Rally gave way to heavy selling throughout the technology sector this week. For the week, the NASDAQ100 dropped 11%, the Semiconductors 11%, Morgan Stanley High Tech index 7%, The Street.com Internet index 15%, and the NASDAQ Telecommunications index 14%. The Biotechs sank 13%. Elsewhere, there was relative calm, with the Dow dropping 2% and the S&P500 4%. The Morgan Stanley Consumer index actually gained almost 1% for the week and the Transports declined only about 1%. The Morgan Stanley Cyclical index declined 4% and the small cap Russell 2000 sank 6%. The financial stocks held together, with the S&P Bank index dropping 4% and the Bloomberg Wall Street index declining 2%.
It was a tug-of-war in the bond market between strong economic data and a faltering equity market. For the week, bond yields were largely unchanged with the key 10-year Treasury yield rising 3 basis points. Spreads did generally widen a few basis points today as stock prices sank. Agency securities under performed this week, with yields generally rising 5 basis points. The dollar ignored the stock market and focused on economic data, gaining more than 1% for the week.
We don’t have any brilliant analysis that explains this week’s stock market decline – maybe it is just the old battle between greed and fear. Certainly, the market is sensing what has been apparent for some time: all is not well throughout what should be considered a highly distorted and unstable technology sector. Throwing a bucket of ice cold water on the “soft-landing” scenario, there were a flurry of powerful economic reports this week – stronger than expected home sales, near record consumer confidence, the strongest durable goods orders in nine years, 12-month wage gains at nine-year highs, and today’s much stronger than expected report on 2nd quarter GDP. The fact of the matter, as we have attempted to explain in the past, is that the U.S. economy, and the technology/Internet/communications sector specifically, have been in the midst of a runaway and hopelessly unsound boom. Yet, the bullish consensus, clinging to “New Era” dogma while continuing to ignore reality, believes that all is well. I couldn’t help but to “roll my eyes” while reading an article from last Sunday’s The Atlanta Journal-Constitution - “Fed May be Applying Brakes Too Hard.” The author was noted economist, and so-called “expert” on inflation - Donald Ratajczak from Georgia State University
From his article: “I must admit, however, that the ultimate source of this slowing is the monetary restraint that began after Y2K proved to be more fear than reality. In the past three months, M2, a measure of money that includes the money market holdings of households, has increased at an annual rate of only 2.2%. My studies suggest that M2 is closely related to spending over time. With inflation as measured by the GDP deflator approaching 3%, this money growth leaves little room for real spending.”
First of all, we have no idea where Dr. Ratajczak came up his 2.2% growth number (perhaps he used non-seasonally adjusted money supply heavily impacted by tax payments). From Fed data, we see an M2 growth rate more than double this, at 5% over the past 13 weeks. At the same time, broad money supply (M3) continues to expand quite excessively. Over the past 13 weeks, M3 has increased by almost $120 billion, or greater than 7% annualized. Last week, M3 increased $34 billion, compared to $5.5 billion for M2. This afternoon, the Fed reported that bank credit expanded by $29 billion last week, with security positions increasing $13 billion and “other assets” expanding $17 billion. Bank “other assets” have increased $32 billion over the past three months to $410 billion. Looking at year-to-date numbers, M3 has increased about $300 billion (about 8.5% annualized), while M2 has expanded $135 billion (5.5% annualized) – an extraordinary difference between M2 and M3 of about $165 billion in less than seven months!
Interestingly, during last year’s first half, M2 and M3 grew at very similar rates, both just under 6%. However, during the historic 2nd half - with credit market turbulence late in the summer and then Y2K - M2 growth tempered slightly to 5.5%, while M3 accelerated to 8%. During this period, both Asset-Backed Commercial Paper and “Institutional Money Funds” expanded rapidly. The key development this year is the continued extraordinary growth of M3 that has led to a staggering $566 billion (greater than 9%!) of broad money supply growth since last August. Wow! Should it be any surprise that real estate inflation has at the same time been especially acute, while wages have escalated at the strongest pace in nine years. Is it beyond understanding that general inflationary pressures are now building rapidly, with energy prices surging? Would one not expect the technology sector, the epicenter of this historic bubble, to develop into an absolute speculative and over investment melee replete with an unprecedented misallocation of resources? You know, there is really not much of a mystery in all of this. Yet, the “soft-landing” and “New Paradigm” crowd choose to believe in permanent prosperity while ignoring this historic explosion of money supply. We believe conveniently disregarding broad money supply leads to erroneous analysis by Mr. Ratajczak, as well as most analysts.
