During 1999, only two kinds of traders were able to make the easy money… those who really believed, and those who didn't but profited from those who did. So far this year, there has only been one trade where you will have found the easy money… short paper, long most of the CRB.
NASDAQ Composite Index
Commodities Research Bureau Index
First, the paper…
Last week started to shape up interestingly when Richard Bernstein, an analyst at Merrill Lynch, put out a very bullish report on oil prices. Though the call was hedged by inferring a cyclical prognosis (as opposed to a structural unwinding of pent up inflationary pressures), the fact remains that the growing consensus in the business community is for much higher oil prices.
This point ought to have been hammered home by Wednesday when Mr. Lee Raymond, of Exxon, on CNBC spoke loudly against tenuous assumptions for lower oil prices. He showed quite clearly that while the world is focused on a couple of million barrels a day from here (US) or there (Saudi Arabia), it is underestimating the size of a market where Exxon alone buys and sells up to 8 million barrels of crude and crude products each and every day. Every time I see factual analysis like this, I am reminded how bubble like in nature this wacky paper bull market has really been.
Then Jeffries & Co. analyst, Mark Kellstrom, on Thursday reported that an energy roundtable with important business leaders led to new analysis, which showed that due to an extremely low dollar price for oil during 1998, two important supply constraints have developed. Daily global oil production has declined by almost 1 million barrels per day since then, and more importantly, many producers have cut their exploration and capital investment spending by roughly 30% from 1998 levels. The meeting also revealed that spare OPEC capacity has been overstated and that the additional 800,000 barrels of oil per day that was announced by Saudi Arabia for release does not appear to be leaving their ports. At least one oil tanker executive was present at the meeting.
So in case you haven't noticed, there is certainly a storm brewing in paper wonderland. For what few investors have yet to understand is to what extent is this problem the result of dollar inflation, and hence, how many other supply/demand imbalances are brewing in the other commodities? In all probability, the implications for the stock market and for global interest rates are bearish.
A Brief Recap
By Wednesday, stock market bulls thought that they got what they wanted… a quick morning selling climax in the Nasdaq and the S&P500, following a similar sell off in the Dow industrials on Monday morning. Earnings warnings and frightening rumors kept flying through the street all week long, prompting contrarian (bullishly biased) market calls for a short-term bottom. The most prominent of these was Mr. Ralph Bloc's (chief market technician at Raymond James) call on Thursday for a "bear market reversal," but not until he says so, which he didn't yet sort of??
That was the day that we found out that Clinton's cancelled trip to Egypt the night before was probably a warning for what was to happen in the market that morning - the Dow dropped 300 points within 30 minutes on fears of escalating violence far too near to Israel to ignore. Now, two things came to mind. First, I guess that this surprise wasn't accounted for in the calculation of a risk premium. Second, the bulls got another nice selling climax (their fourth buying opportunity of the week). By Friday… the headstrong Bulls came out of the closet to fight again in what was perceived to be a "no-brainer" bounce after a wicked week, where all of the main US stock market indexes tested important chart support.
S & P 500 Large Cap Index
NYSE Composite Index
Both, the S&P500 and the Nasdaq composite printed an outside "day" (a technical term describing the fact that both, the high/low range was wider and the close was higher than the previous day's ranges and closing price) on Friday, and after testing support at just above 3042 on the Nasdaq (and 1325 on the S&P), both look ready to make a small move -- to 3500 (3700 at most) on ND and to about 1425 on the SP500, where significant bearish overhang awaits. From a bullish standpoint I would like to have seen some stronger volumes and a confirmation from the other blue chip indexes -- the Dow and the NYSE Composite. Furthermore, the snap back has occurred mainly in the volatile sectors that are perceived to be technically oversold relative to how these stocks used to behave in the bull market of past. And while Friday's rally hasn't even dented our bearish hypothesis, it does perhaps set up a narrow index rally for this week, as risk managers wind down their losing bearish hedges.
Dow Jones Industrial Average
If you're managing a portfolio of stocks, perhaps weighted towards the technology sector, and you think that there is substantial market (the theoretical beta) risk nearby, you have three choices: First, you can grin and bear it because you think your holdings have too much upside to get shaken out of, on an emotional whim. Second, you can sell them if you are confident enough that you can buy them back lower. Third, you can hold them and put on a hedge (buy some insurance) to protect your downside. Rather than writing call options or buying puts on every stock in your portfolio, however, you will be lured to the liquidity and economics of either index options or futures for this purpose.
Indeed, this strategy worked well for many funds in October 1999. But now, the magnitude of the drops in the individual issues is proving to be worse than the drop in the index. What that means is that you're probably losing money on the hedge this time around, and because everyone else has hedged the indexes also, chances are that the alpha risk (the risk attributable to the individual stock issues) far exceeds the beta (market) risk.
