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Today's WrapUp by Mike Hartman 05.09.2003 Mon Tue Wed Thu Fri Archive |
The U.S. Peso Falls Again
The U.S. dollar was tagged again this week for a loss of 1.8% with the U.S. Dollar Index closing at 95.16, down from last week’s close of 96.94. The dollar has now been down seven out of the last eight weeks. In spite of the dollar’s decline, U.S. Treasury bonds and notes gained slightly for the week with the yields declining to 4.67% for the 30-year bond and 3.67% for the 10-year note. The broad stock market indexes were little changed from last Friday with the Dow Industrials adding 22 points to close at 8605, the S&P 500 added a skinny 3 points to close at 933, and the NASDAQ gained 17 points to close at 1520. Without today’s gains, the market would be negative for the week. Stocks are sure looking like they are due for a pull-back.
If you take a look at the Dow chart, you can see that we have had higher stock prices on lower volume and declining momentum indicators. The divergence in price and momentum are a precursor to lower prices. With the lack of a convincing breakout from last week’s bullish rising triangle formation, the Dow is now taking the same shape as the S&P 500 and the NASDAQ. The VIX (Market Volatility Index) is showing extreme complacency. The index dropped 7% today to close at 22.04, which is the lowest reading since May of last year. Stocks continue to hold their recent gains even as the economic data deteriorates and more American workers find their way to get in line for unemployment benefits. Initial jobless claims have now exceeded 400,000 for twelve consecutive weeks, which has not happened in over a decade!
Buy the Rumor and Sell the News
Earlier today I was busy working on allocations within client accounts while the Dow was up about 40 points. About two hours later I looked at the screen to see that the index was up over 100 points. What happened to launch stocks higher? Seemingly nothing! I am interpreting today’s move as, “Buy the rumor and sell the news.” It seems that the market is responding to the economic weakness sighted by the Federal Reserve in their press release this past Tuesday. There are now rumors abounding that we could see a rate cut at the next Fed meeting in June. I scratch my head and ask myself if the spin of a possible rate cut is needed to keep Treasury bond prices high, and to keep demand for Treasury instruments high so that the dealers that bought the $58 billion in Treasury debt this week can keep selling it to the public. If there is no rate cut next month, both stocks and bonds should come down. Is that what the Fed is alluding to? Let’s take a look at their statement from Tuesday.
The Federal Open Market Committee decided to keep its target for the federal funds rate unchanged at 1-1/4 percent.
Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing. However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets. These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.
Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.
Spin of the Week
We could spend lots of time taking the press release apart piece by piece, but let’s focus on one particular sentence in their statement. This one sentence has got to take the prize for the “Spin of the Week.” In the third paragraph they state, “In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level.”
First of all, let’s be sure that the time frame that they are referring to is, “The next few quarters” as noted in the preceding sentence. For conversation’s sake we can safely say sometime in the next nine months. The next key to the sentence is the word “probability” along with some clarification to the degree of probability stated as “though minor.” This should be translated as more than a 50% chance (probable) though minor (let’s call that less than a 70% chance) that we will see, “An unwelcome substantial fall in inflation.”
What is Inflation? With all of the disinformation out there, most people don’t even know how to define inflation. All these years we have been spoon fed the notion that an increase in inflation is a bad thing. Most people think of inflation as having to pay more money for the things we need and use. To be more specific, it is usually referred to as consumer inflation. That is why inflation is usually measured by the CPI (Consumer Price Index) and the PPI (Producer Price Index). We usually hear that low inflation is a good thing. So how can the Fed say that it will be an “unwelcome” large decline in inflation? Also note that they could have said “deflation” instead of a “fall in inflation.” Funny use of words.
Wouldn’t you welcome a decline in price for school tuition, homeowners insurance, medical and prescription costs, lower gas prices, more affordable gas and electric bills, knock 20% off your weekly grocery bill, etc.? So how can it be considered unwelcome? I’ll tell ya’ how. It’s called ASSET DEFLATION. What are the biggest assets Americans hold? I would have to say they are stocks, bonds (meaning debt instruments of all kinds) and real estate. That is the only way the deflation would be considered unwelcome.
To digress for a moment, inflation occurs when the Federal Reserve INFLATES the supply of money relative to the economic expansion of goods and services (GDP). When excess money is created it has to go somewhere. Back in the seventies, Americans endured tremendous inflation of consumer goods after the excess money creation of the sixties that was used to fight the war in Vietnam. The dollar link to gold was broken back in 1971 and the consumer inflation took-off straight through the seventies. This last time around, it has been very different. The excess money creation of the nineties (massive monetary expansion) found its way into financial assets. Remember that now-a-days, debt is considered an asset. All things financial have been over-inflated. The first victim has already been the stock markets. Could they fall more…I would have to say, “Yes” based on today’s price to earnings ratios over 30, when traditionally anything over 20 is considered overvalued. Could bond prices come down? I would have to say, “Yes” again, since we are at 40-year lows on interest rates. There’s just not much room for bond prices to go much higher. Can real estate prices come down? I again would have to say, “Yes.” After the last few years of 20%+ gains in real estate values, there is plenty of room to come down. When bond prices decline, forcing interest rates higher, how will unemployed workers or even working people for that matter, be able to afford today’s home prices if mortgage rates were to go back above 10% as they were back in the eighties? Higher mortgage rates will lead to lower prices so that people will be able to afford the monthly payments.
I’m beginning to ramble, but let’s pull it together. I would like to replace the Fed’s sentence in the above press release with my own interpretation of what they are saying. It would go something like this, “Sometime over the next nine months we will probably see a substantial deflation of financial assets.” In my mind, it will probably happen sooner than later, because next year they will need to clear the way for an election-year rally to get President Bush re-elected. We shall see if the Fed cooperates. So far it looks like they will as there seems to be no hesitation to continue pumping liquidity into the system and pegging long term interest rates below 5%. That is why we continue to see the dollar in decline.
The Fed is really between a rock and a hard spot. They can’t raise interest rates to strengthen the dollar, as higher rates would crush any chance of an economic recovery. They continue to expand money faster than GDP which will put continued downward pressure on the dollar. First quarter GDP came in at an annualized rate of 1.6%, but monetary aggregates (as measured by M-2) have been growing at an annualized rate of 7.2% for the last year. With all the spin on Bubblevision, it looks like they are trying to force the excess liquidity back into the stock market to re-inflate the bubble. We need foreigners to invest roughly $1.5 billion per day to support our negative balance of payments. With a falling dollar it will be difficult to attract foreign investors.
For now, we’ll just keep plodding along. Watch out for the complacency in stock prices. That is when investors tend to get caught off-guard when stocks tumble. The Fed is actively buying debt instruments off the market which is providing excess liquidity to prop-up stocks. If the dollar falls too far, too fast, they will have to back off on the money pump. We shall see how it all unfolds as we continue to monitor the markets. In the meantime, best of luck to you in all of your investment decisions!
Copyright © 2003 Mike Hartman
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