Three BIG Words: Revision, Recession, and Intervention

Financial Sense Online ^ | July 31, 2002 | Jim Puplava

[Axion]

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^{Wednesday's Stock Market WrapUp}

Three BIG Words: Revision, Recession, and Intervention
Three words can best describe today’s markets: revision, recession, and intervention. The morning began with the government’s report on GDP for Q2 and the revisions for years 1999-2001. First a look at the Q2 numbers which show the economy has weakened considerably from the first quarter. The rate of economic growth slowed down to only 1.2% versus economists’ estimates of 2.4%. In addition to the slump in economic growth, another report by the Chicago Purchasing Managers Index for July showed a sharp drop in manufacturing activity. The Chicago CPM Index fell to 51.5% from June’s 58.2%. A reading below 50 indicates the economy is contracting. Like the GDP numbers, which fell short of expectations, the CPM Index came in far lower than expected.

In addition to these numbers, the Fed’s periodic Beige Book report showed the economy expanding modestly and unevenly across the country. The Fed used words such as "stable," "steady," "modest," or "moderate" to describe economic conditions. Four of the Fed’s districts in New York, Boston, Atlanta and Dallas show that economic activity is tapering off. Six other districts reported marginal growth; while only two regions of the country, Cleveland and St. Louis, showed signs of growth. Retail sales are mixed, and in most regions of the country there are visible signs that consumers are starting to retrench on their spending plans. Labor markets are weak and real estate was mixed.

Back To The Past?
It appears from the above reports that the economy is likely heading back toward a recession. This is worrisome for most analysts and economists who have been consistently wrong in forecasting a second half recovery. They were predicting 3.5% to 4% economic growth along with Wall Street. The widely held view is that we get strong economic growth in the second half of the year and this strong economic growth will help fuel corporate profits. Wall Street has some very hefty earnings growth figures for the third and final quarter of the year. The prediction is that pro forma earnings will grow at a 30% rate in the third quarter and a 40% rate during the fourth quarter, even though these projections aren’t real numbers. There is nothing on the horizon, either, in the economy or in the business world that would indicate these projections are even close to becoming a reality. This could be a big shock for the financial markets this fall, which have been counting on a big boost to earnings. Those projections for economic growth and miraculous earnings are looking more like a fantasy at this point.

GDP Revisions Ominous
More ominous for the economy and the financial markets is today’s government revisions of the economic numbers for the years 1999-2001. The major revisions show an economy that was much weaker than originally reported. GDP growth for the first quarter was revised down from the original 6.1% growth rate to 5%. What is more telling is the revisions of 2001 GDP, which show only a rise of 0.3%. Instead of one quarter of negative economic growth, we actually had three consecutive quarters of economic decline. Economic growth actually peaked in the fourth quarter of 1999 and slowed substantially during all of 2000. During 2000, the economy was already heading toward recession with the first quarter of recession beginning in the first quarter of last year. Previous reports had shown the economy had been strong throughout 2000, when in fact it had been weakening all along. A summary of other revisions are listed below:

• The annual GDP growth rate from 1998-2001 revised down to 2.7 % vs 3.1%
• 2001 overall growth revised down to 0.3 % vs 1.2 %
• Revised estimates show a longer downturn than previously reported
• Personal income was revised down to 0.4%; wages and salaries were revised down 2.9%
• Economic growth for 4th quarter of 1999 was revised lower
• The largest downward revision in real GDP for quarters 1999-2001 was 1.9%
• Corporate before tax was revised down from all three years: $19.4 billion for 1999, $88.3 billion for 2000, and $35.5 billion for 2001
• Personal outlays were revised down for all three years

The Bureau of Economic Analysis (US Commerce Department) issued their GDP report today. A link to the report is listed here for those who want to delve into the statistical data and form your own conclusions. Suffice to say this report is one more nail in the coffin of the new paradigm economy of the 1990’s. Like so many of the corporate revisions we have witnessed -- with more to come in the future -- the 1990’s "New Era Economy" has turned out to be more fiction than reality. As corporations come clean with their books, the government is coming clean with its own revisions as well.

Pinpointing The Truth
What these economic restatements reveal, and what so many other corporate revisions show, is the economy and corporate profits have been much weaker than expected. They point to one of the worst profit recessions in decades and an economy that is plagued by many imbalances. It also points to a day of reckoning that will be ominous when it occurs. The economy is heavily dependent on foreign capital to finance burgeoning trade and current account deficits. The US is taking in and consuming about 75% of the world’s savings. Between US foreign investment outflows and trade and current account deficits, the US needs to take in capital inflows of around $900-$1,000 billion per year. The trade and current account deficits require about $450 billion. Add to it the outflows of US capital, and it isn’t too hard to conclude a dollar crisis of a magnitude never seen before lies directly in front of us.

