Posted on 05/13/2002 5:12:21 PM PDT by Dialup Llama
Flickering rallies aside, don't you wonder why the markets are lower a year into a generous helping of interest-rate cuts? It always worked before. Well, almost always.
Last week, a rally stoked by Cisco Systems (CSCO, news, msgs) cast a fleeting, feel-good haze over Wall Street. With its eventual dispersal, our festering economic problems will return to the fore. How did they get here? Via a stock-market bubble conceived and coaxed to monstrous proportions by the Federal Reserve. The majority of investors, and many economists, deny or scorn this fact -- placing them squarely in the way of another 30% or 40% decline in the broad market.
It's important for everyone to understand that we are still headed for trouble because we are suffering from the aftermath of an asset bubble. This is continually lost on people. Our problems were created two, three, four or five years ago, as the Fed kept inflating the bubble. Subsequently, the Fed has tried to fight off the problems, but it has succeeded only in postponing the inevitable. That analysis is important because of what it portends. Hardly anyone believes that we had the biggest asset bubble in history, and that the consequences are going to be horrific. This is the minority view.
But how else can you explain the following data in the most recent Liscio Report? In a rather amazing table, the independent economic research publication shows that in the long history of the Federal Reserve, the stock market has never been lower 15 months into an interest- rate cutting cycle. And yet it has happened this year despite one of the central bank’s greatest easing programs ever. In fact, if one looks at nine or 12 months into an easing program, the S&P 500 Index ($INX) was lower only in 1930 and in 1981, two horrific recessions. The average for the 16 different easing periods that they cite was a gain of 14.9% after nine months and a gain of 20% after 15 months. This, naturally, is why most people have been bullish, because they know the consequence of past Fed easings.
However, the one time that we saw the S&P lower 15 months into an extended Fed easing was 1930, which, of course, came after a bubble. The problems that we had after the bubble were not caused by subsequent Fed policies. That is what a lot of people say who do not understand the issue. The problem came in creating the bubble to begin with.
Basis-pointy heads
I continuously hear people making excuses why a replay of the 1929 aftermath or the Japanese aftermath can’t play out, and generally this comes from people who don’t know much about those periods. This is not to say that we are exactly like Japan, or exactly like we were in the 1930s. We aren't. That misses the point, which is that when you have an enormous bubble, with massive misallocations of capital and excess capacity, the problems that you then are faced with are not so easily solved. It makes it easy for the central bank to be wrong, and of course in this case, we’ve got a central bank that is beyond incompetent to start with.
That said, while I am hardly a fan of the Fed, I was stunned to read a recent editorial in The Wall Street Journal by yet another clueless economist who thinks that the Fed's former tight money policy – not the stock market bubble -- precipitated our current problems. As the title suggests, "Hike Rates Now" is Brian Wesbury's unusual solution to what he says is the Fed's pursuit of an inflationary monetary policy. Back in my Dec. 3 column at another publication, I debunked the same specious argument when it was set forth by Larry Kudlow. The data have not changed since then, and because this topic is so important for new readers to understand, I would like to reprise my comments (so just to be clear, this is me quoting me for the next several paragraphs):
Earth to Larry: Please call home Someone forwarded me an article by none other than Kudlow, chief economist for Bubble Vision, a man who never met a rate cut he didn't like and a partisan of revisionist history. Here is the key point in the column, titled “Bubble Busting: It Was the Recession That Vanquished the Technology Boom:” 'So, the demise of the tech boom was not so much over-investment as it was undergrowth. It was not so much the speculative bubble as it was the collapse of GDP -- down from 9% growth two years ago to the present recessionary contraction. And the blame for that collapse rests squarely with the money managers at the Federal Reserve. Plagued by the idea that the stock market was "irrationally exuberant," and the economy "overheated," the Fed raised interest rates nine times between mid-1999 and mid-2000 in order to clamp down on the money supply and restrain the boom. . . . The evidence is clear for all to see: Excessive monetary restraint, coupled with rising energy prices, was the chief recessionary culprit -- not a tech bubble.'
I once saw Kudlow make the same statement about the late 1920s and 1930s. He claimed that were it not for a little Fed tightening in 1929, the 1930s wouldn't have turned out as they did. Obviously, Kudlow cannot recognize a bubble even when one blows up all around him. He is starting to blame the Fed, but he's doing it for the wrong reason. He criticizes them for a little bit of tightness as opposed to easing, and their raising of the moral hazard.
