Weekday Commentary
from Jim Puplava
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Market WrapUp for the Week
Monday l Tuesday l Wednesday l Thursday l Friday
Week in Graphs 
Storm Watch 
Geopolitical News 
Energy 
Precious Metals 
Raw Materials
Thursday, October 31, 2002
Looking For a Catalyst
The economic news was disappointing. Q3 GDP was below estimates and the trend in GDP looks like the economy is beginning to stall again. What little strength there was in the economy during the third quarter once again came from the consumer. Consumer spending on autos delivered most of the punch during Q3 besides government spending. Auto companies had to entice buyers with zero down and zero interest plus rebates to get buyers in the show room. Now it looks like those incentives are failing to bring in new buyers however, as auto sales have fallen off sharply during the month of October. The economy has less momentum as it enters the final stretch of the year. The strength in consumer spending during the third quarter came mainly from mortgage refi’s with households’ extracting more equity out of their homes to maintain spending. As household wealth declines due to falling stock prices, homeowners are spending the equity built up in their homes to maintain consumption.
The Chicago Manufacturing Index also fell to recession levels last month and the Chicago Purchasing Management Index fell to 45.9 from 48.1 in September. A reading below 50 indicates a contracting manufacturing sector. From the viewpoint of manufacturing, it looks like the double dip recession is here. The Institute For Supply Management report out tomorrow is also expected to show that manufacturing in general around the country is heading back into recession. More worrisome for Q4 is that consumer confidence is now at a decade low indicating that consumer spending may have peaked. Without the stimulus of another round of mortgage refinancing the consumer has no place else to go for money to maintain spending.
What Will It Be?
This raises the question of, "What comes next?" What will be the next catalyst to spur economic growth, capital spending by business and give the debt- laden consumer a second wind? The consensus seems to be for the Fed to help create another bubble by lowering interest rates and bank reserve requirements in order to inject more credit into the economy. The US is already borrowing $2 trillion annually with very little to show for it. GDP should be much stronger than it is, but deflating asset values, debt liquidation, and foreign imports are siphoning off most of the benefits. If the consumer cuts back on spending, what will take consumption's place? You can forget capital spending. Businesses are still contracting, laying off more workers, and shutting down plants with one out of every four factories in the country now idle. Most companies are making every effort to conserve cash in order to survive. Next year’s profits are going to be worse as a result of new pension funding requirements in order to keep pension plans 90% funded, so there will be no help coming from business. Most firms are saying next year will be another rough year, which explains all of the firing of workers. Furthermore, comparisons for earnings will be much tougher by comparison to 2001 when everything was going south, so you can forget business as a stimulus.
That leaves the good ole’ consumer. It will be important to watch chain store sales next month for signs of consumer retrenchment. This will give clues as to the all-important Christmas retailing season. If consumers pull back, then the economy will be back in recession. There don’t appear to be any new catalysts that can drive consumer spending now that mortgage rates have moved up somewhat from last month. In order to create another spending boom, Greenspan needs to create another bubble somewhere that can be tapped and monetized, such as mortgage refis. Without a new asset to borrow against, the consumer is left only with credit cards to support additional spending.
The Buyer of Last Resort
This leaves only the government where both parties are in favor of new government spending plans, resulting from the Keynesian belief of emphasizing the merits of consumption versus the benefits of savings and investment. It is one reason that the US has become such a debt-ridden nation. There are a few ideas for a tax stimulus which would be the right thing to do, but that would not be possible if the Democrats hold on to the Senate. The Democratic leadership is opposed to lowering income tax rates and would prefer to roll back the Bush tax cuts and raise taxes even further. Across the country governors are raising taxes again, exactly the wrong thing to do. Politicians seem to be repeating the same mistakes of the Hoover and the Roosevelt Administrations during the 1930’s. Tax rates were raised to 94%, regulations were imposed on business, and fiscal spending went through the roof. If you look around the country and in Washington, both the right and the left are advocating the very same policies. There is very little hope that tax cuts will become a reality unless there is a change in leadership in the Senate. At this point, not even the experts can predict the outcome of this election. It is simply too close to call.
