Reinflating The Bubble
On Main Street, the pain is already visible. For investors, it shows in their portfolio statements. The agony of seeing their wealth deflate or seeing their family or neighbors lose their jobs tells the story. Since the summer of 2000, the economy had begun to turn down and the bubble in the stock market was in the process of deflating. The markets were adrift and the economy was headed for recession. By December of last year, the job layoffs began to accelerate. By the first quarter of this year, it was obvious that the economy was in trouble. In January the Fed embarked on one of its most aggressive rate-cutting plans in the history of the Fed. The Fed has brought interest rates down from 6.5% at the beginning of the year to the current rate of 2.0% on Fed Funds. It has lowered interest rates 10 times and it looks like another rate cut is coming in December just in time for Christmas. (See Money/CNN)
For investors and consumers it was obvious from the mounting layoffs and shrinking asset portfolios that the economy was in trouble, obvious to everyone except Wall Street and the Networks. The economy continued its descent which began in the summer of 2000. The job layoffs, the drop in capital spending, and a contracting manufacturing sector told the whole story. Wall Street was convinced that the downturn was just a minor squall that would soon pass. The consecutive Fed rate cuts would surely guarantee a return to normal weather. The mantra became the “V” shaped recovery, a short blip on the radar screen, expected by the third quarter with profits and the economy back on track. Unfortunately, it became clear by the second quarter that wasn’t going to happen. Company earnings were contracting along with the economy. Layoffs continued and companies issued warnings for the second half of the year.
Then there were the terrorist attacks of September 11th. Those attacks changed many things, including the recovery scenario. Now the recovery has been postponed to the second half of next year. The tragedies of September 11 gave Wall Street an easy way out of its bullish forecast which had been wrong all year. According to many experts on the Street, 9-11 delayed the hoped-for recovery expected by the fourth quarter of this year. Their forecasts are now off by a year. So while the rest of the country was feeling the pain of a recession, Wall Street reluctantly accepted its reality after 9-11.
What We All Knew Is Now Official
This week the National Bureau of Economic Research (NBER), the official arbiters of recession, proclaimed that the US economy had officially entered into a recession. The economists on the board said that the recession began in March of this year. The six economists stated the statistics on employment, industrial production, retail trade and personal income pointed to the first recession since 1990-91. As soon as the NBER declared we were in a recession, Wall Street was quick to respond that the recession had bottomed and would soon be over. After all, the run up in stock prices since late September was a sign of better times ahead. Wall Street, which was late in acknowledging the existence of a recession, was even quicker in saying we were now headed for recovery. What else could higher stock prices be telling us? Members of the financial media were already declaring the fact that we had begun a new bull market. My wife and I sat stunned and incredulous that same evening when a financial anchor introduced a segment called "The Next Bull Run." The stock market was close to crossing the key psychological level of 10,000. Could there be any doubts that good times were just ahead of us? The financial markets seemed oblivious to the temporary nature of the post 9-11 recovery.
While Some Celebrate ~ Others Are Skeptical
At the same time of unanimity between analysts and anchors on an economic recovery and a new bull market in stocks, Fed officials and companies were lamenting a different tune. There was nothing in the economic data or financial reports from corporations to suggest a legitimate recovery was under way. The Fed’s Beige Book released this week pointed to additional slowing in the economy that was prevalent throughout all twelve Federal Reserve districts. The survey showed that manufacturing weakened further with declines in production and new orders. Consumer spending was mixed. If consumers were spending, they were doing so reluctantly. It is taking zero percent financing to get them to buy cars. New car sales and trucks reached a record level in October of about a 21.5 million annual unit rate. The sales were a result of free financing and other incentives.
Source: Money/CNN
Meanwhile consumer confidence, a key gauge of future spending plans fell for the fifth consecutive month in November. The index fell from 85.3 in October to 82.2 in November, a new 7 ½ year low. The index, based on a survey of 5,000 US households, is a closely watched indicator because consumer spending drives two-thirds of the nation’s economic activity. Consumer spending has fallen, but it is still holding up much more than expected thanks to rebates, zero percent financing and huge retailer discounts. With the holidays upon us, retailers are doing everything they can to attract shoppers from deep discounts and delayed payments to zero percent interest rates. All of those alluring promotions are coming at the expense of profit margins and ultimately profits.
