More than a Conundrum

Signs of inflation mean the Fed will keep on hiking short-term rates through the summer. But what then? Sell stocks? Sell bonds? Dan Denning explores…

It is a huge data week on Wall Street. The Producer Price Index reading for May comes out tomorrow. On Tuesday, the May Consumer Price Index reading will be announced. Whatever the actual reports announce, I think it’s safe to say they will understate inflation.

What’s not clear is how the markets react. As for the Dow, I turn the floor over to my colleague at Fox Investments, Steve Belmont, who had this to say in the latest alert to his readers:

"Every year we read about the coming ‘summer rally’ in stocks. While there have certainly been summers during which stocks have rallied – 2003, for example – the recent reality is not as sunny. Indeed, some of the biggest stock market declines have taken place during the summer – no doubt exacerbated by thin market conditions associated with Wall Street’s annual pilgrimage to the Hamptons.

"Two of these big sell-offs have occurred within the past four years. The Dow topped out at 10,400 in mid-May 2002 and didn’t stop falling until 7,490 in July – a decline of 28%. 2001 saw the same kind of price action, with the Dow dropping 30.6% from late-May to late-September. Will the same thing happen again this year? It is too early to tell, but given the rather sideways nature of the current market, it would not surprise us to see a downside move of lesser magnitude.

"Following a late spring rally last year, the Dow topped out at 10,530 on June 24, before declining as low as 9,746 on August 13 – a drop of 7.4%. Sound familiar? The Dow is currently hovering right around the 10,500 mark. The market is sideways, testing strong resistance, and price action is anemic – just like 2004. Last year’s sell-off stopped at the bottom of the trading range. A similar test of that low again this year would not surprise us at all."

Me, either. And as a trader, I’d be a put buyer on the Dow. As an investor, I note that even on dollar strength, both gold and oil are inching up. This tells me that the underlying support for tangible assets is still strong, and can only strengthen on dollar weakness.

The New Bull markets: The Bond Market

The bond market is more perplexing. Eight times, the Fed has raised short-term interest rates. Yet despite all that, yields on 10-year bonds are spending an awful lot of time under 4%. In other words, higher short-term rates are not forcing up long-term rates.

It’s more than just a conundrum. It could be a recession. For one, if the Fed’s goal is to get real interest rates into a more "neutral," less accommodative stance, its eight rate hikes have achieved nothing. Adjusted for inflation, interest rates remain low. Second, long-term rates going lower than short-term rates typically suggests a recession. That is not exactly bullish for stocks.

But if figuring out what all this means is a little like trying to figure out if France is obligated to go to Russia’s defense should Germany invade Belgium and bring England into the war, don’t worry.

The bottom line is this: The Fed is losing control of American monetary policy. Bond prices are set by the market, even if interest rates are set by the Fed. Faced with a crumbling euro, anemic yields in Europe, and a shaky environment for stocks, global investors are buying U.S. bonds and keeping long-term yields down, despite the U.S. deficits.

And if Alan Greenspan gets his way, he will limit the size of the mortgage portfolios of Fannie Mae and Freddie Mac. The GSEs have been large issuers of debt in the last five years. If they are legally restricted from issuing more debt to grow their mortgage portfolios, it will take a big chuck of bond supply off the market. In Greenspan’s universe, this is more pent-up demand for Treasuries.

How will it all end? Right now, it wouldn’t surprise me to see another wave of refinancing in the housing market. The strengthening dollar and the prospect for more Fed rate increases add up to the possibility that long-term rates will go down before they go up.

But I wouldn’t expect it to last long, perhaps not even all summer. A lot can happen in a summer to damage confidence in the global order of things. And that brings me to an interesting point…

The New Bull Markets: The US Can’t Afford To

The main point of my new book, The Bull Hunter, is that America can literally no longer afford to be the engine of the world’s growth. We don’t have the money to keep buying. And our debts cannot keep growing forever. The sooner investors see this, the better they’ll be able to profit from other bull markets, wherever they may be.

Those new bull markets will be in places where economic growth is more balanced and where pent-up savings exist that can be unleashed to drive consumer spending and rising standards of living. Asia is obviously where I’m talking about.

But between here and there, the migration is likely to cost a lot of people their jobs and fortunes. It will not be effortless or seamless. One of the biggest risks is that low global interest rates have led to far too much production of consumer and durable goods. China has increased capacity based on inflated assumptions of American demand.

While this may lead to a slowdown in China’s consumption of natural resources, it will also signal that American consumption is no longer going to drive the world’s growth. Whole national economies will not be able to exist by selling things to America.

Instead, they will sell them to China, India, Malaysia, Indonesia, Australia, the Philippines, and the rest of the Far East. It will be an enormous adjustment in the structure of the global economy – one that will see the dollar fall relative to gold and hard assets and one that will see a new economic order emerge that’s not based on debt and consumption as if consumption itself were the same thing as growth.

Will it happen smoothly? Of course not. As I note in The Bull Hunter, Asia’s capital markets aren’t mature enough yet to allocate investment where it’s needed most. But that will change with time. The old system, the one that subsidizes American spending habits, cannot last however. You cannot eat and grow thin – or spend your way to wealth.

You can appear to do so for a while, though. And we are in that "while" right now. The investment strategy hasn’t changed, though. Buy stuff. Sell paper.


Dan Denning
for The Daily Reckoning

June 14, 2005

Dan Denning, editor of Strategic Investments, is one of America’s most respected "big picture" analysts working today. His new book, The Bull Hunter, details how the collapse of the U.S. credit bubble will see Asia emerge as the No.1 market for profit-hungry investors over the next three to five years.