The left is calling for more spending and more taxes to support new government transfer programs. The tax burden is already greater than 40% for most Americans, and even higher if you include state, property and sales taxes. Tax rates in the US are higher today than what the average serf paid his liege lord in feudal times. Yet more taxes are being advocated. Here in California the governor passed a major energy tax on consumers that will be implemented over time after next week’s election. With the state now financing 25% of the annual budget with debt, more income tax hikes are coming after the governor wins his reelection bid.
It isn’t understood by most politicians that in hard times, government should decrease the burden of taxation on its citizens. Instead it does just the opposite. After the Clinton Administration increased taxes in 1993, they followed it up with monetary stimulus and a credit boom, which gave us the 90’s bubble. Now it appears that the same prescription is being advocated again, to raise taxes to pay for more spending and follow it up with lower interest rates and more credit. This is the standard answer you hear coming from Democrats, and you are increasingly hearing it come from Republicans as well. They should know better. Very few politicians today have the moral courage to tell voters the truth.
What's The Truth?
The truth is that our country’s finances are a mess as a result of the 90’s credit and consumption boom. The US is borrowing $500 billion a year from overseas to finance its trade and current account deficit. It is now running annual budget deficits that are heading back up to $400 billion and may be more if we go to war. Borrowing close to $1 trillion a year is not healthy. At some point, foreigners may refuse to lend us more money to finance our trade deficit. The government may also find it difficult to finance its budget deficits without paying higher rates of interest. During this quarter the US government will have to tap the bond markets for $76 billion in capital to finance its spending plans. This is a prescription for financial calamity.
The Road to Perdition
Debt has become so ingrained within our society that nobody questions this financial insanity. Instead, whether you get your news from reading the paper, television, or the Internet, there is a major movement in this country for more government intervention in the economy instead of allowing the markets and the economy to heal itself naturally through debt liquidation and business failure. Weak companies would go under, debt would be liquidated, markets would fall, and the economy would contract until the excesses were wrung out of the economy. Once cleansed of these excesses, a natural restoration process would begin.
Instead we hear more calls for government to alleviate the pain when it was government that created the pain in the first place. There seems to be this mistaken belief that the government can solve all economic problems with continuous intervention in the economy and the markets through price supports, monetary expansion and fiscal stimulus. In each case of intervention, it has paid with more debt.
It simply has not dawned on policymakers, academics, economists, or analysts that there is a limit to all of that debt. The financial profession is filled with a plethora of advisors from financial planners, brokers, anchors and news columnists who are out giving everyone advice based on a bull market. There are all sorts of rationalizations and explanations as to why there was a recession or bear market. It is easy for the profession to explain everything; while understanding nothing. The idiotic commentary that accompanies most earnings reports is a good example of this, as are the comments for 3-4% economic growth based on a continuous stream of borrowing by consumers, corporations, and lastly government. If federal, state, or municipal governments can’t balance their budgets, they borrow more money. When borrowing money isn’t enough, they raise taxes and that action is looked upon as fiscal discipline.
It is the credit bubble of the 90’s and the mortgage, consumption, bond, real estate, and dollar bubble that now exist on top of a stock market bubble giving me confidence that my ‘Perfect Storm’ thesis is correct. In fact, I would recommend the reader pick up a copy of Charles Mackay’s “Extraordinary Popular Delusions and the Madness of Crowds” and read the chapters on the South Sea Bubble and John Law’s Mississippi scheme to look at where we are heading. It is also recommended that the reader look at Charles Kindleberger’s “Manias, Panics, and Crashes” for an understanding on what happens when governments and markets go to extremes as they are today.
It's Here.
Besides the usual news events of the day of falling profits, more scandals, and a slowdown in the economy, there was no new news other than talk about another Fed rate cut. However, of the four elements I’ve written about in a bear market rally, it now looks like the fourth element is now in place.
