The Great Disconnect
The stock market and the economy have diverged. So the fundamentals are not being valued correctly. Gary Shilling explains why there are so many parties with an interest in keeping it this way.
Financial markets and the economy parted company in the late 1990s. With stock weakness this year in the face of a strong economy and robust profits, the great disconnect still exists.
The unwinding of inflation in the 1980s and 1990s spawned the long 1982-2000 bull market by driving up P/Es and profits. By the late 1990s, its length and intensity put fear to flight, leaving nothing but intense greed. Speculation rivaled that of the late 1920s, and the subsequent revelations of Wall Street and corporate malfeasance take the parallels even closer.
So powerful was that 17-year, eight-month bull market that even a three-year bear market – one which cut the Nasdaq index by 78% – was not strong enough to bring the financial and economic worlds back together. And massive monetary easing and huge fiscal stimuli actively promoted a continued separation. The nose dive in interest rates spurred housing and cash-out mortgage refinancing. Tax cuts and leaps in defense and homeland security spending pumped big money into the economy.
Speculative Financial World: Their Own World
As a result, financial speculation survived largely intact, but shifted from stocks to residential real estate and hedge funds. Those private partnerships – along with banks, brokers and other pools of capital – took advantage of cheap short-term money to invest in Treasury bonds, junk bonds, convertibles, emerging market stocks and bonds, currencies and commodities.
Evidence is rampant that financial markets remain in their own levitated world. Sure, like most services, the financial sector grows faster than the overall economy. As U.S. business expands, financial services become more widespread and more complex and make up an increasing share of economic activity. Still, the continuing upward departures from early, consistent post-World War II trends testified to the persistent disconnect from the real economy. These intact bulges are significant since corrections of the huge 1990s speculations should have taken them below their long-term trends for at least a few years.
The Wilshire 5000 Total Market Index contains almost all U.S. stocks, so its ratio to GDP gauges the stock market’s value relative to the economy. The ratio is well below its 2000 peak, but at 96% remains substantially above the 1971-1996 trend projection that puts it at 60%. Similarly, mutual fund assets in relation to GDP now stand at 64%, well above the 54% dictated by the 1984-1996 trend line.
The financial services sector, of course, benefited from the stock surge in the late 1990s, and the market capitalization of the financial stocks in the S&P 500 index leaped to 18% of the total. But after a brief setback when the market swooned, those companies were recharged by residential real estate and spread lending activity. So their market caps now account for more than 20% of the S&P 500 total. Meanwhile, the notional value of over-the-counter derivatives such as currency and interest rate swaps climbed from $90 trillion at the end of 1999 to $197 trillion at the end of 2003.
Speculative Financial World: No One Wants Reunification
Almost no one wants the financial and real estate spheres to reunite with the economic world, since the fusion could be bloody. Not the speculators involved. Not the brokers, banks, hedge funds, money managers, venture capitalists, financial TV channels, consultants and purveyors of financial data and research that serve them. Not even the administration and the Fed.
History says the two worlds will rejoin sooner or later. Still, the Fed, whether it knows it or not, is trying to prevent just such a reunion. Here’s why.
The Fed has already telegraphed its intentions to raise the federal funds rate it controls. Futures markets have so firmly anticipated future credit tightening that if the Fed does not proceed, it risks losing credibility – a no-no for the central bank.
But higher rates could be curtains for spread lenders and house prices. A serious financial crisis could turn my forecast of the good deflation of excess supply into the bad deflation of deficient demand as incomes are shattered.
But suppose the Fed succeeds in raising interest rates slowly enough that speculators can adapt without major failures. Most would probably figure that Washington had again raised the safety net so they could climb to yet a higher perch from which to take that half-mile dive into a wet sponge. They’d no doubt take even bigger speculative positions in real estate, commodities, stocks, junk bonds, currencies, etc. The gap would widen and the prospects of closing it painlessly would fall.
Sadly, the Great Disconnect of the last decade between the speculative financial and the real economic worlds will probably persist until a lot of people not only lose a lot of money, but also give up all hope of being bailed out.
for The Daily Reckoning
September 23, 2004
Editor’s Note: Dr. Gary Shilling is president of A. Gary Shilling & Co. Inc., an investment advisory and economic consulting firm and publisher of the monthly INSIGHT newsletter.
Not only has Dr. Shilling beaten the stock market by a wide margin over many years, he has provided consistently accurate forecasts to his subscribers. Twice ranked as Wall Street’s top economist by polls in Institutional Investor, Dr. Shilling was also named the country’s No. 1 commodity trader advisor by Futures magazine. And last year, MoneySense ranked him as the third-best stock market forecaster, right behind Warren Buffett.
A regular columnist for Forbes magazine, Gary Shilling appears frequently on radio and television business shows and has written six books, including Is Inflation Ending: Are You Ready? in 1983 and, more recently, two books detailing his forecast for the new world order and its consequences for your wallet.