What must be keeping Fed officials up at night is they are seeing their credit bubble turn into their own worst nightmare. The economic numbers show an economy that is once more heading back into recession and a credit crunch that is developing in the credit markets. The Fed however, is caught in a Catch-22 of its own making. If it lowers interest rates again to combat a weakening economy and flood the financial system with money to combat a credit crunch, it risks losing its credibility. Lower rates could send a signal to the markets that the Fed is losing control. On the other side is the plunging US dollar, which may require raising interest rates to keep foreign money invested, which in turn could damage the economy. Moreover, raising interest rates would pop the Fed’s latest bubble in the housing market. Rising interest rates would abruptly end the consumer-refinancing boom that is helping to prop up consumption as homeowners extract more equity out of their homes. Once the housing bubble bursts, there will be nothing left to prop up the economy besides deficit spending by the government, which has taken on a new dimension.

Cornered, With No Way Out
The 1990’s Clinton/Greenspan credit bubble leaves the Fed no attractive options. In every direction it looks, the Fed finds itself backed into a corner with "no way out." Once realization comes that the economy and the markets aren’t coming back, there is going to be a very severe reaction in the financial markets. The one area to watch is the dollar. Foreigners now own $9 trillion of US financial assets. Those assets are taking a beating with falling financial markets and a plunging US dollar. When some of that money decides to leave our shores, the day of reckoning will be upon us. The excesses of the 90’s will be dealt a severe retribution in the financial markets. There is also the $3 trillion in US equity funds. Up until this time, most investors have been in a state of denial, preferring not to look at their financial statements. At some point when the Fed can’t control the financial markets through intervention and spin, I suspect that John Q. Public and his neighbors are going to be heading for the exit gates at the same time. Trading curbs could be a daily feature of the financial markets if they don’t lock up.

I’m not sure that Fed indirect intervention in the markets will be able to contain the rush towards the exit gates. It is becoming more apparent by the day that intervention is holding up the markets. These miraculous last hour recoveries are becoming more obvious. The one-day wonders when the markets jump up by 4-6% defy rational explanation. Stories that the markets rallied on news of the Rigas family being taken off to jail on July 24^th, or the story for Monday’s rally due to investor optimism over the rescue of miners over this weekend are shallow and insulting to one's intellect. Intervention was able to turn the markets from the abyss to a minor gain in the Dow and the S&P 500, but they couldn’t save the Nasdaq.

A Brief Window of Opportunity
What investors may have to understand at this point is they have been afforded one more opportunity to get out of stocks. The predicted second half recovery, or the miraculous earnings recovery, will not take place for the third consecutive year. The cleansing process of the 90’s excess credit boom is about to take a turn for the worst. It could begin as soon as August or at least by this fall. The markets and the public are going to need something to distract them and perhaps a war will do just that. The miracle earnings predicted for the last three years are not going to appear. The economy is going back into recession. And if the dollar plunges, the Fed may be forced by foreigners to raise interest rates at a time it doesn’t want to with severe consequences for the housing market, the economy and the financial markets. If the Fed believes in miracles, it better hope that the $9 trillion of foreign money in our financial markets doesn’t decide to head for the exit gates. If it doesn’t, that will be a miracle worth praying for because there will be no miracle in earnings. 

Heads Up Everyone
Watch the dollar and the US bond market -- they are the keys to what is going to happen going forward. Watch the gold market. It is currently reacting to the derivative markets as James Sinclair and Harry Schultz have explained in their essays on this site. Also watch the gold and silver equities markets reacting in a leveraged way to the price action of bullion. We are now in a corrective process that is taking some of the froth out of the gold markets from second quarter. Once these excesses have been taken out, and gold has been transferred from weak to stronger hands, the stage is set for the next advance of what I believe will be a decade-long bull market. At the moment, gold and silver are climbing a wall of disbelief by both bulls and bears. By fall, and finally by winter, much of this disbelief will turn to conviction. There is nothing like a strong price move to new highs to create new converts. A spike in prices is going to depend, to some extent, on what happens to the dollar and Treasuries. If they both plunge, which I suspect they will, then you are going to see some very large gaps in the price of gold and silver. When that happens, the precious metals stocks will go parabolic. The reason they rise so quickly and dramatically is because of their scarcity. It is similar to the Internet stocks. The floats are small -- even for some of the majors. So when demand hits these stocks, the prices fly.

