Financial Sense Perspectives

Part 1

Part 1 - An Introduction

July 18, 2000 © Copyright 2000 James J. Puplava

In the fall of 1991 an event took place which had never been seen in recorded history. A powerful storm was developing off the northern Atlantic coast. It was a force of nature so intense it would be unlike anything the present world had ever known. Nature was about to unleash a force and fury never before witnessed in the collision of three potent storms at one moment in time. The dynamic power of that collision would be propelled by winds of 120 miles an hour, creating waves ten stories high.

The engine behind this collision was the jet stream. In meteorological terms, the jet stream is a river of cold upper-level air that travels above the earth's surface at heights of thirty to forty thousand feet. As the jet stream moves around the globe, it drags storms, cold fronts, and on the ocean floor, short-wave troughs, at will in often-unpredictable patterns. The jet stream is inconstant. It moves, convulses and careens off landmasses creating weather eddies that can heighten into major storms. How these storms unfold has long puzzled scientists. They typically occur when subtropical air collides with the cold air jet streams of the Great Lakes and Canada.

Hurricanes begin to brew in tropical waters around the equator. They are created by the evaporation of water heated by the warm sun of the tropics. The evaporated water into the atmosphere creates unstable energy. Hurricanes begin when trade winds or desert winds get drawn into the upper atmosphere. The more air that gets sucked in, the faster it spins and the more water is evaporated off the ocean surface. The spiraling air becomes the vortex of the hurricane. As a hurricane gathers force, it turns into one of the most powerful forces of nature. It can pack winds up to 200 miles per hour, create seas as high as tall buildings, and unleash more destructive force than a nuclear detonation.

The 1991 Halloween Storm was just such a storm. A rare occasion of fate, the honorably mentioned Storm of the Century was the violent impact of an Artic cold front meeting head on with a hurricane. What made this storm so unique was the force of a tropical hurricane joining with the force of an Artic cold front, creating a pressure gradient meteorologists would seldom see in a lifetime. It became "The Perfect Storm" a brief, but dynamic clash of power seldom seen and destructive beyond measure when it was joined by a storm on a third front. This extraordinary event, three meteorological forces combining at the same time, made one perfect storm.

In 1997 Sebastian Junger chronicled the events and tragedy of this storm in his best seller, The Perfect Storm. Junger's book made the New York Times Bestseller List. Summer 2000, it has captured the nation's attention in Wolfgang Petersen's screenplay adaptation of the bestseller in a movie by the same name. "The Perfect Storm" has become a summer box office hit.

Looking at The Big Picture

I read Junger's book when it came out and was enthralled with the story. The movie was long anticipated. I've seen the movie three times. Why? Because each time it's as if I see a greater parallel to the financial markets of the last ten years. Meteorologists and those who make their living by the sea use various instruments to measure and judge the force and direction of the weather. Meteorologists look at the big picture in an effort to forecast weather patterns. They use sophisticated tools such as weather and data buoys, Doppler radar, and super computers. Sailors and fisherman often look at the big picture, but must deal with the microenvironment as they plow the seas. They need their charts and compass to get them where they are going. Their barometer and anemometer tell them how rough and safe the journey will be. Even with all of their sophisticated electronics, they are guided by their experience and knowledge.

Against the weather forecast and visible signs on the ocean, the meteorologist, and the sailor and the fisherman are subject to the whims of the jet stream. The jet stream can turn any weather forecast upside down and any safe journey on the seas into a perilous one.

Our Financial Jet Stream

In the financial environment, the jet stream is the international monetary system. It is the huge inter-bank market that moves trillions of dollars of currencies around the globe on a daily basis. Like the jet stream, it too is unpredictable. The monetary system is no longer anchored to any standard such as gold and so it has become more volatile. Like the vicissitudes of the jet stream, the international monetary system has subjected nations and financial markets to chronic turmoil. Businesses must contend with unpredictable exchange rate fluctuation that can quickly turn profits into losses or conversely, rags to riches. The value of money in today's system is determined more by the frenzied machinations of speculators than by any objective standard.

As exchange rates gyrate, they can send domestic economies reeling, stock markets crashing and interest rates soaring. We only need to look back as far as the Mexican Peso storm of 1994, the Asian tsunami of 1997, and the Russian debt and Long-Term Capital Management derivative crisis of 1998. Economic storms are becoming more frequent and more severe.