Unemployment Claims Heading Higher Still
However, what is worrying consumers is the deterioration in the job market. The Conference Board’s Help-Wanted Advertising Index fell six points in October to 46, the lowest reading since 1982. It has fallen from a reading of 78 less than a year ago. The lack of new hiring and the continual layoffs are impacting consumer attitudes. Yesterday the government reported that unemployment claims rose by 54,000 in the latest week. The government also reported that the number of Americans continuing to receive benefits jumped to 4.018 million, a number not seen since December of 1982. The jump in claims is the largest since the country's last major recession in 1974. In a Bloomberg survey of financial analysts for November, they expect the economy to shed an additional 213,000 jobs this month. This number would follow a loss of 415,000 jobs lost in October. Economists now expect that the unemployment rate will rise to 5.6% this month. By next summer, they are predicting that the unemployment rate could hit 6.5%. If Wall Street is predicting an economic recovery, it will be a jobless one.
Oct. 01
Sept. 01
Aug. 01 Oct. 00
National Index
46
52
52 78
Proportion of Labor Markets With Rising Want-Ad Volume
12%
41%
12% 49%
Unemployment Rate
5.4%
4.9%
4.9% 3.9%
Source: The Conference Board
Housing Still A Bright Spot
This loss in jobs is causing consumers to spend and shop more selectively. They are still spending money thanks to zero percent interest rates and steep discounts. But the current round of spending may be front-loaded at the expense of future sales in the first quarter of next year. The only sector that seems to be doing well is housing. Low mortgage rates have helped to keep the housing sector alive with new home sales rising 0.2% last month. The housing sector is still holding on -- but for how long? Mortgage rates rose to over 7% this week. The government's attempt to lower long-term rates by suspending the sale of 30-year bonds has appeared to have backfired with long-term rates now spiking up again. The strength of housing depends on long-term rates which are controlled by bond market vigilantes -- not the Fed. The recent jump in mortgage rates has caused weekly mortgage applications to drop over 7.5% in the latest week.
What's Behind The Market Moves?
So what is the stock market telling us? If not a recovery, what else is it saying? I believe the recent trend in rising stock prices is saying the bubble is back, if only temporarily. As the money supply figures indicate, the Fed has flooded the financial markets with money. Like before, that money has found a home in the stock market and in housing. The broad money supply aggregates surpassed $8 trillion for the first time in our nation’s history. The money supply has grown by over $280 over the last nine weeks growing at an annual rate of 21 percent. Interest rates are heading lower and recent statements made by Federal Reserve officials Lawrence Meyer and William Poole seem to indicate that we may be heading towards zero percent interest rates if the current rate cuts don’t bring about recovery. Fed officials seem to think that they still have plenty of bullets left to reinflate the economy. Expansion of the money supply by close to $1 trillion over the last 12 months and 10 (soon to be 11) cuts in interest rates haven’t worked so far. Maybe another trillion and taking interest rates to zero will.
Another Year Older and Deeper in Debt
Our economy seems to be running on credit. Without debt, it would be hard to stay afloat. The Bond Market Association reports that new issue volume rose to $3.2 trillion in the first three quarters of this year. Federal agencies have doubled their debt issuance this year to $660.8 billion. Municipal bond issuance has risen by $236.8 billion; while corporate debt rose by over $673 billion during the first three quarters of the year. Credit card debt along with home equity loans continue to rise. The trade deficit is still growing. It declined in September thanks to foreign insurance disbursements. Imports have declined but not as fast as US exports. Many ports on the west coast report ships leaving with empty containers. Americans continue to borrow and the economy seems to be requiring even larger doses of credit to keep it from deflating. What these numbers seem to indicate is that an expanding money supply and concomitant expansion of credit is all that keeps the economy and the financial markets from falling into the abyss.
The financial markets seem to be the only indicator that is telling consumers and investors that things are getting better. But what are rising stock prices based on? It certainly can’t be earnings now or in the future. There is no evidence of an earnings recovery in corporate annual statements. In fact, analysts are busy downgrading earnings for this quarter, the next quarter and for the entire first half of next year. The only good news is that companies are beating analyst’s estimates which are akin to a pole-vaulter jumping over three feet. You don’t need a pole to beat analysts' estimates. Even when we do get earnings, they need to be questioned. The recent example of Enron reinforces that view.
Hype, Hype, and More Hype
What we keep hearing is more hype than anything else. On Wednesday of this week, three articles appeared in the press, each telling its own story. One article trumpeted by Wall Street and network anchors was that Intel was comfortable with its latest sales forecast for the current quarter. After all, the quarter is almost over. Let's hope the company knows which way sales are headed. The company lately dropped its consumer electronics line. Intel is also uncertain as to when the recovery will arrive and refuses to make any predictions. The analysts, anchors and the markets focused on the company being comfortable with its broad revenue predictions. And yet...