I did a quick check of Fed fund rate changes this morning, and I wanted to pass along a few facts that people can look at, juxtaposed against Larry's convenient version of fact-spinning to support whatever conclusion he likes. In the beginning of 1995, Fed funds were at 5.50%. Though they fluctuated a bit, as of mid-August 1998, they remained at the same level. Next, we had the Long-Term Capital Management debacle, and rates were dropped to 4.75% by the middle of 1999. Then they were bumped back up to 5.50%. Over the course of 2000, we saw rates rise to 6.50%. So, the bottom line is that from the beginning of 1995 and, more importantly, from the middle of August 1998, Fed funds went from 5.50% to 6.50%, a whopping increase of 100 basis points -- not exactly what should have been earth-shaking damage to all that stuff about the 'new economy' and 'new era.' Certainly, no one with an IQ over 40 can believe that a lousy 100 basis points of tightening did all the damage that's been done. And if 100 basis points did so much damage on the upside, how come the 10 rate cuts and a 400 basis-point drop that we've had so far this year haven't alleviated the same?
Whacking away at the undergrowth
It's very important to understand that it wasn't so much the Fed funds rate that was meaningful or that caused the problem. It was the growth in the money supply (credit creation, if you will) that powered the mania. Even when the Fed was raising rates, money wasn't “tight,” since the money supply as measured by M2 was still growing rapidly. To put this in perspective, M2 growth peaked at about 8.5% in early 1999 and then retreated to just under 6% in mid-2000 before rocketing back up to 8% as 2000 ended. To give some meaning to what 6% M2 growth looks like in the context of recent history, that was approximately the peak rate for money growth in 1988, 1990, and 1995.
In other words, the roughly 6% M2 growth that Kudlow claims was so onerous was the fastest it grew at from 1988 until mid-1998, when it was in the process of screaming back up to 8.5%. What he deems restrictive had previously been as expansive as M2 growth had been in the prior decade -- which is why I say, even when the Fed was raising rates, money was never tight. But I guess the motto of the Bubbleheads must be: never let the facts get in the way of a good story. No, Larry (and everyone else who seems to think that the Fed's little bit of tightening created our problems). Our problems are a function of the massive bubble that went on and was left to grow unchecked for over five years. And our problems will not go away by pretending that something else put us in this predicament. That's why everyone who did not understand the existence of the bubble and that it is the culprit continues to be confused by why things are happening as they are.
Back to the present
To wrap up this economic rehash, I'd like to reprise a crucial point. Several months back, I stated that you could divide people into two camps: those who understood that we had a bubble and what it meant, and those who didn’t. I believe the people in the former camp have a chance to succeed in the incredibly difficult environment coming up, and the people in the latter camp are headed for a tremendous amount of pain. On that score, I think that before it's safe to be long in any kind of size, the S&P 500 and the Dow Jones Industrials ($INDU) will probably be at least 30% or 40% lower from than where they are today. And this means that retail stocks, housing stocks, restaurant stocks, cyclical stocks -- all the places where people are hiding now -- will be repriced to reflect reality before this is all through.
William Fleckenstein is the president of Fleckenstein Capital, which manages a hedge fund based in Seattle. He also writes a daily Market Rap column for TheStreet.com's RealMoney. At time of publication, Fleckenstein Capital had no positions in the stocks mentioned in this column, although positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security. The views and opinions expressed in Bill Fleckenstein's columns are his own and not necessarily those of CNBC on MSN Money. While Bill Fleckenstein cannot provide personalized investment advice or recommendations, he invites you to send comments on his column to fleckrap@hotmail.com.
A SHORT hedge fund, possibly?
Don't pay attention to what they say. Pay attention to why they say it.
Article completely IGNORES Greenspans statements dating back to '98 where he cited "irrational exuberance" and "over-priced stocks" repeatedly up to the 2000 election.
Gimme a break. This article defies reality.
Funny how this guy never refers to 9/11 once.
Yes, but they all are. They are trying to connect the markets to the economy. I will briefly try to explain to you how the scheme works:
On the markets, there are limited amounts of shares. If you have deep pockets, and start buying them at a certian level, the stock will reverse. Not because the economy is good or bad, just for a simple reason: supply and demand. There is no more stock to be sold, the shorts are getting scared and start buying back. The stock will accelerate, as long as the ungreedy buyers start selling. You can hardly say that this has anything to do with the economy. Now you've got the schemers, depends on what side they are, short or long, they will try to make you believe in their story. The longs will want you to keep the stocks, and the shorts will advise you to sell to them. That way, the markets and the economy are very often pretty far apart.
The illusion of markets and the economy is mostly perpetrated by the sheisters, and their cronies.
Commodity markets do reflect more often where the economy will be in the near future.
Where do you think the indexes are going?
Next time he's on TV, close your eyes and picture Charles Nelson Reilly. OK, maybe that's not a good idea, but you'll see what I mean. The pink tie he had on the other night seemed like a dead giveaway.
