Weekday Commentary
from Jim Puplava
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Market WrapUp for the Week
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Wednesday, November 6, 2002
Time to Take Out an Insurance Policy
The dictionary defines insurance as “an insuring or being insured against loss; a system of protection against loss….” I would suggest to most investors that now is the time to think about owning insurance against financial loss. The insurance I’m referring to is gold and silver. The surprise rate cut by the Fed today of 1/2 a point speaks volumes as to the amount of risk in the financial system. Systemic risk is everywhere and especially here in the US. The fact that the Fed cut rates a half a point says that economic prospects are much more bleak than is reported. The profit picture in the US has been in a freefall since 1997. Whatever gains in the economy that has been accrued from consumer spending has mainly been in the housing sector and in foreign imports. Despite record consumption by consumers, the main beneficiary of that consumption binge has been with foreign manufacturers as America’s traded deficits have ballooned from close to $130 billion in 1997 to today’s annual deficit of $500 billion. While the trade deficit has ballooned, debt levels have skyrocketed across all sectors of the American economy.
Yet in most financial reporting that covers the financial markets, very little attention is given to this imbalance. Annual debt growth in the US at $2 trillion is now 20% of GDP with no signs of letting up. In yesterday’s election, voters across the land approved a record $46 billion in new municipal debt. This occurred at a time when most state budgets are in deficit. In my home state of California, the deficit of $24 billion is larger than most other states' entire budgets. California voters approved $10 billion in bond sales by local school districts.
Bond Market Showing Signs of Topping Out
The standard response to America’s multiple bubbles in stocks, bonds, mortgages, real estate and consumption is lower rates and more credit. Our entire financial system runs on credit and nobody questions this insanity. There is only one constituency that is large enough to bring discipline to America’s economy and that is the bond market. Up until recently, it has been the beneficiary of inflows of institutional money as pension funds, banks, and insurance companies have moved into bonds as a safe refuge from a plunging stock market. This has driven interest rates down on long-term debt as inflows of new money have driven up prices. However, it looks like the bond market has topped as long-term rates are now starting to back up as it appears foreigners are now dumping Treasury bonds. As the graph of the long-bond indicates, interest rates have backed up as stocks have rallied. Unlike past rallies where stocks and bonds rose simultaneously, the bond market has been selling off. US interest rates are no longer competitive with those in Europe and the hot money appears to be moving out of our bond market. There is a direct linkage between the stock market and the bond market and it is breaking down. The stock market has failed to rally along with the bond market in response to lower interest rates. In fact for the first time in over 70 years the economy and stock market has failed to respond to the most aggressive round of interest rate cuts since the Great Depression and the largest credit expansion in our nation’s history. As pointed out in yesterday’s graph of interest rate cuts and the stock market, monetary policy has failed to arrest the decline in equities. It has also failed to give us a sustainable recovery in the economy. All that it has managed to do is create more imbalances and malinvestments in the economy. In summary, it has created additional bubbles and nothing more.
Charts courtesy of www.futuresource.com
Fed Surprise 1/2 Point Action Sets Off Bells
The financial world scoffs at the mere mention that the US economy appears to be heading in the same direction as Japan, but that is exactly what it is doing. Today’s surprise half a point rate cut brings the federal funds rate down to its lowest level in 41 years. It raised alarm bells around the globe, as the initial response to the rate cut was that stock indexes plunged along with the bond market. It took large buying in the futures markets to turn all the major indexes and the bond markets around. The Fed tried to sound upbeat in its assessment of the economy, which didn’t jive with the half a point surprise cut. The Fed blamed the upcoming war and the threat of terrorism for inhibiting spending plans by business and consumers. (How about massive debt, and declining profits, not mentioned in its press release?) They accompanied their rate cut by the usual gibberish in saying, “The risks are balanced.” The Fed is hoping that the Bank of England and the European Central Bank will follow suit. The Fed fired two of its remaining six bullets. What do they do next after this rate cut fails to work? To put this rate cut in context, what do they think this rate cut will do that the other 11 didn’t? What do they do when they only have four bullets left in their chamber? The answer to that question, I believe, is to start monetizing assets. It is obvious if an investor studies yesterday’s chart of rate cuts in the US during the 1930’s, Japan in the 90’s and the US in the 21st century, is the ineffectiveness of monetary policy to resurrect a bubble once it starts to deflate.
