An in depth analysis of global financial and economic debates
August 28, 2000
An in depth analysis of relevant
Global Financial and Economic Debates

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Talk involving the inevitability of a credit cycle collapse is beginning to sound almost second nature to many analysts. Though bearish sentiment comes nowhere near the generally visible bullish sentiment, within the bearish camp arguments are beginning to surface about how, not whether, the cycle will unravel. Indeed, the debate between an inflationary outcome and a deflationary one, almost as a rule, discounts a market collapse.

Wall Street bulls have been taunting the FOMC, perhaps trying to set the Greenspan Fed up for a fall by moving equity prices higher in thin market conditions, ahead of the FOMC meeting this past week. If the committee had raised interest rates and buckled the stock market, then the bulls would have gotten their scapegoat all the while knowing that the Fed Chairman is not going to take the fall anyhow. As the FOMC did not move on interest rates and the stock bulls try to take this equity market off into new territory, Greenspan may have to spoil the party later at any rate, as the extra stimulus during an election campaign may be to hot for the general inflation indicators to handle.

Besides, it is way too early for the stock market to start anything that might resemble even a more moderate price trend, because the hoped for fundamentals have not yet crystallized, nor solidified, and because the excess has not yet been purged! There is too much inertia in this market for a new "sustainable" leg to develop, without something completely unexpected to arrive, like for example, a cure for cancer. Wouldn't that be something? In our view, however, it is more appropriate to reconcile the loud bullish hype with the lousy general momentum, conspicuously expensive valuations, and dearth of liquidity. Perhaps it is also correct to consider the growing skepticism in the psychology of the market? Last year's stealth bear market, doubtless did much damage to investor's wallets and psychology. Perhaps, the sheep have already been fleeced.

Is the Fed friendly, or not
Even as the bulls scream slowdown, bloody slowdown, Wall Street's arrogance about the Fed will have to face a new reality - that the Greenspan Fed is not as friendly as it may appear. At least we hope not. For when the time comes to defend the integrity of the reserve currency, Greenspan may have to raise interest rates even as the bulls are on their knees…even as this slowdown turns into a steep dive in equity prices and the economy. For now, the bulls have got his faith in the productivity argument, as feeble as it may in fact be. If it is at some point revealed that his faith in the productivity argument has somehow compromised monetary policy, hell hath no fury as to what will happen to the international reserve currency of the world. Hopefully, closer to the truth may be, that he has embraced this argument as he tries to prepare the financial system for the inevitable breakdown, in another classic Greenspan sterilizing coup.

Nobody saw this coming
When a consensus finally develops that the oil crisis is not OPEC's fault, nor any other evil empire's doing, attention will have to come back to US/global monetary policy and its substantial contribution to the misfiring of the price mechanism in energy market1.

How is it possible that this was not foreseen? I remember watching my ticker literally explode in front of my own eyes in February 1999 on news that was about to be the first in a long run of bullish API and DOE announcements. Energy demand would begin blowing past any and all reasonable expectation sets. Crude rallied hard off of its lows near $10, and within a month, flew right through $15.

Light Crude Oil Futures
Light Crude Oil Futures

As I stood up to reveal my excitement that glorious day, our prestigious captain asserted his leadership and said that we were too sophisticated to trade in that old economy bull$#&^. At the time, you see, talk was beginning to surface that oil has become irrelevant to the new economy, that OPEC will imminently dissolve, and therefore, that the price of a barrel of oil will be no more than a morning cup of coffee at an ESSO gas station. Delirium had set in.

As Crude prices pushed through $17 not two months later, commentators and quasi-economists began blaming the "unfriendly" influence from OPEC's production cutbacks as the culprit. This was not called for, they clamored! Since then, prices have nearly doubled. It wasn't until only a few months ago now, that the market had begun to appreciate the enormous demand that has actually been straining global production capacity. Up until then, the focus was largely on supply cutbacks. Remember, it is now only 18 short months since $11 Crude.

