Black Holes and Bubbles
by Paul Mampilly
My, my, how suddenly the worm turned. But there’s little pain yet as investors are still playing with house money, i.e. gains investors have from the cyclical bull market that began in October 2002 and that we believe ended on January 20, 2006. We’ve been warning our readers, first in our December 18, 2005 edition “Has the stock market reached the peak…” and then once again in our January 8, 2005 edition entitled “Top of the world, end of the road,” that the gains being experienced then were the last flickering embers of the extraordinary and astonishing rally in asset prices of all shapes and colors that was ignited first by Greenspan’s hyper-liquid monetary policies and then by the “tax cut and spend” policies of George W. Bush.
We have not forgiven ourselves for the skepticism with which we viewed both policies, rejecting them as being misguided, and further, believing that they would compound the problems created by the burst stock market bubble. In hindsight, it should have been obvious that investors would not ignore the liquidity and filthy lucre being shoved into their palms, with unseemly persistence. Not only did Greenspan lower rates, he provided a verbal guarantee as to how long the hyper-liquidity would stick around, while Bush cut taxes while expanding government spending to heretofore unseen levels. For skeptics, it has been a difficult three years, as investors have bid up all types of risky investments and asset types at their expense, while their bearish concerns have been ridiculed and dismissed as being delusional. Greenspan has saved his professional reputation and Bush won re-election handily in 2004, at least partly, due to the exuberant economy that their combined policies wrought. Yet, the final judgment of history as to the wisdom of their actions is ahead, as they may have torpedoed us for the long-term.
Greenspan’s hyper-liquid monetary policy has inflated a giant housing and home refinancing bubble, while Bush’s fiscal policies have blown up a black hole of debt and corruption, leaving us at the mercy of the treasury bond market, now dominated by the central banks of the world, and their potential capriciousness to hold Dollars, short-term or long-term debt or cash. In other words, the Fed has lost control of our bond markets. If the Fed cannot effect a rise in long-term rates by raising short-term interest rates, then, it may be equally ineffective when it wishes to effect a decline in long-term interest rates through reducing short-term interest rates.
Few today consider this a serious risk, despite the recent inversion of the bond market. Instead, the bond markets are content with Greenspan’s incessant repetition of the word “conundrum” while stock investors have been gotten themselves punch drunk at the prospect of lower interest rates. Any reluctance that investors first had at taking Greenspan and Bush’s invitation to lap up the “riskless” monetary and fiscal policy has long disappeared. The Greenspan and Bush monetary and fiscal party is now done and the rush for the exits has begun just as investors have loaded up on purportedly cheap shares, expecting them to soar. We wish them well.
We acknowledge that we have been a Cassandra, concocting every rationale for why the party should have ended some time ago, and believing that the bear market was about resume in 2004 and in 2005. In retrospect, we wholly underestimated how much Greenspan’s hyper-liquid monetary policy and Bush’s “tax cut and spend” policies would stimulate the animal spirits and the speculative impulse despite the tech/dot com bubble bust. As our grammatically challenged friends would say “our bad.”
Nonetheless, don’t ignore the fact that Bush’s “tax cut and spend” regime is finished and can no longer provide the steroidal stimulus it once did. Greenpan’s monetary hyper-liquid policy madness is also about to end and will leave rates far higher than most estimate today, especially for long-term maturities. Finally, the Dollar is no longer weak, and will no longer provide easy margins to companies with international operations.
So, it’s time to put away the baubles and tchotchkes and get ready to play some serious “defense,” even though it’s not clear what will play “defense?” Will it be the usual defensive warhorses of pharmaceuticals and financial stocks or consumer staples shares? As always we have ideas, including one area that few would consider to be a defensive sector. We have much more on what we think are good defensive plays in our stock section along with outlook changes on gold and the dollar.
Editor’s Note: Paul Mampilly, CFA is the Editor & Publisher of Capuchinomics. Paul previously worked at Bankers Trust, Deutsche Bank and ING as portfolio manager/equity analyst between 1991 and 2003. He earned his MBA from Fordham University and his BA from Montclair State University. Paul was awarded the Chartered Financial Analyst (CFA) designation in 1997.
For more from him, see www.capuchinomics.com