Why monetary policy isn’t working this time is that this is no ordinary recession or bear market. Unlike past recessions, which were caused by inventory accumulations and tight monetary policy, we are dealing with a bubble. There is a big difference. Inventory accumulations can be worked off and monetary policy can go from being tight to reversing itself bringing about a recovery in the economy and the markets. However, this time there have been no major inventories to liquidate outside of technology. Inventory levels, thanks to “just’n time” inventory management have been kept lean. Most inventory levels have been worked off and most companies are seeing their revenues decline. They have gone to cost cutting to survive, which is why unemployment is rising. The real problem in the American economy is record debt, lack of savings, exploding trade deficit and an implosion in profits. These problems can’t be fixed with monetary policy.
No Sir - e - Bob, this isn’t your ordinary recession or bear market. It is a bursting bubble that is in the process of deflating, and there is nothing the Fed can do but make matters worse by creating another bubble to replace the ones that are deflating. The Fed’s aggressive rate cuts have created bubbles in mortgages, housing, and consumption. What happens when these bubbles deflate? The consumer looks like he is tired and ready to call it quits. Unless long-term interest rates can be brought down to even lower levels and generate another round of refis for consumers, John Q looks tapped out. In fact, more alarming for the Fed than a plunging stock market is a plunging bond market. Rates have backed up on both the 10-year note and the 30-year bond. If the bond market plunges as a result of a falling dollar, rising gold and commodity prices, the Fed and US government will have a bigger problem on their hands.
It's Time To Take Our Medicine
The fact remains that the government needs to be forth telling with the American voters and tell them it is time to tighten the belt, pay down debt, and allow the economy and the markets to heal themselves as painful as it may sound. Instead, we keep encouraging consumers, investors, companies and governments, local and state, to go deeper into debt to keep the economy afloat. This isn’t sound medicine. It is like giving an alcoholic another pint of vodka and telling him he can drink his troubles away. Most investors know better and know that when you catch a cold or get the flu your doctor is going to tell you to get some rest, stay in bed, and drink plenty of fluids and allow your body time to heal itself. You may wish the doctor could give you a pill and avoid this process, but that isn’t possible. Apply this logic to today’s bubble economy. The 1990’s were an economic orgy of borrowing, spending, and rabid speculation. What we are now seeing unfold is the hangover that accompanies any binge, and the 90’s were the biggest binge in this nation’s history. The binge far exceeded anything that occurred during the roaring twenties. By comparison the expansion of credit by the Fed, GSEs and the financial system has nothing else to compare it to other than 17th century France and England, and perhaps the 16th century Dutch tulip mania.
Given the Fed’s penchant for greater inflation by expanding the money supply and credit in the financial system, a bit of insurance to protect against the seismic earthquakes should be taken to protect investors’ net worth. The fact that gold shares and bullion have been rallying throughout this recent bear market rally should be a telling sign of things to come. The more that stock prices continue to rally against a backdrop of a falling dollar, rising gold and commodity prices and rising interest rates, the greater the chance that the US stock market is headed for another crash. Forget this nonsense that the stock market has bottomed out. Bear market bottoms are accompanied by mass selling of stocks by the investment public, which has yet to occur. Dividend yields and P/E ratios are usually between 6-7. To repeat the words of Warren Buffett, we’ve only made a down payment in this bear market.
