Green Thumb Losing Its Magic?
The Problem With Fraternal Twins ... double the trouble ... alike yet different
By James J Puplava CFP, July 16, 2002
There was a time when it seemed Mr. Greenspan could do no wrong. A crisis would erupt and he would take care of it. It didn't matter if it was the 1987 stock market crash, the S&L crisis, the peso, problems in Asia or a troubled hedge fund. If there was a problem in the financial system, he was "Mr. Fixit." The ability to pull the U.S. or the world out of one financial crisis after another earned him the gratitude of Washington and Wall Street. It appeared that the man could do no wrong. It didn't matter -- whatever the nature of the crisis -- the Fed Chairman always managed to pull a rabbit out of his hat. Even on a day like today, the Fed Chairman was treated by accolades from grateful senators. At one point during his testimony, a fawning Senator Sarbanes, Chairman of the Senate Committee on Banking, Housing, and Urban Affairs, stopped to comment that the Dow, which had been down as much as 233 points had recouped its losses. A joke was made that maybe senators should give up some of their questioning time to allow the Fed Chairman to talk more, intimating that his very word would restore confidence to the financial markets. The markets did rally if only briefly. We went from being down 233 points to slight gains before heading back into negative territory.
Mr. Greenspan failed to restore confidence as the Dow Industrials closed with steep losses for the seventh straight session. News of additional earnings misses overshadowed any positive effect the Fed Chairman's comments may have had for the markets.
Caterpillar missed its earnings estimates and Intel said its number would fall short of expectations. In the case of Intel, the company missed its earnings targets due to lackluster demand for personal computers. In addition to missing profit targets, Intel said it would cut 4,000 jobs or 5 percent of its workforce. The news from Caterpillar was followed by additional disappointments from Apple Computer and another SEC charge against Raytheon for giving profit forecasts to analysts before telling the public. The markets turned down with the Dow losing 1.9 percent.
So much for the lasting effects of Mr. Greenspan's speech and positive comments about the economy. The markets headed where they wanted to head, which was a continuation of its downtrend. One analyst commented that no one person, whether it is the President or Mr. Greenspan, could instantly cure what ails the markets. In fact if you read through the fine lines of today's testimony, there were hints of future rates hikes coming down the road. In his statement the Fed Chairman said, "the Federal Open Market Committee has recognized that the accommodative stance of policy adopted last year in response to the substantial forces restraining the economy likely will not prove compatible over time with maximum sustainable growth and price stability." Translation --- we will have to raise interest rates.
Dollar Crisis Looms
Mr. Greenspan recognizes he has a major crisis on his hands in the form of a declining U.S. dollar. The dollar continues its relentless descent against the yen and the euro. For the U.S. capital markets, this is becoming a critical issue. With a widening trade and current account deficit, the US is heavily dependent on inflows of foreign capital to finance this deficit. This is one of Mr. Greenspan's dilemmas -- to raise or not to raise interest rates. If the Fed raises interest rates to protect the dollar and make it more attractive to foreign investors, he runs the risk of harming the economy. Low interest rates have held up the housing markets and consumer spending through the refinancing of mortgages. In his own words, "Monetary policy also played a role by cutting short-term interest rates, which helped to lower household borrowing costs. Particularly important in buoying spending were the very low levels of mortgage interest rates, which encouraged households to purchase homes, refinance debt and lower debt service burdens, and extract equity from homes to finance expenditures". Indeed, recent sizable increases in home prices, "have significantly increased the equity in houses that homeowners can readily tap through home equity loans and mortgage refinancing. But those sources of strength probably will be tempered by other influences."
This is the Fed Chairman's major problem. By attempting to keep one bubble from deflating, in this case the U.S. dollar, he risks deflating another bubble of his own creation, which is the housing market and consumer spending. The Greenspan magic, which worked so well in the past, isn't working anymore. In effect the Fed has backed itself into a corner. If the Fed keeps monetary policy loose and expands the supply of money into the economy, he risks a falling dollar. If he raises interest rates to hold up the dollar, he risks popping the housing and consumer spending bubble. Outside of government spending, housing and consumer spending remain the only sectors left holding up the economy.
The Fed has backed itself into a corner with no way out. Either option may prove unacceptable to the financial markets. In fact one can argue that the easy days of inflating your way out of a financial crisis are over. You can also argue over the efficacy of Fed policy. Lowering interest rates and flooding the financial system with easy money has failed to resurrect the financial markets and in addition has created new problems with the dollar and another housing bubble. How do you deflate one bubble (U.S. dollar) without harming the other bubble in the housing market?
The Fed now confronts many problems of its own making. Unlike the past, when a crisis presented itself, the Fed would lower interest rates, flood the markets with money and the stock market would respond. The money went into the financial markets driving stock prices higher. It happened in 1995, 1997, 1998, and in 1999. This time around monetary stimulus has failed to revive the stock market bubble, but instead has found a new outlet in the housing market. So we now have a housing bubble, a dollar bubble, a consumer bubble and a bond market bubble to take its place. The financial markets have failed to cooperate. So instead of one bubble (stock market) to contend with, the Fed now has multiple bubbles which have yet to deflate.
