Too Many Ifs to Say When
by James J Puplava CFP, President & CEO, PFS Group. December 14, 2001
The Bad. . .
This year is turning out to be a year most people would like to forget, especially for the stock market. For investors, it has been the second year in a row of negative returns, even with interest rates at record lows. There aren't many investment alternatives. The economy is now in recession. Companies are reporting lower earnings and layoffs continue. Congress is caught up in gridlock with politicians more concerned about next year's elections. Our nation was attacked and we are at war. Events are erupting daily in the Middle East with another war front becoming a distinct possibility. These are the negatives we wish would simply go away. This year is turning out to be the year everyone would like to write-off.
The Good . . .
On the positive side, the nation has united in resolve as a result of the September tragedies. Operation Enduring Freedom has been successful and no other major terrorist attacks have occurred since 9-11. In the wake of terror, it seemed like everything was crashing... the market, industries, and the economy. We have seen the economy make a partial recovery. At least the slowdown has moderated. On the economic front, there are signes that things will improve next year. The combination of lower interest rates and the possibility of a stimulus package from Congress raises the possibility of an eventual recovery. Companies are trimming costs and analysts are optimistic that this will lead to a return to higher profits by the second half of next year. The Fed vows to keep the markets liquid and more interest rate cuts are soon to follow. These are the positives that raise our hopes.
The Questionable . . .
We all know, at the moment, our economy is still in a recession. Efforts are being made to improve the situation and many expect improvement in 2002. As with every year end, Wall Street, academics, and Washington economists are taking out their crystal balls to forecast the next year. Consensus is building for the economy to pull out of recession by mid-year with a 1% rate of growth. The stock market and analysts are forecasting more vigorous growth. The recent rise in technology stocks since their nadir in October suggests that another boom is ahead of us. So, we now have a two-handed forecast for the year ahead. Economists are forecasting an anemic recovery on the one hand; while analysts and the stock market are forecasting a bigger boom on the other hand. One wonders at this point if the one hand knows what the other hand knows. In the words of President Harry Truman, "What we need are one arm economists."
The stock market's rise is suggesting that the recovery will be more robust than the one forecasted by economists. Over the decades, the stock market has been a more accurate barometer of the future than forecasts made by economists. While the market is saying better times lie ahead, it may already be reflected in current stock prices. The technology sector is selling at 50 times forward 2002 earnings. So the market isn't cheap. This will be one of the few times that a recession hasn't been fully discounted by the market. All of the major averages are selling at high PE multiples. Normally, recessions take stock prices down to levels where stocks become cheap enough to attract new money and initiate a recovery in the market. This time around, the stock market never sunk to levels where stocks became bargains. Stock prices remained expensive throughout the boom and have remained expensive throughout the bust. Investors would be wise to take a skeptical view of the market given current valuations. We are already in bubble-like conditions with the SOX selling at close to 170 times earnings.
Optimists look for new catalysts for the economy and the market's recovery. The two catalysts most often sited are lower interest rates and higher corporate earnings. As I have already touched upon in "A Penny Less a Penny More" and in last week's update, "Déjà Vu", the profit recovery remains questionable. There is also the question of what will be counted and measured as profits. Will they be pro forma profits or will they be real earnings reported on the bottom line as net income? The distinction between the two numbers can be as wide as the Grand Canyon. So it isn't clear just what we will be looking at next year.
Source: Christian Scientist Monitor
If we weren't so burdened with debt . . .
The problem of debt at the consumer and corporate levels raise further questions as to the recovery 's durability. Debt simply doesn't disappear. It either has to be paid or it is written off. High debt levels have been one of the reasons that corporate profits have been so dismal. Debt levels and mounting layoffs have also been responsible for making consumers more cautious in their spending. Yesterday's retail sales figures for the month of November show that sales fell by 3.7%. The drop in sales was the largest decrease in almost 10 years. Even with zero percent financing, auto sales retreated last month as well. With debt levels remaining high, there will be self-imposed limits on spending by both business and consumers. A recent report showed that the slowing economy has pushed up credit card delinquencies. This is expected to worsen as unemployment grows. The credit agency Standard & Poor's recently reported that delinquencies are averaging 5.3% which is up from September and also up from last year. The agency reported that credit quality is deteriorating. This has been evident in credit card companies reporting larger loan losses and banks increasing their loan loss reserves. Even industrial companies that provide credit through their financing units like Ford have been forced to write off hundreds of millions in bad loans.
At the corporate level, companies have defaulted on a record $107 billion in debt this year. The numbers are staggering in their size. The amount of defaults has risen by 150% from last year. So far, 196 issuers have defaulted on their debt in 2001. The rate of defaults on junk bonds is even higher. According to S&P, the default rate on junk bonds is 8.9%. The reason given for the surge in defaults is the slowing economy which has cut into corporate profits and the ability of companies to meet their debt payments. The acceleration in the economy's downturn as a result of September 11th is another reason for the surge in non-payments.