Watch those long bonds! Instead of going down with higher interest and higher inflation rates, they’re going up. They’re telling us to beware…
George W. Bush tells us that the economy is strengthening and Iraq is on the road to peace and ballot boxes. He appears to be wrong on both points.
Yesterday, the Dow seemed to notice. It slipped toward 10,000 – again.
And all over the country, people are having trouble keeping up with their obligations.
The city of San Diego has $1.2 billion in pension benefits it can’t seem to cover.
General Motors has a glut of unsold 2004 models – so many it is offering 0% financing for six years to get rid of them. But it also owes so much in pension and health care costs for its employees it is almost impossible for the company to ever make any money. Over at Honda, each car costs the company $107 in pension and health care costs. But at GM, the cost is $1,360. You can imagine what the cost is for Chinese manufacturers. How can GM compete? How can it stay in business?
What do you do when you get in this situation?
"Welcome to the bankruptcy economy," says Jim Jubak over at TheStreet.com. You cut prices…forced by competition, of course…but you can’t cut your costs – especially the promises you’ve made to employees. Then, you declare bankruptcy. What else can you do?
Delta and US Airways, for example, were greased up by the bankruptcy courts and are now wiggling out of their obligations to pilots.
The steel industry, says Jubak, showed the way. Nucor, for example, "employs far fewer steelworkers at far lower total wage and benefit costs than it did in 1975."
Go bankrupt. Cut costs. Cut payrolls. Cut spending.
Not something to look forward to. But something to expect.
More news, from our man in the action:
Eric Fry, from Wall Street…
– Fannie Mae got caught with her hand in the cookie jar…so investors spanked every kid in the house. Fannie Mae shares tumbled more than $5 yesterday, forcing the entire stock market to share her pain. Today, they fell another $1.70, or 2.4%, shortly after open. Crude oil also took a few whacks at the market’s behind, by jumping $1.59, to $48.35 a barrel. Once all the wailing and sobbing had subsided, the Dow Jones Industrial Average was nursing a painful 135-point loss to 10,109, while the Nasdaq was 35 points lower at 1,886.
– Apparently, Fannie Mae is not the squeaky clean, do-gooder that the well-compensated officers of the company purport her to be. This sly vixen has been up to no good, according to the Office of Federal Housing Enterprise Oversight. After eight months of peeking under Fannie’s skirt, OFHEO published its findings yesterday…and what findings they were!
– OFHEO informed Fannie Mae’s chagrined board of directors that, on at least one occasion, company executives had deferred expenses in order to meet executive bonus targets, while also dipping into improper "cookie jar" reserves to boost reported earnings. The report also criticized a corporate culture "that emphasized stable earnings at the expense of accurate financial disclosures."
– OFHEO insists that its findings "are serious and raise doubts concerning the validity of previously reported financial results, the adequacy of regulatory capital, the quality of management supervision and the [company’s] overall safety and soundness."
– Fannie Mae’s shares tumbled 7%, as if the findings were a complete surprise…they weren’t. For many years, rumors of accounting impropriety have been swirling around this company like flies around a cow’s flank. Many professional short-sellers known to your New York editor have been betting against this stock – unprofitably – on the idea that the company’s impossibly steady earnings growth is exactly that: impossible.
– Thanks to the insights of these astute investors, your editor remarked one year ago (Aug. 14, 2003, to be exact) in this column: "Imagine a parent who stores crates of explosives under his baby’s crib and you will understand something about Fannie Mae’s approximate financial profile. Now imagine that the parents slide the baby’s crib and explosives over next to the radiator (in order to make room for more explosives) and you will understand something about Fannie Mae’s corporate philosophy…"
– But even those folks who do not read The Daily Reckoning every day – we call them "infidels" – should have suspected something ill-becoming at Fannie Mae. Didn’t kindred spirit Freddie Mac admit last year to "smoothing" earnings? And wasn’t this confession the trigger for OFHEO’s inquiry into Fannie Mae? And weren’t Fannie Mae’s earnings as impossibly smooth as Freddie Mac’s? Hmmm…curious.
– Now that the OFHEO report has piqued the public’s interest, federal regulators are lining up to take a peek at Fannie’s private parts. The SEC is first in line…perhaps the Fannie Mae saga is closer to its beginning than to its "unhappily ever after."
– While Fannie Mae shareholders were licking their wounds yesterday, crude oil investors were rubbing their eyes…The Energy Department reported a stunning 9.1 million-barrel drop in crude inventories for the week ended Sept. 17 – the eighth-straight weekly decline. Separately, the American Petroleum Institute pegged the size of the week’s crude drawdown at a huge 12.9 million barrels. Both organizations reported total inventories at 266.7 million barrels – the lowest level since early February, and close to the lowest level in 28 years.
– Since Hurricane Ivan brought oil importation to a halt in the Gulf of Mexico last week, refineries and other crude oil consumers had no choice but to dip into existing stockpiles. The news of falling inventories sent oil prices soaring to near-record levels, which also triggered sympathetic rallies in unleaded gasoline, heating oil and natural gas.
