The Stress Test

By: Ed Bugos | Wed, Jan 10, 2001
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When Arthur Burns (allegedly in 1973) said that this process can take 25 years, or it can take 100 years, before it destroys mankind, he had no idea that the statement would only inspire his protégé, Alan Greenspan. He was referring to the changeover from a gold standard to a paper Fiat system of dishonest money, though arguably, that changeover probably occurred years earlier anyway. -- Edmond J. Bugos

The game is afoot! Of course, it is not really a game; it is your life, and your life savings that are about to become annihilated through a desperate push on the interest rate lever by the Federal Reserve Board. How do the guardians of your money justify this action? Well, that is a topic of discussion we will have to pursue today. But first, have a glance at the following charts. They are all interrelated, right? Yes, even if very different fundamentals affect each of them, there is one common denominator that directly affects all of them. No, it is not the economy. It is the value of money.

NYSE Composite
NYSE Composite Index
Two Year Bond Prices
Two Year T Bond Prices
US Dollar Index
US Dollar Index
CRB Index
Commodity Research Bureau Index

But which asset is going to benefit the most from this, or any future, interest rate cut? Since Wednesday, the real winner so far has been short-dated (less than 2 years) treasuries, as Wall Street players expect the FOMC to continue to cut, and cut, and cut, interest rates until the economy (stock market) shows a marked improvement in tone. Of course, four days makes absolutely no material difference, but in order to get you thinking in the right direction, consider the relative performance of the above four asset classes since last Tuesday's close:

Ranked in order of 4 day % return1
Commodity Research Bureau index + 1.55%
Dollar index + 0.50%
Stocks (NYSE Composite) - 0.50%
Bonds (30 year treasury securities) - 0.70%

In order for the rate cut to actually work, either for stocks or the economy, there must be no other inflation to compete with. For the record, we do not count the CPI because it is not an inflation indicator. Its main value is to the Fed, and it is designed to deflect the truth, not to measure it. Every change in the calculation of the CPI since Arthur Burns (Chairman of the Federal Reserve Board during the Nixon era) invented the "core" inflation model has only obscured the fact that inflation "is" our system. Nevertheless, the inflation is beginning to manifest as a loss of real purchasing power in the dollar. This is not in any way arguable, yet it is understated in the government's inflation data, which for our purposes is simply a government declaration.

Indeed, Mr. Greenspan does not worry about inflation nearly as much as he might worry about an "inflation breakdown." This may sound like a change in terminology for us. Perhaps the reason that it sounds odd is that most investors incorrectly perceive that there has not been any inflation this decade when in fact, it is the foundation of our entire economic system. There has been nothing but inflation, which really only means any expansion in the money supply. The inflation breakdown that we allude to is what Ludwig von Mises might call the "crack up boom," or what we might otherwise refer to as hyperinflation.

The inflection point in that economic inevitability is in large part psychological, in that as long as people generally believe that prices will come back down, the breakdown can be contained, or postponed. Some people believe indefinitely. But we do not. Indeed, we continue to see bunches and bunches of evidence that the US dollar, and economy, are approaching this point of inflection with the speed of a Concorde jet (pun intended)… not the least of which is the observation that the pilot is himself, is a dice roller.

The Rate Cut
Anyhow, that was still quite a surprise. We did not anticipate a rate cut of such magnitude, and so early on in the game. Clearly, something on the horizon has made the FOMC flinch. Having said that, we do anticipate the increasing likelihood that it will not work. The reason? Because.

Ok, there are a few reasons. For one, and as we have already mentioned, liquidity seeks out inflation (Doug Noland). Another way to put that is, more money cannot stimulate economic activity, period, only more inflation. To be sure, this process is not entirely predictable, as human preferences (psychology) play a significant role. Nor can it be forced into certain assets over others, which we know from axioms such as "you can take a horse to water, but you can't make it drink." But, we can use this knowledge as a guide to expand our perspective. For instance, if it is true that inflation only works on what has already been inflating (or is inflatable) then it is obvious that the target of the rate cut should not have been the stock market.

Since Bush has yet to be inaugurated, then it is also not likely that the rate cut is part of a new economic plan to let all the markets "go," find their free market equilibrium (for better or for worse), and deliver us from this (evil) monetary socialism. Wouldn't that be fun? Though I doubt that anyone's gonads are quite that large.

That leaves the credit markets, and thus, the dollar. Since the only already inflating paper within the credit markets are essentially government treasuries and perhaps (still) the issues of certain Government Sponsored Enterprises, though I have not checked these lately, then clearly this is one place where the new liquidity might go. In fact, this is also one place where the Fed can generally make it go, for a while anyway. At least until investors begin to recognize that there is no end to the amount of currency that Mr. Greenspan et al are willing to provide. Though, we think that point is already behind us. Perhaps that is why the bond has performed so poorly in the relatively short time span covered by the table, above. But is this the intended target?

