In economic terms things have never looked better. Most Americans have jobs. Wages are rising. The stock market is booming and the world is at peace. As far as economic recoveries go, we are enjoying the longest running expansion in the nation's history. As the graph below indicates, the economic recovery that began in March of 1991 continues to barrel along. Yet, recently in Washington the Fed Chairman, Alan Greenspan, warned that the prosperity we now enjoy is in danger. The problem is there are forces at play that may fuel a return of inflation. There are severe imbalances within the economy that, if left alone, could jeopardize the nation's prosperity.
Fed Identifies Three Imbalances
The Fed has identified three potential threats to keeping the good times rolling. The first is the tight labor markets. Hardly a day goes by without some Fed official talking about how difficult it is becoming for employers to find qualified employees. The second is our nation's soaring trade deficit. The fact is, our deficit is being financed by foreign capital. The risk here is found in America's reliance on foreign money at a time when economies around the globe are recovering. The third imbalance is the rampant rise of the stock market. In this case, the Fed has identified the key components as a soaring Nasdaq and what it calls "The Wealth Effect."
I Foresee a Fourth Imbalance
To these three problems, I would add a fourth problem of the Fed's own making—which is the accelerating growth in the nation's monetary base. The Fed has kept the monetary spigot on full throttle since 1994. Last year, in an effort to liquefy the financial markets ahead of Y2K, the nation's monetary base rose parabolically as the Fed flooded the banking system with money. That money found its way into the stock market, the economy and the credit markets which fueled above-average economic growth. Now the Fed is lamenting that there is too much consuming going on. They highlight unemployment, soaring real estate prices, and an over-valued stock market. The growth in the stock market and the rise in housing prices are creating additional demand within the economy, which in itself is not sustainable.
The Fed's Dilemma
These three issues put the Fed in an uncomfortable position. How does it prevent these imbalances from getting out of control? The dilemma the Fed faces concerns three major constituents. It must solve this problem while keeping Wall Street, Main Street, and Washington happy. This is an election year and politicians want to keep the good times rolling. Wall Street is complacent. Consumers are content and Washington is oozing with congratulatory speeches. The largesse is everywhere. Politicians are promising the moon - from tax cuts to new government programs. There is enough prosperity to promise something for every one. That's how elections are won. Wall Street and Washington are telling consumers and investors that the business cycle has been repealed. The same consumers and investors see no end in sight to the good times they now enjoy.
Meanwhile, back at the Fed, officials are monitoring rising debt levels, soaring asset prices, an influx of foreign money, the evaporation of savings, and the rise of inflationary pressures. Fed officials know that this boom has been artificially created by the vast expansion of the nation's supply of money. It is the ample supply of money churned out by the Fed that has created this boom. This influx of money is what is behind the stock market's rise, the boom in housing, the expansion of credit, and all of our "consuming." As the graph below shows, household assets and net worth are soaring right along with rising debt levels.
Greenspan knows that the country can't continue to run record trade deficits with a heavy reliance on foreign capital to finance them. One of the main reasons that the country hasn't experienced a higher level of inflation is due to our trade deficit. Foreign manufacturers have made up the excess supply needed to satisfy America's insatiable consumption demands. In addition to supplying consumer demands for autos, electronics, clothing, and oil foreigners have also supplied financing. If American consumers could only buy American goods from American firms, the price of those goods would be skyrocketing. The strong demand could not be supplied from domestic producers without driving prices upward. Fortunately, that excess demand has been satisfied by foreign imports which has helped to keep down prices.
While foreign imports have helped to keep prices down, foreign capital has also kept the cost of borrowing low. Household debt is at record levels. Normally when the demand for credit increases, the cost of credit also goes up. That hasn't happened until recently because there was an ample supply of money supplied by the Fed and foreign capital. When Asian and European economies went into decline during 1997–1998, the U.S. acted as a magnet for that capital. The Fed supplied the banking system with money and foreigners recycled export surpluses into our markets. The net impact was the cost of money was kept low.
