08/03/2000 The Emperor Has No Clothes!!! *

It was, unfortunately, just another “typical” week for an acutely dysfunctional stock market. During the past two sessions, a veritable buyers panic saw the S&P bank index and the AMEX Security Broker/Dealer index surge 8% and 5%. For the week, these indices increased 10% and 9%. Since lows established on May 26th, the AMEX Security Broker/Dealer index has risen 50%. From March trading lows, the S&P Bank index has gained 30%. The AMEX Biotech index surged 10% this week, increasing year-to-date gains to 70%. Elsewhere this week, the Dow added better than 2%, and the S&P500 increased 3%. The Transports advanced 4%, and the Utilities soared 6%. Both the Morgan Stanley Cyclical and Morgan Stanley Consumer indices gained 2%, while the small cap Russell 2000 increased 3%. The technology sector was generally strong, with a 4% advance for the NASDASQ100 and 3% increase for the Morgan Stanley High Tech index. The Street.com Internet index gained 5%, and the NASDAQ Telecommunications index added 3%. The previous high-flying Semiconductors were the major exception, dropping 4%, and reducing year-to-date gains to 31%. The gold stocks dropped 2% this week.  The credit market continues to demonstrate extraordinary liquidity. Treasury yields between 2 and 10-year maturities declined 13 basis points. Ten-year Treasury yields ended the week at 5.9%, the lowest since mid-April. With spreads narrowing, mortgage and agency securities outperformed. Yields on both the Agency futures contract and Fannie Mae benchmark mortgage-backs dropped 15 basis points. Mortgage-back yields ended the session at 7.75, 61 basis points below the highs established back in mid-May. On the inflation front, crude jumped 6% as oil prices quickly ran right back to $30 a barrel. Natural gas prices surged 12%. While broad money supply and bank credit growth were more tempered (M3 expanded $3 billion and bank credit $7 billion), we see that commercial paper outstanding increased $24 billion during the past week. During the last four weeks, total commercial paper has expanded $57 billion, or at an annualized rate of 39%. Year-to-date, total commercial paper has increased $161 billion (more than total M2 growth of about $130 billion!), or at a rate of 20%. We will begin with recent quotes from top Federal Reserve officials. “I think the economy can grow at 4% a year or maybe even a little faster. Why do I think that? Because it is has been doing it for 4 ½ years - that is why I think that. If you go to a rodeo and you are riding a bull, I think you only have to stay on for 8 seconds, then the buzzer sounds and somebody helps you get them out and it is all right. Unfortunately, we are in an experiment here - we have been on for 4 ½ years and people still have not been acknowledging what is right before their eyes. The buzzer is not going to go off until something bad happens. That is the problem. The bell will sound when the experiment fails, as long as the experiment is working it won’t sound. So there is no way that I can ultimately win this debate that we are engaged in. Just with my own eyes I can say that (it) is capable of growing at 4% without inflation picking up. That is still a minority view - not as much as a minority view as it was a year or two ago. Most of the people in the technology areas agree with me; I think most of the businessmen agree with me, and there are 2 or 3 maverick economists out there that agree with me--- Larry Kudlow, Brian Westbury, Ed Yardeni---people like that. But the people who don’t agree with me at all are the older establishment economists from elite universities that don’t have good football teams. They still evoke the view that it may be working in practice, but will it work in theory.” Robert McTeer, President of the Federal Reserve Bank of Dallas, July 25, 2000 “What we know about household debt is, one, that, even though the ratio of debt to income has been rising, that the debt-service burdens, meaning the actual monthly payments as a percent of disposable income, have been rising less, although they nonetheless, have been rising in the last couple of years or so, as I recall. There is very little evidence to suggest that rising debt burdens on the part of households per se, are a trigger for an economic recession. Most people have a generally good idea of how much debt they can carry, and they don’t go beyond it. The problem is not that rising debt will create a problem for the economy but that, should the economy turn down, then the high debt burdens could create some significant problems for a number of America’s households. That’s been the typical pattern over the years. Consumer debt has been a remarkably beneficent force in moving people into the middle class in this country over the last two or three generations. And it continues to be a very potent and very desirable financial institution. But you (Representative Melvin Watt) are quite correct in raising the issue that there are potential concerns. The concerns, however, are when a recession occurs, not that consumer debt can create a recession; at least the evidence certainly does not suggest that that’s a problem.” Alan Greenspan, Hearing of the House Banking and Financial Services Committee, July 25, 2000 “So there is good reason to believe that the relationship between money and GDP, or price level, should be more variable and therefore money growth is a less important guide to current economic policy than it used to be. That said, anyone who totally ignores money growth does so at his peril because the fundamental responsibility of the central bank is to control the amount of money that is created. And we have ample reason in history to know that if we let money creation get out of hand – on the upside or the downside – that there is going to be big costs to pay – big cost that the economy will have to bear. And I think what we have seen in recent years is that money growth numbers have never gotten grossly out of line. If you look at the numbers over the last five to eight years there’s been periods when it looks to be on the low side, periods that looked to be a little bit on