A Google-Eyed Market
By James J Puplava CFP, January 31, 2005
Speculation is back, day trading is on the rise, and margin debt is increasing. After taking a shellacking in the markets between 2000-2002 investors are showing a penchant for highfliers again. One only has to look at the recent batch of IPO's to see a familiar pattern. Risk taking is back in vogue. Evidence of risk can be seen everywhere. It can be seen in narrowing credit spreads between junk debt and Treasury's or in the yields offered on emerging market debt. It is visible in P/E multiples on tech and Internet stocks and the returns on IPO's. The average IPO rose 11% in the first day of trading last year. While the markets eagerly awaited the arrival of Google it underperformed its peers. From its initial public offering Google shares soared by 126%. As good as those returns sound they were dwarfed by the returns from Chinese online game maker Shanda Interactive which closed out the year with a 286.4% gain. The IPO market is hot again and experts expect it to remain hot this year. The once shy and shaken investor is back in the game again, looking to make a fast buck.
While nobody is saying last year's market is reminiscent of the heady days of the late 90's, there are similar characteristics. The percentage of unprofitable companies coming to market is increasing. Close to 40% of the companies going public last year didn't make a profit. That is up from 2001 and 2002. This year that percentage is expected to increase. According to one investment banker, "The ducks are quacking again so we need to feed them." The backlog of companies coming to market in the past few years were concentrated in energy and real estate which were profitable. On the docket last year and this year are more healthcare and technology companies which are losing money.
|2004 Initial Public Stock Offerings Best Performers|
--- From Offer ---
|Issuer||Date||Offer Price||U.S. Proceeds (millions)||In 1st-Day Trading||Through
|Shanda Interactive Ent Ltd||May 12||$11.00||$169.0||8.8%||286.4%|
|Marchex Inc||Mar 30||$6.50||$26.0||35.4%||223.1%|
|Volterra Semiconductor Corp||Jul 28||$8.00||$36.5||3.1%||177.0%|
|Ecost Com Inc||Aug 27||$5,80||$20.1||3.5%||175.0%|
|Cogent Inc||Sep 23||$12.00||$248.4||49.8%||175.0%|
|Jed Oil Inc||Apr 05||$5.50||$10.5||103.6%||165.5%|
|Syneron Medical Ltd||Aug 05||$12.00||$60.0||-10.4%||155.0%|
|Kinetic Concepts Inc||Feb 23||$30.00||$621.0||34.7%||154.3%|
|Kanbay International Inc||Jul 22||$13.00||$106.9||16.9%||140.8%|
|Source: Thomson Financial|
Venture capitalists are returning back to the technology and Internet sector. Last year they boosted their investment in Internet companies by more than $20 billion. There is a sense in Silicon Valley that the good times are back. Companies are leasing space and a few former employees of high tech start-ups are finding work again. However, robust job growth is absent this go- around. The State of California is down over 200,000 jobs since 1999.
Another feature of this market similar to the late '90s is that mergers are back in style. Today SBC announced plans to buy AT&T for $16 billion; MetLife is buying Travelers Life & Annuity for $12 billion, and Kodak is buying Creo for $980 million in cash. Other deals are in the works but it looks like 2005 is off to a great start with over $110 billion in deals announced in January.
While the investment bankers on Wall Street and investors appear excited, another institution is less sanguine. The Federal Reserve looks at narrowing credit spreads and the increase in IPO�s and mergers as signs of excessive risk taking and they don't seemed too pleased, judging by statements made at the last FOMC meeting. The Fed is not in a party mood. Although short-term rates have risen with five rate hikes last year, long-term rates have remained low, locked in a narrow trading range. With long-term rates remaining stable, monetary tightening hasn't had an effect on the economy. The cost of home mortgages and corporate debt offerings has actually declined. The numerous mergers announced this month point to growing confidence amongst companies and their willingness to take on more risk.
Not all Fed governors are cautious. Fed governor Ben "Helicopter" Bernanke recently played down speculation concerns in a speech given on January 19th where he said, "I disagree with the view that low interest rates promote a sort of moral hazard in financial markets." Other Fed governors have also shown similar views, expressing skepticism about the risks of excessive speculation. The present consensus at the Fed is that the economy remains strong enough to enable the Fed to continue along its present path of raising interest for most, if not all, of 2005. That is until something breaks in the financial markets or the economy. In other words, they will keep raising rates until financial problems begin to surface.
