Whither the American Boom?
stockhouse.com
Summary:
Is the bull market over? Every time the U.S. markets do anything but hit new highs, this becomes a chorus. We do not know what the stock market will do. If we did, we'd be rich. Our interest is in what the economy will do. The markets and the economy are certainly overdue for a major correction and a short, sharp recession. In some ways the United States needs one for its long-term health. But the fact is that, whatever happens to the markets in the short run, the core indicators do not point to recession. The financial markets remain liquid, with positive free reserves, while the yield curve remains positive. Serious structural realignments do not take place in this sort of environment. The forces that created the boom in the first place remain, it seems to us, in place.
Analysis:
For the past few weeks, the burning question in the world of economics has been whether or not the United States is about to enter a recession. The question has been driven by the performance of the American stock market. The performance of the stock market is, of course, not identical to the performance of the economy, but in the past it has been a decent view of how the economy has performed. It also, therefore, is not a bad indicator of how the economy might perform in the future. The behavior of the stock market, particularly in a country like the United States, in which capital formation and the equity markets are tightly linked, is by no means a side issue.
That said, we must remind our readers that while Stratfor does economic forecasting, we do not do stock market forecasting. If we could do stock market forecasting, we would not be working for a living. Nevertheless, since we are interested in the dynamics of the international system, the health of the American economy is a critical issue for us. As the behavior of the stock markets is tied up with the health of the American economy, we cannot ignore their performance.
Let us begin with the obvious. The Standard & Poor's (S&P) 500 closed Friday, Oct. 22 at around 1300, having fallen from a little more than 1400 in July. This drop raised speculation that the bull market - underway since 1982, but which began its intense upward move in 1995 - may be coming to a close. Last year at this time, the index was below 1100. Five years ago, the same index was below 500. So, the S&P has given up about one-third of its approximately 25 percent gain for the year. In the last five years, the index has nearly tripled in value, rising from below 500 to 1400, only giving up 10 percent of these gains in the recent losses.
Based on those statistics, the temptation would be to dismiss all of this with a giant yawn. The American stock market has been surging for a generation, and roaring for the past five years. During that time, we have seen other corrections. For example, in the summer of 1998, the S&P 500 fell from 1200 to below 1000, a decline of about 25 percent, equaling most of the gains of the previous 12 months. In 1996, it fell by 10 percent, from just below 700 to just above 600.
This summer's decline, at its worst, was only about 10 percent. What do people expect - a rocket to the moon without any turbulence? In fact, it is extremely bullish that pessimism kicks in as quickly as it does. Consensus Index, which tracks market sentiment, reported bullish opinion fell from 30 percent two weeks ago to only 20 percent this week. Market Vane reported a less dramatic decline from 29 to 25 percent. These numbers indicate investors are not only pessimistic, but the growth of pessimism is accelerating and reaching rock bottom levels. When you get down to the area of 20 percent, just about everyone able to form an opinion has gone bearish or neutral.
Following contrarian theory these sentiment figures are bullish. If everyone is pessimistic, the market can't go down. It can't go down because everyone has acted on their pessimism and sold their stocks. There is no one left to sell. This assumes that sentiment and action go hand-in-hand, an assumption we find fairly reasonable. That means we should be near bottom for this down turn.
There are some other reasons for being, if not optimistic, then at least not pessimistic. The first is the liquidity of the banking system. The Federal Reserve Bank, which controls America's money supply, has a measure called Net Free Reserves. Net Free Reserves is a measure of how much surplus cash is kicking around in the system, once all of the credits and debits of the system have been totaled. The actual number is not all that important - especially as it bounces around and is revised and never really settles down. However, whether this number is positive or negative is important. A positive number means there is liquidity in the economy. A negative number means liquidity is drying up. This has become an extremely boring indicator, because it has been generally positive for a generation. But then, so has the stock market. Serious bear markets tend to correlate, for obvious reasons, with Fed policies that pull money out of the economy, creating credit squeezes. The Fed has not given us a serious credit squeeze in nearly a generation. It is not giving us one now. That argues against a serious bear market.
There is another argument closely linked to Net Free Reserves: the shape of the yield curve argues against a bearish turn. The yield curve is a display of the cost of money borrowed for various periods of time. For example, at closing on Oct. 21, three-month U.S. Treasury Bills carried a yield of 4.96 percent. The yield on six-month bills was 5.03 percent. Ten-year treasury notes yielded 6.18 percent and 30-year bonds yielded 6.35 percent. Prime corporate bonds were yielding more than 8 percent.
Interest rates may be trending upward, but the yield curve remains positive. During the late 1970s, yield curves were negative. Short- term rates were higher than long term rates. This was bearish. With short-term rates high, investors looking for safety could abandon the long-term bond markets and, with them, the stock market. Money markets provided safety, liquidity and higher rates of return. Long-term rates higher than short-term rates are bullish, encouraging long-term investment and capital formation.
Two factors create negative yield curves. The first is the Fed. It has tremendous influence over short-term rates and much less influence over long-term rates. When the Fed wants to drive up interest rates, it can drive up the short-term rates, but the long-term rates may not follow. This can create a negative yield curve.
The second is borrowers' fears of locking into long-term rates. As instability and uncertainty develop, borrowers increase short-term borrowing and decrease long-term ones. Theoretically, investors, seeing opportunities at the short end, should pile their money in and bring down the short-term rates. The Fed can override that tendency; also, in an overheated economy, demand so outstrips supply at the short end that rates go up anyway.
