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Today's Market WrapUp  10.29.2003  Mon  Tue  Wed  Thu  Fri  Puplava Archive

SPECIAL EDITION
Last Bear Standing
BY JAMES J. PUPLAVA, CFP WITH ERIC KING

Fundamental Review
by Jim Puplava

Bullish sentiment has become ubiquitous. You’ll find it everywhere you look. It's on the cover of investment and business magazines. It makes the headlines of morning papers. Nightly news casts proclaim the obvious; markets are moving up and the good times have finally arrived. In Washington, politicians point to rising stock prices as verification of economic policy. On Wall Street, investors are told they can expect more of the same. Investors will find few dissenting voices today. The dominant sentiment regarding markets is all bullish. Most bears have gone into hibernation. If you can find a die-hard bear these days, it is rare find indeed.

The bulls have a plethora of reasons as to why this bull market has plenty of room left for advancement. The economy is growing rapidly at the best pace in nearly two decades. Corporate profits have improved with most companies beating estimates. Fed policy is accommodative and should remain so for the foreseeable future. Consumer spending has remained resilient in spite of job losses and mounting debt burdens. It is hard to find any negatives detractors from Wall Street’s bullish view of the markets. The main perceived headwinds to a sustainable recovery are household and corporate debt. Consumers are taking on a record amount of debt. Household debt has recently climbed to 110% of household income with savings at near record lows. The only worry is that consumers may be forced to retrench as the benefits of tax cuts and mortgage refinancing wane. A Fed report on consumer financial obligations shows that the ratio of obligations to income is close to an all-time high. Despite the high ratio of debt payments to income, the Fed report indicates there are very few signs of distress.

Consumer Debt Mounting

One of the main factors holding up consumer spending is still the real estate market. Mortgage refinancing continues to remain positive. Home sales remain strong. The housing sector persists as a key indicator for gauging future consumer spending. As long as rates stay low, creative financing still makes housing affordable. Many of today’s buyers are using variable rate mortgages or short-term fixed rates in order to qualify and purchase a new home. Even though rates have risen from their May lows, they are still low by historical standards. Housing has become even more important to the economy since it has become the main source of strength that undergirds consumer spending.

The economic recovery is predicated on the strength of consumer spending. Consumer spending in turn is dependent on the strength of housing. The housing sector is then dependent on low interest rates. The whole scenario rests on interest rates remaining low for as far as the eye can see. The one uncertainty that could bring everything to a screeching halt would be a sudden spike in interest rates. A spike in interest rates is the economy's Achilles heel. What might cause interest rates to suddenly move upward is a surprise jump in the inflation rate or a sudden plunge in the dollar. What we do know is that interest rates won’t remain low indefinitely. It is question of timing. The credit markets are currently forecasting an increase in the fed funds rate of 50 basis points by next summer.

If rates rise, what will be the impact on the housing sector? And in turn, what will happen to consumer spending? Housing will be a key indicator to watch going forward. Real estate loans now make up over 50% of all bank lending and mortgage debt now comprises over 70% of household debt. If real estate rolls over, the whole economy could go down with it. It is one reason why the Fed is expending so much effort in convincing bond investors there is no reason to worry over higher interest rates or inflation. The bond market has become a high wire act where it has become a question of who will flinch first--the Fed or bond investors.

Corporate America Not So Strong

If the bulls remain sanguine about the prospects for the market, it is because they believe that business spending will eventually kick in. And when it does, it will replace consumer spending as the main driver of the economy. Yet, the same debt problems that plague consumers also shadow corporations. Despite low interest rates, the creditworthiness of many companies remains fragile. According to a recent report done by CFO.com, the recent improvement in corporate credit has more to due with rising stock prices than it does the pay down of corporate debt. In their article, CFO Magazine cites that most major issuers of debt have not shored up their balance sheets as is widely believed.

