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from Jim Puplava
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Market WrapUp for the Week
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Week in Graphs 
Storm Watch 
Geopolitical News 
Energy 
Precious Metals 
Raw Materials
Wednesday, October 30, 2002
Here We Go Again
The economy is in trouble again. The leading economic indicators have fallen four months in a row. Durable goods orders are falling and it appears the consumer is in the process of retrenching. The stock market has become a casino with daily fluctuations becoming as predictable as the weekly lottery results. Prices gyrate each day in uncontrollable fashion with a Herculean effort to prop up the markets and keep them above key support levels. We have gone from a second half recovery to a possible second half slowdown. The second half recovery scenario no longer sells. The new mantra has become a recovery in earnings. The trouble is that earnings have been terrible on a GAAP basis. S&P estimates that reported earnings are 30% below actual earnings when ordinary expenses from restructuring, stock options and pension losses are added back in. On a net income basis, stocks are selling at 54 times earnings. No bargain here. Spinning away the earnings story is getting more difficult as investors wise up to the real numbers. Simply beating earnings doesn’t sell or hold up stock prices beyond a few days.
Fed To The Rescue?
So how do you sell equities to investors when things aren’t going as planned? The new hope is once again in the Federal Reserve. Washington and Wall Street are hoping an aggressive move by the Fed of at least half a point will rescue the economy and financial markets. Investors are now being told to place their hopes on Mr. Greenspan’s magic thumb. The problem is that Mr. Greenspan’s thumb is no longer green. It has turned red. After 11 rate cuts which brought interest rates to the lowest point in half a century, the market has failed to reinflate and the economy has gone soft again. Their answer to this problem is for more of the same. Print more money and create more credit in the system. In other words, create another bubble or reinflate the bubbles that are in danger of deflating. We still have a stock market bubble based on valuations and lack of investor capitulation. For this stock market bubble, the Fed has created additional bubbles in mortgages, consumption and housing. The housing and mortgage-consumption bubble has kept the economy from experiencing a more serious recession. But it has created additional problems that will have to be dealt with sooner rather than later. Instead of letting the markets cleanse the economy and the financial excesses of the 90’s boom and mania, every effort is being made to keep the bubble alive.
What the Fed may be considering is not only lowering interest rates, but also lowering bank reserves, which will enable banks to lend more money. The Fed may be signaling that it wants the financial sector to lend more aggressively by lowering lending standards and pumping more credit in the economy. In essence what Washington and Wall Street want to see happen is for the Fed to create another bubble. The problem is that when money is pumped into the economy, the Fed can’t always control where it goes. After the stock markets plunged, money rotated into real estate and things. The consumption binge by consumers is money that is spent on depreciating assets, or momentary thrills or entertainment. There is no guarantee that lower interest rates and more credit will do what the Fed wants.
Three Contraindications to Lower Interest Rates
Pension Funding
In fact I see three major problems with lowering interest rates. The first is that by lowering interest rates, it will cause the return assumptions on defined benefit plans for companies to be lowered. This means that companies will have to make larger contributions to company pension plans to make up for lower returns. These additional pension plan contributions are going to zap earnings next year for the majority of S&P 500 companies that have defined benefit pension plans. It is one reason why GM has seen its debt ratings lowered. Lower returns for pension plans will translate into lower profits next year. Pension plan contributions will be next year’s major problem for the financial markets outside of war.
Need For Income
The second problem with lower interest rates is that a sizable portion of the US population is now dependent on the income returns from their investments to support their living standards. I’ve received hundreds of emails from individuals these past few months bemoaning the dismal returns from fixed income investments and the pitiful returns offered from bank savings and money market accounts. It appears that short-term rates in the US could be heading the way of Japan. Lower interest rates may benefit the borrowing class, but they also do irreparable damage to the savings class.
Foreign Investment
The third problem from lower interest rates is that fixed income returns in the US are no longer competitive with returns offered elsewhere around the globe, especially in Europe where short-term rates are almost double what they are in the US. This is important because so much of our bond market is now in the hands of foreign investors. They own about 43% of our treasury market and about 25% of all agency and corporate bonds. While Wall Street and Washington were fond of talking about the wonders of fiscal discipline in the 90s, they failed to mention the deteriorating trade and current account deficits that grew to enormous size throughout the 90s. The US is now totally dependent on inflows of foreign capital to the tune of $500 billion a year. Negative returns in stocks, pitiful returns on fixed income and a depreciating dollar and deteriorating government deficits are giving foreign investors reason for pause as they view their US investments. Graphs of financial stocks speak of problems ahead for the financial system. The drop in financial stocks indicates the possibility of a system risk in the financial system becoming a reality. I firmly believe after viewing mounting bankruptcies and growing delinquencies, that the financial system is headed for major problems. I wouldn’t be surprised to see several large financial institutions go under before this plays itself out. I would avoid financial stocks and the shares of industrial companies who derive a major portion of their sales from financial operations.