Importantly, there are critical structural developments that go unrecognized by traditional analysts that focus only on narrow money - M1 and M2. For one, we continue to note the burgeoning market for “Asset-backed Commercial Paper” (ABCP). During the period from last August to the end of June, ABCP commercial paper expanded by $146 billion, or at an annualized growth rate of 38%. During June alone, ABCP expanded $19 billion to $570 billion. Keep in mind that there was only about $50 billion ABCP outstanding at the beginning of 1994. This explosion in ABCP is directly related to the proliferation of loan securitizations and other lending programs that have for some time fueled the surge in corporate and household sector debt. Most economists would like to believe that since M2 includes the majority of household “money” balances, M3 could simply be ignored. We disagree and, instead, endeavor to understand the structures and vehicles responsible for this phenomenal growth. We suspect that increasingly the major, and often very aggressive, consumer lenders are being financed by “institutional” funding sources captured in M3 components. For example, think of it this way: a consumer may choose to place her “savings” in the stock market and then use her credit card as “money” - the source of purchasing power. Her expenditures are then financed by a credit card company that receives its financing by securitizing a pool of credit card receivables. These securitizations, with Wall Street as intermediary, can then be purchased by a “funding corporation”/Asset-Backed Commercial Paper Program that receives its funding by issuing commercial paper to an “institutional money fund” managed, of course, by a Wall Street firm. Or, perhaps, “institutional money funds” invest in repurchase agreements, whereby the fund provides financing for leveraged speculators to purchase securitizations from the major consumer lenders. Either way, the institutional money funds are funding consumer spending. Admittedly, these examples are not easy to follow, but suffice it to say that there is today a strong relationship between M3 and spending. More than ever before, M3 should be monitored closely as an indicator of the creation of additional purchasing power.
Looking at money supply, we see that over the past year “Institutional Money Funds” have increased $136 billion, or 25%, to $692 billion. Year-to-date, this component of M3 has jumped $85 billion, or 25% annualized. Interestingly, and we would say importantly, Institutional Money Fund assets have surged a noteworthy $47 billion (annualized rate of 63%!) during the past six weeks. These are funds generally managed by Wall Street firms, and it is no coincidence that these funds balloon during periods of heightened credit market stress.
In the past we have written about the ability of the financial sector to create its own “liquidity.” Through the creation of liabilities such as commercial paper and other money market instruments – unfettered by capital and reserve requirements – Wall Street has enjoyed virtually unlimited capacity to create money and credit. While stoking housing inflation and massive trade deficits, this wide open and gushing “money spigot” has at the same time financed virtually any enterprise desiring funding, at least in the technology area. It has truly been a classic bubble, with increasingly problematic distortions and maladjustments. The longer this bubble has been allowed to grow, the greater the underlying instability for both the financial sector and economy. This rapidly escalating bubble appeared to be in the process of being pierced back in 1998, and then again last summer, only to be rescued by only greater money and credit excesses. The credit and derivatives markets again faltered this Spring, and with stock prices sinking, it appeared that the money and credit bubble would be pierced. Once more, however, the U.S. financial sector refused to allow the party to come to an end. In fact, with Wall Street coming to dominate the money and credit creation process, there was a greater push than ever toward the aggressive use of “New Era Finance” to perpetuate the bubble.
In this regard, we take note of the first paragraph from one of the credit insurers earnings releases that shed interesting light on the second quarter. “Commenting on the results, AMBAC Chairman and CEO Phillip B. Lassiter noted, ‘It was another superb quarter as international and domestic structured/asset-backed business more than made up for relatively low, but improving, issuance in the municipal business as we progress through the second half.’” Year over year, “adjusted gross premiums written” for structured finance increased 74%. Wall Street’s reckless use of credit insurance, derivatives, and sophisticated structures – financed by commercial paper, repos, and other money market instruments – is certain to come back to haunt our financial system and economy.
This week we will again focus on money, credit, and business cycles while highlighting another of our favorite books - Prosperity and Depression - written by Gottfried Haberler in 1937. Dr. Haberler was born in 1900 in Austria, and was a student of Ludwig von Mises. He spent the majority of his adult life at Harvard. This classic is quite pertinent today, with Haberler’s focus on the cumulative nature of booms and the inherent instability that develops for both the financial system and economy during periods of prosperity.
“Money and credit occupy such a central position in our economic system that it is almost certain that they play an important role in bringing about the business cycle, either as an impelling force or as a conditioning factor.”
“The banks, and especially the leaders of the banking system, the central banks, should not watch the reserve proportions so much as the flow of purchasing power. The demand for goods, the flow of money, is the important thing – not the outstanding aggregate of money. The aim of banking policy should be to keep the consumer’s outlay constant, including outlay for new investment…In other words, the aim should be to stabilize, not the price level of commodities, but the price level of the factors of production.”
“The upswing of the trade cycle is brought about by an expansion of credit and lasts so long as the credit expansion goes on or, at least, is not followed by a credit contraction. A credit expansion is brought about by the banks through the easing of conditions under which loans are granted to the customer.”