Today's Markets
Looking at today’s casino results in the financial markets, stocks and bonds initially plunged after the surprise 50 basis point rate cut. As mentioned earlier, massive buying in the futures markets was needed to turn things around. The rate cuts may be more designed to shore up a financial system that is on the brink of falling profitability, rising loan defaults, delinquencies and other system risks in the derivatives markets. As far as lower rates, they are now actually doing more harm than good. The lower rates have failed to carry through to the corporate bond market where credit spreads have been widening on corporate debt, both quality and junk. The negatives to lower rates are summarized below:
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Lower pension returns require greater company contributions. This lowers corporate profits
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Lower rates harm investors and those dependent on income from their investments to live on.
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Lower interest rates hurt the dollar and may actually cause long-term rates to rise.
The Fed is now caught in a catch 22 situation of its own making. The more they lower rates, the worse things are going to get. If lower rates don’t resurrect the economy or the markets they will have nothing else to work with then to start monetizing assets, which may indeed come next.
The markets eventually responded after plunging on the news of the rate cuts after large buying in the futures markets. The markets rose for the fourth consecutive day. Wall Street was giddy with the news believing as they do that another rate cut will resurrect the markets. The biggest winners today were gold shares, defense stocks, drug companies, energy, and tobacco. The banking sector actually finished on a negative note which may be why the Fed decided to surprise the markets by a half a point rate cut. Adding to the surprise rate cut was the Fed shifting to a neutral stance on rates.
Cisco also helped to drive a rally in stocks after reporting profits that beat estimates. That was the good news. The bad news was that the company said the book-to-bill ratio, which compares new orders coming in to shipments out the door, remained below 1 during the company’s first fiscal quarter. The company also stated that next quarter’s sales would be slightly lower or unchanged. The company reported earnings of $618 million which were an increase from a loss of $268 million the year before. The company had a pro forma profit of $1.04 billion before accounting for investment losses, acquisition related expenses, stock-option expense, and other miscellaneous expenses. Deferred revenue, which measures whether orders are coming in faster than shipments, dropped from $3.89 billion the previous quarter to $3.75 billion in the current quarter just ending. Allowance for doubtful accounts rose to $346 million. The good news is that Cisco beat lower revolving estimates by a penny. The stock trades at 27 times trailing earnings versus it’s bubble PE multiple of 192, average PE multiple of 77.5, which in Wall Street’s view makes the stock a strong buy. Of the 44 major analysts that follow the stock, 29 rate it a strong buy, 13 a hold, and only 2 a sell. These analysts are obviously, shall we say, not value investors.
Gold, along with defense and oil shares, had a good day. It now appears that the US could be at war within the next 30-90 days. Drug stocks did well along with tobacco stocks, as it is believed a Republican victory could curtail frivolous lawsuits and put a crimp with run-away lawsuits by the appointment of more conservative judges. The biggest winner overall today were the shares of defense stocks as it now looks like war has become almost a certainty.
Volume was heavier than usual with 1.63 billion shares trading on the NYSE and 2.16 billion on the Nasdaq. Breadth looked better with advancing issues besting declining issues by a 22-11 margin on the NYSE and by 21-12 on the Nasdaq. The VIX rose .20 to 34.48 and the VXN fell 1.14 to 50.06.
Overseas Markets
European stocks fell amid concern an interest-rate cut by the U.S. central bank won't revive the economy enough to justify 2003 earnings forecasts. The Dow Jones Stoxx 50 Index shed 1.4% to 2590.78, after earlier rising as much as 1.6%. All eight major European markets were down during today’s trading.
Taiwanese stocks rose, driving the TWSE Index to a two-month high, on optimism lower U.S. interest rates will bolster demand for the island's exports. Taiwan Semiconductor Manufacturing Co. led the gain. Japan's Nikkei 225 Stock Average rose 0.2%, with drugmakers such as Takeda Chemical Industries Ltd. and Yamanouchi Pharmaceutical Co. leading the gain after they said increased overseas demand boosted profits.
Bond Market
Treasury bonds retained modest gains after the Fed startled markets with a deep rate cut. The 10-year Treasury note put on 10/32 to yield 4.035% while the 30-year government bond rose 12/32 to yield 5.055%.
Copyright © Jim Puplava
November 6, 2002
