The Lull Before The Storm

For a brief moment in time it looked like all economic storm fronts were ready to collide to form the Perfect Storm. The markets fell as the equity bubble burst. The economy went into recession. Companies with poor business models failed or went under and corporate scandals abounded and were found everywhere. For the first time since Pearl Harbor, the nation was attacked on its own soil. The nation headed towards war, a war that would be fought differently unlike anything in our past. Gloom was pervasive and it appeared that storm fronts in the economy and the financial markets were heading toward collision. All seemed lost when suddenly the weather changed. The winds calmed, the seas subsided, the rain stopped, and the sun shown brightly again. Optimism returned first to the markets and then to the economy. Consumer optimism rose, while investors became bullish once more.

Is it morning in America or is it the calm before the storm of the century? Washington and Wall Street believe the good times have returned. Investors and consumers are inclined to agree. Investor euphoria has returned. Day trading has made a spectacular comeback and confidence in stock picking is on the rise. In the view of one market seer, “We’ve seen a move from fear to comfort, probably on the way to greed.” Whether it is a new corporate scandal, another terrorist attack [considered by most to be unlikely], the war in Iraq, missed earnings estimates or high priced markets, investors are taking everything in stride. Investors seem to be forgiving as long as markets continue to rise. If Wall Street is optimistic, investors are even more bullish.

What is behind this change in public sentiment? It is supreme belief in the gods of the economy, the stimulus from Washington and the money flowing from the Fed. Americans believe the economy is getting stronger as profits are improving, which will lead to even higher stock prices. It would appear that this optimism is justified. Stimulus is pouring into the economy and the markets as never before.

This year’s government budget will be $2.3 trillion resulting in a $477 billion deficit. Last years deficit was $374.2 and over the next decade that red ink will total $1.9 trillion. In Washington there is no real desire to cut spending because it is believed that government spending creates prosperity. The President has been criticized by the opposition for his tax cuts believed to be behind all of the red ink flowing out of Washington. That criticism comes from jealousy over controlling the purse strings.

The opposition is also in denial. According to the National Taxpayers Union, the opposition would increase federal spending even more resulting in even bigger deficits.

If there is one thing that all politicians have in common in Washington, it is the desire to spend more taxpayer money and their willingness to go even deeper into debt to do so. This year’s budget deficit will come in at 4.2% of GDP, an increase from last year but it still has room to grow. Yet, despite its size, it isn’t at a critical stage. The deficits will not enter into a critical stage until foreigners cease to be willing buyers of U.S. government debt.

At the moment Asian currency intervention in support of the greenback continues to accelerate. Foreign accumulation of U.S. Treasury debt has been massive amounting to almost 7½% of all outstanding Treasury debt on an annualized basis.  All that stands between sunshine and rain is foreign willingness to finance the U.S.’ twin deficits now over $1 trillion annually and growing. The latest Fed reports show that foreign central bank holding of U.S. Treasuries stand at $1,105 trillion up $247 billion over the last 52 weeks. As high as the U.S. deficits are, they still appear reasonable on a percentage basis when compared to historical standards and with other countries.

If the economy begins to soften, by mid-year fiscal spending could become even more expansionary. This is an election year and our dear politicians are passing out candy to the voters. If the economy softens, Washington knows only one thing and that is to spend more money. So expect fiscal stimulus to be operating at full throttle. It is one of the pillars holding up the U.S. economy.

The other pillar is monetary policy which is also operating at full throttle. The Fed has its foot to the pedal and is doing all that is possible to goose the markets and economy with cheap and abundant credit. Since it began slashing interest rates in 2001 the Fed has managed to bring interest rates down to a half century low and keep them there. The result has been a flood of money into the economy and the financial markets. Low interest rates have spawned a bubble in real estate, mortgages, bonds, and in stocks. The rise in the stock market since the October lows of 2002 has all been liquidity driven. 

For the first time in nearly half a century, the yield on the S&P 500 exceeds the 3-month t-bill rate. (S&P 500 yield = 1.5%, 3-month t-bill yield = .9%) The Fed is able to keep rates this low only as long as foreigners continue to finance America’s burgeoning debt burdens. It is an untenable position fraught with much risk. The difference between calm markets and storm conditions requires constant intervention to hold back the storm clouds. However the more that intervention takes place, the greater fuel for even larger storm fronts developing later this year.

Cash is Trash

Money growth, which has fueled these brief moments of sunshine, has fallen sharply. Part of this has to do with last summer's tax rebates and mortgage refi money generated from the May-June interest rate lows. Another reason for the slowdown in money growth is the “cash is trash” syndrome. The returns on savings are at record lows and in fact are negative when compared to inflation rates and taxes. Savers and investors are pulling their money out of banks because of poor returns and seeking higher returns elsewhere. This is what is in part fueling the financial markets.