It looks like the Fed is running out of time and bullets. As today's graphs of the Dow and dollar indicate, we have two bubbles that are in the process of deflating while two other bubbles are still inflating: the housing and the bond market. In the meantime, all that can be done is for Washington and Wall Street to plead with consumers to keep the bubble going by spending more money and taking on more debt. This trend is unsustainable and it may be the dollar crisis, which deflates the housing and consumer bubble through rising interest rates. If the U.S. financial markets continue to deflate and the dollar continues to decline, foreign investors may begin to exit in mass out of U.S. financial assets. This would force U.S. interest rates up as foreign investors sell off part of their holdings of U.S. assets, thereby forcing down their price and raising interest rates in the process. As these graphs of our trade deficit, current account deficit and foreign holdings of U.S. Treasury show, foreign investors now may be the Fed's most important constituency. (Source: Grandfather Economic Report by Michael Hodges.)
Foreign Confidence in Our Markets is Important Too
In many ways, the fate of the U.S. financial markets and the U.S. economy may now rest in the hands of foreigners. What they decide to do with their U.S. holdings may decide the outcome for the U.S. markets. Washington and Wall Street may not like it, but foreign confidence may be just as important as consumer confidence for holding up the markets. All that can be said is at the moment they are still holding on. They still own their T-Bonds and T-Bills. In a similar fashion most investors are still holding on to their mutual funds. The question remains as to how long both investors, foreign and domestic, hold on to their U.S. financial assets. This is what is keeping the lights on late in Washington and on Wall Street.
To find a similar situation as we now face today, it is necessary to go back to the early 30's when dramatic monetary ease failed to initiate a response from a falling stock market. Back then, like today, all of the crucial monetary and fiscal policies had been put in place to bring the markets and the economy back. They didn't. Instead the Dow lost 90 percent of its value and the economy went into the depths of a depression. Like then and similar to today, the decade of the 30's had followed a decade of prosperity in the economy and the financial markets. The 1920's were hailed as a new era of prosperity for the American economy in many of the same ways as the 90's. What economists and analysts have failed to realize is that the monetary excesses of the 1920's were what fed the stock market and consumption boom of that era. The conclusions that the U.S. markets were some how different this time are in error. The same monetary policies of the 20's have been repeated in the 1990's and the consequences will be similar. The excesses in the financial markets have just begun to correct and it may be a very long time before they are fully discounted in the markets. Bear markets can take a very long time to unwind.
The profit squeeze now being felt by American businesses continues to take hold. Businesses face pricing pressures at the same time their costs for raw materials and labor are rising. The net result is profit margins are falling and businesses are cutting back expenses in response. Today's plethora of earnings disappointments and job layoffs from companies such as Caterpillar, Apple Computer and Intel are an indication that this vicious trend still remains in place. This makes the profit miracles that Wall Street is forecasting for the second half of the year less likely. Especially now if Congress moves to force companies to start treating stock options as an expense. Standard & Poor's estimated that earnings for its component companies would be 23 percent lower in 2001 if stock options were treated as an employee expense. The S&P 500 currently trades at 38 times earnings for the most recent four quarters. If stock options were treated as an expense, lowering profits as a result, the S&P 500 Index would trade at 48 times earnings. This is roughly three times the indexes historical average.
The Message of The Markets
This is the problem that the markets now face regardless of Fed policy or the actions of Administration and Congress. Stocks are simply overpriced. It is that simple. The hype and spin of the 90's, that valuations don't matter, are finally starting to haunt investors. Valuations do matter! With dividends this low and P/E multiples this high, stock prices will have to fall considerably before stocks become a bargain again. It may be the hubris of those in Washington and on Wall Street to think that they could defy the lessons of gravity. What goes up can also go down as the charts of the markets verify. No spin, no rate cuts, no fiscal policy, and no speech a President or Federal Reserve Chairman gives will bring these markets back again. At least -- not until these excesses have been cleansed from the financial markets and value is once again restored will the stage be set for another bull market to begin. We are far from this point. Investors would be wise to consider that while a bear market has begun in "paper" assets, there's a new bull market in "things." On this very day, while the major indexes ended up on the negative side, the CRB Index is climbing to new highs. The price of crude oil rose $.68 to $27.75 a barrel. Natural gas is up $.08 to $2.863. Grains are all up from corn to wheat to soybeans. It looks like money is moving out of paper and back to things. This is the message of the markets.
Investors lost ground on both sides of the financial markets today. Instead of rising as they normally do when the stock market falters, bond prices took a beating as investors dumped longer-dated bonds on news of improving economic conditions. The 10-year Treasury note lost 15/32nd with the yield rising to 4.69 percent. The 30-year government bond tumbled 1 and 1/32nd as its yield rose to 5.455 percent.
Foreign markets fared much better with five out of the eight major European markets rising or remaining unchanged. Markets fell throughout most of Asia with the Nikkei falling 125 points to close at 10,250 a loss of 1.2 percent. Hong Kong's market fell 160 points to 10,241 for a loss of 1.51 percent for the day.
© 2002 James Puplava