Of course, the FOMC would not be targeting the general economy with the rate cut, for it must know that the consequence of such an action is as moot as it is in the case of the stock market. Well, maybe not if they are listening to Alan Blinder (ex Fed governor) these days.

Mr. Blinder hopes that the FOMC is gearing money policy to the economy, not the Nasdaq. What? Where do these guys come from? This, we will have to rewind a little bit. First of all, since when does a central bank take its signal from the economy, rather than from the interaction between the demand and supply for money? Secondly, does not the economy already include the Nasdaq anyway?

Also, when he speaks about the economy, I think that what he really means is consumption, which is credit driven, or has been. Though the credit bubble has burst, perhaps he thinks that the credit cycle is still intact… meaning still inflatable. Not likely. Lenders have got to be feeling more risk averse these days, and borrowers must certainly feel over borrowed, especially if a good sized portion of either of their capital has been blown up in the stock market. Furthermore, monetary policy can perhaps influence the broad risk premium (risk aversion) under normal conditions, but only if the "financial" asset inflation can still work.

So here we come, full circle, back to the stock markets. After all is said and done, our feeling is that this is precisely the target of FOMC action last week. Why? God only knows, but the reason that we think so is because the timing could not be more stock-market-bound, if it were planned by Greenspan himself (Oops). Please, bear with me.

Lessons of a Stock Operator
The first thing that one learns in stock promotion 101 is that when they want to get out, do not get in their way. Jesse Livermore2, for instance, knew that a promoter could only accentuate a trend, though both him and Murray Pezim3 must have gone to the same school of insane extremities. The second thing one learns is that if "you don't know whom the sucker is when you look around the table then it is probably you." In other words, if the FOMC thinks that it is doing the public (or the financial system) a favor by providing them (it) with liquidity, guess again. The public is last in line… simply another source of liquidity, though not as good a source as last year. What is really going on is that in trying to "manage" the stock market correction, many dealers have bought way too much stock. Maybe the rate cut will help them get off of these positions, or to at least square them.

But then what? We have already established that monetary policy cannot be used to "re-ignite" stock market speculation while other things are inflating. Especially just as investor psychology shifts toward panic mode, which is indeed what was happening (but had not yet "happened") prior to the rate cut. Furthermore, the move was made ahead of the bad earnings warnings and reality check season just ahead of us this month.

Suckers. I wonder who really pushed their button? To be sure, nothing came out of the rate cut (so far) except for more anxiety that Greenspan, and the FOMC, know something that we do not... I should say that anyone except for our well read readers. But word is spreading.

The Press "almost" Got It…
For we know exactly what they know. That the Greenspan productivity argument is going down the sewer faster than a surprise narcotics bust.

In what seemed to be a special meeting of the minds on the infamous stock channel, CNBC, Friday after the market, Bill Wallman (from Business Week) and Larry Kudlow (Chief economist at ING Barings) attempted to experiment with their open minds a little, perhaps a New Year resolution. Puzzling over the rate cut and the jobs (employment) report, they almost had it right when they observed that not only was there no surprise in the jobs report, but that average hourly wages continued to accelerate and total hours worked on the week declined, again... right then, and I kid you not, they had to go to a commercial... and never came back.

But in any case, thanks to them, I am convinced that the point of recognition for the inflation "breakdown" is closer than it otherwise may appear. Those two facts, rising wages and declining hours spent working, infer a productivity adjustment, and perhaps the first of many.

Average Hourly Earnings
Average Hourly Earnings YOY% Source:
Average Work Week
Average Work Week Source:

The Bear Bites Back as Greenspan offers up another Selling-Op
The Put/Call gave off another near precise sell signal (in US equities) after the rate cut, and stayed in sell territory until Monday morning, this week. The financials might get some kind of a lift this week, but we think not, because traders have already discounted several rate cuts, there, and have yet to discount serious credit problems. Meanwhile, the Biotech's are in the process of breaking down, and the rally in the Retail group has already discounted a good fourth quarter, which makes no sense at all since Xmas sales are probably gonna disappoint?

Nevertheless, the reason that we really do know that the target of FOMC policy was the stock market is that the move came just as the Nasdaq went into crash mode, early in the week, and it came just as the SP500, as well as a number of other global stock markets, including the London FT index, the French CAC, and the German DAX, were headed off to new lows… many of these averages having already decisively moved through important support points the week before last.

S&P 500 Index
S&P 500 Large Cap Index
NASDAQ Composite Index
German DAX Index
German Dax
French CAC Index
French CAC

Still, by the end of the week, we saw no bullish bias develop in any of the averages, as a result of the easing, except for the Dow Transports, where last month's decline in crude prices will probably give their 4th quarter bottom line a boost this month. The weekly chart on the transports is convincing, but the earnings play cannot have legs if our inflation hypothesis is correct. Sure, some costs can be passed on, but fuel and labor are the transportation industry's largest cost components. Besides, the sector has a big negative going against it - it is still a bear market for almost all stocks.

