Excerpts from TimingWallStreet June 22, 2003
One Last Desperate Gamble to Save the Economy -TraderMike Everyone expects the Federal Reserve to cut interest rates when they meet this Wednesday and according to Larry Kudlow they better deliver. This is what he wrote in the National Review: “We must not risk another disappointment in the stock market or the economy. That would be devastating. Mr. Greenspan and all his little maestros need to pour it on. This is no time to take chances. Add more money.” Other Wall Street spokesmen have demanded that the Fed enact a 1/2 point cut next week and it looks like they are going to do it. When has Alan Greenspan not followed the dictates of Wall Street?
“The very existence of the Federal Reserve System is a safeguard against anything like a calamity growing out of money rates...In former days the psychol-ogy was different, because the facts of the banking situation were different. Mob panic, and consequently mob disaster is less likely to arise.” - Benjamin Strong, Chairman of the Federal Reserve, April, 1929.
“The stars could not be better aligned for economic growth!” - Bank One Chief Economist Diane Swonk on CNBC, June.
There is no economic recovery. Over the past month recent dismal economic reports and growing unemployment have caused the Fed futures contract to price in a certain 1/4 point cut next week and a good chance of a 1/2 a point. This week the June Philadelphia Fed Manufacturing index showed that prices received dropped -9.5% while the current account deficit grew to a crisis 5.1% of GDP. According to ManPower, the nation’s largest temp agency, 3 out 4 employers expect to cut jobs or hold off on hiring this summer.
An article in the Washington Post by John Barry on Thursday almost assures that we’ll get a 1/2 point. Barry’s Federal Reserve articles, based on leaks from Fed members themselves, are accurate forecasters of Fed moves. He notes that several high profile Federal Reserve officials have publicly talked about the need to fight deflation. In fact, according to Barry, overshooting and cuasing inflation “would almost be welcome” to Alan Greenspan. He knows that if we have deflation it will mean depression, economic chaos, and the ruin of his public reputation. In Barry’s words many Fed officials “aren’t convinced” that predictions for a second half economic recovery by Wall Street economists, like Diane Swonk, are correct.
So far we have seen 13 interest rate cuts from the Federal Reserve in the past 27 months and have yet to see a real economic recovery. We have now reached a point where interest rates have gotten so low that the Fed only has one more shot at lowering them. Fed “officials believe this will be the final step that, coupled with the income tax cut that will show up in workers’ take-home pay next month, will put the economy on a strong, sustainable growth path,” writes Barry. One can’t help be but a little skeptical. Alan Greenspan and his cohorts have been saying this same thing for the past 3 years. It seems that after this rate cut all they’ll have left is hope.
In fact there are people inside the Federal Reserve who don’t believe that this rate cut will make any difference at all. According to their logic the problems facing the economy aren’t due to a lack of liquidty or a restrictive monetary policy and therefore can’t be solved by lower interest rates. Kevin Lansing, the senior Fed economist at the Federal Reserve Bank in San Francisco penned an internal memo that has provided these doubters of Greenspan with a mouthpiece.
Dated June 20, 2003, and titled Growth In the Post-Bubble Economy, Lansing’s articles notes that this recession has been different due to past ones, because it has been led by a severe drop in business investment spending. This sharp drop was due to an “investment boom of the late 1990’s” that was “overdone,” according to Lansing. “The extraordinary burst of investment during the late 1990s coincided,” he continues, “with the emergence of a major speculative bubble in the US stock market.” In the Fall of 2000 firms started to sharply cut back on new investment as it became clear how much excess capacity had been accumulated. “Rather than investing in new technology or capacity, firms started to make better use of the technology and capacity they already had. Firms also began to undertake the painful, but necessary steps to bring their cost structures into line with the post-bubble demand enviroment,” he writes.