That has been Greenspan's intention all along. In order to fund consumption and prevent a reckoning of the debt binge of the 90's, it has been necessary to keep the markets or asset bubbles inflated. Consumers, corporations, and the government continue to go deeper in debt requiring reinflating of all asset bubbles. The debt burdens have become so large that it has become unthinkable to consider the consequences of a deflationary debt collapse. The Fed needs to keep interest rates low in order to keep the mortgage refi and housing markets from collapsing. Mortgage debt has become the main props holding up consumer spending and as long as the housing bubble stays inflated consumer debt burdens appear less ominous. 

Today’s report that existing home sales jumped to an annual rate of 6.47 million units in December concluding a record year indicates the housing bubble is alive and doing well. Low interest rates are critical to keeping this bubble inflated. As shown in the graph below the monetary base still remains positive indicating the Fed is still priming the pump. The housing market is dependent on cheap mortgages, cheap mortgages are dependent on low interest rates, and low interest rates are dependent on foreign intervention. This is an untenable situation and will not last.

The Bond Carry Trade

Besides the intervention of foreign central banks, another critical factor in keeping interest rates low is the bond carry trade. The Fed’s commitment to keep interest rates artificially low has provided the fuel behind the carry trade. Hedge funds and institutions can borrow at artificially low interest rates and invest the difference in longer-dated Treasuries. The difference in yields has ranged between 300-350 basis points making it extremely profitable to borrow. It is one reason why the bond market has been asleep. It is making money ignoring all the visible signs of monetary inflation. What matters most is the profit from arbitraging spreads and that is all that counts. However, the bond market and hedge fund community is ignoring a fundamental risk of borrowing which is never borrowing short and invest long. The dangers of this trade will be examined shortly. The profitability of this trade could change suddenly if foreigners were to stop intervening.

Three tell tale signs to keep watch over are signs of shrinking foreign inflows into the Treasury market, a blow-out in credit spreads, and a sharp deceleration in money growth.

Real Estate & Recovery

Meanwhile, the real estate market will continue to play a key role in the U.S. economic recovery. The fact that real estate prices keep going up only reinforces that view. In my view there are four critical factors that all support the real estate market remaining strong this year. They are listed below:

1. Rising Prices

2. Low interest rates

3. Lower lending standards

4. Tangible enjoyment

Nothing attracts money more than rising prices. A trend once in place tends to remain in place until it is discredited. For most Americans housing appears to be a ”can’t lose” proposition. When the equity bubble burst at the end of the last millennium, housing prices took off, spurred on by the cashing in of stock options and low interest rates. The prices of real estate have risen remarkably, but those price rises have been countered by the lowest mortgage rates in half a century. This has made housing affordable to a whole new class of home buyers. In addition to low interest rates, lenders have made it easier to purchase a home. Lending standards have been lowered to the point that it is possible for a homebuyer to buy a new home for little or no money down. Instead of the traditional 10-20% down payment prospective buyers can buy a new home for as little as 5% down. In many instances even that amount of equity is no longer required. I recently was told of a home in Malibu that sold for over $800,000 with the buyer putting only $20,000 down.

If Americans have been willing to pay more to own a piece of the American dream and if lenders have been willing to lower standards in order to buy this dream, it may also be because lenders believe their risk is low. Real estate unlike other investments has a tangible benefit. The homeowner can live in and enjoy his investment. There is a personal attachment to real estate that isn’t offered by other investments outside the ownership of gold and silver. Making friends with neighbors, sending your kids to a good school, attending a local church create a sense of belonging, an attachment that can’t be replicated by other investments. This makes the real estate market less volatile and less susceptible to sudden downturns as so frequently occurs in the financial markets. Investors are less attached to stocks these days as evidenced by shorter holding periods and frequent trading. This is less true of housing.

The tangible benefits of home ownership are one reason why the housing markets have remained so strong. The other factors such as low mortgage rates and tax benefits are other reasons. But perhaps the most important benefit of housing for most consumers is the ability to monetize an asset and turn it into ready cash. It is the closest a homeowner will ever come to becoming a central bank.

Unfortunately, while the real estate market rolls over much more slowly than the stock market, when it rolls its impact will become more troublesome for policymakers, bankers, the financial markets, and the economy. For roll it will. The housing market is like a big ship that is heading into an approaching storm. The ability of a boat to clear itself in boarding seas is one of the most crucial aspects in any boat's design. A boat needs to clear its decks of water in order to stay afloat. If it can’t, it begins to wallow and lose steerage. As a passenger if you see white water on deck, all is well. If the water is green, you’re in trouble, and if black, the boat has become a submarine.

By comparison, the ability of an economy and financial markets to clear itself of unwanted debt can determine whether the economy sinks or survives an economic storm. So far the decks have been cleared by lower interest rates and only white water and green water has been visible. This may not always remain so because one of the main props holding up the real estate market is artificially low interest rates. These low rates are totally dependent on foreign central bank intervention and the speculation of the bond carry trade. If foreign money exits, the U.S. Treasury market rates would rise forcing the Fed to start monetizing government debt. A sudden jolt in interest rates would also create a conflagration in the bond and derivative markets which remain heavily leveraged and highly geared.

