleansed of all excesses. This becomes even more critical to the recovery process when a boom has led to a speculative bubble. So far, this process has just begun. The record bankruptcies and corporate defaults over the last two years such as Enron, Global Crossing, Kmart, and WorldCom are just the beginning of this process.
However, this process is not allowed to take place as a result of monetary intervention and government fiscal policy. The only thing that cleanses the economy and regenerates recovery is for the government to cut taxes on the private sector and restrain government spending. The tax cuts ease the burden in the private sector and help to restore savings and investment in the economy. Government restraint in spending is also necessary in an effort to keep fiscal imbalances under control. The Senate just voted to cut the President’s $725 billion tax cut in half. Instead, recommendations are made to expand government spending in order to stimulate the economy. There is a belief in Washington that only the government is capable of generating a recovery. The market and the private sector can’t be trusted. Fiscal measures and monetary policy prescriptions are recommended in their place.
We Can't Have It Both Ways
The Bush tax plan is a step in the right direction, but the fiscal spending measures outside of defense throw fiscal policy out of balance by creating monster deficits. Like the Vietnam era, we are trying to have it both ways with both guns and butter. It simply won’t work and will lead to further imbalances in the economy and the financial markets. Instead of trying to allow the economy and the markets to recover naturally, as painful as that might be, the government is stepping in and trying to speed up the heeling process. The more the government interferes in the process of cleansing all of the excesses of the 90’s boom, the more counterproductive its policies become. The result is more bubbles, greater volatility, and market instability.
The market is now in grave danger due to direct government intervention in the market place. It has been remarked upon by many outside the US as to the artificial nature of our markets. What should be going up is going down, and conversely what should be going down is going up. The tonal quality into this market is out of balance with fundamentals. In fact, fundamentals have been altered to justify this imbalance. I find it hard to believe that the US financial system is incapable of coming up with bottom line numbers or that the government and accounting industry is incapable of requiring a clean balance sheet. Debt is debt no matter where it resides. Expenses are expenses no matter how large and infrequent they occur. We have gone to pro forma numbers because they simply are being used to justify what are still high valuations for individual stocks and major market indexes. By using pro forma numbers, earnings can be made to look better and much higher than normally would be the case. It makes it easier to sell the markets.
Reflexive Relationships & Boom/Bust Cycles
The reader must understand that markets move on perceptions. These perceptions become inherent human biases that lead to action that in turn create underlying trends in the market. The trend in stock prices then becomes reinforcing and a feedback loop that perpetuates trends and biases until those biases are altered. This is what George Soros refers to as reflexive relationships in which stock prices are determined by the underlying trend and prevailing market biases. Both of these two variables are in turn influenced by stock prices. If the prevailing bias is bullish and the underlying trend is rising, then rising stock prices reinforce both the bullish bias and reinforce the underlying trend. Most of the time these three variables are all lined up in support of each other in one direction. The markets are either in a bull trend or in a bear trend. When prices become the overriding variable, the trend is in danger of reversal. If prices fall, perceptions can change, which leads to a change in bias, which can effect the underlying trend of the market. When this bias reverses the underlying trend in the markets, a change in perceptions and biases take place and lead to a change in motion in the markets. As Soros points out, this trend change and where it manifests itself is the key to understanding boom/bust cycles.
There are times when this process can be altered and extended through government intervention. A good example is the monetary policy change that began in 1995 by a conscious decision by the Fed to expand credit. This credit expansion gave us our boom. Lower interest rates and abundant credit led to artificial buying and the increase in consumption. It also gave us irrational markets. Lower interest gave us lower discount rates that were applied to future earnings. This made for easy comparisons that made overvaluations of stock prices seem remote. However, booms can’t be perpetuated forever. At some point they end or collapse of their own excesses. The stock market boom ended in March of 2000. The economic boom ended in 2001. Since that time, the Fed and the government have interfered constantly in the economy and in the markets to prevent a recession from occurring or to stop the hemorrhaging of stock prices. The only success has been in making the recession shorter. However, by doing so the Fed has sown the seeds of the next recession and eventual depression. By artificially lowering interest rates to half-century lows and below, where a freely traded market and fundamentals would dictate, they have resurrected multiple bubbles in the mortgage market, real estate market and in consumption. By lowering rates to such extreme levels, it has given consumers a false sense of well being. They have borrowed money to buy bigger homes, new cars, take vacations, and spend money on all kinds of goods and services altering their spending pattern towards excesses.