If unemployment levels continue to rise . . .
While debt delinquencies and defaults are rising, evidence suggests that they will worsen in the months ahead because of growing layoffs. This week alone the number of new layoff announcements indicates companies are paring back expenses in order to conserve cash. This week's job cut announcements indicate the unemployment rate is headed higher. The layoff announcements have been staggering in their scope. Applied Materials is cutting 10% of their workforce on top of previous cuts of similar magnitude. Qwest Communications will cut 7,000 jobs or 11% of its workforce. American Express will fire up to 6,500 people in its travel division and Aetna will eliminate 6,000 employees or about 16% of its workforce. Even those sectors of the economy that are considered immune to downturns are shedding employees in order to cut costs. This week the giant supermarket chain Kroger�s said it will fire 1,500 workers and reduce their profit forecast through fiscal 2004.
If consumers stop shopping . . .
If layoffs continue to increase, consumers will become even more cautious in their spending. There is growing evidence in this holiday's retail sales numbers to suggest that this is already happening. Retailers are reporting that sales have been soft this month. Even discounters like Wal-Mart said sales have been hurt by unusually warm weather. So if consumers are retrenching on their spending plans, that leaves only business and government spending to generate a recovery. It is safe to assume that government can be counted on to fulfill its end of the bargain. Plans for restraint in spending and talk of the size of the surplus have been abandoned. Now the talk is on how to spend an additional $100 billion. The debt ceiling is being raised, new entitlements are being proposed, and plenty of pork is on the table.
If Congress doesn't pass the Economic Stimulus Package . . .
The size and scope of the stimulus package, if it occurs at all, will shape the durability of the projected economic recovery or prevent its occurrence. So far the debate on what to do is shaping up according to party ideology. Senate liberals led by Majority Leader, Tom Daschle, want the program to mainly consist of government spending programs. The Democrats believe that new and larger government spending is the only way to generate a recovery. Senate Republicans want the package to contain more tax cuts in order to stimulate business and create new jobs. Democrats are opposed to accelerating the tax cuts approved earlier this year. The President is trying to forge a consensus with moderate Democrats and Republicans. The President's plan would include rebate checks for low-income earners, enhance write-offs for small businesses, a 30% bonus depreciation on plants and equipment over three years for bigger businesses, accelerate the reduction of the 27% tax bracket to 26% and increase the 10% bracket to $14,000 from $7,000, and increase unemployment benefits for displaced workers with added health care benefits. The President is enlisting Democratic moderates such as Senator John Breaux of Louisiana who helped him pass his last bill. Moderate Democrats acknowledge that the economy is in recession and needs a stimulus to help lead it to recovery.
If liberals have their way . . .
The problem is with the liberals. Senate majority leader Tom Daschle is completely opposed to speeding up tax cuts and has told President Bush that any tax cuts other than transfer payments to non-tax payers are an impossibility. Make no mistake, Daschle has his eye on the upcoming elections next year. A weak economy next November would aid his party in winning back control of Congress. Daschle has been very successful in thwarting the President's plans for an energy plan to make the country less dependent on foreign oil. He has been able to block judicial appointments and has stalled all attempts to reduce taxes other than the rebates given last summer. The left wing of the Democratic Party is counting on a weak economy to regain political control of the House. They are mindful of what happened to the President's father. After winning the Gulf War, his popularity sunk as a result of an economic recession. Even though the recovery began during the second half of 1992, Bush Sr. lost the election to Clinton who promised to focus on an economy that was already in the process of recovering. Democratic strategists are hoping for another replay of 1992. So their aim is to thwart all efforts for a recovery and saddle the President with a recession.
The result has been gridlock. The President's economic stimulus package has been passed by the House where Republicans are in control. It is now stalled in the Senate where Democratic liberals led by Daschle control the agenda. Unless the President is able to use the force of the presidency to move his economic agenda along, his party may suffer the same fate as his father's administration. The President can command the headlines, but the networks and the media outside of Fox News favor the liberal agenda. If there is any doubt to this bias, one should read a new book out by Bernard Goldberg called "Bias: A CBS Insider Exposes How the Media Distort the News".
The current gridlock in Congress may prevent the passage of any economic stimulus package that is strong enough to generate anything other than an anemic recovery. Even though we are now at war, the economy will become the number one issue next November. Unless terrorism strikes again or the war widens on all fronts, voters will turn their attention away from the battlefield to their pocketbooks. Major wars favor incumbent presidents and their party.
If businesses don't invest in business . . .
