Fire?
by Barton M. Biggs
I still think the most likely outcome of the great boom cycle of the
1990s is an episode of Ice, but there is the possibility that it could end
in Fire. Either way, to mix metaphors, The Piper must be paid. Although an
episode of Fire would generate a sigh of relief and briefly warm some
extended citizens, in many ways it would be even more painful in the long
run. Which outcome actually occurs is not an academic issue - whether it's
Fire or Ice makes a huge difference to what one does with money.
If it's Ice, government bonds and true growth stocks are the places
to be ... Growth-rate
expectations for many companies now are too high for such a cold
environment, but as long as an enterprise can sustain some growth, the
shares will work, because P/E ratios will soar. The pharmaceutical and
consumer products sectors are obvious choices, but valuations are full. The
capitalization rate of stable, defensive streams of earnings and income will
rise as interest rates fall. Debt and leverage should be eschewed at all
cost. There will be possibly severe deflation of profits, and balance sheet
analysis will be crucial. In Ice, the dollar ould be stable.
But if it's Fire, the investment world will be turned upside down.
Of course, a lot depends on the form inflation takes, but for sure the bear
market under Fire would be a different kind than that under Ice. Treasury
bonds and growth stocks will get hammered, but
it seems to me that safe havens from Fire would include Treasury bills,
gold, silver, commodities, high-yield bonds, real estate, and companies that
have fixed assets with earning power or natural resource bases and are
beneficiaries of inflation. Interest rates would rise, P/E ratios would
shrink drastically and the dollar would fall.
My basic belief is that a boom driven by debt, capital spending and
inflation in equity prices should end in a bust characterized by a decline
in capital spending, a slowdown in consumption, debt liquidation, weak
pricing power and a collapse in profits. In other words, I think a serious
recession, mild deflation and a bear market in equities one way or another
is
the most likely case.
Japan's spiral of interlocking vicious circles shows how agonizing
Ice can be if it is compounded by policy errors. If our Authorities are wise
and do not become paralyzed as the Japanese have, there is no reason we have
to experience such long and severe trauma, but I do not believe that this
time monetary and fiscal policy can avert a recession. Bubbles have to be
burst, debt has to be liquidated, savings rates have to be restored and
busts have to follow booms. However, the right monetary policy can ease the
pain.
The question is, what is right? Some, including hardcore Austrian School
disciples and economists such as Ludwig von Mises, would argue that since
this cycle is about over-investment, a policy of aggressive ease is
absolutely wrong, since it would cause one more spasm of speculation and
investment that only adds to the overcapacity at the root of the
problem. On the other hand, if the central bank by accident or design
follows a restrictive monetary policy, the result will be either a long
recession or a depression with persistent deflation and many unintended
consequences.
The right policy may be one of benign neglect and monetary
neutrality. History suggests that when you interfere with the markets,
timing is a very difficult thing to judge. You may be better off allowing
the markets to clear and the economy to stabilize in their own sweet time
and rhythm. Laissez-faire economic policies will allow market forces to
complete their adjustment in the shortest time possible without the
distortion of artificial stimulation of
consumption or the preservation of unsound investments and enterprises.
In the discussion after his January 25 testimony, Chairman Greenspan
said that fiscal policy was a "blunt instrument" for fighting recession,
because it almost always gets the timing wrong. Since the rule of thumb is
that it takes a year for monetary policy to have an
impact, you could say it, too, is a blunt instrument. Greenspan's record
with timing monetary policy, at least in 1990-91, is not
confidence-inspiring. The Fed didn't even know the economy was in a
recession. The record of other central banks is no more encouraging, and in
fact one could argue that the Bank of Japan, for example, in this cycle has
done almost everything wrong.
However, I think it is absolutely obvious that Mr. Greenspan will be
very aggressive this time. Not only has he said he will be, but even if all
the adoration heaped upon him hasn't gone to his head and he doesn't believe
he is the omnipotent maestro, he also knows everyone expects him to be the
messiah. I would guess he must feel compelled to do something. If he isn't
aggressive and follows a policy of monetary neutrality, the outcry will be
overwhelming. All the people who bought stocks with their savings and
retirement money expecting 20% a year will be screaming for his head.
Furthermore, he will get no credit if he follows a policy of "benign
neglect" and it works - but he'll get all of the blame if it doesn't. He is
an activist, as all politicians in democratic societies have to be. Perhaps
the right thing for Mr. Greenspan would be to do what he is very, very good
at. Talk. He should use his exalted status to reassure and educate the
public while following a steady monetary policy that allows the system to
clear. The chances of his doing this are probably zero.
Mr. Greenspan must be targeting not only the economy but also
Nasdaq. He must know the
incredibly close correlation between Nasdaq and retail sales. I think he
is going to flood the system with liquidity, and rate cut will follow rate
cut. For many reasons, I don't believe that this policy will work to revive
the economy: Lower interest rates are not going to restore Joe Six-Pack's
balance sheet or liquidate the excess capacity. Joe is spent out and
"re-fied" out.
Furthermore, Nasdaq is still very expensive and earnings estimates
even for the old economy companies are too high, so it will be hard to
revive the wealth effect. But massive doses of liquidity could rekindle
certain kinds of inflation. After all, the money has to go somewhere. There
will be an increase in the money stock. The U.S. banking system, the
transmission mechanism, is not nearly as burdened with bad loans or as
demoralized as Japan's.
Are there signs that Fire is beginning? Not many, actually, except
that virtually no one is talking about a resumption of inflation.
Nevertheless, you could argue that the Fed panicked last month and cut rates
too much, too soon. After all, the Dow is close to its all-time high, the
S&P is down only 12% or so, and even Nasdaq is only back to where it was two
years ago. Some commodities and junk paper have rallied and Treasury bonds
have sold off even though
everybody loves them. But this is hardly conclusive evidence.
In his latest letter, Marc Faber says that Jim Rogers wrote him that
commodities markets are where stocks were in the early 1980s - at the
beginning of major, long-term upward moves. Rogers is also very bullish on
unleveraged futures on natural resources. Interesting, and Rogers is a
home-run hitter, but he also strikes out a lot.
In short, I still consider Ice the likeliest outcome, but Fire is
one more thing to watch for and worry about. It would be the ultimate
indignity to be right about the recession being severe but wrong about the
way to play it. |
