Irrational Exuberance Revisited!
"But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade" - Alan Greenspan, Chairman Federal Reserve, December 5, 1996.
It has always been baffling that Fed Chairman Greenspan was so concerned with the sharp rise in the stock markets in 1996 yet later was largely silent as the stock market roared to even higher extreme valuations by 2000. Indeed the extremities in asset valuations seen at the end of the millennium were caused in no small part by the easy monetary policy of the Federal Reserve during that period. Of course some of the massive liquidity injections during the latter part of the 1990's were fueled in part by the US Dollar crisis of 1994-1995, the Asian Currency crisis of 1997 and again in 1998 along with the Russian Ruble and Latin American currencies and LTCM meltdown, Y2K in 1999, and finally September 11, 2001.
Of late though we have been witnessing another round of liquidity injections into the US market. Over the past six months money supply as measured by M1 is up 4.9%, M2 up 4.7% and M3 the broadest measure of money supply growth up 4.6%. Annually that is 9.8%, 9.4% and 9.2% respectively. For all of 2002 the respective growth was M1 3.1%, M2 6.6%, and M3 6.6%. The sharp growth in M1 in particular is a departure from the norm as M1 is currency in circulation, traveler's cheques and demand deposits. Further there has been a series of injections via a mechanism known as repurchase agreements (repos) whereby the Federal Reserve adds liquidity to the system by purchasing securities for cash.
The concern of the monetary authorities is that the economy is weak, therefore a combination of low interest rates and massive injections of liquidity should allow for economic stabilization followed by growth. Interest rates have been effectively falling for the past few years and there are calls that more are on the way. The monetary growth came largely during the period of uncertainty surrounding the war in Iraq. The economic numbers remain mixed and job growth, which is important to any economic recovery, continues to slide. Not a positive sign.
So it is always surprising to watch the stock market soar to new heights on the back of what should be bad news. We can only guess that the excess liquidity instead of going thus far into the economy to create job growth and for that matter business investment which also remains moribund is finding its way into another speculative bubble in stocks, bonds and real estate. Certainly the consumer continues to live off of his credit cards as consumer credit rose 4.5% in the first quarter and over 7% in April. We can only wish the economy and incomes were growing as fast but they are not. What this raises, as some noted analysts have pointed out, is that the velocity of money is slowing. The velocity of money is measured by dividing GDP growth by monetary growth. Despite the rapid monetary growth it is not translating into any discernible economic growth. This is a trap that we have been seeing now for years in Japan and we also saw it during the Great Depression.
Right now the bulls continue to be in charge. On a chart basis the bulls are becoming increasingly excited because not only are we trading above some key long term moving averages (chart below we are above both the 13 and 40 week moving average) but we have penetrated above the neckline of what appears as a massive head & shoulders top on the S&P 500 that was formed from 1998 to 2002. This head & shoulders top has long-term targets down into the 300's. Indeed based on the chart there is potential to go as high as the congestion zone that formed in the rally after September 11, 2001 that could take it to the 1050-1100 range.
While it is clearly possible we don't put a lot of stead in it. We respectively point out that the Tokyo Nikkei Dow also made a massive head & shoulders top from 1987 to 1991. Over the ensuing years the Tokyo Nikkei Dow made at least three forays above the neckline of the head & shoulders top before finally succumbing. Curiously enough the first forays were made in 1993 and again in 1994. The first one was three years after the top that was made in 1990. This corresponds quite nicely to the pattern we are seeing for the current S&P 500.
The massive liquidity injections into the financial system over the past several months, largely corresponding with the war in Iraq, has also being accompanied by a declining US Dollar, and announcements of massive tax cuts that seem destined to increase the US deficits even further than they currently are. Recent studies have noted that US deficits could grow to $44 trillion based on forecasts as a result of obligations and the impact of the tax cuts. If these forecasts are correct then the US Dollar will fall further and some have suggested it would mean the bankruptcy of the USA.
There are of course numerous risks going forward. While the bulls like to say that the market is climbing a wall of worry this would have considerable more impact and meaning if the market were not so overvalued to begin with. When the market began its climb over a decade ago the Price Earnings (P/E) of the S&P 500 was closer to 15-17 rather than today's 35 plus. To those who continue to believe that this is a new paradigm we can only say no it is not it is merely a period where too much money is chasing too little paper fuelled by the massive liquidity injections. As we pointed out earlier rather than finding its way into productive investments that would result in an improving economy and job growth it is once again chasing paper. Ultimately all paper is worthless.
Recent bullish consensus numbers show that the number of bulls in the market has hit well north of 70%. This is a very high number suggesting that even if a major top is not in that at least some significant correction may be soon upon us. As well it is clear that the corporate malfeance that plagued the market in 2001 and 2002 is not over with the recent announcements of both a criminal and regulatory investigation into Freddie Mac (FRE-NYSE) the giant mortgage securities firm. We note that as well Freddie Mac makes extensive use of derivatives. Warren Buffet has described the $100 trillion plus derivatives market, of which over $24 trillion are with one institution J.P. Morgan Chase & Co. (JPM-NYSE), as financial weapons of mass destruction. While we may not go quite that far there has been very serious derivatives blow-ups in the past most notably the Long Term Capital Management (LTCM) debacle in 1998.
The Freddie Mac investigation we believe signals the top in the financials. We would avoid financial stocks. But financial risks are not the only thing lurking in the background. Of bigger concern might be political risks. One of the biggest risks of course is the so called "road map" to peace in the mid-East between Israel and Palestine will be derailed by extremists on both sides as has happened in the past. Already there are clear signs that this will occur.
As well Iraq remains a cauldron that could explode, as the US invasion has clearly become a US occupation. Buried in the news is continued scathing reports about not finding any weapons of mass destruction, which was the prime reason the war was launched. The leadership of Tony Blair of England is under heavy attack over this issue and there are cries emanating in the US as well directed at the Bush administration. As well there has been almost daily attacks on US servicemen in Iraq many of which have resulted in deaths since the declaration of victory. The occupation of Iraq is becoming a colonial guerilla war. Little of the aid promised to Iraq is forthcoming as the country is mired in poverty with most people unemployed amidst growing dissension. Meanwhile it is costing the US $3 billion a month to maintain forces there.
Finally while on one hand there are signs of deflation in the economy (which will be exacerbated if a debt collapse starts) there are also inflationary pressures mostly coming from the energy sector. Even Fed Chairman Alan Greenspan has gotten into the act here with his notes on the growing pressure on natural gas prices. Like oil, natural gas reserves are dwindling. And with gas there is a shipping problem. One potential source of huge reserves is in Central Asia (Caspian Sea) once again emphasizing the importance of the region not only for its energy resources but the potential for it as a geopolitical cauldron.
All of this continues to have us supporting gold as the one key investment going forward. Our second chart shows the Dow/Gold ratio. What is particularly interesting here is that even as the stock market has surged forward over the past few months it has done little for the Dow/Gold ratio. Since topping near 42 in 1999 and forming a giant symmetrical triangle top through 2001 it has been in a downtrend reaching as low as under 22. Since topping the 40-week moving average has stopped all rallies.
For the past few months we have been trading in a downward drift against the 40-week moving average. This is a bearish pattern and signals to us that the downtrend should resume. This continues to favour gold investments over stocks. While the recent liquidity injections have played a big role in the recent stock market rally irrational exuberance has once again raised its ugly head. Investors would be well advised to heed the charts and batten down the hatches.