Lansing notes that in the past two years the “consenus economic forecast has consistently predicted a robust near-term acceleration in business investment, which has yet to emerge, notwithstanding substantial monetary policy easing and the enactment of two fiscal stimulus packages(with a third signed into law on May 28, 2003).” People have blamed the sluggish nature of the recovery on the September 11th terrorist attacks, the corporate accounting scandals, and the war in Iraq. However, as Lansing concludes: “it is quite possible that investment is being restrained by fundamental factors that will take longer to overcome. Capacity utilization in the U.S. industrial sector is currently at a 20-year low — only 74.4% as of April 2003. Large amounts of excess capacity combined with technological advances that foster market competition in a global economy have created an environment where many firms lack pricing power. The lack of pricing power restrains the growth of nominal sales—typically an important factor in the determination of a firm’s capital expenditure plans. It is worth noting that much of the recent earnings gains of S&P 500 companies have been achieved not through increases in sales but instead through cost-cutting measures.”
In short the Fed cuts this week won’t make much of a difference because they won’t cure the problems that are holding our economy back: excess capacity and debt created by the financial bubble of the 1990’s. As I’ve said before, only time and liquidation can do that. However, stocks have rallied sharply since March on the belief that the Federal Reserve has successfully laid the ground for a huge upturn in the economy in the second half of the year. If that recovery doesn’t come then stocks will be swooning by the end of the summer and will likely crash again in the Fall. This would be nothing new. All of the large bear market rallies of the past three years have been created by people speculating that the market has bottomed and that economy was on the verge of recovery. These speculators have been motivated by the belief that Alan Greenspan would force both of them higher. However, each of these rallies also has seen intense doubt on the part of insiders who used them to sell stock just like this one has.
What is new is that this time we are approaching some sort of end game. After next week the Fed will run out of interest rate cuts. What is more the current account deficit has reached the crisis 5.1% level, the dollar is mired in a bear market, and we now have people claiming that we have a “bubble” in bonds and real estate. If the economy doesn’t substantially improve over the summer then we are going to see all of the excesses unwind in the inevitable phase of a financial bubble: massive liquidation. Personally, I do not think the economy is going to boom. I don’t see any signs of it. The only sign that people are pointing to is the stock market rally, but the market has proven itself to be an unreliable forecastor of the economy. There is a third possibility. This is that the Fed fails, but somehow manages to keep the stock market afloat by pumping more and more liquidity into the system. This would create even more imbalances in the real economy and push off any real recovery further into the future, but would succeed in boxing the stock market into one big wide trading range. In the past few months M1 - the measure of money supply - has grown at an annual rate of 30%. At the same time Greenspan has been buying long term bonds to keep their yields down.
About 16 months ago Greenspan commissioned a flurry of internal Federal Reserve studies that compared our current economic situation with that of Japan. The consensus conclusion they came to was that Japan became mired in a depression, because their central bank didn’t cut rates fast enough. Likewise, these studies have come to a similar conclusion about the Great Depression of the 1930’s. However, in both cases the central bankers cut rates as much as they could to stimulate recovery to no avail. The truth is that the best way to fix the fallout from a financial bubble is to get rid of the overcapacity as quickly as you can. Keeping the cost of capital down through low interest rates only prolongs it. The Federal Reserve was unable to fix the Great Depression. During the 1930’s a group of economists with answers for the economy came to the forefront, with many of them serving in the Roosevelt administration. Everyone now thinks of the era as a time of in which Keynesian economic theories, which blamed the depression on low consumer spending, prevailed. Roosevelt supported labor unions and price controls in an attempt to stimulate the economy. Although he succeeded in stabilizing it, no real sustainable recovery came until the onset of World War II put the economy on to a war footing.
What is forgotten today, is that other economists at the time also had theories about the Depression that turned out to be more accurate. The so called Austrian school of economists, led by Ludwig von Mises, saw the Depression as the aftermath of a speculative bubble created by lax monetary policy, while men such as Gardiner Means traced it to the power of corporations to manipulate prices and over turn the “free market,” which he theorized led them to inadvertently weaken consumer demand, by continously cutting costs while holding prices as firm as possible. One could compare his theory to today’s diverse critics of the “new world order” or “one-world economy,” such as Pat Buchanan on the right and William Grieder on the left, who argue that it leads to perpetual deflation and the dissolution of manufacturing and industry in the United States. You can debate what caused the excess capacity of the Great Depression, but we know for sure is that there was no sustainable economic growth until the boom in defense industry eliminated it. Defense spending is different than any other sector of the economy. Military production exists outside of the free market framework of supply and demand. Its products provide no useful utilitarian function in themselves. They cannot be bought or used by consumers, but only used up in war, placed in storage, or destroyed. Since they don’t enter the marketplace they can’t create inflation. Military production exists as a large section of the total economy that is subject to complete and aribitrary government control. As one economist put it: “Why is war so wonderful? Because it creates...artificial demand..the only kind of artificial demand, moreover, that does not raise any political issues: war and only war, solves the problem of inventory.”
