The Bear’s Lair: The bell tolls for thee!

They don’t ring a bell at the top of a bull market, goes the popular aphorism.  Well, last week the U.S. stock market broke decisively through its 2005 lows and my advice to those with long positions is: seek not for whom the bell tolls, it tolls for thee!

This column’s record as a stock market prognosticator is mixed.  Being more or less uniformly bearish, it looked brilliant for the first two years of its existence, from October 2000 to October 2002, then extremely foolish for the next 2 years, as the market recovered from its 2002 nadir, which was still far above the bottom predicted by the column, and ventured back fairly close to its 2000 levels, at least in terms of the Dow Jones Industrial Index.  While the market’s major rise occurred in the last three quarters of 2003, its continued upward bias and failure to weaken significantly during 2004 made bearishness seem ever more irrelevant.
 
To give credibility to a bearish prediction today, the column must answer two questions: what was going on during 2002-04, when the market seemed to defy gravity and what has changed now, that it should not carry on doing so.
 
After the stock market bubble burst in 2000, it was natural to suppose that a lengthy and deep recession would follow. The “wealth effect” of so much overvaluation of stocks had pushed other indicators, notably the Federal budget balance, to unsustainable levels, and it was reasonable to suppose that the unwinding of so much excess could not be painless.  Capital, too, had been spectacularly mis-allocated in the dot-com boom, and the experience of both the early 1930s in the United States and the early 1990s in Japan suggested that a mis-allocation of such a huge amount of resources would have to be paid for in some painful fashion.
 
Both the Federal Reserve and the George W. Bush administration moved quickly in early 2001 to counter the recession that appeared to be gathering momentum, and their intervention worked, at least in the short term.  The Fed reversed the marginal tightening of monetary policy that it had undertaken in 1999-2000, and lowered short term interest rates until they were heavily negative in real terms, with M3 money supply continuing the growth at almost 10 percent per annum that it had pursued since 1994. 

The administration cut taxes, not once but twice, in 2001 and 2003. In both cases the centerpieces of the tax cuts, a lowering of marginal income tax rates in 2001 and a sharp reduction in the excessive taxes paid on dividends in 2003 were genuinely helpful to the supply side of the economy. Indeed, had the administration in 2003 removed altogether the pernicious double taxation of dividends, at the corporate and the individual level, it would have increased the intrinsic value of common stocks to the extent that, at the low levels of late 2002, they would have been close to their appropriate value.
 
The stock market and economic recovery of 2003-04, therefore, should not have been a surprise.  Monetary policy was highly inflationary (the “deflation” fantasies of Fed governor Ben Bernanke notwithstanding) and fiscal policy was also highly stimulatory, since the administration’s wholly beneficial tax cuts had been matched by wholly irresponsible increases in Federal spending, producing the inevitable budget deficit, smaller than the peaks of 1983 and 1992 in terms of the economy only because interest rates were so low and the economy itself was expanding at a good clip.
 
All the loose money was also reflected in a surge in construction, which produced a house price bubble largely confined to the big-city East and West Coast markets, but an enormous overhang throughout the country of ugly oversized and overpriced houses on minute lots, which will be filled with drug-crazed squatters by 2025. In the Washington area, for example, house prices as a whole, at an average of around $450,000 in affluent Fairfax County, are only moderately in excess of their sustainable level, but the large number of new houses priced to sell at over $1 million, most of them very unattractive and badly located, is a financial and aesthetic disaster waiting to happen.
 
Contrary to much European opinion, neither the surge of cheap money nor the imbalances it produced have been confined to the United States:
 
? Spain’s inflation and balance of payments are seriously out of kilter, due to the stimulative effect of euro interest rates over the last 5 years that have been negative in real terms when matched against Spanish inflation.
? France and Germany, conversely, are staggering under real euro interest rates that are too HIGH for their domestic economies, and a currency that has made their products increasingly uncompetitive on the world markets.
? Britain’s house prices have headed towards Pluto, particularly in the London area – far higher in real terms than at the end of the real estate bubble of the late 1980s.
? China’s banking system is heading to an inevitable denouement when the entire retail deposit base of the country’s banking system has been lent out in unrecoverable loans to politically connected real estate speculators and state-owned money pits.
? Latin America is rediscovering the joys of Marxism, country by country, and has learned that if you don’t pay back the international banks and bond markets, there’s not a lot they can do to you.
? Because of rapid growth in China and India, supplies of oil and some other commodities are being outrun by demand to an extent not seen since 1973. Oil prices are at levels that would have been unimaginable two years ago, and show no signs of any more than modest retreats.

Ask yourself one question: is this a planet in which you seriously want to invest? Is this a world in which stock market price-earnings ratios close to record highs and bond market risk premiums for lower grade credits close to record lows make any sense at all?

The imbalances have mostly been caused by a flood tide of world liquidity, and by interest rates that have been kept far too low for far too long.  At some point, reality is going to return, the cost of capital is going to revert to its historic level, and high oil and commodity prices are going to choke off economic growth. At that point, with money being tightened to ward off inflation, and budget deficits in the United States, the EU and Japan already far out of balance, there will be no weapons remaining by which the world’s governments can stave off a recession that will be the more severe for having been so long delayed. 

It is very unlikely indeed that the current excesses will be worked off by a gradual and orderly decline, because the conditions needed for such a favorable outcome, fiscal and monetary room for stimulative policies that can counteract the downwash and produce a soft landing, are no longer present.

The timing of the debacle is uncertain, but cannot be delayed much longer.  There are indeed signs that it may be soon be upon us.  Job growth, consumer confidence and economic growth in the United States have shown a significant downturn in the figures announced in the last few weeks.  The U.S. trade deficit, on the March figures announced last week, appears to have lurched upwards again to a still more unsustainable level. First quarter corporate profits, being announced in a steady stream last week and in the next 2 weeks, are producing more downside surprises than upside. General Motors and Ford, both entering a down-cycle in automobile sales and earnings, appear weaker than ever as they struggle with the legacy pension and health care costs of past pandering to union demands – because of the amount of debt both companies have outstanding, this will affect the bond markets even more than the stock market.
 
The tech sector in particular is showing signs of weakness, both in terms of sales and profits – IBM’s surprising inability (announced Thursday) to book the end-quarter sales needed to make its numbers must be an ominous sign. Furthermore, the gravy train by which much of the tech sector’s top management remuneration was paid in stock options whose cost magically disappeared seems likely to be brought to a long overdue end within the next few months.  Large granters of management stock options such as E-Bay and Cisco, the glories of the tech sector for so many years, will look very different when their true net-of-options earnings are revealed in all their insignificance for even the dopiest analyst to see.

The flood of cheap money that overwhelmed the world economy after 2001 not only produced housing bubbles worldwide, it also allowed the wizards of Wall Street to re-inflate stock prices, convincing gullible investors, particularly in the tech sector, that flim-flam was indeed magic and that an Internet search engine was indeed worth $60 billion, twenty times its 2004 revenues.

Last week’s downturn on Wall Street suggested that the green smoke may at last be clearing, and that the perspiring Wizard will soon be seen frantically manipulating levers behind a curtain. At that point, Wall Street’s permabulls will discover that not just a bell is tolling for them, but a Last Trump, that will put them out of business for a generation.
 
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ‘90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
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Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005)—details can be found on the Web site greatconservatives.com.

Posted by karlmagnus on Monday, April 18, 2005 at 08:12 AM in Economics & Finance,  U.S. Politics
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