The Buck Stops

Funny what a difference a year makes, isn’t it? The euro is the new darling of the currency world and the dollar, down 12% for the year, is on the rocks. The market, says Andrew Kashdan, is not quite ready to put in a major bottom and the U.S. economy will probably disappoint forecasters yet again.

The Buck Stops

The euro’s recent strength seems improbable – even baffling – in the context of Europe’s feeble economic data, until one considers the alternatives. In other words, the euro’s strength is nothing more than dollar weakness, and there’s nothing baffling about the greenback’s struggles, as Bridgewater Associates explains below. Our prediction: more euro “strength” to come.

The news from Europe seems to become bleaker by the day (a group of German business leaders said this week that they are facing the worst crisis since World War II). And yet, the euro has been gaining against the mighty U.S. dollar. If nothing else, the euro’s run-up is a reminder that there’s more to the value of currency than economic growth. In the long run, of course, it all boils down to supply and demand, and at some point, the long run catches up to all of us. The U.S. is supplying truckloads of its currency – literally as much as banks want to borrow at any particular fed funds rate.

Meanwhile, the U.S. depends on foreign demand to soak up the excess of dollars – and foreigners had been quite obliging until recently. Is it any wonder that our friends abroad might be having second thoughts, given the Fed’s declaration (by way of newbie Ben Bernanke in his November 21 speech) that government printing presses might soon be running overtime?

As we noted back on November 15, the interest rate differential favoring Europe has been supporting the euro, despite the Continent’s economic struggles. Further boosting the euro is the selling of U.S. assets, especially bonds, by foreign investors, who then reallocate the proceeds into euro-denominated assets.

Even though U.S. asset markets have been acting better lately, foreign investors are losing interest. And with the U.S. sporting a towering current account deficit, it only takes a small change at the margin to drive the dollar lower, and thus the euro higher. As the following graph from BCA Research shows, the euro is highly correlated with euro-area purchases of U.S. corporate bonds, of which Europeans apparently have had their fill. Euro-area purchases of U.S. stocks have also continued to plummet. BCA concludes that “the slow upward grind higher in the euro should continue provided that Europeans continue to avoid U.S. assets.” No matter how Europe and the rest of the global economy fare in 2003, the buck has its work cut out.

It’s no secret that the Fed has the will and the ability to get the inflationary juices flowing again. Mr. Greenspan and his merry band have let it be known that the Treasury’s printing presses will not lack for either parchment or ink – a phenomenon that Paul McCulley of Pimco refers to as, “We the people using our collective power over resources to protect ourselves.” The “protection” to which McCulley refers is the sort of monetary reflation that enables borrowers to repay their debts in less valuable dollars. Creditors would not view the process of reflation so enthusiastically. “We the people” is a nice-sounding formulation, but a monetary expansion is always a redistribution of wealth – not a collective decision to increase wealth (that would be an easy decision indeed!).

McCulley also notes with approval an implied “Bernanke Put” on private sector debt, based on the newest Fed governor’s much talked about speech in which he mentioned the possibility that “the Fed might next consider attempting to influence directly the yields on privately issued securities.”

An expansionary monetary policy can sometimes give a boost to the markets, although, again, recent history would seem to caution against a hard-and-fast rule. Notably, however, the usually bearish Stephen Roach is looking for a temporary “reflation” trade. “The recent pullback in equity markets after an eight-week surge off the early October lows,” the Morgan Stanley economist said recently, “has the appeal of an intriguing entry point. I suspect we’re about to enjoy a long overdue respite – albeit a temporary one at that. If that qualifies me as bullish, so be it.”

Yet, not surprisingly, Roach still has his doubts about “whether the policies of reflation will ultimately work,” adding that consumer durables, homebuilding, and business capital spending have all gone to excess in recent years. Roach’s qualifications are strong ones, so we certainly wouldn’t take his comment as a contrarian signal. But even though we are forced to admit that inflation can give stock prices a boost (after all, businesses pay their expenses in nominal dollars and people will invest some of the newly created money), we still have a hard time believing that the stock market is poised for another major move higher. Rather, the “reflation trade” is already under way in the commodity pits, and we suspect it is just beginning.

If Roach has become quasi-bullish, just imagine what the average salivating investor must be thinking now that brokerage accounts have stopped bleeding: “Wow, I could have made so much money if only I’d jumped back in with even more gusto.” But even after the market’s recent pullback, sentiment indicators are no longer so bullish as they were in early October (on October 11, for example, we noted that the VIX was signaling a potential bottom).

A few weeks ago, cited an investor sentiment poll that showed bears outnumbered bulls by about 43% to 29% on the eve of the October rally, compared to a recent reading of more than 50% bulls and about 25% bears. CI observed that the majority of investors were dead wrong then; will they be dead right now?