In fact, just the opposite has occurred. The main reason that debt ratios have improved, according to Moody’s, is higher stock prices and lower asset volatility. When stock prices rise, debt ratios such as debt-to-equity and debt-to-total capital improve. The improvement so far has had more to do with rising stock prices than it does falling debt. Total liabilities of nonfinancial corporations have risen by $3.56 trillion or 55% since 1997. [1] Furthermore, many of the assets that stand as collateral in support of this debt remains questionable since it reflects goodwill. Goodwill is a non-earning asset unlike plant and equipment. Companies have been forced to write off hundreds of billions of worthless goodwill over the last few years. A rising stock market has kept a major portion of this goodwill on the balance sheet even though it reflects malinvestments left over from the 90’s acquisition boom, a time when companies overpaid to acquire assets.

The corporate debt overhang, like consumer debt, presents a problem if rates rise. Companies that carry high debt loads at a time of anemic economic growth are faced with the problem of how to reduce debt without impairing the products and services that are necessary to maintain business growth. While debt ratios look good on paper it is mainly due to paper gains and not any real improvement in corporate financial health. Debt at the corporate level is one reason why, in addition to excess capacity, business spending and investment remain low. It is very doubtful whether business spending could kick in and replace consumer spending when the consumer finally rolls over.

Less Bang for the Fed's Buck

Even more worrisome for the Fed is the fact that money velocity is contracting. Velocity measures how many times money turns over in an economy. Under our present fiat money system, the money supply can be increased without limit. There is nothing backing it, so government can increase the supply of money as much as it wants. The only limit to its expansion is the desire and demand for money. The corollaries of money supply and demand are quite simple. The more rapidly the quantity of money increases, the lower the demand for it tends to be. Conversely, the slower the rate of money growth, the higher tends to be the demand for it. From a Fed policy perspective, it is the velocity of money that becomes paramount to the success of Fed policy. If the Fed expands the supply of money and credit in the financial system, it wants to see that money turnover. If you get a check or loan, you usually will end up spending that money. In turn the money you spend with others is also re-spent. This additional money is spent and re-spent over and over again increasing the turnover of those dollars within the economy. The higher the velocity of money, the higher the turnover of dollars and the more effective Fed policy becomes. A higher money velocity means that the Fed is getting more bang for the buck and conversely the lower the velocity the less bang the Fed is getting through its monetary efforts.

Regarding money and its turnover within the economy, there are four factors that influence its outcome. These four factors change people’s preference for either spending or holding money.

Factor #1  Change in Price
The first factor is the change in price for goods and services. When prices rise rapidly, as they do in periods of inflation, consumers' desire for holding money diminishes. This is because they perceive money to be less valuable because it will buy less in the future. Therefore, there is a preference for spending money now before prices rise for goods. Inflation erodes the purchasing power of money, so there is a desire to hold less of it. Conversely, when the supply of money contracts and the prices of goods and services fall, there is a greater demand for money because falling prices enable money to buy more in the future.

Factor #2  Availability of Substitutes
A second factor influencing money velocity is the ability to find substitutes for holding money. Examples of substitutes are gold and silver and other tangible, hard assets. When the supply of money is rapidly increasing or eroding its purchasing power, there is a desire on the part of consumers to hold other assets such as commodities. In the same manner, if the supply of money is decreasing, then the demand for money increases along with its purchasing power. Therefore, consumers desire to hold more cash because during periods such as a depression or deflation, holding on to cash affords greater security. During times of depression and severe deflation, the individual is less confident in financial institutions and their solvency, so they prefer to hold on to their money, thereby decreasing its velocity or circulation within the economy.

Factor #3  Credit Supply
The other two factors that influence the demand for money are the supply of credit and the rate of interest offered on holding money. When credit is ample and easily obtainable, then there is less of a desire to hold money. Conversely, if credit is tight and the ability to borrow money is difficult, businesses and consumers will increase their desire and preference for cash. The supply of money in the financial system affects both the preference and the desire to hold or not to hold onto cash. When the supply of money is expanding and the financial system is flush with cash through rapid money creation, then money velocity increases. Loans and credit are amply available. The opposite situation holds true when the supply of money contracts as it does during a recession or depression. During a recession or depression, money supply contracts as a result of loan defaults, delinquencies, bank failures, and tightening credit standards. During a depression, consumers and businesses hold onto money because they desire the ability to meet their payment obligations when they come due. So, money velocity decreases as the desire to hold money increases, thereby lowering the velocity of money or its circulation within the economy.

