The Myth

By James J Puplava CFP, August 20, 2002

Classic Credit Squeeze
Slowly but surely the myth of the second half recovery is starting to fade. Economists, analysts, and anchors are still hopeful, but chances of a second half recovery just aren't in the works. The corporate sector is hemorrhaging and unlikely to produce the pro forma miracles Wall Street is still predicting. In fact, credit spreads continue to widen, taking out levels not seen since September 11^th. This means investors are less certain of a company's financial health. As these spreads continue to widen, it is keeping the cost of borrowing high for most companies. With corporate debt at near record levels, this is hammering the bottom line. When the cost of borrowing or tapping the capital markets is high companies are less reluctant to spend money on capital expenditures, so the economy is getting no lift from the corporate sector. With the capital markets off limits for most companies many have to go back to borrowing from banks. There are too many companies running into trouble. Banks are becoming reluctant to lend having lost billions in loan defaults over the last 18 months. In short, what we are seeing is a classic credit squeeze.

On a global basis most economies are either in recession or are experiencing stagnant economic growth. Germany's economy, like the US, grew at an annual rate of 1% in the second quarter. Economic growth in Europe is anemic at best, while in Latin America most economies are stressed. In Asia, Japan's economy is a mess so there is no big countervailing force to offset weak economic growth. In '97 and '98 with the Asian crisis, and in 1998 with LTCM and Russia, the US economy and financial markets were still strong enough to offset weakness overseas. That is not the case today. Even the tone of the latest IMF forecast is becoming gloomier with each new update. In summary, there is no outside force at the moment to bail economies out of a vicious downward cycle that is correcting all of the excesses created during the last boom.

Consumption & Housing Still Strong

The last remaining source that is still standing throughout this bust has been the American consumer. The ability and the willingness of the American consumer to go even deeper into debt to maintain consumption have surprised even the experts. This ability to take on more debt has been attributable to the next bubble, which has been the rise in housing prices. Lower interest rates have not only lowered mortgage payments, but have also fed into creating a bi-coastal housing bubble. The rise in housing has allowed consumers to extract additional equity out of their homes without increasing payments significantly. In an effort to keep the housing market alive, consumers and lenders have switched to variable rate mortgages. This will enable the housing bubble to stay inflated a little while longer.

However, there are signs that consumption spending and even housing are nearing their end-run. The bank of Tokyo-Mitsubishi and UBS Warburg both reported declines in weekly chain store sales that point to a trend of slowing sales. In the report they say, "Sales were generally below plan for retailers."

If lower mortgage rates and rising housing prices have kept the consumer sector unusually strong throughout a recession, the next leg down in the stock market and the next wave of layoffs will soon begin to override this strength. Optimism is still running high with investors who have kept themselves fully invested. Everyone believes what they read and see on TV that things are going to get better. My own personal belief is that the bubble in real estate is what stands behind that optimism. Once real estate starts to deflate that optimism will evaporate. Right now the bubble has been granted an extension through variable rate mortgages, which is helping to extend the life of the bubble. Homebuilders are also throwing in more incentives to make the sale. The switch to "interest rate only" and variable rate mortgages is helping only to postpone the day of reckoning. Even when the downturn comes, real estate won't crash like the financial markets; it will whittle its way down for years.

The final thorn in the economy is the recent rise in energy prices. They helped to bring about the last recession and they are helping to bring this one to fruition. Most post-war recessions in the US have been associated or triggered by a rise in energy prices. Today's rise in crude oil above $30 a barrel is going to act as an additional tax on the economy. Most of oil's rise reflects growing political risks associated with an upcoming war. And if war breaks out, the price may go even higher depending on the war's outcome. Inventory levels were much higher in the US in the last Persian Gulf War. In the last war, inventory levels were close to 400 million barrels as compared to today's 300 million barrels of inventory. War has added another element of uncertainty to an already uncertain financial market and economy. No matter the outcome to this war, higher energy prices are just one more element the economy and markets will have to deal with that will slow down growth.

Given all of these uncertainties, I am amazed at the amount of complacency in the markets. Everyone is still buying the second half recovery scenario. This applies to professionals as well individual investors. The recent momentum based rally is nothing more than that. Even then, this market has been weak. It hasn't generated the liftoff that most experts were hoping to see. Volume has been anemic, breadth has been unexciting, and the rate of change has been less than spectacular. We are having a rally as predicted, but it won't last long without additional intervention. This is because the fundamentals for a sustained rally are weakening.