Furthermore, corporate insiders aren’t acting like the “bottom is in.” Corporate insiders may not be the most esteemed members of society at the moment, but one thing we can still count on is their self-interest. So if they’re buying stock, that’s a bullish sign. If they’re selling, well, it could just be that they’re raising cash to renovate the kitchen.

Nevertheless, the rest of the investing public would prefer to see buying instead.

That said, John Q. Investor may be disappointed if he looks to tech insiders for affirmation. Since October, technology stocks have regained a bit of their past glory, but insiders seem unimpressed. Another graph from BCA Research shows that the tech insiders’ sell/buy ratio has turned up, which indicates a decline in the value of purchases and a rise in selling activity. The ratio’s rise in late 2001 preceded the reversal of a rally. Even though the ratio is still below last year’s levels, investors might consider putting their faith in management on this issue at least.

In any event, this doesn’t have the feel of a major bottom.

As for the economic outlook in the U.S., the consensus seems to be that monetary and fiscal stimulus will continue to do their job, helping the economy get back on the growth path. In The Economist’s recent annual issue, “The World in 2003,” one writer declares that “sensible, stimulative economic policy and the underlying strength of productivity will, once again, set America’s economy apart from the rest of the world.” A year ago, the same author, while acknowledging the economic imbalances, said “the American economy will bounce back by the end of 2002…with a classic “V” shaped recession.” Let’s hope his batting average improves this year.

Happy New Year,

Andrew Kashdan,
for The Daily Reckoning
December 31, 2002

P.S. Just so we don’t close the year on a gloomy note, we hasten to add that we share The Economist’s optimism about the U.S. economy when it favorably contrasts this country’s flexibility to that of the other major economies. The unemployed may not appreciate the bigger picture, but it’s the “creative destruction” – to use economist Joseph Schumpeter’s phrase – that makes capitalism work so well.

We agree, and the U.S. allows more of it than most other countries. Thanks to another year of Fed-created distortions, however, we’ll need a little more creativity and a little more destruction to return the economy to good working order.

It is the last business day of 2002. We’d like to offer a special Thank You to the patsies. Without them…and the Fed and Wall Street goading them along…the year would have been an even bigger disaster.

While the big money has been steadily leaking out of stocks, the little guys have been stuck with the program. Only 1% of assets was pulled out of stock mutual funds in 2002. Small investors “have been the steadiest force in the market,” said Russel Kinnel of Morningstar.

They should have panicked a long time ago. The average fund lost 22.7% this year. But the lumpeninvestoriat are still believers. They still think that if they leave their money ‘in the market’ long enough – they’ll get rich.

Besides, they’ve been told that the market almost never goes down 4 years in a row. So what do they have to lose? Of course, the stock market almost never goes down 3 years in a row, either. But that’s what it has done – taking the average fund down 33%…and the S&P 500 down 43%.

And after the market has gone down 3 years…why not another?

A subscriber to Richard Russell’s Dow Theory Letters calculates that the odds of another down year are much higher than people think. Stocks rarely go down 3 years in a row, he points out. But after 3 years of falling prices, the following year is a loser in one out of two cases.

But the Moms & Pops and Widows & Orphans haven’t a prayer or a clue. They never seem to calculate the real odds of anything. Instead, they just ‘hang in there ‘ trusting the Fed, the President, or somebody to ‘do something’…until they go broke.

While the stock market relies on small shareholders…the world economy has its own patsies – American consumers. The Fed has pushed down rates so that consumers could continue spending money they didn’t have on things they didn’t need.

Economists are counting on the little guys to keep digging themselves in deeper – until businesses finally begin a new cycle of capital spending.

But a Business Roundtable poll showed that 80% of CEOs of big companies had no intention of increasing capital spending in 2003…60% of them expected to layoff more workers.

“Companies set record for Bankruptcies,” says a headline from yesterday’s news. “Foreclosures closing in on cash- strapped families,” adds a Minnesota paper.

Over the last 2 years, more than half of all mortgage refinancings have been “cash out,” meaning that the borrower added to his mortgage, took money out of the deal and spent it. Now comes the Dallas paper explaining that people who increase their mortgages by 20% or more are 3 times as likely to default.

Homeowners are adding about 13% to their mortgage debt each year or about 4 times as fast as the growth of GDP.

They’re believers, too. They think the economy will turn up…that their houses will rise in price…and that people never lose money in residential real estate. God bless ’em. But our guess is that they’ll go bust, too, before this long, slow, soft downturn finally ends.

Eric, what’s the latest from Wall Street?


Eric, brining tidings from New York City…

– The stock market and the U.S. dollar both continued to struggle yesterday. While the Dow managed a gain of 29 points to 8,333, the pathetic Nasdaq dropped half a percent to 1,339. The dollar fell to a three-year low of almost $1.05 per euro – its lowest level since November 1999.

– If stock market investors raise their champagne flutes at all tonight, they will be raising them to toast the demise of 2002 – a year that dispensed far more pain than pleasure. As a sort of financial dominatrix, 2002 tormented investors by dangling the hope of capital gains early in the year, only to deliver a third straight year of painful losses…Most investors have been crying “Uncle!” for months already.