What kept fooling the pro's on the way up?
They had learned to rely on efficient market assumptions, and hence, take their signals from what was happening in the markets, as we all have. At the time, the price mechanism pointed toward abundant supplies of oil relative to demand. Indeed, after the Asian economy first got the flu in 1997 to when it spread to Russia in the fall of 1998, excess oil supply was offered at fire sale prices to the global importer with the most purchasing power. Ergo, the dollar price of oil collapsed, which not only fueled the babble, but it also dissuaded oil producers from wasting money on new exploration and investment. What's more, the whole experience has played havoc with energy users whose business models are built on expectations for the cost of energy products going forward.

So much for the efficient market hypothesis

Has the oil price mechanism become dysfunctional somehow? We now know that certain collapsing global currencies were clearly behind the collapse in Asian demand in 1997, and European demand in 1998. We have assumed that the fault can only be theirs.

At the other end of that rainbow, however, is a strong dollar policy. The same one that is responsible for collapsing gold prices; The same one that is responsible for our new economy delusions and virtuous investment cycle; The same one that has been responsible for inflating consumer's purchasing power and simultaneously hiding the excess consumption; The same one that has now inflated global financial markets and economies, through a global wealth effect double whammy - inflated US financial assets and the rising exchange value of the dollar; The same one that is responsible for the cumulative economic imbalances, unmistakable in the nation's balance of payments accounts. As likely as the strong dollar policy has created such tentative prosperity, it is likely that such a policy is also at the root of the increasingly calculable propensity to import, as well as the propensity for capital to traditionally flow into dollars.

Due to the apparent rise in time preference for both, consumption and capital, it is conceivable that capital has been allocated more and more toward shorter, seemingly more profitable, production processes, and that consumers are more and more spending an uncertain future. This whole process is not only likely to engender the economic imbalances mentioned in the previous paragraph, but also to eventually thin the nation's capital structure, rather than deepen it. Sorry, I am counting as capital neither the goodwill nor the intellectual property that is valued in inflated dollars today. In short, this structure is unstable and inflationary.

In dollars anyway, oil prices seemed on the surface to confirm the new economy delusion by late 1998, at least until the Greenspan Fed threw caution to the wind and put the pedal to the medal in the fall of that year. By doing so, he created this unstable, paper inflation induced, global demand for real goods - big surprise. Now, on the verge of a potential reversal in dollar prosperity, the prospect of an oil shortage is becoming an incredibly precarious state of affairs.

Do not worry; the bulls claim that we have got our economic slowdown, blah, blah, and blah. Whatever will be the ultimate trigger for gold prices, when the consensus develops (as it already is beginning to) that our entire monetary arrangement is at the root of many economic dislocations, look out paper wonderland.

On Wednesday,
"OPEC said it would increase oil output 500,000 barrels a day only if the so-called OPEC basket price -- the average price of six crude grades produced by OPEC members and one crude pumped by Mexico -- breaches $28 a barrel for 20 consecutive days. Prices exceeded $28 a barrel on six consecutive days through Monday, Aug. 21, the last time OPEC updated its basket price. "Adding 500,000 barrels a day is not enough, OPEC has to increase output by at least another 1 million barrels a day'' to meet current demand, said Lee at Hyundai Oil." - Bloomberg news Wednesday August 23 2000

Sounds as if the market is screaming for oil!

New Highs for the NYSE composite

As tout television turns the hype machine towards the new highs in one index or another, it may be worthwhile to get a second opinion. The New York Stock Exchange Composite index is one of these. The ticker's push to new highs is the validation that the bulls think that they need, and that they hope will bring in more money.

NYSE Composite Index
NYSE Composite Index

Allow me, however, to point out some valid objections about the legitimacy of this move. Clearly, any technician ought to first worry about the declining volume and questionable momentum, accompanying such a bullish break out to new highs.

Of particular interest, are the money flow data and the accumulation/distribution line (a volume weighted stochastic) at the bottom of the above chart. Considering that the index has gained 18% since March, and is off to new highs, it is remarkable that there is a conspicuous lack of meaningful accumulation.