The Problem With Easy Money
The problem with cheap money is that it eventually runs out. The Fed can't keep the monetary spigot running full time without creating the inflation it is lamenting over. There is also a limit to outside capital. As economies in Asia and Europe recover, foreign capital will be needed back home to finance business and investment opportunities. Eventually, the cost of money becomes expensive as the supply of money becomes scarce. That is what is happening now. Even though the Fed raised interest rates three times last year, the economy did not slow down. While the Fed was raising interest rates, it was also injecting vast sums of money into the nation's banking system ahead of Y2K. It is the supply of money rather than the cost of that money which becomes most important. As long as the banks had plenty of money to lend consumers, investors and businesses could continue to borrow money.
The ample supply of money kept interest rates artificially low, which sent mixed messages throughout the economy. Consumers continued to borrow and finance consumption. Housing and the sale of autos continued to expand at record levels due to cheap mortgage rates and subsidized auto loans. Margin debt was setting records, which further encouraged speculation in the financial markets. So, while the Fed warned of the dangers of inflation, financial speculation and excess consumption, in reality it was helping to reinforce all three with easy money.
Blue Chips for Computer Chips
Greenspan is known for his poignant remarks regarding the stock market. "Irrational exuberance" has been replaced by "The Wealth Effect" and for good reason. Even though the Dow has pulled back 14% as of this writing, the Nasdaq continues to soar. Investors have simply traded in Blue Chips for computer chips. While the Dow has been steadily declining, the price of most technology stocks heads straight up. Never before have investors been so willing to pay so much for so little. The Nasdaq, which is now up 24 percent for the year, trades at over 390 times earnings. It's all about the new era. Investors are being told that technology stocks are immune from interest rate hikes and economic downturns. Nobody is pointing out that the new era economy companies sell their products to the old economy companies. If those companies continue to fire employees, restructure and downsize, those same companies and their employees may spend less money on "new economy" products.
The new era and it's-different-this-time thinking echo the mind-set of investors during the 1920s. Investors during that period were led to believe that the good times would go on forever. The stock market was intoxicated with a momentous technological revolution. The introduction of electricity in the home and factory, the airplane, the radio and talking motion pictures captivated the country's attention. There were the industrial giants of the day from Henry Ford, John D. Rockefeller, Bernard Baruch, Joe Kennedy, and Crapo Durant to Alfred Sloan. Like today's Bill Gates and Warren Buffet, the 1920s saw its own empire builders and investment geniuses.
These men saw the times for what they were and recognized that market over-valuations would not continue forever. Despite the calls from Wall Street for permanent prosperity, these men had the good sense to take their winnings off the table and preserve their wealth.
It's All About Price—Not Value
Their wisdom stands in sharp contrast to today's stock market investor. Today's investor can tell you everything about price and nothing about value. It's all about rising prices, better known as "momentum investing." Pricing information is ubiquitous; while wisdom remains a scarce commodity. Earnings, or the lack thereof, don't matter in this new era. Valuations are irrelevant. Nothing matters but hype, sizzle and hope. Rising prices become the focus. The hype becomes the sizzle. And rising prices become the hope. Nothing else matters as long as there are others willing to pay even higher prices. All that is needed to keep prices rising is a new fad or a new story that captivates the investor's attention.
The supply of hype and sizzle is endless from financial networks to the Internet. There seems to be a continuum of fads from biotech, emerging markets, the Internet to the human genome. It's as if investors are echoing their children's attention span. We've seen the trends from Cabbage Patch dolls and Beanie Babies to Pokemon. As I write this article, Wall Street brought three new companies public at a share. Share prices for all three took off like a NASA space launch. Gains for the three ranged from 140% to over 310%. None of the three companies made any money. In fact losses were accelerating at these same three companies. And yet investors flocked to these stocks like bees to honey. At the end of the day the three companies commanded market evaluations that ranged from to billion.