If you are new to investing in gold, you must understand that this is a volatile sector. It moves on emotion and fear as well as fundamentals. You must also understand that like the metals themselves, it is scarce. Very strong hands also hold it. Those who are strong believers aren’t parting with it. So when it rises, it moves quickly because there isn’t enough supply. This is why you may want to consider adding to your position on weakness, buying at support levels for the metals or the equities. Finally, avoid the hedgers. They have done poorly when prices rise because they aren’t as leveraged to the price of gold and silver because they have sold their production forward. So when prices rise, they don’t benefit to the same extent as the unhedged companies. You can see this difference reflected in the price run up of the HUI versus the XAU.

Today's Markets
Volume was high coming in at 1.92 billion on the NYSE and 1.64 on the Nasdaq. Advancing issues outpaced declines by a narrow margin on the NYSE while losers beat out winners on the Nasdaq by 20-14. The only green light on the board occurred in oil, drug and bank stocks.

Overseas Market
European stocks climbed as companies including Unilever, Allied Irish Banks and Sanpaolo IMI said earnings will be better than forecast or topped estimates. The Dow Jones Stoxx 50 Index was 0.9% higher at 2744.83 at 5:45 p.m. London time. Five of the eight major European markets were up during today’s trading. Japanese stocks fell, led by exporters such as Kyocera Corp., after a drop in a U.S. consumer confidence index stoked concern that spending will slow in the nation's biggest trading partner. The Nikkei 225 stock average lost 1.3% to 9877.94 as of 3 p.m.

Treasury Market
Treasuries reacted positively to the day's weaker-than-anticipated data, which fully support the notion of a sidelined Fed for the foreseeable future. But Treasury investors also had to contend with a large refunding package. The government will auction $22 billion in five-year notes and $18 billion in 10-year notes next week. The 10-year Treasury note rallied 1 point to yield 4.46% while the 30-year government bond gained 1 10/32 to yield 5.305%.

The Fed's Beige Book report on economic conditions revealed that growth expanded moderately across sectors and regions. The Fed also indicted that retail sales were mixed and that manufacturing was improving while labor markets remained stable. Thursday will see the release of another slew of reports: weekly initial claims, June construction spending, expected to have risen 0.3%, and the July Institute of Supply Management Index, which is seen posting

© Copyright Jim Puplava, July 31, 2002 a 55.4% reading.

[arete]

Of course he is and things seem to be going his way right now.

Richard W.

[razorback-bert]

11:00AM: The market remains bogged down by the weaker than expected ISM Index and is trading near its worst levels of the session... We would also note that rumors are circulating regarding Cisco (CSCO 12.37 -0.82); in particular, rumors revolve around possible executive departures and the possibility that CEO and/or CFO are not signing off on the financials... Briefing.com would hasten to add that with the Aug. 14 deadline for CEO/CFO sign-offs on financials approaching, many such rumors will no doubt surface and should generally be treated with skepticism...

[sinkspur]

Of course he is and things seem to be going his way right now.

Well, he'll certainly tell you they are, anyway.

[Tauzero]

"The language may slightly vary, the numbers vary, but the message never does."

Just like the eternal bulls.

Is there any reason a varying message would be better?

I concede a varying message would serve short term traders better.

[razorback-bert]

So what message can be gleaned from JP Morgan credit default swaps? By the middle of last week, default spreads referencing JP Morgan had widened considerably, indicating a dramatic downturn in confidence. The cost of buying credit protection on JP Morgan debt was being quoted as high as 127 basis points, up from 60 basis points a week earlier. Senior credit default swaps traders also say that unusually heavy volumes were traded on the bank’s name last week, with the bulk of protection buying coming from hedge funds.

Source: Financial News, 29th July 2002

[Wyatt's Torch]

Anything bad happens to CSCO and look out below. Chambers, and his conference calls, have set the tone for the quarter. That would not be good at all. Thanks for the note.

[RightWhale]

The housing market is not driven by low interest rates. It is driven by immigration population growth.

The housing market could crash even with continued population growth. Identifying a single dominant factor may be be an interesting exercise, however, both interest rates and population growth are factors. Another might be willingness of landowners to subdivide their parcel, to give up elbowroom in return for some temporary cash flow. Still another would be regional factors such as opening or closing of major employers. It's not simple, and it's not small in importance to the national economy.

[dennisw]

Wait till a contraction of both happens in ernest and all those 50% gross income mortgages become junk.

These were "Democrat mortgages" designed to get Blacks, Mexicans, immigrants into the DemonCrat fold forever by snaring them a house they could not otherwise afford. That they really couldn't afford anyway but the FedGov was beating the drum on the "right to homeownership".

Sure looked great during the Clintoon years but will come back to bite the taxpayer who funded/subsidized this nonsense.