In other words the defense industry of the 1940’s filled all of the empty factories of the Great Depression by creating a new massive demand for products. Military production eliminated the excess surplus that caused so much misery.
Why do I bring this up? Because only way to get out of a post-bubble maliase is to eliminate all of the excess capacity and surplus that it created. That is how the United States got out of Great Depression. Unfortunately, none of Greenspan’s policies are designed to do this. I’m not sure exactly what policies should or could be used to do this, but he has actually made things worse by making the imbalances larger. The last time the Federal Reserve pumped liquidity into the market at the rate it is doing now was in the late 1990’s, when Greenspan tried to avert potential financial disasters he saw coming from the Russian currency crisis, Asian “flu”, the collapse of the Long-Term Capital Management hedge fund, and fears that the Y2K computer bug might cause a panic. All of that liqiduity created the bubble in stocks and brought us to our current situation. In the past 3 years he has tried to pump even more liquidity into the system to fix the fallout from his bubbles, but we now have a bubble in bonds, a dangerous current account deficit, record consumer debt, and a bloated real estate market in some areas of the country. A free market approach would have brought us none of this. If Greenspan would have sat and allowed the market to work these problems out by themselves - through massive liquidation(for instance if he would have allowed the stock market to fall on its own weight and hit a real bottom in 2001 instead of trying to fix it with interest rate cuts) - then we would be in a booming economy and real bull market right now. However, we would have seen a year or two of total economic misery which would have been politically unacceptable so we just have to sit and hope with Greenspan that these problems will simply go away. But in trying to create a “soft landing” we now face the danger of an even worse crisis in the future.
Ironically some people at the Fed are coming up with wild policies to use if Greenspan fails and we enter an unstoppable deflationary depression. Evan Koenig and Jim Dolmas, two staffers at the Dallas Federal Reserve, wrote a paper titled “Monetary Policy in a Zero-Interest-Rate Economy. They blame the problems of the 1930’s and Japan on central banks not acting quickly enough. Their paper then goes on to talk about the problem of trying to influence the economy when interest rates are zero and the central bank runs out of bullets. They argue that if that happens the Fed could buy securities outright. But they then contemplate putting a tax on savings to force people to spend. Their proposal is for a “stamp tax” whereby your dollar would have to be stamped periodically “in order to retain its status as legal tender.” The fee could be changed to generate any interest rate the Fed desires. For example, Koenig and Dolmas say that your dollar could be taxed at 1% a month, a rate that would cost you 12% a year to save money.
Insanity?! Yes! But we are all in Alan Greenspan’s hands now, and if his hopes fail then the government and the Fed will be forced to take unusual and strange measures to “fix” their mistakes. What the “stamp tax” proposal reveals though are the moral hazards of Federal Reserve bailouts. Let’s suppose the Fed enacted this “stamp tax” and forced people to spend half of their savings. Undoubtedly that would create a boom in consumer spending and would stimulate the economy, but once that money was spent consumers would be left with no savings and a bunch of goods. They would not be able to go out and buy more. Stores would be left with goods that they couldn’t move off of the shelves and factories would have no orders. Sounds familiar? Those are the problems of surplus and overcapacity. Forcing people to liquidate their savings and spend them would create yet another bubble! In a similar vein the Fed is trying to keep rates as low as possible to punish savers and force asset allocators to speculate in the stock market. Now you see why constant bailouts and intervention on the part of the Federal Reserve is so dangerous. The problem is always the same. What do you do after your bailout fails? A bigger one? We will know which path we are going to down by the end of the summer. If Greenspan is successful then the stock market is going to enter a wide trading range and our economy is going to enter a long period of stagflation. It will take years, but once the stagflation problems, that will be created as a result of the current low interest money pumping bailout, come to an end we’ll enter a new real growth phase in the economy and a new bull market. This could take a decade. However, if Greenspan fails it means deflation, depression, and disaster.