The Four-Step Bear Market Rally Process
Phase 1 One-two-three-day rallies, sparked by intervention at key support levels.
Phase 2 Short covering drives violent upside surge in indexes.
Phase 3 Day traders come in and increase short-term momentum.
Phase 4 John Q comes in at end of rally after uptrend has run out.
The individual investor is coming back into the market after the majority of the rally has taken place. Up until last week, money has been flowing out of stock funds each month since July. Over $52 billion came out in July, $3 billion in August, and it is now reported another $16.1 billion came out in September. I believe it will be more of the same for October, since up until the middle of last week, money was flowing out of equity funds. Investor sentiment has done a remarkable turn around. It has gone from 28.4% bullish to 43.4% bullish, exceeding the number of advisors who are bearish. Investors are now putting money back into the market as the rally nears completion. The biggest worry now is missing out on all of the action. The advice given to the public is to buy now before all of the good news comes in before it is too late to own stocks. This next phase of the bear market should shear investors once again, but this time I believe it will lead to capitulation. Once burned, twice shy -- three times, bye-bye.
For the month of October, the Dow gained 10.6%, its best showing since January of 1987. It was the first monthly gain for the Dow since March. The S&P 500 gained 8.6%, the biggest advance since March of 2000 when it peaked. The NASDAQ added 13.5%. During this month, smart-money commercial hedgers doubled their short position from 16,452 contracts to 31,052 contracts. Tomorrow’s report should show additional short positions being added. What’s more, this latest rally has taken place against a backdrop of declining volume, lower breadth, fewer new highs versus lows, and the bulk of the gains experienced in three-day gaps. Mutual fund cash positions are also at very low levels so there is very little fuel to support another rally without strong investor support coming in off the sidelines out of cash.
Technically the market pattern is emerging out of a diagonal triangle that came too far, too fast. This is usually a pattern that signals an approaching end with some sort of reversal pattern to follow. The next leg down should be more horrendous taking the averages down to newer lows before we get a sustainable intermediate-term rally. It should be interesting to see what happens next week if the Fed cuts rates. Investors should watch the dollar to see how it holds up. A fourth reason not to cut rates not mentioned yesterday is that it telegraphs to the world that things aren’t going well. Lowering rates again leaves the Fed with very little ammunition to ward off a financial crisis when the next one occurs. Suffice to say there are plenty of financial crisis candidates around to give the Fed reason for pause.
Volume increased on heavier selling today. Most days of distribution are accompanied by heavier volume while rallies have been occurring on weaker volume, which is not a good sign. Big board volume rose to 1.51 billion shares and Nasdaq volume rose to 1.7 billion. Volume on the NYSE was nearly 5% above the three-month average. Market breadth remained barely positive by 6 to 5 on the NYSE and by 10 to 9 on the Nasdaq. The VXN rose 1.7 to 52.99. The VIX fell .17 to 35.91.
Overseas Markets
European stocks wrapped up their first monthly gain in seven, as the prospect of improved earnings at companies including Royal Dutch/Shell Group and Cap Gemini SA boosted investor optimism. The Dow Jones Stoxx 50 Index climbed 1.4% to 2561.29, its first back-to-back daily increase in three weeks. All eight major European markets were up during today’s trading.
Japanese stocks fell, completing a fifth month of declines, after the government backed away from bank industry changes some investors say are needed to end a 12-year economic slump. Nippon Telegraph & Telephone Corp. and other companies that rely on domestic demand slumped. The Nikkei 225 Stock Average dropped 1.3% to 8640.48.
Treasury Markets
Treasuries were little changed with the 10-year Treasury note losing 2/32 to yield 3.97%. Among the raft of data tomorrow, the key indicators will be a national factory-sector report and a monthly labor wrap-up. What those reports say will help investors factor in a possible cut in interest rates next week when the FOMC meets on Wednesday.
Copyright © Jim Puplava
October 31, 2002