Ignorance is Bliss

By James J Puplava CFP, April 1, 2003

There is an old saying, "What you don't know won't hurt you." That saying seems most appropriate when viewing today's economy and investment markets. The one common perception is what ails the economy and the financial system is the war. If it weren't for the war then things would be peachy. The economy would be booming, companies would be spending money and hiring workers, and the consumer would be cheerfully borrowing and spending. If we can just get through this"war thing," we can get back to the boom times of the 90's. Nowhere do I read in the mainstream press or the financial press this nation's looming debt problems. It just doesn't seem to be an issue. Budget deficits, trade deficits, debt ratios, and bankruptcies are considered temporary problems. The alarming rate of debt accumulation at all levels of society is usually explained away by some new metric that trivializes the problem. If, for example, consumer mortgage debt and equity extraction is at a record level it is compared to the rising asset value of real estate. No one examines this process to think what would happen to debt ratios if real estate prices fell.

I can remember in the late 90's as the tech boom turned into a mania how margin debt was trivialized or how valuation metrics were replaced by new measures such as clicks and stickiness. Price earnings ratios of 600-2000 were ignored. New valuation measures became commonplace that seemed to justify any price paid for an asset. Anybody who questioned these absurd measures was considered out of touch with the times because we were living in a "new era." I began to question this thinking first on the air on my daily radio show, privately in my client only briefings, and then publicly in print. It began with my "Stock Market Series" which then led to my "Perfect Storm Series." Since that time, many events have transpired, not the least of which were the events of 9-11.

What has been ignored since the events of that fateful September is the cost this country has paid to pull itself out of that storm. The money supply has increased by over $1 trillion, the trade deficit has mushroomed, interest rates are now at a half-century low, and are actually negative on an inflation adjusted basis, and personal and financial debt is at a record level. The expansion of credit under Clinton/Greenspan gave us the credit bubble. It is the expansion of credit under Bush/Greenspan that is keeping that bubble inflated. Stocks may be drifting downward but signs of the bubble's continuation can be seen either in the housing market, the mortgage market, or in consumption. Credit was expanded, mainly in the consumer sector and that is what made the recession short and brief.

The next question that would follow, ignoring the war for a moment or assuming that all ends well, what keeps the economy going after the war is over? Is it the consumer, business, government or a combination of any of the three? The consumer and personal consumption accounts for over two-thirds of our economy. How, for example, does a consumer sector that is over burdened with debt or a consumer who is being downsized by corporations increase his purchasing power? For that matter, how does a company, which has more debt off balance sheet than on the balance sheet, lacks pricing power, and is seeing everything from raw materials, energy, to labor costs rising, improve profit margins? With profit margins narrowing, where does the money for increased capex spending come from? Furthermore, with plenty of excess plant capacity, what are the incentives to add even more capacity to the unused capacity that already exists?

Then we have the situation with government. How does local, state, and the federal government finance growing monthly deficits, and a new and widening war? Will rising state and local taxes offset directly the tax incentives if passed by the federal government? What will a half a trillion a year current account deficit combined with nearly a similar budget deficit do to the value of the dollar? And how long will foreign investors continue to finance America's consumption binge? There is also the issue of lack of savings and investment in this country. Can a country the size of the US, which borrows trillions each year to finance consumption, build permanent prosperity built on a philosophy of borrow and spend? By contrast, the average Chinese worker saves about 30 percent of what they earn. Our economic philosophy is to encourage debt accumulation and consumption as opposed to growing a nation who encourages savings and investment.

These are all important questions that need to be answered if any meaningful recovery is to take place. I seldom see them addressed. Most of the time they are quickly dismissed. In their place I see optimistic assumptions that are based on hype and hope and nothing more. Each year economists and analysts promise a second half recovery. Instead, we have seen just the opposite. Therefore, as we look to this war's conclusion and to any brief celebration it might bring, assuming that all goes well, we still look for answers to these questions and can find them nowhere.