In contrast to the last recession when the Fed lowered interest rates, consumers used lower rates to refinance and pay down debt; while increased cash flow was used to rebuild savings. Expenditures were cut and savings replenished. In other words, the consumer acted responsibly. This time the consumer and households acted differently. Instead, lower interest rates led to a mortgage refi and home equity extraction boom. This in turn led to above-average consumption and above-normal debt accumulation. It also helped to create a bubble in the real estate markets. I believe the boom of the 90’s also led consumers to abandon their conservative financial behavior. The urge to consume was, I believe, a desire to perpetuate the boom of the 90’s. Without the benefit of rising stock prices, the consumer turned to rising housing prices and lower interest rates to keep up the lifestyle of the 1990s boom.
Lower rates and rising housing prices also led to complacency in the financial markets. Instead of liquidating investments that were losing money, consumers held on in the belief that the boom times would return. Washington and Wall Street reinforced this belief. The Fed extolled the virtues of productivity and the soundness of the economy as evidenced by the real estate and the consumption boom, which kept the recession short and mild. Wall Street helped to reinforce the concept that the markets were going to recover by leading investors on with second half recovery theories. At no time were risks explained or alternative investments strategies offered that might have preserved assets. Instead, investors were urged to hold on, and keep buying even as insiders sold or shorted the markets.
Intervention... a Matter of Public Policy?
This brings us back to where we are today: stocks are still treading water, financial markets are more volatile, earnings trends remain in doubt, and economic indicators are once again deteriorating. The 12 interest rate cuts and expanding fiscal policy have failed to generate a long lasting recovery. If it did, there would be no reason to generate further tax cuts. With the failure of rate cuts and the aggressive expansion of credit to generate an enduring recovery, monetary policy is now moving in a dangerous direction. It appears to several astute observers of recent market machinations over the last six months, that intervention in the financial markets has now become part of public policy.
Observers of recent market behavior acknowledge many anomalies that exist in the markets. Intermarket relationships have broken down. There is now a wide gulf between fundamentals and the markets. Fundamental and technical relationships are out of balance. The markets now move on erratic momentum that is both unstable and unpredictable. The monetary authorities I believe are trying to alter biases and through the change in biases the underlying trend in the market. It has been freely admitted and expounded upon in recent Fed speeches that the Fed had at its disposal other means besides interest rates to effect changes in the economy and the financial markets. It has admitted to intervening in the past to control and manage interest rates. It is also known that the government has intervened in the gold markets most notably during the London Gold Pool of the late 60’s and more recently in the strong dollar policy of the mid-90’s.
It now appears that this has become part of policy again as major markets rise and fall violently in unpredictable and unexplainable fashion. Perceptions and biases have been created that the business capex spending will lead the economy this year. Once this takes place, the economy will be put on a firmer footing. Consumers will continue to support the economy through additional consumption made possible through equity extraction and rising housing values. The assumptions and biases that have been created from this myth led to a brief rally at the beginning of the year. Since then Q4 earnings reports and warnings over this year's profit outlook, along with weakening economic reports, produced another negative year for blue chip equities. The response was that the war with Iraq was holding back the recovery in business and in profits. Once the war was over, the good times would begin. The war was expected to be brief and short. When it looked like markets were once again in danger of breaking below support levels, miracles appeared in many unexpected ways. The markets rallied on news of the delay in war and then immediately rallied on the eve of war. The worse the news gets, the better the markets perform. This has led many on the Street to comment that bad news is a lagging indicator so investors need to look beyond the horizon to the good times that will follow. The recent rise in the markets are simply the markets discounting mechanisms at work predicting the good times that lie directly ahead. So biases have been created that have led to market behavior in rising prices which in turn are reinforcing widely held perceptions in a self reinforcing feedback loop.