“Productive activity cannot grow without limit. As the cumulative process carries one industry after another to the limit of productive capacity, producers begin to quote higher and higher prices. When prices rise, dealers have a further inducement to borrow. Rising prices operate in the same way as falling interest charges: profits are increased and traders stimulated to hold larger stocks in order to gain from a further rise in prices. In the same way, the producer is stimulated to expand production and to borrow more freely in order to finance the increased production. The cumulative process of expansion is accelerated by a cumulative rise in prices…To sum up, expansion is a cumulative process – that is to say, once started, it proceeds by its own momentum. No further encouragement from banks is required. On the contrary, banks have then to be careful not to let the expansion get out of hand and degenerate into wild inflation. They should raise the rate of interest drastically: slight increases will not deter people from borrowing if prices rise and are expected to rise further. That is what is meant in saying that the process has gained momentum. A discount rate which would have sufficed to nip the expansion in the bud would later be much too low to stop it.”
“Let me explain first what I mean by instability. I define it as fluctuations in aggregate output and employment. However, even with stable aggregate output and employment, price instability is possible in the sense of change in relative prices as well as of the price level (in any one of the possible meanings of this ambiguous term). Price instability introduces instability in the income distribution which may well present serious social and economic problems. Sharp changes in the terms of foreign trade, which are an especially serious matter for highly specialized primary producing countries.”
“The supply of investible funds is sometimes very elastic, so that a higher demand can be satisfied at slightly higher interest rates. At other times it is inelastic, so that a rise in demand is calculated to lead to a rise in interest rates rather than to evoke a greater supply.”
“Prosperity comes to an end when credit expansion is discontinued. Since the process of expansion, after it has been allowed to gain a certain speed, can be stopped only by a jolt, there is always the danger that expansion will be not merely stopped but reversed, and will be followed by a process of contraction which is itself cumulative.”
“While monetary arrangements and policies during the upswing probably cannot entirely prevent the emergence of real maladjustments – except perhaps by preventing the upswing itself – imprudent monetary policies surely can aggravate them; moreover, the financial crises which frequently mark the downturn of the cycle and the monetary and financial complications during the depression are partly the consequence of monetary forces and polices operating during the preceding expansion…While these real maladjustments are closely tied up with growth and expansion itself and most difficult to diagnose and to avoid (except by preventing the expansion itself) most upswings are characterized in varying degrees by excesses which at least post-festum appear unnecessary, undesirable and avoidable, even though the line which separates them from the maladjustments mentioned earlier cannot always be drawn neatly at the time when things are going well. What I mean are speculative excesses in the real as well as in the financial sphere: overoptimistic overproduction in particular lines of industry and overbuilding, speculative land booms and speculative overinvestment in inventories, and in the financial sphere, excessive speculation on the stock exchange. It is mainly in this area that money and monetary policy become important during the upswing. These ‘unhealthy’ developments are not possible, or at least not possible on the large and disturbing scale on which they actually occur, without excessive credit expansion.”
Certainly, this is a powerful and particularly pertinent passage as it notes speculative excesses in the real as well as in the financial sphere. One cannot overstate the tight relationship between credit excess and the bubble that has developed in both the “real” and financial sphere to this historic technology bubble.
“Depression is induced by a fall in consumers’ outlay due to a shrinkage of the circulating medium, and is intensified by a decline in the rapidity of the circulation of money. The prosperity phase of the cycle, on the other hand, is dominated by an inflationary process. If the flow of money could be stabilized, the fluctuations in economic activity would disappear. But stabilization of the flow of money is no easy task, because our modern money and credit system is inherently unstable. Any small deviation from equilibrium in one direction or the other tends to be magnified.”
Going forward, it is our expectation that the “stabilization of the flow of money” will be of great importance. It is not clear how a system that has become addicted to runaway money growth will respond to any meaningful slowdown. Our analysis holds that a reduction of money and credit growth will spur financial system illiquidity.
Looking at the “big picture,” we see our financial system again coming under significant stress. One thing about speculative bubbles, they may appear wonderful on the upside but they don’t function well at all in reverse. There is no doubt that the economy remains desperately overheated, yet the Fed not dare “slam on the brakes.” After all, the degree of rate increase necessary to temper demand would likely prove fatal for our highly leveraged financial system and its unfathomable/unmanageable derivative positions. Actually, lower stock prices may in some respects prove advantageous to the system, a necessary factor in helping to temper consumption by both households and business. However, lower stock prices create a whole other set other problems. Undoubtedly, there is momentous leverage that has accumulated over the years as it has fueled wildly inflated stock prices. With this vulnerability, a process of forced liquidation would likely prove self-reinforcing and destabilizing. Presently, margin debt exceeds $247 billion, but this likely pales in comparison to derivative-related leverage in the equity market. There is also no way to rule out a derivative-related accident for the stock market. How exposed the financial sector is to stock prices is also a major issue.
It is our view, however, that if the authorities were compelled to try to rein in the out of control U.S. financial and economic bubble, it would be advisable to allow stock prices to decline rather than move aggressively on rates. The danger, however, is that faltering stock prices could engender lower interest rates that only throws greater fuel on the national real estate bubble. Unfortunately, the number and nature of current imbalances is truly historic and certainly creates a highly unstable system. To be sure, this is one monstrous bubble that will prove particularly unwieldy and problematic going forward.