That just hasn't happened yet. The economy is certainly hot, and the Fed has tightened money. But the yield curve has not
flipped negative. This indicates that the financial markets can still accommodate the demand for money from businesses, without causing distortions in the yield curve. It also means both speculators and investors in the stock market - tempted though they might be to find other, safer havens for their money - don't have anywhere to go. The bond markets carry substantial risks should interest rates rise, and the short-term markets are relatively unattractive on both an absolute scale and psychologically.
In our view, the foundations for a bear market are not yet in place. Investor sentiment is too negative, the financial system is too liquid and the yield curve is positive. At the same time, several serious clouds hover on the horizon.
The first is simply time. The current economic expansion has been underway for a generation. It took a downturn in 1991-92, costing George Bush his job. Even if we accept that the United States is in an unprecedented long-term boom - which we do - there ought to be more downturns within that boom.
Recessions are healthy for long-term growth. They originate in rising money costs as businesses expand and consumer demand quickens. As the cost of money rises, competition among businesses for scarcer and more expensive money increases as well. Weaker businesses, with lower rates of return on capital, cannot afford to borrow and end up either cutting back operations or going bankrupt. More efficient businesses can borrow. This clears the field and channels money toward more efficient businesses. Recessions may hurt, but not having them can result in the Asian disease.
From the historical record, we are overdue for a short, sharp recession. Indeed the Fed seems to be nudging the economy in that direction, in increasing interest rates; but it has not moved the Net Free Reserves negative. However, the markets are not acting as if a recession is near. The cost of money is rising, but not to a culling level. The yield curve refuses to flip negative. Such behavior usually indicates that a recession is not imminent.
In showing no indications of imminent recession, the financial markets are telling us that the traditional calendar for the business market does not apply. They are not saying the business cycle is dead. They are saying traditional post-war theories of timing don't apply.
Another cloud on the horizon, perhaps a more serious one in the long run, is the rise in commodity prices - particularly in oil prices. Stratfor has argued that one of the foundations of the generation-long boom was the collapse of commodity prices across the board to record low levels. The decline in commodity prices reduced the cost of production for industrial countries dramatically, tilting the advantage from producers to consumers. The rise in commodity prices indicates two things. First, that demand for commodities by expanding economies like that of the United States has finally raised prices. Second, that as commodity prices rise, the advantage might tilt back to producers, and consumers might start experiencing significant inflation
once again.
This should be bearish. But here again, the bearishness is mitigated. Going into this summer, one fear was deflation. All of Asia was suffering from deflation caused by excessive, inefficient industrial capacity and extremely low consumer demand. This was compounded by banking systems and financial public policies, which were driving prices downward. Deflationary pressure appeared to be spreading around the globe. The oil price bounce is, in a perverse way, a positive factor. By counteracting deflation, it could actually help stabilize the system.
On balance, therefore, the Stratfor view is this:
* The United States is undergoing a short-term correction in a long-term bull market of unprecedented proportions. Speculative fever, extremely high price earnings ratios and the appetite for profit all argue for a pause in the bull market. At the same time, sentiment figures indicate that a great deal of the enthusiasm has been beaten out of the market. We are continually startled by how quickly sentiment turns negative at the slightest correction. We find this lack of confidence in the market quite bullish, as it provides a self-correcting balance.
* The foundations for a mid-term recession lasting a year or so are simply not yet in place. They could materialize fairly quickly, particularly if the Fed wants to impose a recession, but they are not there now. The Fed is maintaining liquidity in the financial system and the yield curve is positive. Interest rates are rising, which may cool growth, but the market is not behaving as if a recession were near at hand.
* The rise in commodity prices should be a negative. However, given the deflationary threats and fears of this summer, the rise in commodity prices may even be a positive sign, if it doesn't get out of hand. With the Asian and European economies sluggish at best, we do not see the rise as a significant threat.
* There certainly ought to be a recession some time in the next 36 months, and we would not be surprised to see it sooner rather than later. This is based on the timelines of previous economic expansions. We see this expansion as extraordinary, but it will not abolish the basic laws of capitalism. Under these laws, pruning back the economy is, in the long run, a positive development rather than a negative one.
In short, the United States appears to remain on the path it has been pursuing for a generation. It is quite likely that the stock market will take a serious break from the past five years of growth. Indeed, we may well be that we will not again see such a sustained and intense bull market as sustained and as the one from 1995-1999. That is not the same as saying that the U.S. economy will crash. We simply do not see the evidence.
It is important to understand the dramatically unexpected pattern that has developed in the global economy. Rather than moving together, it has fragmented along geographical lines. Asia, the United States and Europe have all pursued radically different economic paths, sometimes behaving as if they were living on different planets. Even within geographical regions, there have been differences. Germany's economic performance has been very different from the United Kingdom's. Japan has behaved differently from South Korea.
The fragmentation of economic activity into geographical elements is based on the fact that, economically, what goes on within a nation remains more important than what goes on between nations; Japanese domestic economic structure and policy determine Japan's fate. The U.S. economy has operated under its own power for the past several years, and it will continue to do so. In our view, it may not expand as it did in the past. It may even make a cyclical contraction. But there are no structural shifts evident to us that would indicate the expansion begun in 1982 is coming to an end. Cooling off is not the same thing as crashing. |