This is what some scientists might call financial alchemy. A company with million in sales and million in losses commands an immediate market valuation of .8 billion. It must be the new math every one is talking about. Another hot IPO this week was Palm, the spinoff from 3com and maker of the popular Palm Pilot. The shares that went public at , climbed as high as 5 before ending the day at 95 and 1/16th… a gain of 150 % in it's first day of trading. Palm had sales last year of 3 million and profits of .6 million. Its market value was billion more than Ford Motor which last year had 3 billion in sales and .2 billion in profit.
Meanwhile on Main Street, the old market of the Dow and the S&P 500 continue to languish. What investors are doing is dumping their old economy stocks and mutual funds and piling into the new economy stocks. This is what is powering the Nasdaq. The tech market is ignoring the Fed, because investors believe that its success has little to do with the business cycle. The momentum players are jumping into concept stocks where the "Greater Fool Theory" prevails. Investors are hoping for someone else to buy them out at a higher price, either in the public market or via a corporate takeover.
Boomer Theory Justifies the Rise
The higher stock prices are being justified by the paradigm of technological transformation. Technology is advancing and the markets, despite high prices can only go higher. One theory that justifies all of this is the "Boomer Theory." Baby boomers worried about their upcoming retirement will continue to fund their retirement plans, 401(k) plans and other savings. This will supply a continuous stream of new money into the stock market. With constant demand for stocks coming from worried boomers fretting over their retirement needs, their only outlet for all of that money appears to be the stock market.
In less than a decade, an onslaught of boomers will hit the retirement market. Unlike their parents, who held lifelong jobs with one company and had guaranteed pensions, the boomers have been more mobile. The old defined benefit pension plans, which guaranteed a pension at retirement have been replaced by today's popular 401(k) plans. The boomers will only have their 401(K) plans and their savings to get them through retirement. Since they don't have many years left to fund their retirement, boomers will look for higher returns afforded by the stock market to make up for time and lack of savings. Because the stock market has been the vehicle of choice for higher returns, the boomers will continue to flood the market with their retirement savings. This desire to fund their retirement shortfall is forcing boomers to be more aggressive with their investments. As we've seen the sector of choice for higher returns this decade has been technology.
The New Gold Rush
The rise in tech shares has lifted the major stock averages sufficiently enough to encourage irrational behavior by investors. Investors are spending more than their incomes and borrowing money to invest in stocks at a record-setting level. The stock market has become the new gold rush. Dreams of never-ending wealth gains continue to feed a frenzy of trading and insatiable appetite for speculation. The result is a massive divergence in the old economy and the stock market as reflected in the graph below.
Market liquidity is being reduced as the Fed shrinks the monetary base. All previous bubbles or bull markets have run into trouble when the money necessary to sustain a rise in asset prices is reduced. The Fed is in the process of withdrawing money from the system. The final outcome will depend on financial acumen, political courage, and a good amount of luck.
Can We Learn From 1928–1929?
The country is at the crossroads of heading toward the path of destruction or unparalleled prosperity. The future will be decided upon by the results of the next election and the policies adopted by its administration. This country has experienced three major periods of money expansion, including the present period. The two previous periods the 1920's and the 1970's produced a depression and inflation. During the 1920's Benjamin Strong, the first Fed chairman allowed the supply of money to expand at an unprecedented level. It helped to fuel the speculative boom of that era. Like today, the 1920s was a period of extraordinary technological progress. However, alongside that progress, the expansion of money created an enormous stock market bubble. The country was running a huge trade deficit, while consumers and investors took on massive amounts of debt to sustain spending and speculate in the stock market.
Eventually, the Fed began a series of interest rate hikes from 1928-1929 that eventually burst the bubble. But it was the policy mistakes afterwards which turned the bubble into a depression. The stock market crash was followed by bad fiscal policies, protectionism, rising interest rates and taxes. Tax rates during the period rose to over 90%, destroying all incentives within the economy. It would take a war, which required massive government spending, to pull the country out of the depths of the depression.
Can We Learn From the 1970s?
