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Too Many Holes in the Dike to Keep Plugged
The economic news keeps getting better. For most Americans it appears as if the good times are here again. The economy is improving, the job picture has brightened, and stock prices keep heading higher. What’s not to like about this picture? The situation in Iraq remains a bit cloudy if not troublesome, but most Americans are concerned foremost about the economy and not what happens over there. So for now unless a series of rogue waves hits the economy in the form of a major terrorist attack on U.S. soil or a major financial institution’s derivative portfolio blows up, it would appear that it is smooth sailing from here through the elections.
Things look better economically but there are too many risks that will have to be managed. In order of importance they are the dollar, interest rates, and the stock market. In addition to these risks there is always the threat of an unforeseen event that triggers a shockwave throughout the economy. If that happens then all bets are off. The U.S. economy and financial markets have become too levered and are in no condition to withstand another shock similar to the events of 9-11. By keeping the federal funds rate at 1% the Fed has created a new wave of speculation in the financial markets, and as a result all kinds of financial distortions are starting to emerge. By keeping interest rates artificially low the Fed has encouraged American consumers to take on more leverage in the form of bigger mortgages, more installment debt and larger credit card balances. As long as the job market doesn’t get any worse, the housing bubble remains inflated and interest rates remain low, the consumer should be able to keep on spending.
Preliminary reports from last Friday’s holiday shopping seem to confirm this thesis. The Christmas shopping season got off to an encouraging start. ShopperTrak, which compiles data from over 30,000 stores, reports that sales are up 4.8% from last year. Retailers are optimistic that the robust start to the holiday season can be maintained through to Christmas. Retailers are using discounts and sales promotions to keep people coming back and buying. In addition to promotional items, regular priced merchandise is also moving off the shelves. While the tax rebates from last summer have been spent analysts say that rising consumer confidence is leading more consumers to go deeper into debt because there is greater confidence in the durability of the recovery. Consumers are still spending but they are increasingly doing so by talking on bigger debt loads. Consumers remain confident because they continue to see higher housing and equity prices. As long as housing prices remain firm and equity prices continue to strengthen, the American consumer should be able to continue to live beyond his means. Problems surface if interest rates begin to rise or if the job market deteriorates again.
On the corporate front operating profits continue to improve. Thanks to cost cutting, and more recently top line sales growth, the profit picture looks brighter. Third quarter annualized sales growth came in at 8.7%; a good portion of this gain came from currency gains. Capital spending is starting to improve marginally as companies move cautiously to free up capital for improvements in infrastructure and IT spending. Companies have been very cost conscious when it comes to hiring and rebuilding inventories but things are also starting to change there. Balance sheets have also strengthened. Debt burdens remain high as shown in the graph on the right. What companies have done instead of getting rid of debt is refinanced at lower interest rates. Maturities have lengthened with many companies moving out of short-term paper taking advantage of favorable long-term interest rates. The improvements in the financial markets, thanks to rising equity prices, have made the debt to capital picture look and appear healthy. The corporate sector looks and appears healthy as long as equity prices hold up.
The financial markets have also remained buoyant thanks to amply supplied liquidity coming from the Fed. However, money supply growth has declined recently and is now negative over the last 13 weeks. This trend is visible across the whole money spectrum from MZM to M1-M3. The Fed is hoping that by keeping interest rates artificially low and below economic growth rates that enough stimulus can be supplied to the markets and the economy to keep momentum going forward. With a fed funds rate of 1% and economic growth rates of 4-7% there are still plenty of stimuli coming from the Fed. The Fed’s main problem is keeping the bond markets pacified and the dollar from plunging. The Fed has gone out of its way to convince bond investors that it will keep short interest rates down. Last week just about every Fed governor on the board was out making speeches in an effort to assuage the bond market’s fears. Keeping bond investors pacified is an important Fed Strategy in keeping long-term interest rates low. The Fed controls short-term rates while the bond market controls long-term rates. By keeping the fed funds rate at 1% the Fed is encouraging the spec community to play the carry trade. Speculators can borrow short-term at interest rates of 1% and then reinvest the borrowed money into long-term Treasuries paying over 5%. The carry trade and foreign central bank purchases of Treasury debt is what is keeping long-term rates artificially low.