Presently the financial markets remain complacent. Investors have come to regard FOMC meetings as a non-event. There has been very little damage to the stock market. IPO's are on the fast track this year, mergers are back in vogue, as is speculation. Despite the difficulties experienced this year, experts are still forecasting another good year of single digit returns for the markets.
Source: Barron's (chart on right)
Is this complacency justified? I don't think so. Rarely do markets respond favorably to Fed rate hikes. In the past 11 rate cycles the markets, the economy, or both have suffered severely. We either get a recession or a bear market in equities. The futures market is currently pricing in a 3.5% fed funds rate by year-end. With short-term rates rising and long term rates remaining flat, the yield curve is flattening. This is going to reduce profits at most financial institutions, which make money on a steepening yield curve. Financials have recently made up as much as 40% of the profits in the S&P 500. Look for these profits to narrow as the year progresses. Higher short-term rates are also going to impact industrial companies with finance arms such as GE, GM and Ford. GE gets half of its profits from its financial subsidiary.
What is clear from reading the notes from December's FOMC meeting is that the Fed's resolve to lift rates appears to be getting stronger. The Fed seems to be concerned over increased financial speculation in the financial markets at a time it is raising interest rates. It appears that Mr. Greenspan is annoyed that the financial markets don't take the Fed seriously. Stock prices on average have risen on days the Fed raises interest rates. At the moment markets seem unconcerned. That may change this week if the Fed changes its language accompanying this week's rate hike. Next month investors will get another chance to divine what is on the chairman's mind when Mr. Greenspan testifies before House and Senate committees on the economy and monetary policy on February 16th & 17th.
However, the Fed is facing powerful headwinds during this rate cycle. Chief among them is that the economy is far more leveraged today than where it was back in 1999, the last time the Fed raised interest rates. The U.S. economy has been adding enormous amounts of debt since 1999. Since 2000 the federal budget has swung from a surplus of $189.5 billion to a deficit of $412.3 billion in fiscal 2004. That deficit doesn't include unfunded liabilities which rose by $11 trillion last year. (www.fms.treas.gov/fr/index.html) Using accrual accounting or GAAP measures, the unfunded liabilities of the U.S. government increased substantially and the baby boomers have yet to hit the retirement system in full force. The following graphs taken from the governments 2004 Financial Report should be enough to give the financial markets pause; instead they are completely ignored.
(Above charts' source: 2004 Financial Report of the U.S. Government)
So far we are talking about the U.S. government. Consumers and corporations are also in debt. As the following two graphs illustrate consumer debt servicing has skyrocketed since 1995 and the savings rate has gone from 5.9% in 2000 to a minus 0.3% in the third quarter of last year. Since 2001 nonfinancial debt grew by $4.2 trillion and financial credit increased by $1.9 trillion. In just three short years total consumer and business debt grew by $6.1 trillion. Since 2000 it has grown by over $10 trillion. According to Kurt Richebacher, since 2000 there is $10.40 in additional debt added for each dollar added to GDP. While Wall Street and Washington appear to be pleased at the growth in the U.S. economy, the rest of the world is worried. Of particular concern is the U.S. trade deficit which shows no sign of improving despite a 30% fall in the dollar. The trade deficit is unlikely to improve in the future unless there is substantial dollar depreciation and a serious cutback in consumer spending. The U.S. consumer keeps on buying goods and taking on more debt. Unfortunately for the U.S. economy most of those goods are foreign made. If policy makers marvel at the strength in the U.S. economy they shouldn't take much comfort. The U.S. economy is made up of debt based consumption and financial speculation. Both are untenable as we should soon find out as the Fed raises the stakes in the financial markets by making that debt more expensive to accumulate.
As the Fed keeps raising interest rates this year, and as longer-term yields remain flat, it will become increasingly difficult to speculate through borrowing. The carry trade is coming to an end. When it does the bond market is headed for trouble as are speculative asset classes such as junk bonds and emerging market debt. Stocks will also come under pressure. But first the rate hikes.
It is possible that stocks will head higher in the short run spurred on by mergers and IPO's. As the markets become more speculative the Fed's resolve should increase. The Fed will continue to raise rates until the fed funds rate reaches 3-3.25%. At that point spreads between 2-yr and 10-yr notes should narrow to within 20 basis points. We should then see visible signs that the U.S. economy is rolling over. Debt defaults should be on the rise and delinquency rates should start to rise on home mortgages. The financial markets should start to see signs of duress in widening credit spreads and in lower stock prices. Perhaps there will be major fallout triggered by a troubled hedge fund or financial intermediary that shakes the markets out of their complacency.