Ray Dalio, in Barrons, says that finance now represents 40% of all U.S. corporate profits. Manufacturing only brings in 10%. Finance, of course, adds not one jot or tiddle to Americans’ real wealth. It merely moves money from one pocket to the next.

Finance companies are making money because Americans lust for wealth and don’t have it. So, they borrow – which puts money in pockets all over town, including those of the finance company.

Americans borrow so much that their own savers can keep up with them. They are forced to rely on the kindness of strangers in strange places just to make ends meet.

You, dear long-suffering reader, have heard us say so many times. You are probably getting sick of hearing it.

Especially when each time we add: "This can’t go on much longer"…and yet, it seems as though it will go on forever!

But we learned yesterday that 2,000 new readers join The Daily Reckoning every month. What must they think? They come aboard a klunky freight train that has been rolling for six years next month. It must be a bit puzzling. So, today, we back up in order to pick up stragglers and new passengers.

First, we begin by explaining that our approach is not that of the modern mumbo-jumbo-spouting economist, but that of the original Scottish and French ‘moral philosophers’ who founded the discipline. We believe that the world is moral, in the sense that you can’t get away with anything. When something appears to be too-good-to-be-true, there’s bound to be a catch. You don’t get something for nothing. And you don’t get what you expect, we say; you get what you deserve. In investments, as in the rest of the life, you can never know what will happen in the future. And what you think you know about the past and present is mostly wrong. So, you can’t guarantee success; all you can do is deserve it.

How do you deserve financial success? The same way that you come to deserve success in the rest of life: you do the right thing. You work hard rather than lay about; you save rather than spend; you invest rather than speculate. You follow the old time-tested rules. You mind your manners, stay on good terms with the local gendarmes, and thank God when things go your way. There’s no magic, no mystery, no tricks.

Of course, magic, mystery and tricks are just what people want. They always yearn to "get rich quick" and regularly vote for politicians that offer a free lunch.

The result is a constant tension, expressed cyclically, between honesty and humbug, played out as a vast and entertaining public spectacle. When stocks are cheap, no one wants them…and yet, it is then that you should buy them, for they represent the greatest value for money. When they are expensive, everyone wants to buy them. Go figure.

Currently, most stocks are expensive, so we stay mostly away. Real estate is expensive too – worldwide. Today’s news brings a report that New York, London, Paris, and Hong Kong all saw double-digit gains in residential property in 2003-2004. In Spain, from 1997, house prices rose twice as fast as those in the United States. In China, as in California, a bubble in property prices has turned people into speculators.

We are naturally suspicious. If you can’t get something for nothingwhy are people all over the world getting rich doing nothing but living in their own houses? There is a skunk in the woodpile somewhere, as we used to say. (Actually, that’s not what we used to say, but what we used to say can no longer be said in polite society).

The skunk in this woodpile is the U.S. Federal Reserve System. The Fed has flooded the entire world with "liquidity" – cash and credit – much of which has found its way into house prices. Lending below the rate of inflation, the Fed actually did give borrowers something for nothing – money. The result is today’s magic economy…which will prove to be a giant swindle.

New readers may be a little shocked. Has not Alan Greenspan saved the economy from a downturn? House prices are going up. The economy is said to be "growing." What’s not to like?

Ah…that… Well, it is a long story…one that we keep rehearsing in these daily reckonings. For today, we only mention that if the Fed could make people rich simply by giving away money, it is a pity they didn’t think of it sooner.

More news, from our team at The Rude Awakening…


Chris Mayer, reporting from Gaithersburg, Maryland:

"By the time the S&L crisis was over, by the early 1990s, it was by most measures the most expensive financial collapse in American history."


Bill Bonner, with more views…

*** When we asked Greg Grillot to fill us in on the recent Agora Traders’ Seminar in Boston, he told us that we missed "an epic battle."

"Not the kind of battle that involves fist fights, war hammers, crossbows and mass casualties; it was a battle of the minds…a battle to see who can come up with the best and most profitable investment idea…a battle to see who can make the most money in this market.

"Don’t worry that you couldn’t make it…we filmed the entire event, including the invaluable Q & A sessions."

*** A few months ago, your editor invested some of his hard-earned money in a pile of stones in Normandy. He had a new business in mind, which allowed him to justify the purchase to his wife. But the truth was, he just couldn’t resist an old house in need of renovation. This is not the first pile he’s gotten involved in. Nor is it likely to be the last. Nor is it in any of the "hot" areas where he is likely to make any money. Nor is it the kind of real estate that is likely to go up in price. It is a vast, old house – built before the French Revolution – in a beautiful section of Normandy, too far from Paris to benefit from the general boom in urban prices.

He only brings it up to give new readers a demonstration of his shrewd investment wit and practical economic sense. They might as well know what they are getting into.

Well, the house proved a bigger problem than your editor expected. First, we discovered a type of fungus in the old woodwork, which – upon close examination – turned out to be eating up the entire interior of the place. Alas, the beams, rafters and floor joists needed to be pulled out and replaced with concrete. The fungus is so malicious, local law required that we burn every trace of the infected wood. Apparently, it can travel through the ground to attack other houses miles away!

The next major setback was when our lawyer announced that the house was so large and so old it was not only considered an historic monument, but a public building. This was not a problem in itself, but it set off an avalanche of them. Public buildings are required to have elevators and ramps for the disabled. But historic buildings must not be altered.

"You must put in an elevator," says the High Commission for Cripples and Half-wits (the title has been directly translated from French). "You may not put in an elevator," says the Satrap of Historical Correctness.

The Daily Reckoning