There is only one problem with this strategy; it is in direct conflict with the Fed’s other goal of ratcheting up inflation rates in order to avoid asset deflation. The Fed is deeply concerned about asset deflation occurring in the financial markets. Falling stock prices such as we experienced in 2000-2002 created all kinds of problems from debt defaults to economic contraction. The Fed needs to keep all of the financial bubbles inflated—from stocks to bonds and from mortgages to real estate. However, the more money and liquidity it injects into the financial system the greater danger there is of that ocean of money spilling over into the real economy. Commodity prices are already hitting new records not seen in decades. Today copper prices rose to their biggest gains in over two years. Copper for March delivery rose 4.7 cents or 5.1% to 96.1 cents, a level that is close to a six-year high. Gold prices also hit a 7-year high today with the price of real money closing at $403.80, up $5.80 on the session.
As more and more visible signs of inflation begin to emerge, from rising commodity prices to rising wholesale prices to the rising costs of services, interest rates are going to head higher. Bond investors are becoming uncomfortable with rising commodity prices, rising gold prices, an expanding government budget deficit, expanding trade deficit and a falling dollar. All of these factors are a negative for the bond market. Up until this point the Fed has managed to assuage the fears of bond investors. As written in past Wrap Up’s it has now become a question of time to see who flinches first--the Fed or the bond markets? The Fed is playing a confidence game that I believe it will ultimately lose. We are experiencing monetary inflation and as a result interest rates will have to go higher. Bonds are becoming a high risk investment at this point and one the Fed is monitoring closely. If rates suddenly rise as they did in June and July the leveraged financial markets and American economy could be headed for trouble again. It is therefore paramount to the Fed’s strategy of inflation of keeping bond investors fooled and pacified for as long as possible. Interest rate holes are springing up everywhere along the dike.
Another problem for the Fed is the dollar. As shown in the next graph the dollar is at critical support levels. The dollar moved to new record lows intraday against the Euro before bouncing back after key economic reports. Earlier in the trading session the dollar dropped against a basket of currencies. Officials are trying to keep the decline in the dollar orderly if possible, recognizing that the U.S. wants to see its currency move lower in the hopes that it will bring the trade gap back in line with other industrialized nations. The U.S. is currently running a trade gap equal to 5% of GDP. That trade gap is expected to widen over the next year to as high as $600 billion or 6% of GDP. The trade gap is already at a level where currency crises begin.
Right now there is nothing supporting the dollar other than near universal bearishness. Interest rates in the U.S. are among the lowest in the world, the trade deficit continues to climb while foreign investors have been lightening up on their U.S. investments. As the trade deficit grows larger over the next year it is highly unlikely that foreign savings will be large enough to finance the deficit. If it were not for Asian central banks the dollar would be much lower and interest rates in the U.S. would be much higher. Asian central banks have been instrumental in keeping the dollar’s fall orderly, intervening when necessary when it appears the dollar is ready to crumble. The crack in the dollar is another major hole in the dike that appears to be widening.
Finally, there is the stock market bubble which is back in bubble-like territory. Despite the myriad scandals that seem to erupt each week, investors seem unconcerned. As long as prices continue to rise and it appears that the Fed will do all that is possible to keep it that way, investors don’t seem to care. We’ve recently gone through a spate of mutual fund scandals, but outside withdrawals from a few of these funds, money continues to pour into the stock market. Today Boeing’s CEO resigned in order to clear the air amid investigations of contract bids that led to the firing of Chief Financial Officer Michael Sears. At Disney, board member Stanley Gold resigned joining ousted director Roy Disney. Both individuals have called for Michael Eisner to resign. Disney has faulted Eisner for not reviving the ABC television network or upgrading Disney’s theme parks. Both Disney and Gold have been critics of Eisner’s policies over the last five years that have mainly benefited Eisner. Operating income at Disney’s theme parks has steadily fallen, declining 4.3 percent in the last quarter.
