14-Year Bear Itch
By James J Puplava CFP, August 19, 2002
In a Recession
The leading economic indicators tell a story that many people already know: the U.S. economy is heading back towards recession. In fact, we may already be there. The latest government figures show that the economy grew at a 1.1% annual rate during the second quarter. That translates to a quarterly growth rate of a little over 0.25%. Given the propensity for revisions that always come later, and for the most part are less favorable, we probably are already in another recession. As we found out last month when the government revised GDP numbers for 1999-2001, the last recession was much longer and much worse than originally thought. The recession ended after the third quarter of last year. The final quarter of 2001 and the first quarter of this year showed robust economic growth as a result of two sectors: government and consumer spending.
Increased defense expenditures, strong automobile spending, and a robust housing market were what led the economy out of recession. The combination of lower interest rates allowed consumers to refinance mortgages, extracting equity in the process, which helped to fuel additional consumption. Now that may be coming to an end.
Unless mortgage rates go significantly lower and housing prices continue to climb, allowing further equity extraction, the consumer may be tapped out. What policy makers don't know at this time is if the recent data on the economy represents a one-of-a-kind event or the beginning of a new trend. Job layoffs are still rising while hours worked in the economy are at new lows. Deflation in the economy may now be the Fed's greatest fear. Everywhere you look there are signs of deflation. In the manufacturing sector companies can’traise prices as global competition, especially from China, is a growing source of competitive pressure. In the financial markets the drop in equity values ($5 trillion) and the $525 billion in bond defaults over the last 18 months is a deflationary event in itself.
Deflation is the key to a depression and the Fed is well aware of it. It recently published a policy paper analyzing the deflationary depression in Japan. In this paper the Fed looked at everything that went wrong in Japan. Recognizing the U.S. could find itself in the same boat, the paper outlines everything the Fed has in its arsenal of tools to keep that from happening here. They could start to monetize government deficits, lower bank reserve requirements, lower interest rates down to almost zero forcing cash to flee. The government could enact new tax cuts and continue to expand its deficit spending ever further. If faced with the choice of a deflationary depression or stagflation, the choice is clear they will inflate.
So far the Fed has been reluctant to burn the currency. However, that may change soon. The key to lowering interest rates will be cooperation with the ECB (European Central Bank). Interest rates between the U.S. and Europe on short-term rates are more favorable in Europe. The fed funds rate is at 1.75% in the U.S. In Europe its equivalent rate is at 3.25%. If the U.S. lowered now without cooperation from the Europeans, a dollar crisis could erupt. The dollar has already fallen 10.5% since the end of January. If the Fed were to move preemptively without coordination with other central banks, it could turn a dollar decline into a route. It would then be faced with a more serious crisis causing financial markets to plunge, and, in effect, nullifying the Fed's action. The ECB will meet next on September 4th. That will be a key date to watch. If the ECB lowers rates, then the path will be clear for the Fed to start lowering interest rates.
Greenspan is down to seven bullets if he proceeds to lower rates 25 basis points at a time. Therefore, he now needs to make sure each bullet has maximum effect in hitting the target. If it weren't played well, he would have to start monetizing debt and use other means that would show desperation. The government also has a war to fight. Wars cost money; they are inflationary. The new war may give Mr. Greenspan the opportunity to try out one of his theories of using ample liquidity to fight a depressionary cycle. It may be one reason that commodity prices are rising again.
If Mr. Greenspan wanted to get maximum benefit from each bullet fired, he would do it by surprising the financial markets, catching the shorts off balance and the markets themselves. Let's say the ECB lowers rates--the Fed could do an interim rate cut of half a point. This would take the markets by surprise, generating a rally through more short covering. If the Fed played it right it might be able to entice Main Street back into the market in the hopes of recouping losses. If I had only a few bullets left in my chamber that is how I would play it. The element of surprise is more effective when your opponents aren't expecting anything. The gradual 25 basis point cuts are not going to do it this time, so the element of surprise would give the Fed more bang for the buck.