As citizens we can hope for the best, but as investors we have to prepare for either scenario and plan to profit from them. Whether we enter a trading range or are on the way to make new lows investors will need to short stocks when the market has downtrends and go long in stocks with high relative strength when the market has rallies.
At the moment the market has been having ones of its largest rallies in history. Odds are that it is almost over. The market is near major long term resistance levels on the S&P and the DOW and is likely to begin a correction in the next few weeks. We are closer to the top of its range and not the bottom. Only once since 1953 has the S&P 500 gained more than 20% in the first three months after reaching a low. Both times it returned less than 7% in the next 3 months and even less during the next 18 months. Momentum has slowed in the past few weeks. The market gains at the beginning of this rally were dramatic, because they camefrom low levels. As stocks rise and become more expensive relative to their earnings further gains become more difficult and investors become more selective. In the beginning momentum takes everything up, but eventually fundamentals will take over and the fundamentals have yet to improve. At some point in the summer I anticipate taking a lot of short positions when the market enters a downtrend. I also am going to search for long candidates as I outline in The Lessons from the Rally article in this week’s newsletter. In the coming weeks I plan on talking about investing in a range bound market and what type of stocks make the best investments.
The Perpetual Bubble Machine
The Federal Reserve, in my view, played a key role in nurturing the equity bubble of the late 1990s. By setting monetary policy with an eye to the so-called New Economy - a high-growth, low-inflation macro scenario - the US central bank maintained a low interest rate regime that provided extraordinary valua-tion support for equities. A pre-Y2K liquid-ity injection was the icing on the cake. The persistence of low interest rates in the immediate aftermath of the popping of the equity bubble in early 2000 quickly be-came the great enabler for the US prop-erty bubble. And then when the Fed began cutting interest rates aggressively in order to combat multiple pitfalls - recession, the subsequent anemic recovery, and newly emerging deflation risks - a bubble emerged in the bond market. The Fed, in effect, has become a serial bubble blower.
All this underscores the continuum of moral hazards that prevails in this post-bubble era. At first, the equity bubble seemed too big to fail - making the Fed very concerned over the repercussions of a sharp downdraft in the stock market. The Fed’s New Economy mantra added to investor convictions that there was little reason to worry about an interest-rate spike in a rapidly growing, fully-employed US economy. Once the equity bubble popped, interest-rate support to the home mortgage refinancing cycle then became essential in order to contain the damage. By stressing the importance of the “refi-cycle” as a source of economic growth in an otherwise perilous post-bubble climate, the Fed was, in effect, providing a guaran-tee that it would continue to provide the fuel for this wealth extraction process. And now as the Fed’s battle has shifted to the anti-deflation fight, a bond bubble has emerged - a by-product of investor expectations that now envision the central. bank keeping its policy rate unusually low for as far as the eye can see. At the same time, yield-starved investors have moved out the risk curve, taking credit spreads to amazingly low levels. Suddenly, the bond bubble now seems too big to fail — symptomatic of yet another moral hazard. First it was the “Greenspan put” that supported equities and now it’s the “Bernanke put” — the belief that the Fed is about to target bond yields in an effort to fight deflation — that fuels the bond market. America’s Federal Reserve seems to be stopping at nothing in order to keep a post-bubble US economy afloat.
It’s hard to know where and how this all ends. The Fed’s strategy seems to be aimed mainly at buying time — hoping for a gradual and benign endgame to the post-bubble workout. That’s certainly possible. But there’s also the distinct possibility that the Fed is hoping against hope. I would personally assign equal odds to the chance that there will be a more treacherous moment of reckoning. My concerns in this latter regard stem from the increasingly ominous current-account implications of a saving-short US economy. - Stephen Roach, Head Economist of Morgan Stanley |