The point of this discussion is that any prospect for an index rally will likely call on the index hedgers to unwind their losing hedges, force a whole bunch of momentum into a two day rally, which will not mean that there is suddenly more money around but rather that portfolio managers are likely to jump quicker at taking the small profit on their index speculations than at cutting their general portfolio losses.
Apart from the narrow indexes…
What did last week mean to most of the industry sector charts within the overall (US) stock market?
The sum of it is that the selling last week was broad based and forced even many of the previously stronger sectors (Disk drives, HMO's, Biotech's, Insurance, Banks, and even the Real Estate Investment Trusts) into submission. Looking at the market this way (sector by sector), it becomes clear that many sectors of the market are only beginning to roll over, so forget what you hear about this market being oversold. Most industries have now either become a negative influence on the 200-day moving average, or if not yet will perhaps soon, having sliced right through it last week.
The Natural gas, Oil, and Oil services groups did not show hardly a sign of weakness, however, looking as if they want higher. Drug stocks of the bluer chip variety and the Utilities also looked tough enough to survive. On the other hand, last week dealt a fatal blow to the following industry groups:
AMEX Airline Index
Philadelphia Bank Index
S&P Retail Index1
Philadelphia Semiconductor Index
Overall, sentiment indicators were not extreme, but given the parameters defined by the long running bull market, were apparently extreme enough to bring out the closet contrarians (a dying breed in this long in the tooth bull market). There is a point there, and it is that in all probability current bull market 'models' aren't working quite as well as they used to.
The reason for that, we hypothesize, is that we are in a bear market, which brings me to my next point.
Bull Market Models
There is so much confusion about what constitutes a bull market and what should be called a bear market. Unlike so many misinformed experts, we do not use some meaningless statistic to qualify this, such as whenever indexes have been down some 20% historically; a bear market was brought on. In our opinion, the fact that most stocks (which means more than half) have been declining for 14 months, and the likelihood that the average stock price is off at least 20% from its 52 week high is all we need… to call a spade a spade.
The indexes are a statistical delusion and have served only to suck the maximum amount of money into this market. In fact, as a close friend of mine points out, this is one of the bear's survival tricks… the mighty bear will do everything in its power to keep everybody long, in order to survive.
Anyhow, the reason that financial experts point to the 20% statistic is that before now, we actually have not seen a real bear market in (US) stocks for over twenty years. And really, that is the point. Look for yourself:
30-year chart of the S&P500… Logarithmic values!
The last meaningful decline that I can see was in 1973/74 when the Dow shed something like 40% over two full very long years. Everybody lost money and it didn't matter how low interest rates fell, stocks did not go up! Compared to that, I would take a 1987 crash any day. So, perhaps if your models are not working today it is because they probably still discount a primary bull market trend, since most time series would be skewed to favor the past decade, or even two. What we are trying to tell you is that everything that has been taught about the business of investing over the past twenty years has been taught during a primary bull market.
And since many trading models are premised on a primary bull trend, whose intermediate corrections have been foolishly accepted and classified as bear market stuff, few investors yet recognize this bear, which has already taken over the stock market.
Even as some of the smarter bulls may concede that there exists such a stealth (invisible) bear market, they are confident that it will resolve bullishly. Unfortunately, they have been suckered into thinking that they are being contrarian when the sad fact is that while this has been going on (for at least a year), the stealth bear has been bringing in more and more money. Now however, rather than resolving in improved breadth and a restoration to the generally expected bullish trend, the resolution appears to be bearish for the blue chip market indexes as there doesn't seem to be any amount of money that can make this whole market "act as it should." Because we hypothesize therefore, that the US equity market has begun to roll over and develop into a primary bear market, no meaningful bottom will arrive until everyone else recognizes that we have entered a bear market. And as I mentioned in The Point of Recognition, that psychological process has only just begun.
Smells like trouble brewing here
JP Morgan and Co Inc
Chase Manhattan Corp
There is more to this picture than meets the eye. First we find out that bank derivatives and swaps exposures have been rising exponentially, then Wall Street bid the banks and financials stock prices up as recently inflated earnings drew their focus to the bullish side of leverage, then after strange unconfirmed rumors that Deutsche Bank passed on the Morgan house, the two most highly leveraged institutions in the US financial system announced a paper merger. Shortly thereafter, high yield (junk bond) risk premiums explode on default worries and rumors of large investment banking losses at Morgan Stanley emerge. Something wicked this way comes, but I am only guessing.