– "The Gulf Coast needs to pray they don’t get any more hurricanes or tropical storm disruptions, or all bets are off," says Kevin Kerr, editor of Resource Trader Alert. As Kevin’s subscribers are profitably aware, Kevin has been, and continues to be, an ardent bull toward almost every product in the energy complex. He recently closed out a profitable trade on heating oil and is shifting his focus now to the natural gas market. "Gas prices will rise sooner and sharper than most folks expect," the energy expert predicts.
– October natural gas rose 5.7 cents yesterday, to $5.665 per million British thermal units, capping a three-day, 20% rally for the "clean fuel."
Bill Bonner, back in London…
*** Fannie Mae shares crashed 7% yesterday. "Regulators have found serious accounting problems at mortgage giant Fannie Mae, prompting an inquiry by the Securities and Exchange Commission and calling into question its financial soundness," said Yahoo.
Chris Mayer, Fleet Street editor, sends this comment…
"This was bound to happen. The most aggressive of lenders, along with Freddie Mac, has swallowed about half of the U.S. mortgage market. Now we find out Fannie has been fudging on its earnings. What else are they fudging on? For years, Fannie has maintained that its book is adequately hedged against a rise in interest rates. Maybe they aren’t.
You know, Fannie rolls over something like $30 billion in debt per week. Imagine if the market didn’t want Fannie’s paper as much because of concerns over its creditworthiness? Rates would have to rise to compensate for the added risk and Fannie’s cost of borrowing goes up – further exacerbating the problem. Given Fannie’s high leverage (they have something like a 3% capital position – not including off-balance sheet stuff), they don’t have a lot of cushion to fall back on.
Well, they do have the U.S. government (read: the U.S. taxpayer). But, we all know the U.S. government does not guarantee Fannie’s debt, right? (wink, wink).
*** The electronic mailbag continues to overflow:
Here’s a note from a reader in the Dutch Antilles!
"I wanted to offer support to your stance on gay marriage. I wholeheartedly agree with you and knew your comments would draw serious flak. This is, though, the reason why I read your e-mail; I want to read something that very few will dare write.
"As it’s popular to say in the United States, ‘I’m lovin’ it’…keep it coming."
*** A comment on hurricane damage…
"I’m sick of reading how the Florida hurricanes are going to help the economy in the long run. How stupid. But if it’s somehow true that a catastrophe like this is good for the economy, then I think I have a great idea to save a lot of money. How about we abandon all our anti-terrorist activities worldwide? That would save about $85 billion in Iraq alone. Then we do away with all this airport security crap and save another bundle. Then when the terrorists start blowing up targets around the country, there will be a great stimulus of the economy as we rebuild. It seems like a win-win situation."
*** And voting…
"My only purpose in writing today is to beg you to vote, despite our deplorable choices, because that most important privilege – freedom of speech – will not fare equally under Bush and Kerry administrations – see Mogambo’s notes re the importance of lying!
"If Bush stays in – which looks inevitable – human rights worldwide will be diminished, a woman’s right to choose outlawed and our international allies convinced we’re behind that moron!
"You just THINK you don’t have a dog in this fight!!!"
*** And voting for third parties…
"I am completely *disgusted* with your conclusion not to vote based on only two selections – Bush and Kerry."
"What about other party candidates? Personally, I will be voting for Michael Badnarik of the Libertarian Party. He stands for free markets, much smaller government and minding our own business in foreign affairs. That’s what you guys espouse on a daily basis.
"You don’t have to endorse him, but just think of the contribution you could make to America if you at least acknowledged the existence of other party candidates and how they might stack up against the principles you stand for!
"Even if someone like Badnarik received only 2% of the vote, it could signal a coming wave of real voter disenchantment (as opposed to your complete apathy) that might, just might, begin to change the hopeless policies of our two default parties. Default – there’s a good financial choice of words!
"Please don’t advocate not voting. Instead, advocate voting for a third-party candidate!
*** And on marriage…
"As to marriage being ‘the work of the gods, of Nature…of God himself,’ I believe marriage was an institution contrived by tribal people to maintain order in the tribe and to ‘possibly’ prevent other male tribal members stealing one another’s women, although there have been several cultures in which tribal members enthusiastically shared their women with one another, and apparently quite happily so.
"I would assume this cut down considerably on the divorce rate and much male physical conflict if everyone was ‘getting some.’
"As far as this ‘God’ Bill speaks of is concerned, if (he, she, it) created any of this earthly mess, I simply cannot see the logic or plan to it, unless it was to punish every living thing higher on the evolutionary scale than a gorilla, to show them that this was one project (he, she, it) totally screwed up.
"It appears that the ‘works of man’ will in some way soon decimate the Earth and its beings in such a way as to set the program back a few million years so it can get a new foothold on a more productive path. Perhaps by just stopping with plant life and leaving the crawly, swimmy, flying things out of the picture in the next round."