Factor #4  Rate of Interest
The final factor that influences the desire to hold or not hold money is the rate of interest offered on holding cash. A rapid increase in the supply of money can lower the rate of interest offered for money in the short-term. Preventing the rate of interest from rising requires a larger and more rapid rate of credit creation. This becomes a trap. In order to keep the rate of interest from rising, there is an increased requirement for even larger and larger amounts of money creation and credit to be provided to the system. Eventually, the only course of action is to allow the rate of interest to rise or the government risks the destruction of the monetary system.

Where We Are Today

This is exactly the point where we are presently. The rate of return on money is negligible. A saver today is earning a negative return on cash when inflation and taxes are factored in. With 1-year T-bills offering only 1.26% in return, a saver is earning less than the going rate of inflation. It gets even worse if you factor in federal taxes which are owed on the interest. As the graph of M-3 clearly shows, the supply of money has been expanded at ever increasing rates to keep the system supplied with money, to replace the destruction of credit that has been destroyed through default, and to prevent interest rates from rising. Yet recently, the supply of money has been contracting and the rate of change has fallen substantially. This reflects the slowdown in mortgage refinancing and the falloff from this summer's tax cuts, both of which helped to expand the money supply.

Today the demand for money is decreasing as reflected in not only slower money growth, but also in the decline of money velocity. This is due to the occurrence of deflation in the manufacturing sector. Prices for most manufactured goods are falling. GM and Ford both reported lower sales for last month despite sales incentives and attractive financial terms. When the supply of money contracts as it is doing today, there is less money to buy goods so the prices of goods and services fall. With the expectation that prices will fall even further, the demand for money increases and thus the velocity of money declines.

Another factor I believe that is contributing to the drop in money velocity is tightening credit for commercial and industrial loans. Most banks have become hesitant to loan new money for commercial or industrials enterprise. In addition most businesses have been reluctant to borrow money since sales and growth opportunities have been minimal. You aren’t about to borrow money when your sales or capacity levels for production remain soft. Why expand or borrow money when the opportunity for expansion does not exist? With credit not as easily available as before or if obtaining it becomes more difficult, the desire to hold cash increases. A greater demand for holding money rather than spending it reduces the circulation of that money in the financial system.

What This Means to the Markets

There is not enough time in today’s essay to cover all the reasons why money demand growth is falling or why money velocity is falling rapidly. What is important to understand here is that without an increasing money supply or increased velocity of money, the wherewithal to keep the markets and economy levitated becomes limited. The rapid rise in the stock market this year corresponds directly with an increase in the supply of money. Now that the supply of money is contracting, there is less money to keep the economy and the markets expanding. This will become critical in the months ahead because this is a liquidity driven market. The stock market is liquidity-driven. As the supply of money and credit contracts, so will the markets.

We have now arrived at a point in time where the monetary environment has become highly unstable, possessing the potential for both major deflation and inflation. In its attempts to prevent the occurrence of deflation, the Fed increases the danger of creating inflation. The Fed believes that it can reverse course immediately if the inflation dragon rears its ugly head. However with an economy this heavily leveraged, it won’t be so easy this time around. Just imagine what happens to the mortgage and housing markets if rates suddenly turn upward? Higher interest rates would shut down the mortgage refi markets and without that additional credit, consumer spending would come to a screeching halt.

On the corporate side of credit, what will happen to corporate debt ratios if stock prices suddenly turn down in the face of higher interest rates? Many of today’s debt-laden companies could soon find themselves in the position of a credit squeeze unable to get credit or renew their loans. Declining stock prices and debt laden balance sheets will focus investors' attention on default risks once again as they were back during the bursting of the market bubble. As mentioned earlier, corporate credit quality is improving. The main reason is rising stock prices and not falling debt. In summary, debt remains one of biggest impediments to a sustained economic recovery and continuation of this bear market rally. It is one reason why we still remain bearish. All of the malinvestments of the previous boom have yet to be liquidated. The Fed has merely postponed the day of reckoning not eliminated it.