Meanwhile, in anticipation of lower interest rates, investors ignored disappointing economic news to go back into the markets. The technical pattern of the market seemed ripe for a rally continuation. This rally should continue until the VIX (CBOE volatility index) heads lower and the Put/Call ratio drops even lower. The VIX ended the day down by 1.25 to 31.57. When it gets down to complacency levels at 20 the market should be close to a peak. As today's graphs show (from a recent article in Forbes), stocks can rally even during a bear market. With today's markets still at extreme levels the downside has much further to go. Not until we're back to dividend yields of close to 6% and P/E multiples of 7-10 will stocks be considered cheap. What is going on now is a trading rally mainly with professionals. The Financial Times did a story today on how U.S. investment banks are taking on more risk by leveraging their balance sheets. With investors fleeing the market, the IPO market dying, and M&A activity coming to a halt, profits are shrinking. To counter this drop in revenues, firms from Goldman Sachs, Morgan Stanley, to Citigroup have increased their trading and risk taking. Value at risk (VAR), which measures the maximum amount a bank would stand to lose under current assumptions, increased at most major firms, according to recent SEC 10-Q filings.
With derivatives growing to over $110 trillion worldwide, and the U.S. accounting for the majority of that figure, one can’thelp but think that someone, somewhere, is going to be on the wrong side of a trade. With the war against terrorism about to begin a new chapter, with leverage still increasing in the financial system, and corporate profits at Capex spending still contracting, there are plenty of rogue waves that could hit the leveraged trader.
Possible Rogue Waves
The energy market is certainly one of these rogue waves. The oil and gas markets keep rising with the price of crude now approaching $30 a barrel. Natural gas prices are also over $3.25. With lower prices for natural gas over the last twelve months, gas well completions are expected to decline by 40% this year. The deceleration in drilling activity will get worse in the third and fourth quarter of this year. Even last year the peak in gas drilling output increased by less then 2%. The U.S. Energy Agency and the IEA estimate that demand for oil and gas are still growing, especially in Asia. With the energy markets so unstable producers have been unwilling to take on the risk of expanding the supply with the outlook for prices so uncertain. Even with higher prices there are many experts in energy that believe natural gas production in the U.S. has already peaked and is now heading into irreversible decline, similar to oil output in the U.S. which peaked in 1970. Fortunately for the U.S., a recession and a mild winter have helped the U.S. out of an energy crisis. Weather, more than economic factors, has been key in pulling us out of an energy crisis. But as the floods in Europe, the drought in the U.S. point to another irregular weather cycle. If the weather is mild this winter as it was last year, we may be able to get by one more season. However, add the uncertainty of war and the vagaries of weather and it is clear the U.S. is only one step away from its next energy crisis.
Meanwhile on Wall Street, reporters looked for a reason for the markets' rise that would give it some substance. Optimism over renewed consumer spending and hopes for a boost in cooperate profits were given as the reason for today's rally. Twenty-eight out of the 30 stocks in the Dow rallied today with the blue chip average posting a gain of 2.4%. Most stocks in the Dow rallied with 28 out of the 30 advancing. Investors seized on a rise in the profits of Lowe's that the consumer was still willing to dip deep into his pockets to maintain spending. Instead of concentrating on the leading economic indicators, falling investors focused on Lowe's profits.
Wall Street firms have lowered profit expectations again for the third and fourth quarter. The current estimates, if you can keep track of them as quickly as they change, calls for pro forma gains of 11.5% in the third quarter, and 23% in the fourth quarter. Remember these pro forma estimates are not the bottom line. The S&P 500 still trades at 33.6 times trailing earnings and offers a dividend yield of only 1.63%. With all of the funny numbers still used, investors would be better off focusing on the dividend yield as a more reliable measure of value for judging stocks.
Volume still remains anemic at 1.27 billion on the NYSE and 1.54 billion on the Nasdaq. Volume will remain that way until summer's end this month. Market breadth was positive by 22 to 10 on the big board and by 20 to 14 on the Nasdaq.
European stocks rose for a third day as concern eased about the slowing pace of economic growth in the region. The Dow Jones Stoxx 50 Index added 3.1 percent to close at 2846.80. Allianz, Nokia and Aegon, among this year's worst performers, posted some of today's biggest gains. All eight major European markets were up during today's trading.
Japanese stocks fell after U.S. government reports showed that consumer confidence and home construction unexpectedly declined. The Nikkei 225 Stock Average lost 1.9% to 9599.10 today. The Topix index fell 1.7% to 944.41.
Government bond prices ended higher across the board in a session dominated by volatile action. The 10-year Treasury note gained 10/32 to yield 4.285% while the 30-year government bond advanced 18/32 to yield 5.055%. Tuesday will see the release of the June international trade numbers, seen recording a $36.8 billion deficit. Additionally, the July Treasury budget statement will be released.
© 2002 James Puplava