– For gold-bugs and commodity investors, however, 2002 was sheer delight. Most commodity indices have gained about 22% this year, which compares very nicely to the S&P 500’s 22% LOSS. So if you’re looking to sip some elegant champagne this evening – perhaps some Dom Perignon or Crystal – you might try to wangle an invite to a New Year’s Eve party thrown by a gold-bug.

– Defying its myriad skeptics, gold has soared more than 20% this year. But yesterday, the yellow metal took a well- deserved breather. Gold fell $5.60 to $344.10 an ounce. The price of oil also backed off a bit, as crude for February delivery sank $1.35 to close at $31.37 a barrel.

– As we enter 2003, stocks are still expensive and commodities are still cheap. But most Wall Street strategists are predicting good times ahead for the stock market, just like they always do. It will surprise no faithful Daily Reckoning reader to learn that we do not count ourselves among the stock market optimists. We’d like to declare the bear market over and to embrace a glorious new bull market, except for the fact that stocks sell for 30 times earnings. A fourth straight down year for the stock market might be alarming, but it would hardly be surprising.

– And now…after three straight losing years, it’s finally dawning on some stock market investors that capital gains don’t arrive as reliably as a Zurich streetcar. In this post-bubble era, US stocks are more Amtrak than Swiss National Rail – as likely to be cancelled as to arrive at all. And as the stock market has become more treacherous, investors have rightly become more timorous.

– “The individual investor increasingly is preoccupied with risk, having, only a few short years ago, been obsessed only by the risk of being un-invested,” Jim Grant observes. “Bubble-related dislocations still weigh on the market and the economy, and the S&P 500, by the numbers, has still not achieved a traditional bear-market landing…The cycle will end with an overwhelming sense of revulsion toward the formerly cherished asset class.”

– The Age of Revulsion that Grant anticipates has clearly not yet arrived. Furthermore, the economy still grapples with the detritus of the bubble. – “What ails both the economy and the stock market is an extremely severe case of the post-bubble blues,” writes Barron’s Alan Abelson. “The excesses and the abuses of Corporate America and investment professionals, the soiled reputations, the revelations of astounding greed, the stunning bankruptcies, the bulking overcapacity – all ill- begotten progeny of the bubble – continue to exert a powerful and depressing impact on investor sentiment and economic activity…We’ll know it’s the beginning of a better day when Wall Street follows Main Street into total disenchantment. Hey, it could even happen in 2003.”

– …or maybe even ’04. Happy New Year from the Big Apple!


Back in Paris…

*** While the average mutual fund has taken a terrible beating in ’02, gold funds are up 62%! Even bond funds – despite all the talk of inflation – are up 9.5%.

*** What’s going on in Japan, we wonder? Or, to put it another way…what might we expect in America 10 years from now? The Nikkei Dow lost another 19% this year. Not as bad as the U.S. Dow…but it comes 13 years after the bear market began in Tokyo. People don’t even read the financial press in Japan anymore; they’re so fed up.

But it gets worse. Industrial output is “weakening,” says the Financial Times. And the plan to rescue the banks with taxpayer money is “impossible,” says the BBC.

*** At least people aren’t starving to death, as they are in Argentina…

*** State governments are looking at their biggest deficits in 50 years…

*** The dollar has dropped 4 weeks in a row…

*** It has been a “brutal Christmas” shopping season, said a CNN piece.

*** Help wanted ads are at a 4-decade low. And mortgage applications fell in the most recent week.

*** And the gratuitous family news: Sophia and her grandmother headed back to the U.S. yesterday. Sophia resumes her studies…and her grandmother will make an extended visit with her other children. At 82, the family matriarch still gets around. But she suffers from severe osteoporosis and complained of back pain before getting on the plane. We have not heard from her, but we assume she arrived safely.

We all had a good time at Christmas. Henry sang a solo in church. Edward looked misleading angelic in his altar boy outfit, except for when he was swinging his tassel like a cowboy getting ready to lasso a steer. Maria did one of the bible readings, and then joined two friends to sing a hymm.

Later, at home, Jules and your editor led guests in singing English Christmas carols. The French did a good job of singing along, though an English speaker would not have recognized the words.

Here in the office, the Christmas tree has turned brown and is listing badly. There are only a handful of people working. French law insists upon a 35-hour workweek. But most people prefer to work longer and take more vacation at holidays. It is strangely quiet.

Your editor is driving back to the country tonight for what promises to be a very dull New Year’s party.

“It’s going to be terrible,” Maria warned. “Just a bunch of deadly boring old people. Mommy invited her horsey friends…and you know what that is like.”

“Well,” her father replied, always looking on the bright side, “maybe they’ll neigh and whinny for us…and switch their tails at midnight.”

The Daily Reckoning