Economists and monetarists have argued an unfettered system is conducive to today's global marketplace. Their arguments seem shallow when judged against the numerous economic maelstroms that dominate today's financial environment. These financial storms have become more numerous and more disruptive. Policy makers argue that it is possible to calibrate the supply of fiat money to the economic and financial needs of the population. Underneath these arguments lies the expediency of justifying the means of printing money to finance budget deficits that can't be financed any other way.

The creation of this money out of "thin air" acts in a similar fashion to the evaporation of water that gets harnessed into the force of a hurricane. The more money governments create, the more money is sucked up into air of the international jet stream. It becomes a source of unstable financial energy that is unleashed into the financial markets, and in the process, becomes a destructive force of its own. It can mobilize economies, propel stock markets skyward, and drive down interest rates. When withdrawn, it can unleash holy hell on anything it touches.

In the global economy, created money pits the forces of statism against entrepreneurs using the tools of microcosmic technology to integrate world commerce.

Our Storm Fronts & Tropical Depressions

If the international monetary system acts as the jet stream, the storm fronts lie in the economy and financial markets of the world. The biggest storm front is now developing in America where the barometer is dropping rapidly. The creation of fiat money by the Federal Reserve over the last five years is like the evaporation of water drawn into the air. That money has found its way into the banking system and financial markets. Like a tropical depression, if it is met with strong winds, it could possibly develop into a financial storm of destructive magnitude.

Reluctantly, I have begun to see the tide of this gathering monetary storm moving against the United States. The dropping barometric pressure indicates a possible storm front is in developing stages. The severity of this pressure drop will be determined by the probability of other forces occurring at the same time. Whether the storms collide, batter us one after the other, remain isolated, or unite into one massive storm will be determined by the monetary jet stream, the speculators and policymakers that drive it.

THE GATHERING STORM

There are three economic forces that are now becoming storm fronts of increasing magnitude. The first, and by far the most dangerous, is the growing mountain of debt accumulated by consumers and corporations. The second is a gyrating stock market in danger of collapsing. The third is a downturn in the U.S. economic cycle. Each of these forces is an inherently destructive force as they stand alone. Should they collide and become one at the same time, they would create the perfect financial storm.

STORM FRONT #1: CREDIT EXPANSION

The economic miracle so widely heralded by the Clinton Administration is the product of a loose monetary policy that has created the largest credit expansion in U.S. history. At first, the expansion of credit leads to an economic boom. Booms inevitably lead the way to busts that can ultimately lead to depressions. The initial stages of the boom create the illusion of prosperity. Policymakers may try to prolong the boom or bring temporary relief by manipulating the financial system with the creation of more money. But in the long run, they only buy an extension of time before the inevitable catastrophe unfolds.

The top graph illustrates a 20-year borrowing/spending spree resulting in a zero savings rate. The bottom graph of disposable personal income shows mortgage debt growing from 68% to 100.8% in the last 20 years. Borrowing doesn't seem to pose a problem for anyone these days. In reality, this debt is a house of cards waiting to crumble.

Consumption Outweighs Savings

The enormous expansion of credit over the last five years has led people to over-invest and invest badly. It has encouraged financial speculation and over- consumption. The result has been the accumulation of a mountain of debt by consumers and corporations. In the process, today's credit excesses have caused a hyperinflation of asset values as we have seen in inflated stock and real estate prices.

Today, credit stands at ten times the available savings of the nation. It now takes five dollars of debt to create one dollar of economic growth. The Wall Street Journal recently featured an article on the nation's debt binge. U.S. corporate debt has grown by 67% over the last five years to a record $4.5 trillion. Household borrowing has risen almost as much rising 60% to another record of $6.5 trillion. What is even worse is that most of this debt is being accumulated by those least able to afford it. The riskiest borrowers are piling on the most amount of debt. We are seeing low-income consumers with bad credit histories and fledgling corporations using junk bond financing receive easy money.