Global Trends Still to Things
Lowering interest rates may not be the panacea that Washington and Wall Street believe it to be. There is also the real danger the money and credit may not go where they want it. Judging by the emails I get, investors are looking to exit the financial system. It looks like no more than a trickle at the moment, but it is becoming a trend. Each month, money is flowing out of equity mutual funds despite occasional rallies. Commodity prices as reflected in the CRB are in a new bull market. Gold and silver shares are under strong accumulation by strong hands as weaker hands sell off. The price of gold has held up well this year despite the best efforts to talk and push it down. There is now a trend globally, I believe, to move into tangible assets. This is universal as reflected in the price of gold in currencies around the globe.
Today's Market
Looking at today’s casino results, the major indexes went on a wild ride managing to end the day with a gain on diminishing volume. A look at the day’s headlines indicates more problems ahead for the markets and the economy. EDS reported profits fell 59% after the market closed. The company will cut 4% of its workforce. Corning will fire 2,000 workers after reporting its sixth consecutive loss. Retailers are bracing for the worst Christmas holiday season in more than a decade as consumers begin to retrench on spending plans. The markets are also braced for tomorrow’s GDP report by the government. Wall Street is already busy spinning the numbers. The headlines I’m sure will be that GDP beat estimates. However, with all of the ways GDP is statically massaged, it will be hard to tell what the numbers will really be. I’m sure they will also be revised lower once the data is finally in, just like this summer when the government revised GDP for 2000-2001 with the growth rates and corporate profits coming in much lower than originally reported. The economists with the most accurate forecasts for predicting the economy expect it to crawl rather than sprint. Businesses are unlikely to increase capital spending and more job layoffs are in the works. It is hard for the consumer to go out and spend money when he or she has lost their job. The real risks to the financial markets and the economy are too much debt. Consumers are in debt up to their eyeballs and corporate balance sheets are heavily laden with debt. This hasn’t changed other than it has gotten a lot worse, which is why bankruptcies and delinquencies are rising at the fastest clip in more than a decade.
The markets turn-around today, if you are looking for something inane to hang your hat on, was attributed to comments made by IBM’s CEO that the global economy has bottomed. IBM has been reluctant to give any meaningful guidance going forward on their sales and profits other than to warn that they may have to make a $1.5 billion contribution to their pension plan, which has been losing money. The other spin given to the market’s rise was speculation over the possibility of another rate cut coming from the Fed next week. Wall Street money managers have been saying the worst is behind us, which is the opposite of what companies are doing with their revenue and earnings guidance. Companies don’t keep laying off workers if things are turning the corner.
The good news is that the markets have risen 11% this month, the best showing since 1987. Most of that gain occurred in three quick sessions where the markets gapped up in a surprise move. Economists are now predicting two reports out this week on unemployment and manufacturing will show that the unemployment rate is rising again while the manufacturing sector is contracting that they believe will force the Fed to cut interest rates when the Fed meets in Washington next Tuesday. Fed fund futures contracts show traders an 85% chance of a quarter point rate cut coming next week. The yield on the November contract has fallen to 1.58%. There is a strong call, both on Wall Street and in Washington, for the Fed to openly flood the markets and the economy with liquidity and credit. The real motto is “inflate or die.” This may be one reason why gold and commodities have been so strong this year.
The new spin for buying stocks goes along with this. Buy now because the Fed is going to lower interest rates again. Goldman Sachs is predicting a 50 basis point cut at next week’s November 6th meeting. Institutions who have driven this rally after the planned intervention are now using rallies as exit points going back into bonds. The question that should be asked by the intelligent investor is what will the 12th rate cut do that the previous 11 failed to achieve.
The problem for investors going forward is with the government bent on intervening into the financial markets to prop them up through price support, fiscal stimulus, and monetary insanity the markets are going to become more difficult to trade and more volatile in the process. This is one time that investors need to remove themselves from all of the noise and clutter and look at the big picture. From this perspective, it is important to develop a long-term game plan on reality rather than hopes based on fiction.
Volume came in lower today with 1.42 billion shares trading on the NYSE and 1.7 billion on the Nasdaq. Market breadth was positive by 21 to 11 on the NYSE and by 20 to 12 on the Nasdaq. The VIX fell .72 to 36.08 and the VXN dropped 1.18 to 51.29.
Japanese stocks rose on optimism regulators will announce a bad-loan disposal plan later today that reduces bank capital by less than an earlier proposal. Mizuho Holdings Inc. and UFJ Holdings Inc. led the advance. The Nikkei 225 Stock Average added 0.6% to 8756.59. The Topix index gained 0.9% to 870.23, with banks accounting for about a fifth of the advance.
Treasury Markets
Long-dated Treasury issues retreated after rallying to levels not seen in over two weeks on Tuesday. But short issues gained traction, fueled by growing rate cut expectations. The 10-year Treasury note retreated 3/32 to yield 3.955% while the 30-year government bond dipped 7/32 to yield 5.03%.
Copyright © Jim Puplava
October 30, 2002