More recently, during the 1970s, the country was experiencing another run of the money presses. The Fed during this period monetized the government's debt. The result was the economy was caught in a spiral of economic stagnation, rising unemployment, high interest rates, stagnating financial markets and accelerating inflation. It became known as "stagflation." The economy nimbled along, while inflation rates soared. Government tried to cure the problem with tax increases, wealth redistribution, and public-service employment. Nixon, Ford and Carter struggled to turn things around. All three presidents failed. The same policies used during the depression were failing.
A New Approach Saved The Day
Fortunately for the country an obscure professor from Canada argued against loose money, tight fiscal policy, and high taxes. The professor advocated that the Fed should stop printing money and that tax rates should be lowered dramatically. The professor, Robert A. Mundell argued that the markets should be allowed to work freely.
The Reagan Revolution
The professor's ideas were picked up by Congressman Jack Kemp and became popularized by a Wall Street Journal reporter, Jude Wanniski. Mundell's theories became the economic platform for the Reagan Revolution. Reagan spoke eloquently for lower tax rates and free markets. He received the public's mandate to force them through a liberal-controlled Congress. Paul Volcker began to shut down the printing presses at the Fed. The result was the country went from the Carter's austerity to Reagan's prosperity.
The process began to reverse under Bush and Clinton. Policy advocates within the Democratic party began to blame deficit problems on the Reagan tax cuts rather than the accelerating increase in government spending. Tax revenues more than doubled during the 1980's. But they didn't keep pace with government spending which almost quadrupled during this period.
By the time of Bush's presidency, the country was once again embracing austerity economics. The liberals argued for higher taxes to offset the growing deficits. Bush broke his "no new taxes" pledge and lost the presidency. Clinton followed Bush with the largest tax increase in the country's history. His tax increases lost Congress for his party.
Republican control of Congress spared the country from any additional tax increases. However, they could not stop Clinton's spending spree. The result was the printing presses were turned on again. Easy money would be used to offset higher taxes. When money is artificially created, it fuels a boom. And this is what we are going through now. Even so, history has shown that eventually the boom creates inflation.
It's a Matter of Measurement
Today's economists only measure inflation in one way. They measure it in the cost of goods and services. Classical economists measure inflation differently. They measure it in the economy or in the price of financial assets. Inflation has only one root, which is the artificial creation of money. That excess money created by the Fed can fuel inflation in the economy or inflation in the financial markets. During the 1920's and 1990's most of that inflation took place in the financial markets. During the 1970s the inflation took place in the costs of goods and services. When the Fed creates inflation it has no control over where it surfaces. In the '70s people put money into things. Wealth was created in hard assets such as real estate, gold and oil. During the '20s and '90s the inflation has taken place in paper assets such as stocks. Both periods were inflationary, but they took place in different forms: hard assets and financial assets.
The Fed, being the creator of inflation, knows that it has a financial bubble on its hands similar to the Japanese bubble of the late 1980s. Greenspan knows that the bubble needs to be deflated. He is hoping he can do it without severe consequences to the economy. Deflating that bubble is going to cause some pain. The question is: Will he have the courage and acumen to pull it off? The Fed must deal with its main constituents on Wall Street, Main Street, and in Washington. Washington and Main Street don't understand the bubble. Nor do many on Wall Street. Right now everyone seems to prefer the new era theory. Most groups like the way things are going. Tax revenues are up along with stock prices. The government has money to spend on new programs. Investors feel richer with higher stock prices. The trouble is that this prosperity has been bought with borrowed money.
Remember, all booms have been followed by busts. It has always been that way throughout history. The severity of those busts depends on how they are handled by policy makers. If history gives us a clue, policy makers don't handle them very well. Just look at Japan today. They have struggled for a decade trying to pull themselves out of a bust. They still continue to follow austerity economics with high taxes, easy money and fiscal spending. They, like ourselves have failed to learn the lessons from history. Let us hope that when our boom comes to an end, that we will have a leader like Ronald Reagan. President Reagan had the wisdom to recognize that austerity economics doesn't work. He had the courage to lead the country with his ideas and the ability to articulate those ideas to the general public. Ronald Reagan gave us a new morning in America. Let us hope our next president will do the same.
Perspectives Part 6 is a continuation of a series on the American stock market.