[Subprime]

Source: Bureau of Economic Analysis

STORM FRONT #2: STOCK MARKET GYRATIONS

While debt expansion has risen at an unprecedented level, another storm has been brewing in the stock market. The markets gyrate daily as volatility increases similar to the barometric pressure dropping inside a potential hurricane. The vast majority of stocks reached their peak on April 3rd, 1998 when the Advance-Decline Ratio peaked. The daily number of new highs topped out on October 3rd, 1997. The Dow Industrials topped out at 11,722.98 on January 14th, 2000. The Nasdaq reached its zenith at 5048.62 on March 10th. Even though the market remains optimistic, the majority of indicators have topped out.

The q Ratio

By any sound financial measure, whether dividends, price-earnings or price to book value, the markets are at extreme valuation levels. Another familiar measure used by economists since 1969, is Nobel Laureate James Tobin's q Ratio. The value behind q is simple. It compares two different estimates of the value of a company. The first value is what Wall Street says a company is worth represented by its stock price. The second measure is the company´┐Żs fundamental value. Fundamental value is what it would cost today to replace all the assets of the company. q measures the aggregate value of stock price and corporate net worth. To find it, you compare the net worth of the corporate sector with the total value that the market places on stock prices.

The advantage of the q Ratio as a valuation criteria is that it tells, in objective terms, whether markets are overvalued or undervalued. It measures the risk of being invested in the stock market and acts as a good predictor of stock prices longer term. The value of Q doesn't wander all over the place like P/E ratios. It tends to be mean reverting (or levels to the average). As the chart on the right indicates, it is now at extreme levels. The only other time in the twentieth century that it was at this level was back in 1929 and the late 1960's. Both periods were followed by extremely poor returns and both coincided with very a high q ratio.

The common thread of the two previous periods and today's economic environment is that investor perceptions of the market during these periods were extremely bullish and completely divorced from economic and financial reality. Investors have become blase about returns and risk. A good example of this is today's day traders and swing traders. The average investor expects much higher returns on their investments than ever before and they seldom know what it means to lose heavily.

The Sky is Always Blue on Wall Street

The public is being sucked into the market by the new economic theories of Wall Street, which stand in sharp conflict with basic economics. Stockbroker economics rejects data that is inconsistent with the hypothesis that the stock market always goes up. Objective economic analysis relies on data that is scientific and non-manipulative to form basic premises. In the world of Wall Street, the hypotheses of investing are driven by self-interests. On Wall Street, stocks are always beautiful. Any broker or analyst who discards this hypothesis will rapidly join the ranks of the unemployed. Stockbrokers draw on evidence that continuously supports the supposition that buying stocks is always a good thing. Any evidence that conflicts with this theory does not make commercial sense. That is why today any objective measure that points to extreme market overvaluation is quickly discarded. Those who question Wall Street valuation criteria are quickly scorned.

The market's recent volatility and the number of technical and financial indicators that have peaked indicate a storm is gathering force that soon will collide with Wall Street's sunny forecast. Heightened market volatility whereby stock indexes wildly gyrate in either direction, is a precursor to trouble ahead for the financial markets. Volatility is the first sign that the barometric pressure is dropping and a storm is on its way.

STORM FRONT #3: THE U.S. ECONOMY

The final storm front is the U.S. economy. The present expansion is the longest running expansion on record. It has surpassed all other economic expansions before it. The driving force behind it is the rapid growth of the money supply and the explosion of credit that has accompanied it. Like a drug addict, the U.S. economy has become immune to the supply of money and credit that drives it. It now requires an even greater dose of money expansion and credit to keep it afloat.

The continuous rise in equity prices has caused people to put their trust in the stock market. The result has been a dramatic drop in the nation's savings rate. With the stock market rising, consumers have chosen to spend their savings, and more recently, borrow money to maintain their life styles. Last year total credit in the U.S. economy expanded by $2.2 trillion with half of that amount being used by consumers and the other half by the financial system. America is now a capital consuming country, reflected in the fact that the current rise in foreign indebtedness exceeds net domestic investment.

Fudging The Forecast

The current inflation rate and economic growth figures are distorted by statistical manipulations that both understate the inflation rate and overstate the economic growth figures. America has now become the largest debtor nation in the world as a product of a low savings rate and over consumption by consumers. Meanwhile, the consumer borrowing and spending binge continues unabated. July 2000 the Federal Reserve reported that borrowing by U.S. consumers rose in May at the fastest pace since the beginning of the year. Consumer credit increased by $11.8 billion in May, rising $8.8 billion in April and $10.7 billion in March. Consumer credit is expanding at an annual rate of 9.8%. Unfortunately, credit cards are the source of most of that debt. In other words, it's borrowed prosperity.