Dow Jones Transportation Average
Dow Jones Transportation Average
Light Crude Oil Futures
Light Crude Oil Futures

And it is still a bull market for most commodities! Besides, and just with respect to oil, there is just too much stimulus on the horizon to neglect the buying opportunity:

o The (suicidal) prospect for lower interest rates,
o The likely prospect for a lower dollar,
o Probable output cuts in the Middle East,
o Possible war in the Middle East,
o The prospect for more general inventory shortages,
o The substitution economics of higher Natural Gas prices,
o Republican motivated tax cuts,
o A Bush oil industry incentive (he is from Texas you know)

Besides, the chart looks great, putting in a higher low and teasing us with a tricky dip. Last but not least, please do not forget our hypothesis, runaway inflation rates reminiscent of the seventies, or worse. Seriously.

Why the Yen carry cannot work this time around…
The Swiss Franc, Euro, and Aussie dollar gained the "most" momentum last week, in that order. The British Pound extended its momentum nicely too... and so did the Yen, but on the down side! Thus, the trade of the week = Euro/Yen, leaving out the Franc for simplicity. Undoubtedly, this combination is not great for gold, but is it sustainable?

Euro Index
Japanese Yen
Japanese Yen

Goldman Sachs strategists have been talking up the Euro, but have not really mentioned the Yen. Perhaps they (smartly) thought it best be left to the misinformed media to tell us why it is down. The general (financial) media, of course, has lots of explanations for why something has already happened. In Japan, for instance, the economy is still seen to be sluggish and wholly dependent on the US economy. Furthermore, we keep hearing that the country is mired in political turmoil. So we did some quick checking up on that.

First of all, the European economy too is dependent on US trade demand. Both regions have significant trade surpluses with the United States. Second, we found a few interesting reports on the state of affairs in Japan:

In contrast to Bank of Japan Governor Masaru Hayami's continuous optimism for the nation's economy, a growing number of analysts here have begun expressing concern about renewed moves toward deflation - Asahi news, Japan.

How does that reconcile with a decline in the Yen? And from WorldNews,

Japan's Prime Minister has gained more power in a shake-up, which will halve the number of government agencies. Peter Martin reports from Tokyo:

From this week, Japan will have just 13 government ministries and agencies instead of 23, and one of them will be a new super Cabinet Office, reporting directly to the Prime Minister and overseeing the work of every other arm of government. Prime Minister Yoshiro Mori says the changes are designed to ensure that Japan's elected government runs the nation rather than an unelected elite. But, the Prime Minister's critics are skeptical. One says he's changed the container of Japan's government, not what's inside - Worldnews (, Australia.

Perhaps, but the new container should cost much less. Anyhow, sounds like good news to me... much better than Clinton's illegitimate budget declarations, and better than any initiative we have heard to reduce government on this continent. Furthermore, Japanese car sales came in rather strong on Friday:

Sales of new cars in Japan - closely watched as a sign of economic health - rose for the first time in four years, according to data compiled by the Japan Automobile Dealers Association. The association said sales last calendar year rose 2.7 per on last year's figure, fueled by a 9.1 per cent increase in December alone - Financial Times (, Jan 05, 2001.

So as for an explanation to a declining Yen, that which is offered up by the general media does not suffice. Perhaps a better explanation is that the Japanese need to diversify their enormous official dollar holdings? Or perhaps, the ECB, the Fed, and the BOJ are cooperating on a covert version of the Plaza Accord? Maybe Goldman Sachs is putting on another carry trade? We aren't sure, but we also have a hunch that it is not sustainable.

For, as far as a destination for investment capital, we like Europe in the long term, but are very apprehensive about its short and medium term economic prospects. Primarily because their stock markets are in trouble too, but also because Euro businessmen have been buying so much US stock and companies, quite expensively. On the other hand, with regard to investment prospects, we love Asia, and Japan, for a few reasons:

o Capital will someday want to move to where there is real profit potential... inevitably that means Asia, the largest pool of cheap and industrious labor in the world.
o Lumber prices have dropped 50% over the past year, attributing mainly to a glut of Euro lumber and an onslaught of Russian lumber, but which will be available for export to developing Asia.
o Japan is a net global creditor.
o Political reformists in China continue to make progress.

And finally, if our economics are indeed correct, the problem with capital markets today is at the core, monetary. Discretionary Fed policy has created the current dysfunctional environment and accompanying investor anxieties. Investors may soon "see" what is largely "seeable," that the dollar no longer is able to hold its value. And they may one day find that the Fed Chairman has lied to us. Thus, if it is a monetary problem, which we thought just could not happen in this day and age, why would capital flee to a brand new currency, backed by the same discretionary policies, and without a real history of purchasing power to speak of? Furthermore, who is going to trust a central bank that is really a Fed front?

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Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of, one of the original contributing editors to and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

The editor is not a registered advisory and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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