With the consumer plagued by debt and layoffs and Congress beset with election-year politics, this leaves only business to lead us to recovery. In order for business to recover from its present plight, it will need incentives to stimulate new investment. Even tax cuts may not help certain sectors of the economy like technology where there is a glut of capacity and a dearth in demand. Businesses are reluctant to invest at the moment because of the disappearance of profits. It is profits that drive capital spending. Without profits, incentives will have to be created. Businesses are unlikely to take on any more risk by increasing investment in new plant and equipment unless they are motivated to do so. This is why the President is proposing tax incentives for big and small business in his stimulus package. President Bush aims to replace the lack of profits with tax savings to encourage business to invest in new plants and equipment in an effort to create jobs versus dependence on government handouts.
The consumer also needs debt relief. Interest rates have been lowered which has enabled households to refinance their mortgages. But budgets are still tight. That is the reason for lowering the tax burden on a permanent basis and immediately. Households need more than just a temporary rebate. Because of economic uncertainty, the one-time tax rebates were mostly added to savings. The only way to help lessen the burden of shrinking household income is with a permanent reduction in tax rates from what has become the highest tax burden since World War II.
If Congress doesn't pass an energy bill . . .
An across-the-board tax cut as originally proposed by the President would go a long way towards reducing this heavy burden on households. Providing permanent tax cuts for business would also encourage business to take on new risk by spending money on upgrading or building new plants and modernizing equipment. The President's energy bill could also help lessen dependence on foreign oil by spurring investment in drilling for oil and natural gas and new energy alternatives. With nightly television filled with stories of violence and instability in the Middle East and surrounding regions, there are no better reminders of U.S. vulnerability to foreign imported oil.
The problem however is politics. Politicians buy votes through spending. The average person doesn't see the strings attached to every political handout and promise. It is similar to the sport of fishing where the fish don't see the hooks behind the bate that catches them. As a result of nearly a century of economic obfuscation through our public education system, the average Joe can't glean the facts for himself. He misunderstands the economic news as it is reported, so he relies on the media for his understanding on economic and political issues. The result is an absence of real debate and understanding of economics. How else can you explain the public perception that a tax cut that raises their income is bad for the economy? The key to the future of our economy and the resolution of this crisis is a rational debate. In today's world, maintaining political power depends more on manipulation of the news than it does on truth or facts. So the monopoly of news has become a mechanism for mass brainwashing. Analysts and economists are calling for more money creation and government spending to pull us out of recession. Little regard is given to its inflationary implications.
If gridlock continues . . .
So this takes us back to the economic debate in Washington. One side sees government spending and subsidies as the only solution; while the other side looks to tax incentives. Both sides are locked into their respective philosophies. The President has tried to appeal to moderates within the Democratic Party to help him break the gridlock through a compromise package. However, the liberal end of the Democratic Party feels political victory is possible if the economy remains mired in a recession come next November. Unless the President can capitalize on his popularity to mobilize moderates against the forces of Daschle's liberals, there may be no stimulus package enacted in time to generate a robust recovery next year. Even compromises are filled with half-measures that may thwart an adequate enough response to the economy's malaise. At best, even with a compromise, there are too many imbalances within the economy that will take time to sort out. The best that we may be looking at next year is stagflation: anemic economic growth and rising inflation.
If the Fed continues to pump money . . .
The next option is monetary policy. I don't need to beat a dead horse by elaborating on the Fed's present course of monetary expansion. I've already highlighted the fact that growth in M-3 has been over $1 trillion in the last 12 months. The Fed has now lowered interest rates by 4.75 percentage points since January. The central bank has lowered interest rates 11 times this year and has indicated more rate reductions will follow. The Fed can create new money by flooding the banking system with new money. The problem is that it can't always control where that money flows. So far, the only success has been to re-ignite a mini bubble in stocks since October. Rate reductions do have limitations. The reduction in interest rates has created a floor underneath the stock market, but has been unable to send stock prices above previous levels. Lower rates have moderated the downturn, but they haven't been able to stop a recession.
If Fed rate cuts don't do the job . . .
There is always the danger that money creation may lead us into an inflationary environment that the Fed will be unable to control. There is also the risk to the dollar. What would happen if confidence is lost in the American economy? Would this force the Fed to start raising interest rates at a time when the recovery begins to emerge? The U.S. is still running huge trade deficits financed by foreign capital. Greenspan runs the risk of withdrawal of foreign capital if returns get too low or if inflation starts to get out of control. Under those circumstances, the Fed would have no choice but to raise rates at a time that the economy was in a weakened state. Greenspan is performing a high wire act with little room to maneuver. He can't afford to make mistakes or risk loss of confidence. If confidence is lost, the house of cards crumbles.
If the Middle East ignites . . .
