FSU Editorial: "Trees Do Not Grow to the Moon" by Doug Wakefield 12/03/2005

TREES DO NOT GROW TO THE MOON
by Doug Wakefield
December 3, 2005

The recent run up in the markets "proves" to many that there is no bear market. And, since we might become depressed or overwhelmed with all the negative information, we just need to do away with it. Even if there are a great many things wrong with our financial world, the boys at mission control can just keep printing money, or more accurately expanding credit, so the markets could take years to decline seriously. In the meantime, I've got to get on with "making hay while the sun shines."

We can either bite into this hook, line, and sinker, or stand back and look at some comments, articles, and pictures in order to gain our bearings in this maniacal frenzy.

While the Feds can certainly "print money," or expand credit, they are running low on ammo. In December of 2000, the Fed Funds Rate, the rate that the banks charge each other for the use of the Feds funds, stood at 6.5 percent. By December of 2001, it had been reduced to 1.75 percent. If we start in 1954 we find times, like the fall of 1974 and the fall of 1981 and 1982, where the fed funds rate has dropped sharply. Yet, there has been no time in the last half century when rates fell this much to this low of a level. Though the fed funds rate was raised back to 4 percent as of November of 2005, if Bernanke intends to use rate cuts to stimulate the desire for credit, he does not have the same amount of firepower that Greenspan had in 2001. The environment is still one where credit has grown rapidly even as rates have been raised. Some comments on why a little later.

Consider Greenspan's departing words in August of this year.

"Thus, this vast increase in the market value of asset claims is in part the indirect result of investors accepting lower compensation for risk. Such an increase in market value is too often viewed by market participants as structural and permanent. To some extent, those higher values may be reflecting the increased flexibility and resilience of our economy. But what they [investors] perceive as newly abundant liquidity [credit] can readily disappear. Any onset of increased investor caution elevates risk premiums and, as a consequence, lowers asset values and promotes the liquidation of the debt that supported higher asset prices. This is the reason that history has not dealt kindly with the aftermath of protracted periods of low risk premiums." [Emphasis mine] Alan Greenspan, Reflections on Central Banking, Jackson Hole Wyoming, August 25, 2005.

In addition to this, Doug Noland has made it very apparent from his work that the growth of credit is much larger than what the government is reporting in the M3. The growth of Asset-Backed Securities (ABS) is just one example. These tools are very complex and are almost impossible to assess since they involve many variables and multiple layers of risk. According to the Bond Market Association, there were $1.2 billion worth of ABS issued in 1985, the first year they existed. In 2003, there were $474 billion issued. As of November 25th, we have exceeded $720 billion issues thus far in 2005.

While the media talks much about the strong economy, we would be well advised to hear this as a strong expansion of credit. Since the banking system and financial concerns are cranking out credit, we would expect these areas of the stock markets to look strong. The two charts below reveal that, even as I write, these areas are experiencing all time highs. They, like the Internet, telecom, and tech stocks of the late 90's, now comprise the largest component of the S&P 500.

Looking at these charts, since the October 13th lows, it is possible to extrapolate that traders see Chairman Bernanke as a good thing for financial stocks.

But does he have the power to flood more credit? Is the American consumer flagging under the weight of their debt overhang? Will banks continue to accommodate such credit risks with even riskier loans? Can we borrow our way to prosperity? According to John Dugan, Comptroller of the Currency, banks will be coming under closer scrutiny in 2006.

So as we move into 2006, we need to be watchful of the banking and financial sectors of the markets. Is the recent sharp move up the sign of another round of strong credit growth through 2006 and beyond, or will we be surprised by a fast approaching end to the credit mania. As we continue to watch, it is plain to see that the daily noise of talking heads does little to help investors gain their bearings

Contact Information
Doug Wakefield, CFP MS
Best Minds, Inc.
Dallas, TX USA
Email | Website

Best Minds, Inc is a registered investment advisor that looks to the best minds in the world of finance and economics to seek a direction for our clients. To be a true advocate to our clients, we have found it necessary to go well beyond the norms in financial planning today. We are avid readers. In our study of the markets, we research general history, financial and economic history, fundamental and technical analysis, and mass and individual psychology.