Not relevant - Fleck has been dead-on accurate in his calls for the last several years. He warned about the coming NASDAQ crash for at least two years before it happened, and was called every nasty name in the dictionary by the bubble-heads who didn't want their fantasy ruined. Nobody wants to admit that there is much more excess to be wrung out yet...and the politicians (and those close to them, like Kudlow) don't dare.
In my opinion the market isn't remotely safe right now, short or long.
What are Derivatives?
Derivatives are financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g. foreign currencies, bushels of wheat, stocks and government bonds. There are two main types: futures, or contracts for future delivery at a specified price, and options that give one party the opportunity to buy from or sell to the other side at a prearranged price.
The job of a derivatives trader is like that of a bookie once removed, taking bets on people making bets.
Why on earth should anyone want to be a bookie once removed? The answer was given 63 years earlier by John Maynard Keynes in his best-known work.
Keynes on Speculation
Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not the faces which he himself finds the prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.
Derivatives and the Nobel Prize for Economics
Although futures markets have existed in some form since at least the 17th century, modern futures markets developed in the 1850's with the opening of the Chicago Board of Trade. However, since the early 1970s financial futures markets dealing with currencies, shares and bonds have become much more important. In 1971 the Bretton Woods system of fixed exchange rates broke down when the US suspended the convertibility of the dollar to gold. In a world of (mainly) floating exchange rates exporters and importers faced new risks. A couple of years later the Black-Scholes Model for determining the value of options was published. Its use caught on quickly and by the 1990s many financial institutions involved with derivatives were employing mathematicians and physicists to design ever more sophisticated financial instruments. In 1997 the Royal Swedish Academy of Sciences awarded the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel (the Nobel Prize for economics) to Professor Robert C. Merton of Harvard University and Professor Myron S. Scholes of Stanford University, Stanford for their method of determining the value of derivatives.
Merton and Scholes, in collaboration with the late Fischer Black, developed a pioneering formula for the valuation of stock options. Their methodology has paved the way for economic valuations in many areas. It has also generated new types of financial instruments and facilitated more efficient risk management in society.
The $3.5 Billion Rescue of LTCM
Just a year after Merton and Scholes received the Nobel Prize for their work a hedge fund in which they were among the principal shareholders, Long Term Capital Management, had to be rescued at a cost of $3.5 billion dollars as it was feared that its collapse could have had a disastrous effect on financial institutions around the world.
The Paradox of Hedging Risks
Why should a hedge fund that included two Nobel prizewinners among its principal shareholders make staggering losses by trading in financial instruments designed to reduce risk? There was, presumably, nothing wrong with the techniques themselves, just the way in which they were used. It is sometimes argued that measures to improve the safety of car occupants, e.g. seat belts, increase risk by encouraging drivers to go faster than they would without them. It is possible that the sophisticated models that apparently enable risk to be accurately quantified encourage risk taking by financiers who would otherwise err on the side of caution. However that does not explain other scandals that have involved derivatives, e.g. the collapse of Barings Bank or the illegal trades in Swedish stocks by a member of the Flaming Ferraris.
Derivatives Traders and Gamblers
Keynes may have been exaggerating when he wrote about investors who practise the fourth, fifth and higher degrees of speculation. However, futures and options are highly geared, or leveraged, transactions and therefore traders/investors are able to assume large positions - with similar sized risks - with very little up-front outlay. By their very nature they encourage those higher degrees of speculation so that derivatives traders behave, as Linda Davies wrote, like a bookie once removed. The potential rewards are such that a technique designed to reduce risk is all too often treated as a gambler's tool.
Mispriced Derivatives
Derivatives are sometimes deliberately mispriced in order to conceal losses or to make profits by fraud.
Mispriced options were used by NatWest Capital Markets to conceal losses and the British Securities and Futures Authority concluded its disciplinary action against the firm and two of its employees, Kyriacos Papouis and Neil Dodgson, in May 2000.
In March 2001 a Japanese court fined Credit Suisse First Boston 40 million yen because a subsidiary had used complex derivatives transactions to conceal losses.
In Seeing Tomorrow: rewriting the rules of risk by Ron S. Dembo and Andrew Freeman, a case in which "clever but criminal staff got inside an options pricing model and used tiny changes to skim off a few million dollars of profits for themselves" is described on page 23. The culprits were not prosecuted because the bank feared that the revelation could wipe out hundreds of millions of dollars of its overall value.
The NASDAQ crash was a no-brainer for anybody who follows the market closely.
It IS relevant whether or not Fleckenstein is short on the market.
Bears tend to be bears, no matter what.
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