Then there are those wild cards that I have identified in the form of derivatives and war. Currently, both sides in the Middle East want Arafat removed. The Israelis no longer trust him and are moving against him. The radical terrorist groups such as Hamas, Hezbollah, and the Palestinian Jihad (PIJ) would like to rid themselves of Arafat's rule. Both sides would prefer war over peace since they both believe that they will be the ones to prevail. The daily suicide bombings resulting in an escalation of the death toll in Israel means the gloves are coming off. The Sharon government is in the process of destroying Arafat's domestic base and at the same time it is moving to erode his international standing. Sharon and the Israeli military are now moving in full force against the Palestinian government represented by Arafat and the radical terrorist groups. It is a high stake gamble by Sharon to rid his country of a menace that has possibly led to the opening salvo of another battlefront in the Middle East.
If the War on Terrorism spreads to other countries . . .
Meanwhile the U.S. war against terrorism is entering into its next stage. The Taliban have been driven from power and from the cities they once held. But the Taliban as a political entity haven't been destroyed. The shifting alliances within Afghanistan means the Taliban can still side with one warlord or another. So they may survive with any new power that emerges. There is also a debate within the Administration to take the war to the next level. This would be against the states that support and harbor terrorist groups. Already trial balloons have been launched and some of the President�s top advisors are recommending a move against Iraq. This takes the war to a more dangerous level. How can the U. S. move against terrorist states like Iraq with American forces spread wide and thin?
There is also the delicate state of the Saudi monarchy. Beset with lower oil prices, growing budget deficits and a citizenry that has become disenchanted with the royal family, places the regime on thin ice. The royal family has managed to survive a half a century of turmoil, but its support among the population is steadily eroding. Once considered an island of calm surrounded by stormy seas, that stability has vanished. The fate of the Saudi monarchy and its pro-western bias is also at risk of being replaced by a government of Islamic extremists that would control a quarter of the world's oil reserves.
If someone doesn't do something about derivatives . . .
Finally, there is the complex world of derivatives. It is a ticking time bomb waiting to be detonated. In a just released report from the Comptroller of the Currency, the notional value of derivatives increased by $3.5 trillion in the third quarter to $51.3 trillion. Since the beginning of the year, derivatives have increased from $40.5 trillion to $51.3 trillion -- a growth rate of 27%. The bulk of that increase was in interest rate contracts. Interest rate contracts account for 84% of all derivatives with 7 banks holding 96% of those contracts. Total credit risk for the top 7 banks increased to 322% of risk-based capital in the third quarter. That is up from 307% in the previous quarter and up from 247% a year ago. The report states that trading revenues from derivative contracts increased by $641 million to $3.5 billion during the quarter. Banks are relying more on revenues from trading in derivatives as lending operations tighten due to credit risks and mounting delinquencies and defaults. Losses during the quarter were only $99 million. That loss is much less than might have been expected given all that happened during the final month of the quarter.
Credit Exposure to Risk Based Capital
(top banks 01Q2) (%)
Comptroller of the Currency
OCC Bank Derivatives Report, Third Quarter 2001
The main problem with derivatives of this size and magnitude is that when something goes wrong, it is usually fatal. When derivatives approach this size and magnitude, there is no room for error. Because of increasing connectivity and concentration between key players, counterparty risk is increasing. Problem incidents are beginning to surface with more regularity. The past decade is full of them from Orange County to LTCM, and now we have Enron. This is an area that needs to be monitored more closely. It appears however that regulators are asleep at the wheel. Just as government is finally waking up to the problems in corporate earnings, it is blindly ignoring an even greater problem that may surface with derivatives. It usually takes a major disaster before anybody notices. It is just a hunch, but I feel that the next major rogue wave will come from derivatives. There are too many credit problems surfacing and the bond market has become just as volatile as the stock market. Furthermore, much of the money that moves in and out of bonds is hot money looking for a quick buck. The bond market is no longer a haven for conservative money. Foreigners now control over 40% of our Treasury market. A lot of that money is momentum money which makes for greater bond market volatility and which creates the need for even more hedging through derivatives.
So as this year draws to conclusion, many ifs remain. There are the uncertainties over the future direction of corporate profits. There are many unknowns over the shape and strength of the recovery. But the biggest ifs are political as well economic. The war, terrorism and derivatives are at the top of that list of unknowns. That is where the biggest rogue waves lie. Because so many ifs remain unanswered, it is too early to say when the recovery will emerge, or if in fact, the seven lean years are about to begin. This was a year that began with high hopes and promises that ended with surprise, tragedy and disappointments. Let us hope and pray that the new year will be filled with better times, peace, and our tragedies behind us. ~ JP
© 2001 James J Puplava CFP, Storm Watch Update Archive
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