Instead of answers, we find just the opposite. We find further evidence of economic weakness. Today's ISM numbers, which fell from 50.5 to 46.2, indicate a contracting economy. GM, Ford, and Chrysler reported that car sales fell 3.3 last month. Each day we also see more signs of credit weakness emerging in rising delinquencies, defaults, or bankruptcies. Today was no exception. Air Canada and Fleming filed for bankruptcy protection. Nor would I take any comfort in the fact that stocks that were selling at 186 times earnings, such as Cisco which is currently selling at 24 times overstated earnings with diminishing growth prospects.

It doesn't matter whether it is questions on economic assumptions, the outcome of war, prospects for earnings, debt levels, or market valuations; we haven't found satisfactory answers. Therefore, a conservative portfolio position is still warranted despite the prospects for a temporary war rally.

The question of deflation keeps coming up and I must admit, outside of computers and growing bankruptcies I find very little evidence of it anywhere. Just about everything this author needs to live and buy keeps going up. It doesn't matter whether it is food, gas, medical premiums, visits to the dentist, utility bills, tuition and books, or movies; they have all gone up over the last year or last few years. With the Fed policy changing from one of fighting inflation to one of creating inflation, I think they stand a very good chance of creating such a monster. There are major differences between monetary conditions of debtor nations and creditor nations that I believe produce different outcomes. The more evidence I see, the more I lean towards an inflationary outcome.

Looking at today's market outcome convinces me of Didier Sornette's thesis on market crashes is correct. The avoidance of drawdowns seems to be Washington and Wall Street's main policy prescription for avoiding market crashes. After a few days or a week of declining prices, we get surprise rallies that originate in the futures pit. The justification for today's remarkable recovery from an opening fall accompanying news of economic weakness and new bankruptcies, markets rallied on reports that Saddam Hussein would make a live television appearance at noontime. I can’tthink of a better reason for buying stocks than this. Saddam never appeared. An Iraqi government official read a prepared statement that was attributed to Saddam. It has become a game of"Where's Waldo?," or in this case, Saddam. The markets appeared disappointed and gave back half of the day's gains. The rally that remained at the end of the day was attributed to investor bargain hunting. Other stories that were attributed to today's gains were investors were optimistic over growth prospects after the war is over. The big unknowns at the moment are the economy and earnings. The picture on the economy is becoming clearer by the moment and is getting weaker. I assume that from what companies are saying the same holds true for earnings. It is only through obfuscation, alteration, and spin that what is weak appears to be strong. Investors will not only have to try to see through the fog of war, but also fog of financial spin.

Wall Street is calling for another market bottom and a new bull market that began last October. Technically the markets are caught between the markets 200-day moving average on the upside and that Greenspan put on the downside. In other words, this is nothing more than a tradable market until the unexpected arrives.

Volume remained light at 1.43 billion on the NYSE and 1.39 billion on the Nasdaq. Market breadth was positive by 2-1. The VIX fell 1.27 to 32.10 and the VXN dropped 1.08 to 41.97. The drop in both indexes indicates that complacency is coming back into the market.

Overseas Markets

European stocks advanced for the first day in five, led by the insurers Munich Re and Allianz AG, the two worst performing stocks last quarter on the Dow Jones Stoxx 50 Index. The Stoxx 50 rose 1.9 percent to 2138.11. The Stoxx 600 advanced 1.4 percent to 178.92, with energy stocks and resources shares leading percentage gains. Benchmark indexes rose today in all of the 17 Western European markets, expect Norway.

Japan's stock benchmarks rose, led by the biggest companies such as NTT DoCoMo Inc., on speculation government pension funds started buying as much as 1.7 trillion yen ($14.4 billion) of stocks from today for the new fiscal year. The Nikkei 225 Stock Average gained 0.2 percent to 7986.72. The Topix index rose 0.1 percent to 788.96.

James Puplava

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James J. Puplava CFP
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