Source: Financial Times
In an article appearing the day before, Intel’s industry reported that worldwide orders for chip manufacturing equipment plunged 75% in the third quarter from a year ago as demand for chips and the tools that make them fell. Another story the same day reported that IT budgets for next year are shrinking. A recent survey by Goldman Sachs revealed that IT managers were reporting that their IT budgets were declining. Interviews with company IT managers reported that their budgets were being cut by 5-10 percent for next year. Company officials sited that the turndown in corporate profits were responsible for the spending squeeze. It has been my contention that profits drive capital spending. When profits shrink so do capital expenditures. The Goldman survey seems to back this view. Without profits or a reduction in profits, we can expect an accompanying cutback in expenditures. Capital spending requires money. It either comes from profits or by borrowing money. With the economy already in a recession not too many companies are eager to go deeper into debt in order to buy new equipment unless it is absolutely necessary. A study of most R&D budgets show the industry is contracting its spending.
A final story on the same day as the previous two articles was a story about a grim Christmas in Silicon Valley. Silicon Valley bosses are telling employees that the party is over. The expensive parties, generous year-end bonuses and stock option awards are gone. Instead of gala festivities paid with unlimited budgets, pot luck lunches or dinners are the bill of fare. Companies are hoping to keep up the holiday cheer by looking at ways to cut corners. Instead of renting out expensive hotel rooms or uptown gathering places like museums, the affairs are taking place in company lunch rooms or the executive’s home where single course meals will be served.
So, What's Going On In Techs?
These stories stand in sharp contrast to the recent run up in tech shares. The 40% rally in tech stocks since September 21 is running way ahead of fundamentals and it could lead to another sharp correction. It's looking more like another bubble triggered by massive Fed injections of liquidity into the financial markets. This tech bubble is taking place without the fundamentals to back it. The Nasdaq is still trading 60% below its March peak in 2000 and the stocks within the index are trading at about 50 times next year’s earnings. The problem is the earnings numbers are reported in various forms other than GAAP (generally accepted accounting principles). We’re still talking about earnings according to CRAP (cloudy reporting accounting principles) instead of GAAP. Nevertheless, they are still too high no matter which numbers you use. Cisco is selling at 87 times next year's earnings. Intel is trading at a 68 P/E multiple. Microsoft is selling at 35 times next year's profits. Even worse are AOL and E-Bay which trade at a multiple of 66 and 137.
Show Me The Beef
Like the Internet bubble that ran between 1997-99, current earnings don't back the recent rise in technology shares. Like then and like now, the rise is without any regard to fundamentals or financials. People are simply buying because they are being told to buy and the prices are going up. This is a momentum-driven market and nothing more. Most stocks are going up against a weak outlook for profits and a declining economy with very little signs of improvement. The run up in stocks is being fed on hype that plays on hope. Those who have lost at the roulette wheel are hoping to recover their lost winnings. Price earnings multiples of 80-137 certainly don’t exhibit rational expectations. A stock that used to sell at 160 or 200 times earnings isn’t cheap because it has lost 70% of its value and now sells at 80 times next year's profits. The bubble is back and it is being reinflated by the Fed, hype, hope and hyperbole. The question now is, How long will it last?
A Tale of Two Traders
Trader #1
I recently had an experience with a sales clerk who had lost a lot of money in technology funds over the last year. This person trades stock in the mornings and works retail afternoons and evenings. Now this investor had jumped back into tech stocks after taking a day trading course in October. Of course, buying stocks in October, everything that was bought went up. The purchases were the usual suspects: Cisco, Intel, Microsoft, Sun Micro, and JDS Uniphase, with a few biotechs thrown into her portfolio. I asked the perspective client why she thought these stocks had gone up. Her response was because their earnings were going up and the economy was improving. To my trained ear, her responses were more like sound bites than any deep analytical thinking. When I told her that earnings of the companies she had bought were actually going down, she appeared puzzled. She hadn’t a clue as to what was going on with these companies. She simply bought them because they had been going up. I then asked about the economy in relation to business at the store. Business had picked up, but it wasn’t what it used to be. Everywhere I looked in the store, merchandise was on sale and deeply discounted. Like stock investors, she hopes that things will improve at the store. She worked on commission and expensive clothing wasn’t selling that well unless it was discounted. She had not made the connection between the steep discounting in the store and corporate profits. The steep discounting was holding up consumer spending at the expense of profits. She was worried if her job would be there after the Christmas holidays. That’s why she had tried day trading as a means of supplementing her income. So far, it seemed to be working. It at least erased the memory of her prior mutual funds losses.