Today’s Market

The markets rallied around positive earnings news sending stock prices higher. Buying began after the Institute for Supply Management reported that factory activity rose top 57% for the month, up from a reading of 53.7 in September. The government also reported that construction spending rose 1.3% last month. The combination of better economic news and better earnings reports carried over into today’s markets as investors bid up the shares of most stocks.

Volume levels totaled 1.35 billion on the NYSE and 2.05 billion on the NASDAQ. Market breath was decisively positive by 23-10 on the Big Board and 22-11 on the NASDAQ.

The markets continue to benefit from the inflows of investor capital. Trim Tabs reports that U.S. equity funds took in $3.2 billion over the last week. Trim Tabs believes that equity inflows last month could top $32 billion, the largest increase of the year. The money flowing into mutual funds means that the managers of the funds will have to invest this new supply of money by buying stocks. Because there has been such an influx of new money flowing into the markets, many experts believe the Dow could hit the 10,000 level this week. Corporate earnings have grown at the fastest pace in nearly three years, rising 21.7% this quarter with 80% of companies reporting. Earnings have risen mainly due to cost cutting and gains coming from currency appreciation due to a falling dollar. Whether this pace is sustainable remains the big question going forward. What do you do next after you have fired all the workers you can fire?

Lowry’s Investor Services believes the key to the markets this week will be to see if stocks retain their early morning gains at the end of each day. Lowry’s is looking to see if there is a meaningful follow through for the rest of the week. Most of the markets gains occur early in the day, right out of the futures pits. More of these rallies have taken on the shape of a rising flagpole, occurring suddenly and forcefully at the markets open and then lingering there the rest of the day. Nothing has been gradual.

The technical advisory firm has noticed a number of divergences occurring at the same time. Its Buying Power Index has not been making new highs ahead of market advances as in the past. Downside volume in the market also shows that investors are becoming more aggressive in profit taking. Furthermore, Lowry’s exclusive Advance-Decline Line, which removes the influence of bond and fixed income related equities from it, has not made new highs as the market has advanced. There are a number of divergences that are now occurring simultaneously which tells us that a major trend change is in the making.

Jim Puplava

[1] Richebächer Letter, October 2003, p.9.
Source of Money Supply charts: www.economagic.com 

Technical Review
by Eric King

Barron's also reported in their own poll taken recently that 64.6% of money managers are bullish on stocks through June 2004. This broke the old record of 60% bullishness and only 12.4% of money managers were bearish. The next leg down in the DOW promises to be crushing for the over-confident bulls and will also bring back hope to the battered bears.

This unprecedented bullishness has propelled the markets higher because of staggering fund flows. The following quote is from Charles Biederman of Trim Tabs, taken from a Bloomberg Television interview this morning:

"$8 billion a week is flowing into U.S. mutual funds or $32 billion in the last month. The last time we saw that was in February of 2000, so we are back in the bubble."

Recently Jeremy Grantham was interviewed by Lou Stanasolovich. Grantham has $46 billion under management. The following is quoted from the interview with legendary investor Jeremy Grantham, one of the world's greatest value investors along with Warren Buffett:

"current valuations are the third highest of all time...While discussing "bubble markets"...such as the current one, Grantham cited that such market periods have always resulted in devastating losses for investors...In fact, since 1900, not including the current bubble, in 27 out of 27 "bubbles," losses exceeded 100% of the gains previously earned. Furthermore, valuations based upon ten (10)-year normalized (earnings are averaged over years) P/E levels dropped not only below historical median valuations, they went far below the median. This would imply a Dow Jones Industrial Average to be near a 4,000 level."

I agree with Grantham. In my article DOW(n) With The Bull! written 3 weeks ago I stated:

"The peak of this bull market saw a Dow of roughly 11,700 and the first leg down took the Dow to around 7250 intra-day. This rally has taken the Dow slightly above the 50% retracement level, but I strongly believe the rally is doomed and a new leg down in the Dow is at hand which will ultimately take the Dow into a final secular bear market bottom below 4,000."

Some believe that this rally in the stock market is forecasting an economic recovery, but I believe at the bottom of this secular bear market, this rally will show it was nothing more than a rearranging of deck chairs on the Titanic.

Eric King

© 2003 Jim Puplava & Eric King
November 3, 2003

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