By James J Puplava CFP, July 7, 2003
Part of my weekend routine includes stops at my favorite book stores. The big stores such as Barnes and Noble and Borders now offer their customers a coffee café. At the Barnes and Noble I frequent, they have a Starbucks so I am able to satisfy my caffeine needs and peruse the book shelves in an elevated state. I'm always looking for a good book or an author to interview for my weekend broadcasts. I also enjoy reading foreign publications and magazines because they cover news stories we seldom hear about here in the U.S. Over the last month I have noticed a discernable trend in the degree of bullishness in both newspapers and magazines. Everyone is convinced that we are in a new bull market. The consensus is overwhelming with bearish headlines a distinct rarity these days. In fact it would appear that the bears have all gone back into hibernation. Signs of the new bullish sentiment are everywhere. It can be seen on magazine covers, newspaper headlines, CNBC ratings, the increase in margin debt, the return and popularity of day trading, and the profits of discount brokers, such as Charles Schwab.
Riding the Bull
"The good times are back" seems to be the prevailing view of the financial markets. Stock prices are up this year, the war is over and there have been no terrorist attacks on U.S. soil. Interest rates are at half-century lows, monetary policy is accommodative and fiscal policy is now in overdrive. Even more important is that after three down years in the stock market, prices are finally levitating again. If monetary and fiscal policy is stimulative, public confidence is bordering on hysteria. Given the dismal economic data and the degree of confidence in an economic recovery, the new bull market seems out of place with reality. Yet that is what you see. Just about every financial publication I read has either cover stories or headline pieces talking about the new bull market. Financial publications from Barron's to BusinessWeek are heralding a new bull market. A friend of mine sent me a copy of a recent newsletter from a prominent cable money show host. According to this veteran, the bull market in stocks is just getting started. In this man's opinion, "Investors haven't seen anything yet."
In examining the rationale for the new bull market, the main reason given for an economic recovery and a new bull market is confidence in government, especially in Mr. G. The two main arguments are that interest rates are at record lows and the Fed has omnipotent powers to levitate anything that it desires. In other words, there is complete confidence in the Fed's ability to keep bubbles inflated as well as create new bubbles to replace those that have partially deflated. This confidence in the effectiveness of monetary policy is in danger of turning into blind faith, ignoring reality or becoming completely blind to it. As a result, actual evidence of a recovery or sky-high market valuations are completely ignored. It's a lot like a sailor ignoring a dropping barometer reading and heading out to sea just because the skies are clear.
Erroneous Assumptions - Then and Now
This blind faith in the G-men rests on erroneous assumptions. It begins with the assumption that America's economy is fundamentally sound. Therefore, like past recessions or bear markets, the standard prescription for recovery is expected to work miracles. Past postwar recessions were usually the result of excess inventory and tightening monetary policy. The economy heated up, inventories grew and the economy went into a slump. When inventories were worked off and monetary policy eased, the economy recovered. The thinking is exactly the same this time. Inventories have been reduced and monetary policy has eased. The reason there is so much bullishness is that monetary policy and fiscal policy have never before been this accommodative. With interest rates this low and the Fed vowing to fight deflation with everything it has, how can we not get a recovery?
Yet this blind faith in the efficacy of fiscal and monetary policy are ignoring, or worse, turning blind to the structural problems that now plague the U.S. economy. The assumption that America's economy is fundamentally sound is ignoring an economy that is setting new record debt levels within all sectors of the economy, has virtually no savings, and is turning to the rest of the world to finance its voracious appetite for its debt based consumption. We don't produce, we don't save, and we don't invest any more. What drives the American economy now is debt, consumption, and asset bubbles. In present economic and financial circles, there is no recognition given to the maladjustments that come with asset bubbles created through an abundance of credit. This overconfidence comes from a misunderstanding of credit and asset bubbles. When we see price inflation in real goods, policymakers and bond vigilantes become worried. When inflation causes asset bubbles to inflate, we become euphoric, failing to distinguish that both goods inflation and asset bubbles are one in the same thing. They are visible signs of excess credit and inflation. One aspect of inflation is seen as detrimental; while the other sign of inflation in assets is viewed as bullish.
The Underlying Symptom is Ignored
This inability to distinguish between the two different aspects of credit inflation one in goods and the other in paper is preventing authorities from properly treating the problem. What is needed is less credit, not more credit. Excess capacity needs to be eliminated through bankruptcy and consolidation. Debt needs to be cleansed from the financial system and all of the malinvestments of the previous boom need to be eliminated. This is a process that takes time. In our instant gratification society, time and pain are words no one wants to hear. Rather than look at the problem created through excesses, we are applying more of the same tonic to solve the problem. It is a lot like giving someone who has gone on a drinking binge more alcohol in order to avoid a hangover.
Thinking in professional financial circles now runs contrary to actually solving the problem. The current answer is for more of the credit tonic to ease the pain. If more credit is injected into the economy, Herbie Homeowner can refinance his home mortgage and extract more equity to buy things he doesn't need. Lower interest rates also allow bankrupt or profitless companies to stay on life support by borrowing more money. Financially dead companies can borrow even more money at even lower interest rates, allowing them to postpone the inevitable for a while longer. As a result, excess capacity is never eliminated, but in fact is being subsidized by the constant flow of credit. All the Fed is doing is buying more time. Meanwhile, in place of one asset bubble, it has now created multiple bubbles to supplement the original bubble in the stock market.