Rogue Waves, Fat Tails & Outliers and Other 10 Sigma-like Events

This brings up one of the pitfalls of present policy that gets very little attention in today’s euphoric markets. While the Fed has managed to bring interest rates down to levels not seen in over 50 years, it has not been without risk. By lowering interest rates it has created a level of moral hazard that is without precedent. By making the returns on savings worthless, it has discouraged thrift, encouraged the accumulation of debt, and given impetus to speculation. With negative real interest rates, savers have been forced to seek returns elsewhere in the markets. Investors from sophisticated hedge funds to the average Joe have also been forced to take on more risk.

Risk premiums have narrowed considerably as shown in this BCA Research chart. In fact investors are being paid very little for taking on big risks. Interest rate spreads have nearly collapsed on speculative-grade debt and emerging market sovereign debt. One real threat that a storm in the markets is approaching would be for a blow-out in credit spreads signaling a bottom in the interest rate cycle.

Overpriced Markets

While the markets have become highly geared, they also have become highly overpriced.

Investors get very little in return for buying risky debt or risky equities. Dividends are well below normal and P/E multiples remain way above the normal range for the major markets. For investors all that matters now is price and as long as prices keep going up, investors will keep buying. In the back of the minds of most investors is the strong belief that the Fed will bail them out. Forgotten is the fact that the Fed failed to stop the equity bubble from bursting or keep the NASDAQ from losing almost 80% of its value. Likewise the Fed was unable to create a soft landing or prevent another recession from occurring. The latest opinion polls show that investor bullishness is back to levels last seen at bull-market highs of the late 90’s. In the words of Woody Dorsey, “We’ve seen a move from fear to comfort on the way to greed.”

If investors and institutions seem complacent about risks in the marketplace, they remain equally sanguine regarding the risk of terrorism or other geopolitical threats. We are once again at a place of complacency not seen since the bull market highs of the late 90’s. In a recent poll of investors' attitude toward terrorism, they were all positive. Very few felt that another terrorist attack would impact the markets. Even if another event were to occur, most investors feel it would have a positive effect on the markets with more Fed-injected liquidity and even lower interest rates. Investors have been inoculated against another stock market crash or even another terrorist event. Time has once again separated investors from their senses. Today reminds me of something I once wrote in my Perfect Storm series:

"There will come a day unlike any other day, an event unlike any other event and a crisis unlike any other crisis. It will emerge out of nowhere at a time no one expects. It will be an event that no one anticipates – a crisis that experts didn’t foresee. It will be an exogenous event – a rogue wave."

For now it would appear for a brief moment in time that our money masters have rolled back the clouds and caused the sun to shine once more. Unless the unexpected happens, it would appear that for a little while longer, the storm clouds have been kept at bay. But sunshine can be temporary. There is a cold deflationary storm building in the debt markets and an inflationary heat cyclone building in the commodity markets that could lead to a hurricane. The jet stream in the currency markets could lead these two storms on a collision path merging the two storms together to form the Perfect Financial Storm. As credit continues to build and risks increase along with speculation, the stage is being set for an even a larger storm ahead, perhaps later this year but most certainly by next year. Enjoy the sun while it lasts because we are in the lull of an approaching storm.

Today's Market

Stocks rose on Monday as positive earnings reports from companies such as Agilent, Texas Instruments, Safeco and Lexmark fueled higher stock prices. Over 140 companies will report earnings this week including Dow giant Exxon-Mobile. Of the 185 members of the S&P 500 reporting earnings results so far, the average gain in profits has been 24.8%. Of those companies reporting, two-thirds have beaten estimates. Analysts now believe that the earnings momentum will continue this year albeit at a slower pace. The current guesstimates are for profit gains of 13.7 percent in Q1 and 13.5% for all of 2004.

The gains in the Dow came from a late day surge that began out of nowhere and took the Dow to a 31-month high and helped the Nasdaq overcome earlier losses. Pharmaceutical stocks dominated the day with the $60 billion hostile takeover of Aventis by Sanofi-Synthealabo’s. A favorable mention in this week's Barrons of Merck by a money manager also fueled a rally in drug stocks.

Advancing issues led declining issues by 18-14 on the Big Board and by 2-1 on the Nasdaq. Volume totaled 1.4 billion on the NYSE and 1.9 billion on the Nasdaq.

The U.S. dollar rallied against the Euro, fell against the yen, while gold prices eased $1.30 to $406.70 an ounce. Treasury prices fell with the 10-year note losing 7/32nds  and the yield rising to 4.1%.

Jim Puplava

Resources
Congressional Budget Office, "The Budget and Economic Outlook for Fiscal Years 2005 to 2014, January 2004
St. Louis Fed: Federal Debt Held by Foreign & International Investors, January 5, 2004
BCA Research, Bloomberg

Some interesting definitions for the word, "lull" (noun)
1. A relatively calm interval, as in a storm
2. An interval of lessened activity
3. A pause during which things are calm or activities are diminished
4. A temporary cessation of storm or confusion

© 2004 Jim Puplava
January 26, 2004