The inflation fallacy
"Oil prices are going to cause an economic slowdown because they are going to cut into disposable incomes and they are hurting businesses that cannot pass on the higher costs of energy. "
It didn't stop there. Bill Siedman suggested that as a result, we might see easier Fed policy soon. I don't know how many viewers CNBC has left, but I am sure there are enough to make this kind of commentary immoral. Anyhow, as I keep trying to tell my readers, monetary policy in the United States is inflationary. It always has been. The prosperity is illusory, and ultimately it must result in a considerable loss of purchasing power, which will become plain as the nose on your face on a loss of confidence in the US economy and asset prices. And as we keep trying to point out, this point is closer than the neighborhood corner store.
Sure there are tensions in the oil industry now, but many of these are the result of higher than expected oil prices… which are the result of a misfiring price mechanism in the oil market… which has been receiving poor economic signals from the dollar price of oil because the inflation of US money supply and the dollar exchange rate mechanism has forced one global crisis after another… and is likely to precipitate the wide revelation that US monetary policy itself is simply inflationary. Open up your web page to the World Economist, and you will be amazed to find reports of one inflation outburst after another every where else in the world thus far.
Well, who would have predicted…
…a breakout of violence in the Middle East just when oil prices are causing economic disruption. Any money manager who has been following the political developments in that area of the world would have made room for the possibility. That being said let me tell you right now that if global financial markets react negatively to this situation, it will only be incidental. The situation in financial markets today is intrinsically as unstable as are the politics in the Middle East. In fact, a violent exogenous shock to the financial markets is probably in the US interest, so that there is someone to blame other than the Fed and the Clinton Administration for a financial accident. Furthermore, it is also in their interest because escalating war might possibly give a new utility to the grossly abundant and misused dollars. Knowing this, are foreign policy tensions (or perhaps even war) all that unpredictable? Not, thank you.
There are extreme inflationary pressures in the financial system, which are not noticed by the majority of people because as I pointed out in Reason #2 (Why the Fed is in an inflation trap) last week, most everybody is still in denial about the dollar inflation so far - preferring instead to place blame on powerless oil cartels. Indeed, what better way to conceal the real issue than to point to a convenient supply shock for a sensible reason that everyone understands a little better than inflation?
This way, just like everyone remembers the inflation of the seventies as "stagflation" resulting from a series of OPEC supply shocks that resulted in high prices for Americans, everyone will remember this inflation as the fault of those groups which are presumed to be in control of the price of oil. There is no such group who has control over the price of anything, but there are many groups, which are presumed to control the supply of things, such as money. These groups are far more powerful than any oil cartel… they are the banking cartels of today!
Human Nature and Bretton Woods
Markets have historically made thousands and thousands of winners before feeding them to the bear. Many of today's self-made (though self declared is more descriptive) billionaires have hastily taken credit for what, in all likelihood, they do not necessarily deserve. History will not change as regards human nature; people will always take credit for success and blame others for their failure.
The stagflation of the seventies was inflation, and it resulted from a violent break down in US monetary policy. The dollar lost its purchasing power significantly over that decade, and it was Nixon's capitulation to those macro pressures, which persuaded him to break the dollar/gold link. Today's monetary system is not all that different than that one. In fact, almost exactly the same economic pressures are building today for the same reasons as the ones that grew out of the monetary inflation of the 1960's, though today they dwarf those imbalances. Furthermore, OPEC oil was priced in dollars then too, and when the dollar devalued, they simply chose to break the dollar/oil link by selling oil in other currencies.
In the end, we won the day when Mr. Paul Volcker saved the dollar at great cost to our middle classes. The Fed and the media probably resigned to blaming the Arabs in order to avoid the painful deflationary process of self-discovery, and the Arabs were probably unable to find a viable alternative to the dollar in order to facilitate global trade. So the imperialistic dollar policy was able to survive. Besides, Reagan had a few new ideas for the dollar.
Today, however, the situation is even worse than the one approaching the breakdown of the Bretton Woods system. Not only in terms of the comparative size imbalances in the trade accounts and the size of foreign claims on US dollar denominated assets and the relative proportions of excess and credit abuse and delusion, but also because for the past five years, the strong dollar policy has been capsizing other world currencies and forcing the price mechanism in many markets to miss more than a few beats.
In short, dollar policymakers have tinkered with manipulating our global purchasing power so well that everybody now wants to own dollars. It is cheaper to buy things that way, especially after you leave your money in dollars for a little while. Well, now that everybody owns dollars, the ability for the Fed to manipulate its global purchasing power continues to diminish. The credit-consumption-speculation in dollars cycle is very tired. And it will become increasingly difficult to perceive the dollar as a SafeHaven when the prices of real things (commodities) priced in dollars keep going up. This is known as inflation.