Meanwhile, the trade deficit should continue to expand because of its structural makeup. The dollar will begin its next leg down as it dawns on the rest of the world that the U.S. economy is headed for trouble. High interest rates, the usual method of defending the dollar, will prove to be too painful. The economy and its most important constituent, the consumer, are far too leveraged as are the financial markets. Higher interest rates will undermine asset values and consumption. Deficits will begin to balloon even higher as high short-term rates make it more expensive for the government to borrow. In addition to higher financing costs the impact of a growing war, and growing social costs triggered by an aging baby boom generation will cause budget deficits to spiral out of control. The open-ended war on terrorism and the looming social costs of a baby boom generation will eclipse the cost of the Great Society and make it look cheap by comparison. As government deficits begin to skyrocket they will also become more expensive to finance as interest rates rise. Close to 70% of all federal debt matures by the first quarter of 2007.
At some point soon foreigners will begin to lose their appetite for U.S. debt, making it more difficult for the U.S. government to finance without hyperinflating. As the economy weakens and deficits mushroom, the Fed will begin to panic. By the end of summer or late fall we'll begin to hear talk about Fed rate cuts. Money supply growth has historically turned inflationary when the rate of money growth exceeds GDP growth as it did between 2001-2003. Up until this point consumers and the government have benefited from the Fed's credit inflation of the last 10 years. Money supply growth financed the consumers spending binge of the late 90's and this new decade. It also helped fund the capital spending boom of the late 90's. Corporations today are more leery to spend money on building new plants and equipment. Instead they are using the rising value of their paper to buy other companies. This doesn't expand the economy; it causes it to contract. Mergers usually spawn layoffs as staff, plants and equipment is consolidated. Look for increased layoff announcements ahead as merger mania takes hold.
Rising energy prices will also begin to take their toll as costs feed into the economy. As developing nations industrialize, material consumption growth increases. Developing economies consume more energy. This means the demands of an energy- starved Asia will butt up against the energy needs of the developed world. China alone needs to increase its oil imports by over 5 million barrels a day by 2015. With zero production growth coming from the world's industrial nations, where will that extra supply come from? If energy investment banker Matthew Simmons is right, Saudi oil production, which all future supply estimates are based, is about to peak. Regardless if Simmons's is correct or not, the world is transitioning from a period of slack to tighter oil supplies. This will make all industrial and developing nations heavily dependent on Middle East and Caspian oil. It will also reorient security and economic alliances.
Higher energy prices will also feed itself through to food commodity inflation. It will cost a farmer more to buy fertilizer, more to power a tractor and more to process food. Energy is the core of inflation as David Hackett Fisher has pointed in all past inflations. All production of either manufactured goods or basic commodities has an energy component added to it. It takes energy to produce things. The combination of new emerging market consumers and the hoarding of commodities to keep costs down will continue to push up commodity prices in a cycle of shocks. In our present environment where capital is cheap and commodity prices are inflating, tonnage growth is decreasing and hoarding or inventory building is increasing.
What all of this means is that the next inflationary wave is about to begin. It will begin during the next downturn in the markets and the economy. It will be caused by explosive money growth with the Fed operating the printing presses in a way never seen before in history. Each new economic cycle over the last fifty years has required more money and credit to fuel it. As for the deflationists among you, it is time to rethink your position. Debt may be a catalyst for deflation when money has a value as it did when we were on a gold standard. Today under our present fiat money system currencies have no value other than the faith of the beholder. When most debt is backed by government guarantees and that same government is in possession of a printing press, debt produces an inflationary response.
Markets headed higher on this merger Monday ending the month on a positive note. As of today the Dow has lost 2.7%, the S&P 500 is down 2.5%, and the Nasdaq has lost 5.2%. What we got today was a relief rally. Markets will have to struggle through this week digesting the President's State of the Union speech, and this week's FOMC meeting. Then there is this Friday's unemployment report. Based on this months performance, history shows that the markets will struggle to post positive gains this year.
In trading today the Dow Industrials added 62.74 points to close out the month at 10,489.94. The S&P 500 picked up 9.91 points to close out the session at 1,181.27. The Nasdaq rose 26.58 points to 2,062.41.
In other markets crude oil prices jumped by $1.02 on the New York Merc finishing the session at $48.20. Treasuries were mixed with the 10-year note gaining 2/32 to yield 4.13%. Gold fell for the third consecutive day losing $4 to end the session at $424.10.
© 2005 James Puplava