Those who are predicting a soft landing for the U.S. economy, which implies continued economic growth, are counting on the consumer. To generate economic growth, it takes increasingly larger doses of credit and debt creation and a continuous flow of foreign capital to finance it. Any let down in either the stock market or the economy will not be permitted by policymakers because our economy is so highly leveraged. In the minds of policymakers on Wall Street and Washington, the boom must be expanded. This means the Fed will continue inflating money and credit. If the economy begins to soften, conventional wisdom believes that the Fed will merely lower interest rates to restart the economic engine. Therefore consumers and investors reason that they need not worry because Washington and Wall Street have eliminated the business cycle and bear markets.

However, the Fed is in a Catch 22 situation. The rules of the game have changed. The U.S. economy and financial system is dependent on uninterrupted, huge capital and credit inflows from overseas. As of last year, foreign institutions and individuals hold more than $2.7 trillion in U.S. financial assets. There is a strong linkage between the dollar and trillions in assets being held by foreigners. Capital markets remain competitive within today's global financial system. Markets compete for money. Lower interest rates, a plunging stock market or a declining economy could lead to wide-scale capital withdrawals from the U.S. financial system. The international jet stream is the road on which this money travels. As easily as it has entered, it could just as easily evaporate. This would limit the freedom of the Fed to skipper the economy away from a threatening recession through created money.

A loss of confidence in the American economy could lead to either limiting capital infusions into our economy, or even worse, capital withdrawals. This is what exacerbated the Asian currency crisis of 1997. Eventually this will dawn on the Fed if it hasn't already. It will also become more apparent to foreign investors. Mr. Greenspan has only two constituents: our domestic economy and foreign investors. In reality, the more powerful of the two may be overseas investors.

THE LULL BEFORE THE STORM

So far American investors remain oblivious to these facts. The dollar has held up despite its gyrations in the battered financial markets. But once the economy begins to soften, America's weak underbelly may become more exposed. Right now it may be akin to the lull before the storm. Suffice it to say that for now, the barometric pressure is dropping. We are merely marking time.

When this storm will occur and its potential severity will be explored in future installments of "The Perfect Financial Storm?" I will examine the issues raised in this introduction in future Perspective articles on debt, the stock market, and the economy. A final article will include the mechanism or triggering device that may detonate or cause these storms to collide.

I do not propose, nor do I predict that these events will happen in the ways described here. It would be sheer arrogance on my part to say they will occur exactly as written or in a time frame suggested. This Perspective series is drawn from a long period of observation of the financial markets and a search for the truth behind one of the greatest periods of economic growth and stock market expansion in this nations history. My sole purpose is to alert the reader to the possible storm fronts that lie beyond the horizon. I leave it up to the reader to draw his or her own conclusions from the facts presented in this Perspective series. It is my firm belief that there are many storms fronts that are building and heading our way. I do not buy into the popular nostrums of our day that the Boom & Bust Cycle has been eliminated by Washington. Nor do I accept Wall Street spin that we have entered a "New Era" where we no longer worry about bear markets.

Each installment will contain more detail and factual information on my thesis of the financial storms highlighted in this article and will include the sources of my information. Ultimately, I hope to stimulate some thought on what today remains as one of our greatest economic and stock market booms in history. I leave it to the reader to decide whether to continue to plow the financial seas or remain firmly anchored in a safe harbor.

Next Installment

The Perfect Financial Storm?
Financial Storms Heading Towards the U.S. Economy

Part 2 TSUNAMI


Notes for Readers:

Perspectives Part 1: "Introduction" is the first installment of a series on "The Perfect Financial Storm? Financial Storms Heading Towards the U.S. Economy". You might be interested in reading the other stories in this series. Please visit the COVER PAGE.

If you are interested in being notified when the next installment is on line, please complete our FINANCIAL SENSE ALERT PAGE and note "Storm" in your subject line.


Interesting Resources: Storms of The Century and 1991 Halloween "Perfect" Storm

Weather Terms can be found at www.weather.com

FIAT MONEY Legal tender, especially paper currency, authorized by a government but not based on or convertible into gold or silver.

STATISM The practice or doctrine of giving a centralized government control over economic planning and policy.

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