To be fair, the improved breadth, illustrated below by the NYSE Advance/Decline Line, however, provides some encouragement to the bulls. Before jumping on the bandwagon, though, permit me to discuss the goings on in the other markets, indexes, and in overall stock market psychology.

Chart of NYSE Advance-Decline Line
NYSE Advance-Decline Line

Which one is not like the other?
A bull move that is broadening out, quietly, on declining volume, on a decline in momentum, and on insider distributions is not the same as a bull move that is broadening out loudly, on rising volume, rising momentum and unambiguous signs of accumulation.

The latter example was plainly evident in the fourth quarter of 1998, in all of the indexes. Perhaps this year we will have a "stealth" bull market -- an invisible bull market -- where more and more stocks rise, while the indexes do nothing.

Still, I would argue that is the best-case scenario. Observe the softer and softer bounces off of the 200-day (blue) moving average for the broad blue chip S&P 500 index below, within what may turn out to be a massive rising wedge, in hindsight of course.

S&P 500 Index
S&P 500 Index

It has been a couple of weeks now, since the late July sell off in the Nasdaq Composite that upset the bullish cause, and the bulls have not answered the call. The 200-day moving average appears to be an ever more insurmountable resistance point now, and a bottom has yet to be established.

NASDAQ Composite Index
Nasdaq Composite

We just cannot get away from the Dollar…
Looking at the charts of the long bond below, it appears that bond traders do not fear the prospect for "new highs" in stock prices, as they push yields lower and prices higher. In a sense then, the "move" hasn't been confirmed.

30-Year US Treasury Bond Price
30 Year US Treasury Bond Price
30-Year US Treasury Yield
30 Year US Treasury Bond Yield

Not even new highs in energy prices and the prospect for an energy crisis this winter reflect in any credit market anxiety. Perhaps the explanation lies elsewhere. There is no question that some of this is related to Treasury buybacks, but a "seasonal" economic slowdown accompanied by an energy crisis, tight labor market, and potentially rising asset prices, is not the stuff that lower interest rates are generally made of. That leaves few possibilities to explain the bullish sentiment in bonds, other than it is prophetic of a hard global landing where the dollar is expected to benefit as the currency of last resort. Of course, this assumes that foreign dollar buyers are not yet sick of buying dollars at the expense of their own economic freedom.

The fate of the long bond does without a doubt rest with the fate of the dollar. Looking at the yield (the inverse of the bond price on the right chart above), it appears that long-term interest rates are at a critical inflection point. A move in either direction would have significance.

A break out in the dollar/yen AND the dollar/euro to new highs could easily take the bond with it (and push the yield lower), but dollar/yen just whipped back off of resistance on a growing consensus that the stronger Yen will not hurt the Japanese economy.

"Ichizo Ohara, a senior ruling party member, said the Japanese economy could withstand a rise in the yen even though a stronger currency raises the cost of exports. He also said another interest- rate increase from the Bank of Japan, which boosted rates a quarter-point this month, `wouldn't be surprising'' - Bloomberg news; August 23 2000.

I am beginning to sense the implication that it might even bring with it, prosperity. Is it possible, that the Japanese are vying for a slice of this virtuous cycle that has benefited the Americans for so long? Yes. As I mentioned in Inflation versus Deflation, Bank of Japan Governor Hayami said as much in a recent speech in Tokyo (July 14)2.

In fact, it might be possible that the influx of capital may strengthen the Japanese banking system, or as Ludwig von Mises would say, deepen its capital structure - which already seems to be on the agenda. Hayami alludes to both, capital depth and the virtuous cycle, in his speech. Equity prices in Japan sure liked the news, as they quickly reversed what looked like a new low.

Tokyo Nikkei Average
Tokyo Nikkei Average

Dollar/euro, on the other hand, still looks firmly in check. The consensus that is developing is that the ECB is stuck. Economies on the periphery appear to be overheating, while the big German economy remains sluggish. A rise in interest rates may topple the German economy and tear down the Euro zone with it, it is feared on the one hand. However, benign neglect of the inflationary processes, which are building due to the weakening of the exchange rate of the currency, are extremely harmful to a "new" currency arrangement, unfortunately.