The Trap
In essence I believe that intervention in the markets have created this bias, which is leading to speculative behavior by major market participants. Hedge funds, mutual fund managers, and large institutions are falling into this trap in the belief that the Fed in effect has placed a put underneath the markets. Market players are being encouraged to speculate as the moral hazard is reinforced by acts of intervention. The message seems to be go ahead and speculate because we have placed a floor underneath the markets. As to those who are calling for a market bottom and that the current batch of bad news is simply a lagging indicator, I would simply give warning. It may be possible that through enough intervention and speculation that the markets could indeed rise in a brief countertrend as it has done so recently. However, it is unlikely to remain there as more news on earnings and the economy start to filter in. I would simply point to the fact that many of the excesses of the past boom have yet to be purged and liquidated. There are still plenty of malinvestments that have not been liquidated. Market valuations are still at extreme levels where other bear markets have begun. And there are plenty of new excesses, most notably in housing and mortgages that have yet to be liquidated. I expect a new round of delinquencies, defaults, and bankruptcies to start emerging from the consumer sector this year. The process accelerated in Q3 & Q4 of last year. In addition, most investors have held to their positions and mutual fund cash positions are at their lowest level in decades.
This is hardly the place at which recoveries and bull markets begin. The greatest danger now to our economy is that some unforeseen event emerges that throws the markets off course and sets in motion a chain of events that lead to their unraveling. This event whatever it turns out to be overwhelms the governments ability to intervene and counter the markets reactions. Biases and perceptions become permanently altered and complacency is overridden by fear. The imbalances that have been propped up and prevented from unraveling eventually unravel as the market in the end has its way. In my opinion, all of the intervention and the distortions that have resulted from these interventions have in the end lead us down the road to perdition and are now irreversible. It is simply a matter of time as to which event emerges out of nowhere and triggers the inevitable correction.
Today's Market
Meanwhile today’s bad news on the economy, earnings, and accounting scandals could not be overcome. There were several attempts to rally the markets as shown in the graphs below. All of them failed.
Durable goods orders fell indicating further economic weakness. Capex spending by business remains flat. The perception of a short war is slowly giving way to the realization it may turn out to be a long and protracted conflict. The Pentagon released a report that Iraq may intend to use nerve gas on US troops unsettled the markets. Market internals continue to deteriorate. Market breath was negative by 18-14 on the NYSE and by 17-14 on the NASDAQ. The VIX fell .50 to 32.16 and the VXN dropped 1.06 to close at 43.94. A drop in both indicators recently raises the issues of investor complacency. It is when markets are most complacent that the unexpected event usually appears.
Overseas
Markets
European
oil stocks rose on optimism that companies including BP Plc and Royal
Dutch Petroleum Co. will benefit from higher oil prices as war rages
in Iraq. Insurers Allianz AG and Munich Re dropped. The Dow Jones
Stoxx 50 Index fell 1.78 points, or 0.1% to 2236.14. The Stoxx
600 fell 0.1% to 186.64. Benchmark indexes climbed in 11 of
Western Europe's 17 national markets.
Asian stocks rose, led by Toyota Motor Corp., News Corp. and other companies that rely on the U.S. for most of their sales, after President George W. Bush said allied forces are on a “steady advance” to Iraq's capital. Japan's Nikkei 225 Stock Average gained 1.4% to 8351.92.
Copyright
© 2003 Jim Puplava
March 26,
2003
Chart courtesy of Bloomberg, CNN/Money
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