In terms of performance Disney’s profits have been dismal, with shareholder equity declining by over $200 million from 2000. Return on equity has steadily declined over the last five years to only 5.36% for 2003. EBIT margins have fallen from over 15% to 10%. Despite lousy operating performance for the company, Eisner’s compensation package remains generous. Last year Eisner was paid $6 million in salary and restricted stock. Gold and Disney’s complain that the board seems to rubber stamp compensation packages for top management with little relationship to actual performance. An example of the generous performance was demonstrated by Eisner’s 1998 pay package. That year Eisner received $598 million in pay despite Disney’s 10% stock loss. Eisner’s pay package amounted to a third of Disney’s net income of $1.86 billion. This year Disney’s stock is up 42% based on record box office sales that could cross the $2 billion threshold. The rest of Disney’s businesses are performing miserably.
The situation at Disney is being replicated at other companies especially in the tech sector. Top management seems to be the main beneficiary of the business and not the shareholders. The business model seems to be to do anything that drives up the stock price, including cooking the books, then issue generous option packages to the top brass and use company cash flow to buy back stock to keep earnings from being diluted. It is what has been done at Disney, Intel, Cisco and other high flyers. As long as stock prices keep rising on thin air nobody seems to care, which includes most members of the board, excluding Disney’s Gold and Roy Disney.
As long as stock prices keep levitated, investors aren’t interested in what is going on at the companies they invest in. All they know and care about is the stock price. At the moment it appears that stock prices could head even higher into bubble territory. Technical considerations indicate strong breadth with Lowry’s exclusive Advance-Decline line rising to new record highs last week. Selling pressure keeps declining while buying power remains positive. There is still a stockpile of cash remaining on the sidelines waiting to be invested. The longer these rallies goes on uninterrupted the greater the degree of confidence by investors. Valuations remain absurd but this is a liquidity–momentum driven market. By promising investors to keep interest rates artificially low the Fed is doing all that it can to encourage investors to speculate. Perceptions could change quickly if interest rates rise sharply or the unexpected surfaces. Unexpected events have a habit of surfacing when you least expect them, from quarters that appear unlikely, and from crises the experts never foresee.
The Greenspan Fed is playing a confidence game. It remains only a question of how long their luck will hold up. There are too many holes in the dike that need to keep plugged from the dollar, to interest rates and the financial markets, to real estate and the mortgage markets, to the debt laden balance sheet of the American consumer and the American Corporation. You can keep people fooled most of the time but not all of the time. Gold’s rise signals the confidence game may be approaching the final end game.
Today’s Markets
U.S. stock indexes rose to new 52-week highs on Monday thanks to a little help from the futures pit. The Dow gained 117 points, a gain of 1.1%. Most of the Dow’s gains came from a rise in MMM, UTX, IP, MRK and DD. Today’s high was the index’s highest close since January of 2002. Big blue chips such as McDonald’s, GE, and International Paper got a lift from analysts’ upgrades. Market experts are hopeful that December will be another good month for stocks. Historically December is the strongest month for the S&P 500, according to Stock Traders Almanac.
Stock prices were also helped along by better than expected numbers from the Institute of Supply Management. The November Ism index on U.S. factory activity rose from 57 to 62.8 indicating the manufacturing sector is gaining strength. Early reports out on the holiday shopping season also point to robust consumer spending. Visa reports that credit card purchases topped $6.5 billion on Friday and Saturday. That is an increase of 12% from a year ago. Tech stocks took off after the Semiconductor said that global chip sales rose 23% in October, and up 6.8% from September.
While tech stocks were flying, so were gold shares as the price of gold crossed the $400 level for the first time in eight years. The level of interest in gold is starting to pick up even though many within the industry remain cautious. It may be that is what the rise in the Amex Gold Bug Index has been telling us all along. The HUI is up 76% year-to-date and is up 120% in the last 52 weeks. Even the XAU is up over 46% this year and up 77% over the last 52 weeks. Fed inflation policies are bound to produce higher gold and silver prices as the world becomes awash in an ocean of paper dollars. It is one more reason why commodity prices keep heading higher. The next big test for gold will come around the $415-425 level. Silver prices also topped a three year high today closing at $5.47 an ounce, the highest price since early 2000.
Volume came in at 1.3 billion on the big board and 1.8 billion on the Nasdaq. Market breadth was positive by 24-9 on the NYSE and by 20-12 on the Nasdaq.
JP
© 2003 Jim Puplava
December 1, 2003 |