Will the ECB raise its key rate?

Hence, the ECB faces the first test of its main criticism: can it handle the diverse politics, with respect to interest rate policy, to the benefit of the common currency?

Checking with the ECB, I found that M1 has grown 6.79% year over year through June, but has declined for the last three months of that period. Inflation data is sporadic through the EMU, with high inflation rates in Ireland, and other member countries, pushing EMU inflation rates above target for the entire Euro zone. Yet, the broader aggregates (M2 and M3) have grown below target (year over year through June), making it a tougher call at its meeting at month end.

The FTSE and a slight buckle in the French CAC Index, which may make it an even tougher call, are leading equity markets in Euroland, lower.

That being said, it is the currency that is important, and unless they have been "persuaded" to leave interest rate policy alone at month end, the ECB ought to take a stand on the need for a stable monetary unit of account, especially after so much criticism of US monetary policy. The neutral FOMC decision ought to make it easy for the ECB to affect a small rate increase, which may be just enough to firm up the Euro currency.

So, it appears that with the Dollar/Euro and the Treasury bond yield, both at an inflection point, it is perhaps up to the ECB to determine their resolution, at least in the short term. Regrettably, currency markets may already be discounting a stand still on interest rates. If it turns out to be the case, I might be tempted to conclude that the ECB is simply looking out for their dollar interests.

Ominous signs for the consumer
Durable goods down 12% in July! Wall Street will have you believe that the consumer is just taking a breather, but the bulk of the evidence couldn't be more unsupportive of that nonsense.

S&P Retail Index Chart
S&P Retail Index
Gross Private Savings Chart
US Gross Private Savings

Last year's stealth bear market, it is my contention, damaged some stock market psychology through a not insignificant contraction in net worth (right chart above). It not only gradually undermined the greater fool psychology that many bulls presume still exists, but perhaps also, it holds ominous signs for the future of a consumer who has increasingly leveraged his or her contracting net worth.

How many times have you seen this chart?

Personal Savings Rate

What do you think will happen to wage demands, if an energy shortage this winter crowds out excess disposable income, if declining stock prices render stock options inadequate as a remuneration option, and if rising interest rates begin to force higher debt service maintenance? It could result in recession, but what of inflation?

That depends upon how you look at it. The general price level is not yet rising out of control, but that can happen easily in an economic system that encourages inflationary policies. Defined in terms of the purchasing power of the dollar, with respect to its ability to buy real goods, the inflation process is well under way.

CRB Index Chart
Commodity Research Bureau Index
Goldman Sachs Commodity Index Chart
Goldman Sachs Commodity Index - Total Return

Back to the Stock Market
As the summer doldrums rapidly approach an end, it may be useful to evaluate who is trying to dominate today's market leadership. In the soaring financial index, Citigroup, sporting a healthy 23 multiple, is emerging as a strong candidate, while Merrill Lynch, with a 19 multiple, has more than doubled in less than a year.

Citigroup Chart
Merrill Lynch Chart
Merrill Lynch

How about a deal on American Express at almost 30 times earnings? Or Goldman Sachs, which has now taken a run at its old high, offering each share at almost 20 times earnings, as they made a killing on recent AT&T financings.

American Express Chart
American Express
Goldman Sachs Chart
Goldman Sachs

Even JP Morgan, the cheapest of the group at slightly over 13 times earnings, is breaking out now. Ever since UBS' curious acquisition of PaineWebber, there has been mounting merger and acquisition speculation building on top of an expectation set that sees a peak in short term US interest rates this fall.

Additionally, Citigroup, Goldman Sachs, and I believe JPM as well; have been active in capitalizing on the cheaper credit sources overseas. Masquerading as help in the development of Japan and Hong Kong's debt markets, Citigroup has already offered to issue something like 400 Billion Yen in Samurai debt (the terms are fixed in Yen) at a fraction of the cost that it would have to pay to access US debt markets for capital. Instead of trying to re-ignite the Yen-carry trade, shouldn't they be thinking about the potential for bad debt problems in their loan portfolios at home?