Trader #2
In another story equally as relevant, I recently decided to change our financial data provider. A competitor sent out their sales rep to our office this week. She used to work in research at an old line mutual fund company before becoming a sales rep for the financial data provider. She had left the fund company because they “just weren’t with it”. Their performance lacked the high flying funds during the heady days of the Internet and the tech markets of 1997-99. They were eventually bought out by a Swiss company. Our rep liked her new job because it gave her time to use the company product and trade. She’s an option and momentum trader. Much of the fundamental information I was looking for she familiar with, but when questioned about more elaborate technicals, she didn't have a clue. She apologized and said she would call the company Help desk and find the answer. She said she was in the momentum camp and “we don’t look at that kind of stuff”. She admitted to not being very good at sales, but she loved the company product because it gave her a trading edge. Options, techs, and biotechs were her hunting ground. She knew a lot about prices and very little about the companies. She didn’t need any facts, price and volume was her game.
This is where the technology revolution has led us to in investing. Everybody knows price and the latest news, but nothing below the surface. Ask questions about real earnings, macroeconomics, microeconomics, global economies, and monetary inflation policies, nobody knows or cares. Where the price is at the moment and what is currently flashing on their screen is all they know. Everything else is much too complicated. This lack of understanding of economics or investing is why so many people got burned when the market bubble burst. Devoid of independent thinking, they don’t process what they read and hear. It is why they will get burned again. They fall victim to trends and fads and have simply become followers. They are easy prey and like sheep are being led to the slaughter again. History is repeating itself. Today as I wrote this update, I listened to a financial network anchor's remarks on the viability of an economic stimulus package. According to this boobhead, it wasn’t necessary because the stock market already had signaled an economic recovery was ahead of us. His guest looked chagrinned with incredulity in his eyes.
The Grand Experiment
So where does this leave us today? The Fed is still in the fire fighting mode. More interest rate cuts are sure to follow. The closer they push rates down to zero, the greater the danger that the US will enter a Japan-style liquidity trap. A liquidity trap occurs when lower interest rates simply have no impact on consumer and corporate spending and borrowing plans. This is what happened in Japan in the 1990’s. It hasn’t happened here. The Fed was quick to act beginning this year in January. It has been working overtime. Lower interest rates have helped to reduce financial sector strains. The spread between short and long-term interest rates has helped banks and kept the financial system liquid. Lower interest rates have also helped consumers to refinance mortgages. Near zero interest is what is driving current consumer spending. Consumers are borrowing and spending. Lower interest rates have reduced borrowing costs for businesses and consumers. It is what is currently holding up housing. Lower rates have also put a temporary floor underneath the financial markets by making fixed income investments less attractive.
The question is whether spending today is robbing Peter to pay Paul. Is current spending being borrowed from tomorrow's spending? The danger is that current consumer and corporate debt levels leave little room for expansion. So debt limits may impose limitations on spending that could lead to a self-feeding cycle of declining consumer and corporate spending. This could accelerate if profits continue to shrink and job layoffs continue to grow. If retrenchment takes hold in either sector, it may be difficult to reverse. This could then lead us to that liquidity trap that many economists don’t think is possible because of the Fed’s aggressive rate cuts. The liquidity trap in Japan was blamed on a reluctant easing on the part of its central bank and a failure to deal with Japan’s banking problems that were infested with bad loans. Whether we are headed for trouble or not, we should know soon enough. If the economy doesn’t respond and continues to deteriorate in the face of lower interest rates, or if the stock market fails to rally to new highs, then trouble will have arrived. Policymakers will have run out of options and that’s when the real fireworks will begin.
So far the greatest asset bubble of the last century has been partially deflated without generating a systemic crisis. Investors have suffered massive losses in their wealth. The job market is soft and more jobs are being lost each week. The technology industry is still suffering from a capacity glut and the manufacturing sector is still contracting, but the ship is still afloat. The clock is ticking and we still have those wild cards of derivatives, oil, and war. We should know within the next two quarters if Mr. Greenspan’s grand money experiment will have worked. If he is able to reinflate the economy, resurrect the stock market bubble, keep gold and silver prices from rising, keep a lid on energy prices, deflect the collateral damage from war, bring world peace, and tame the derivative monster from turning into a financial contagion, he would have rightfully earned a place on the cover of Time magazine. He would indeed have become Greenspan Superman. ~ JP
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