[razorback-bert]

A bit about the possible Middle East War:

Although the market has probably put it a temporary low in the past few weeks, and despite the odds that are increasing that we're now in a climbing market (although slowly), the Oil Patch Gang will probably get the two things it needs in order to prevent a massive global economic meltdown.  The two things?  A rate reduction and a Middle East War.  Why, you ask?  Ah!  Here's how it works.

The rate problem boils down to some pretty simple stuff, if you know where and what to read.  The Financial Times of England ran a wonderfully enlightening piece this weekend with the title "Debt fuels US gas and power bankruptcy fears".  Besides pointing out that there is $500 Billion of bad debt in the energy sector, the article quotes one time Enron European trading boss Karl Miller, who's now turned to consulting:

    "We are past the point of no return on significant levels of debt default in the energy industry, which will dwarf WorldCom and Global Crossing," said Mr Miller. "There is no doubt we will see multiple bankruptcies shortly."

Well, yes, and no.

Let's pretend for a few minutes that you are the President of the most powerful nation in the history of the planet and that despite your sometimes clumsy image, you really remember some of the pieces from your MBA studies.  You with me?  If you were facing massive bankruptcies in the energy sector, what are two moves you could make that would tend to keep the failing energy traders alive long enough so you could structure a workout, or better, avoid bankruptcy altogether?

The first move would be to lower interest rates.  Although Chairman Greenspan certainly doesn't want to lower rates, because it has let some of the air - OK, a lot of air out of the bubble - the President's argument to the Fed (and it will be confirmed by the in-house Fed Research Department) is that if rates don't come down, the energy traders will blow up and that as the Financial Times notes, will dwarf everything we've seen to date.  The trouble in both Citi and JP Morgan have been related directly to the energy problems of the energy group.

The bottom line is simply this:  The energy group must have the rates lowered and their debt briefly restructured in order to make it through the coming three month "window of pain". 

The second step is to get that damn Middle East war going as quickly as possible, but again, not against the Saudi's because there are moves afoot in the Kingdom that may work out in favor of the oil patch gang.  Here's how this one works to serve the needs of the energy traders:  As we get closer to a war with Iraq, the prices of energy will be bid up worldwide.  Under the cover of a war, energy traders will be able to bid up their prices to the point that they will be able to make profits - damn big profits - and keep everything under the covers.  There will not be a public hue and cry about gas prices going back to $2.00 a gallon.  The reason?  Simply because people expect that gas prices will go up and it will all be because of that Saddam Hussein guy.

From urbansurvival.com

My note on the above, I don't know about the debt, will ask around the oil field.

[Wyatt's Torch]

Chamber's rumor hits the mainstream - Cisco Declines on Rumors, Economic Fears

[tcostell]

Chairman Greenspan certainly doesn't want to lower rates, because it has let some of the air - OK, a lot of air out of the bubble -

Would someone mind explaining to me how lowering interest rates has caused the stock market to fall? (Or is there something else implied here that I'm missing?)

[Always Right]

Anyone who's read Puplava for any length of time knows that he is, at bottom, a gold bug. Talking down the economy, painting the worst possible picture, and getting in a plug for gold is his stock in trade.

Seems like every time I read one of these doom and gloom stories, at the end of the web site there is a pot of gold to be sold.

[Always Right]

Would someone mind explaining to me how lowering interest rates has caused the stock market to fall?

Come on man, don't you know everything the Fed does is evil and is only done to suck the wealth out of this country.

[arete]

Come on man, don't you know everything the Fed does is evil and is only done to suck the wealth out of this country.

Lowering rates could further weaken the dollar and foreign capital abandons US bond and stock markets and goes elsewhere. This is elementary.

Richard W.

[teletech]

I've never seen so many "experts" in one place in my life. Very impressive!

[arete]

Would you like to be added to out experts ping list?

Richard W.

[teletech]

Would you like to be added to out experts ping list?

Richard W.,p>Does a non-expert like me qualify?

[tcostell]

I don't want to get into a big argument Rich, but while you're right about the dollar, and the Treasury bond auctions, lowering of the target rate does not weaken the stock market. The stock market may be weakened by the same causes that inspire the lowering of the fed target rate, but there is no cause and effect between the actions of the fed and a lower stock market.

I know from previous posts that you are more than smart enough to know that, so if you were joking, ... sorry.

[arete]

I wasn't joking at all. It's a paradox, isn't it? There's no bang left in the FED except for short term market interventions. I do believe that they have boxed themselves into a no win situation. Oh, and thanks for giving me credit for being smarter than I really am.

Richard W.

[arete]

Richard W.,p>Does a non-expert like me qualify?

Your HTML abilities alone qualify you. I'll put you on my "unofficial list" for now, but the official list keeper (rohry) is on a 5 week vacation. Mention it to him when he returns to posting the nightly Market WrapUp thread.

Richard W.