Wait a minute though. They have probably already securitized and dumped the lower quality stuff onto the money market for foreign interests to accumulate.

Thank goodness for the opportunity to place the burden on the dollar. Further comfort, in terms of earnings that is, can be taken to heart as the banking industry has already been expensing their potential bad loans. Yet, the lower quality of debt being issued today, and the industry-rising exposure to the already volatile Dollar/Yen rate ought to raise some red flags. Consider that the M&A speculation, assumptions about interest rates, aggressive financial management, and riskier (but cyclically profitable) loan portfolios are as equally likely to explain the momentum in financial stocks, as they are likely to precipitate the onset of an inevitable cycle downturn.

Chips, Technology, and Biotechnology
Intel ardently wants to take another run at the leadership position in the chip sector, offering investors a bargain at 55 times earnings. Look at that beautiful chart with higher highs and higher lows.

Intel Chart
Intel Corporation
Compaq Chart
Compaq Computer

However, I would be concerned about the visibly declining volume and what appears to be distribution. This could be explained either by short sellers who haven't figured out that there may be too many of them, or net sellers that are well learned about selling into strength. I guess they aren't holding their breath about the success of Intel's new chip, in any event. No sign of distribution appears in Compaq's shares, however, and this is about as good a quality breakaway attempt as I have recently seen. The bullish chart signals going off in Compaq's shares at 50 times earnings possibly reflect investor expectations that Intel's new chip will drive new computer sales going forward. But that industry-bullish theme does not seem to reflect in its competitor's share prices so far. If Compaq can deliver on nearby news, however, it might energize this theme, and…Olč, Olč. Or, so is the bullish wet dream perhaps.

Speaking about expectations for stronger technology investment spending looking forward, check out this beauty at 115 times earnings. Great momentum, but…

Sun Microsystems Chart
SUN Microsystems

…do investors have any concept of how big this company will need to become in order to support such a monstrous valuation? The stock is a little shy on volume and momentum, but otherwise certainly deserving as a candidate for the title, leader.

Biotechnology Index Chart
AMEX Biotech Index
Health Care Products Index
Health Care Products Index

In the Biotech index, somewhere is President Clinton's dream to reign over a cure for cancer. Now, if anything can outdo the Internet bubble, it would be this. Accordingly, if anything can justify further currency abuse, it is also this. Don't hold your breath on the former.

Old economy cyclicals

Energy stocks look sharp, but the money flow indicators have been relatively bearish throughout the six-month rally.

AMEX Energy Chart
AMEX Energy - Select Sector
General Electric Chart
General Electric
Philip Morris Chart
Philip Morris

Of course, you could not have a bull market without confirmation from the almighty GE, who brings all sorts of good things to life. A 50 multiple is easy to assign a company whose aggressive financial group, GE Capital, has gradually dominated the company's revenues. What's more, GE has got new leadership.

It almost looks as if the worst is over for Philip Morris. In fact, at nine times earnings and a 6% dividend, perhaps it is time to encourage smoking again?

Speaking of dividends, have a look at the utility index, which certainly has a large interest rate component to consider. More than that, however, today speculators have begun to view these companies with a technology/growth spin.

Dow Jones Utility Average Chart
Dow Jones Utility Average

Certainly, the basic assumption going into justifying these multiples rests on the case for a peak in interest rates. That is the bullish case. Since there are many more bearish charts than bullish ones, I chose to avoid displaying that fact, but rather to provide you with an analysis of the bulls that are vying for September leadership status.

What can we make of all this? Expensive old economy cyclical stocks are competing with expensive old story growth stocks for the prestigious spotlight, without any sort of resolution on the increasingly imminent affairs; interest rates, inflation, credit decay, trade imbalances, an energy crisis, a potential profit slowdown, the productivity argument, and of course, a new young President.

Have a nice Labor Day, next weekend. I will be enjoying my honeymoon until September 11, 2000. Maybe some of these topics will have been resolved by then.

Ed Bugos

1. See Jude Wanniski's argument

2. The BIS Review

All charts courtesy of StockCharts and Economagic

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