The Next Leg Down

What is even more disconcerting for Wall Street and Washington is the upcoming September/October reporting season. This is traditionally one of the worst periods of the year to be invested in stocks, and this year will be even worse. If I was a betting man, I believe that we are more likely to get a full-blown market crash, triggered by an unseen event, either geo-political or financial, that could send the markets into the abyss. Add to this all of the upcoming disappointments heading our way in the form of profit shortfalls and another recession, and it isn't hard to see the next leg or turn in the markets is going to be "hard down;" in other words, a stock market crash. This crash should be strong, fast and deep enough to shake the very core of the markets and shake the remaining apples from the trees. The next leg is going to be a seminal event. If investors haven't realized that we are in a bear market, they will certainly realize it after the next leg down. That is when the real fear factor comes into play. Up to this point, investors have been hanging on in the belief that the markets would recover and another bull market would develop. Most investors, even though the Nasdaq has lost over 70% and the S&P 500 over 40%, have viewed the first leg down as a correction and not a bear market. Everyone still believes that better times are ahead.

Most people can’tremember what a real bear market is like. We've had only two major bear cycles in the last century; one in the 30's and the other one in the 70's. Most experts and investors feel what happened in the 30's and the 70's in the US, and the 90's in Japan, can’thappen here again. They are about to get a painful history lesson. This one will be more painful than the bear markets in the 30's and the 70's in that there are more Americans invested in stocks today than in any other period of history in the markets. Instead of facing these realities, most investors are in a state of denial. The WSJ and CNN recently did a story on why investors are phased by the downturn. Most are complacent and have stopped looking at statements, refusing to deal with reality. That is why the next leg down, which I believe starts this fall, will be a powerful one because it will be driven by fear. Fear has been one of the missing ingredients in this bear market. Years of rising markets and financial advertising have done their job. They have left investors in stocks while insiders have fled the markets. They know more than anybody else what is happening to their companies, which is why they have exited the markets.

Given all of these uncertainties now facing the markets, Fed officials have two decisions to make. They can get ahead of the markets and try to drive prices up before the crash, adding to the myth that they still have some control or influence over the markets. The other alternative is to save their ammunition to help thwart the crash when it arrives. However, they run the risk that once it arrives, their efforts may be overrun by panic and fear, destroying the myth of the Fed's invincibility. Given what Fed officials have been writing and talking about, they may try to get ahead of the curve. The Fed is well aware of the mistakes made in Japan. A preemptive surprise attack, which could come in the form of an interim rate cut of half a point, could get the markets above key resistance levels. If they wait and try to react to a crash or panic, they may be fighting downward momentum that renders their rate cut useless.

The markets are going to get interesting, especially after the holidays. The pros will be back from vacation, the ECB will be meeting in the first week of September, weather conditions will be cooling in the Middle East, and the US stockpile of weapons will be at war levels. Cooler weather in the fall makes an attack more likely. Ammunition stockpiles, troop strength and battle deployments should now be approaching levels sufficient for war. Fasten your seatbelt and pull the shoulder harness tight for you are in for one hell of a ride.

Overseas Markets

European stocks fell as the outlook for earnings dimmed at some of the region's biggest companies, such as AstraZeneca, Nestle and WPP Group. The Dow Jones Stoxx 50 Index dropped 1.9% to close at 2793.88. It has climbed 15% since July 24, when the index declined to a five-year low. All eight major European markets were down during today's trading.

Japanese stocks rose on optimism the yen's biggest drop in almost two weeks against the dollar may increase the value of overseas sales of exporters such as Tokyo Electron Ltd. The Nikkei 225 Stock Average gained 0.2% to 9620.69. The broader Topix index added 0.1% to 945.63, with computer-related companies and automakers the two biggest gainers.

Treasury Markets

Government bonds registered respectable gains across the board, with the 10-year Treasury note rallying 24/32 to yield 4.195% while the 30-year government bond gained 29/32 to yield 5.00%. In economic news, the June trade deficit narrowed a shade to $37.2 billion from May's $37.8 billion deficit. The June deficit, however, was a touch wider than the $36.8 billion expected by economists. Additionally, the U.S. saw a budget deficit of $29.2 billion in July, a little less than the $32 billion deficit predicted by the Congressional Budget Office.

James Puplava

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James J. Puplava CFP
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