And it will happen because in my opinion the traditional utility for the dollar has reached a structural peak. Actually, it did so five years ago. Only today, it has blown a big bubble through a crack at the top of the pyramid. I suppose that I should not be surprised that Mr. Greenspan neither sees nor recognizes these inflationary pressures for what they really are. After all, he denies ever seeing the bubble in the first place.
The solution to all problems is mo' money
As deluded as Wall Street salesmen may be as to what constitutes a bear market, they are equally as deluded in their comprehension about what inflation really is.
US credit markets at the risky end have been ratcheting up their "risk premiums," high oil prices have been cutting sharply into the consumption-speculation-dollar cycle, and the stock market is top heavy. Meanwhile, the rising foreign dollar exchange rate continues to inflate our global purchasing power, but now only at the expense of the value of our foreign assets.
Here is the important part... since the conventional inference from these facts is that they are deflationary; the correct policy response of course is expected to be to lower interest rates (which will allow the money supply room to expand if the horse is still thirsty, that is). Indeed, the Fed's current mandate as the global lender of last resort, virtually guarantees it. The delusion lies in the sorry fact that hardly anyone recognizes the spike in oil prices as inflation.
Two things: First, inflation never shows up all at once overnight (at least it hasn't in the past), and second, it has nothing at all to do with demand or aggregate demand! I cannot nail this point home enough. Just like the long absence of experience with a real bear market has distorted our view on the subject of stock trends, so has the long period of money expansion and rising global exchange rate purchasing power distorted our views about the subjects of inflation, money, and credit.
A rise in the demand for a good or service that forces the price higher is NOT inflation! It is the market mechanism, simple. A fall in the purchasing power of a currency, on the other hand IS inflation. The only way to determine the difference is to try and compute how much of the rise in oil prices is due to dollar inflation and how much is due to the real demand/supply fundamentals of the market. Good luck! Even the latter is not an easy task as I have recently been finding out.
Anyhow, as if to add to the complexity, aggregate economic demand does appear to grow when there is inflation, but it never does in real terms. The demand and supply fundamentals in the crude market have not changed so drastically that you would expect this kind of price volatility.
It is my strong contention that the rise in oil prices is largely a sign that the utility of the dollar, with respect to global finance, has reached a structural peak and that the excess global overhang of dollars is beginning to manifest in a loss of purchasing power. As a result, making money and credit easier should only accelerate this process against the other "hard" assets. As Ludwig von Mises said… people are not allowed to believe that this (money) will always be allowed to grow in quantity, indefinitely. The Federal Reserve System is very close to persuading people that this is currently the case with US money policy.
Both Wall Street and the Fed were lucky on Friday that the winds of global sentiment are still somewhat bullish for the dollar at major crisis points. This shouldn't surprise anyone. The dollar chart is still generally convincing. However, should the stock market continue to weaken (as we expect that it will) and the economy recess (as we expect that it will), the long term implications for the utility of the dollar (currently global consumption and domestic speculation) ought to begin its permanent decline. As I have already tried to prove, this has already begun to show up in commodity prices even while the dollar exchange rate has been generally rising (i.e. inflating our global purchasing power).
Should people begin to believe that the Fed will always be there to provide them with ample new dollar liquidity (and we think many already do), they will begin to make the connection between continually rising commodity prices and what inflation really means... too many dollars, period. Though puzzled at first because aggregate demand appears to be slowing, eventually investors may find the temptation to exchange dollars for hard assets, which prices continue to rise, is too hard to resist. I dunno, what do you think our foreign interests will do with their excess dollar holdings in a recessed US investment environment, especially if the exchange rate value of the dollar begins to decline and eat into their own wealth? Buy more? Right then, they will average down because even as the exchange rate value of the dollar declines and the US economy recedes, they will have eternal confidence in the Nation of Storytellers.
How Fed policymakers will ultimately react to all of this is unknown to me at this point. It is unclear that policymakers other than Mr. Greenspan understand economics such as this. It is unclear even whether Mr. Greenspan himself understands how near these circumstances may actually be. What is clear is that he cannot afford to persuade himself that these dynamics are already in play because there is nothing that can be done about them short of starting a war or sending the economy into a depression. His job is to do his best to at least delay the inflationary outcome of the (perhaps unwittingly) imperialistic US dollar policy. In that regard, he is sure to focus on psychology and expectations, for the problem area is in the potentially declining global utility of the dollar, especially as a Safehaven!
Indeed, the nation's conspicuously rising time preferences have long term structural implications for the nation's capital structure and consequently, for the exchange rate value of the dollar.