Believing Isn't Seeing
Yet on Wall Street and Main Street, faith in the Fed has never been stronger. The current thinking is that the problems of past asset bubbles, such as the U.S. in the 1930s or Japan in the 1990s, can be avoided. The current thinking is that the Depression in the U.S. during the 30's and the deflationary recession of Japan in the 90's can be avoided by aggressive monetary easing. The problem back then, it is believed, is that the central banks didn't move fast enough in their efforts to reliquefy the economy and the financial system. The solution now, it is believed, is to fight credit excess with even more credit excess. Since 2001, non-financial debt has increased by close to $3 trillion; while financial debt has grown by $2.5 trillion. The Fed sees no problem in debt of this magnitude. In fact in research papers dating back to 1999 and more recently last year. Fed researchers concluded that Japan's deflationary problems could have been avoided had Japan's central bank moved aggressively to ease interest rates and inject more credit into the financial system. The problem is never "credit" itself. The only problem in
We have now arrived at a key inflexion point in the markets. Stock prices have levitated again based on a lot of hope and hype coming from the Street and a little help from friends. The second quarter reporting season will begin in earnest next week. As the graph below indicates, earnings expectations have been adjusted downward. Operating profits are expected to be up 5% year over year. The best that can be said about the profit picture is that it isn't getting worse. Everyone is hopeful, but they are still holding back on spending plans, waiting for visible signs that an enduring recovery is in place. Any sign or hope that things may be improving is seized upon by the markets as an excuse to rally. This morning's front page piece in the Wall Street Journal that tech suppliers sense an uptick in spending was given as one reason the markets surged at the opening bell. However, this morning's surge in stock prices had more to do with miracles in the futures pit than it did miracles in the economy. The familiar flag pole rally pattern has become all too familiar, a huge jump in futures that translated into a rally in the indexes and remaining there the rest of the day. It reminds me of a line from a Beatles song “a little help from my friends.”
The Quirks of Q2 Reporting
As results come in for Q2, it is already expected that results will be "better than expected." That is because expectations have already been lowered. Not much is expected this quarter. However, there are great expectations for Q3 and Q4. The rally of hope is based on another second-half recovery miracle. While hope is high; there is very little evidence that an uptick in business spending is about to materialize. I just finished reading Fred Hickey's "The High Tech Strategist." According to Fred, there is still plenty of excess capacity. Capacity utilization rates are the lowest in the tech world while manufacturing utilization rates are at a 20-year low at 74.3%. Fred sites examples of conference calls he has listened into recently with several contract manufactures. Capacity utilization rates are still low and companies still lack pricing power. What has changed is the ability of companies to take on more debt in order to stay alive. Financing debt has never been this easy, but it is precisely this debt financing that is keeping excess capacity from ever being eliminated. It keeps bankrupt companies in business.
Despite evidence to the contrary that an actual recovery is taking place, Thursday's jump in the unemployment rate is a subtle reminder, that confidence in government policy remains high. An abundance of credit, record low interest rates, a growing government deficit, burgeoning trade deficit, and depreciating dollar is giving everyone comfort that a recovery cannot be too far behind.
The only problem with a depreciating dollar is that the countries that the U.S. runs the largest trade deficit with are countries whose currency has moved very little. Japan is actively intervening in the currency markets to prevent the yen from rising and China pegs its currency to the dollar. Bulls ignore this flaw in their devaluation arguments.
In the final analysis it is believed that zero percent interest rates will make holding cash worthless, thereby leaving consumers as well as savers with no other choice but to spend, borrow and invest in stocks. These are rather shallow arguments for a new bull market. However, analyze and sum up the bulls' arguments for a recovery and new bull market. It boils down to this: confidence in The G-Men and Mr. G himself.
The ability of the G-man to create another asset bubble is what keeps the bulls going. I believe this confidence is about to run into a wall of reality when it comes to the second-half of the year. That is when the actual rubber will meet the road. As I have said before, the Grand Banks are no picnic in the fall nor is the stock market
Back at the casino, stocks took off like a rocket ship ignited by powerful buying in the futures pit this morning. The NASDAQ experienced its best close in 14 months. The market's fears of deflation are beginning to fade as asset bubbles reinflate. The major indexes rallied despite profit warnings coming from BMC Software and Schering-Plough. The current thinking is that profits will beat estimates this quarter and that is all that counts even though those estimates have been lowered. Wall Street firm Goldman Sachs issued a bullish report on tech spending projections. If the actual numbers look dismal, just crank up the projections.
The rally took place among the usual suspects: semiconductor, hardware, biotech and Internet issues. On the sell-side were energy and gold the two sectors with the most promising earnings prospects thanks to higher metals and energy prices. Wall Street downgraded the energy sector; while it upgraded the tech sector. The worse a company performs, the more attractive it becomes for investors. The rally this year has taken place among those companies either experiencing balance sheet or income statement problems. Your business can be performing miserably, but what counts these days is beating expectations that are in a constant state of being adjusted down in real time.
While fund managers have been rushing into tech stocks and buying with complete abandon; the insiders who run these very same companies have been selling their shares in record volumes. In short, the insiders are selling; while fund managers and their shareholders are buying. The recent rally has attracted the little guy again with $2.5 billion flowing into stock funds last week according to Trim Tabs, which keeps track of money flows. The company has become aggressively bearish recently based on the largest insider corporate selling it has seen in years.
While stocks elevate, keep your eye on the more important bond market. Rates have risen by over half a point as shown in this graph. It is becoming a question of how long Mr. G can keep both the stock and the bond market fooled.
Volume came in today at 1.38 billion on the NYSE and 1.81 billion on the Nasdaq. It appears that stocks are going through a distribution phase. The insiders are selling and the public is buying. Market breadth was positive by 22-10 on the Big Board and by 23-9 on the Nasdaq. The VIX added .44 to close at 22.05 while the VXN popped 1.04 to close at 33.51.
© 2003 James Puplava