the high side. But it’s not been grossly off on either direction. I use, look at those numbers but I use it in conjunction with other information we’re receiving at the same time.” William Poole, President of the Federal Reserve Bank of St. Louis, August 2, 2000 “I am quite ready to insist that our situation is far far more stable. We are much less subject to this being a critical period than in many times in the past – many times in the past. We are not dealing with the upset that we were about the time of the Asian crisis. Things were moving pretty fast back then, and we were watching the data really carefully. There were a lot of peculiar things going on. And we don’t have that in the economy today. We’ve been through a pretty big increase in energy prices. But that all seems to be sort of shaking out and settling down now. So I would say to you that the current environment is actually more benign, more stable than the run of the mill environment. Certainly, a lot more stable than it was in the 1970’s.” William Poole, President of the Federal Reserve Bank of St. Louis, August 2, 2000 While the bulls and the media continue to trumpet the brilliance and unparalleled competence of the Alan Greenspan Fed, we strongly question the validity of this perception. Unfortunately, it is becoming clear that many top Federal Reserve officials have little if any understanding of the underlying factors, nor appreciation of the great risks posed by the continuation of this momentous bubble. In fact, and I do not say this without considerable contemplation, many of our top Federal Reserve officials are flirting with ineptness and bordering on negligence. How can the President of the St. Louis Fed, a devoted monetarist, ignore the fact that broad money supply has increased by almost $1.1 trillion, or 19% over just the past 24 months? “Looked to be a little bit on the high side” Mr. Poole? Come on… How can William Poole talk about stability when the US and global financial system nearly buckled less than two years ago? Is an unprecedented $400 billion current account deficit indicative of a stable future for the U.S. financial and economic system? Does the unprecedented leverage and derivative holdings within our financial sector create a stable situation for the financial system and economy? Is continued unprecedented corporate and consumer borrowing symptomatic of inherent health and stability? How can anyone look at the U.S. economy, with the historic bubbles throughout the enormous technology sector and California real estate market - mentioning only the most blatantly obvious - and see anything but precarious instability? Are historic speculative bubbles and the most volatile stock market in modern U.S. history consistent with a stable environment? There is absolutely no question that our acutely unstable system is being allowed to only deteriorate into a more vulnerable position each week that incredible excess continues. Any discussion from Federal Reserve Bank Presidents professing current stability is absolutely ridiculous. We suggest that Mr. Poole and other Federal Reserve officials read the history of the South Sea Bubble, the Mississippi Bubble, and the “roaring” 1920’s bubble. To Mr. McTeer, we would like to remind him that his region has a dramatic and expensive history of booms turned ugly bust, with enormous cost to the U.S. taxpayer. In fact, looking at FDIC data, we see that 849 banks failed in Texas between 1980 and 1998. Further, several of the most costly bank failures in U.S. history have occurred within the greater Dallas/Ft. Worth area, and basically every major Texas bank failed or was severely impaired after the most recent boom/bust cycle. So, we would argue his role and responsibility is that of a serious and cautious central banker, warning stridently against overlending, overbuilding and other excess within his jurisdiction. It is most inappropriate for McTeer to ignore obvious excess in the guise of a “New Paradigm.” Importantly, the soundness of the U.S. financial system and economy, as well as our nation’s future prosperity are definitely not to be put at jeopardy by any “experiments” by a group of aggressive central bankers. This is not a game, and there is absolutely no analogy to be made to an 8 second rodeo event. When the “bell” inevitably sounds, it will be much too late. Looking at the big picture, how can one see anything but instability – a period of perpetual and ever larger booms and busts - after the US experienced the 1987 stock market crash, the collapse of the Japanese financial and economic bubble beginning in 1990, the S&L debacle and our country’s worst banking crisis since the depression during the early 1990s, a near financial debacle with the Fed’s tightening cycle in 1994, the Orange County Bankruptcy and Mexican collapse in 1995, the SE Asian melt-down that began during 1997, the Russian/LTCM/credit system meltdown in 1998, and general derivative/credit market tumult last fall and again during this year’s first quarter? The way we see it, with the leveraged speculating community completely dominating the credit market, it is now clear that the Federal Reserve caters to and basically allows Wall Street to dictate the terms of monetary policy. At any sign of trouble, the Greenspan Fed quickly pampers the markets, in history’s greatest episode of moral hazard. In response, the financial sector aggressively takes on additional leverage to purchase securities, creating the money and credit that liquefies the financial markets and leads to lower interest rates. This result, then, is interpreted as evidence of the “proper” monetary policy, and the Fed relaxes until the next storm cloud arrives. With “New Era” Greenspan making it clear that he accommodate the markets and will specifically not pierce the bubble – that the Fed is basically frozen and short-term rates pegged at current levels while injecting “liquidity” when necessary - one must now accept the harsh reality that Wall Street and the leveraged speculating community are now firmly “running the show.” (This is supported by the fact the AMEX security broker/dealer index sports a 34% y-t-d gain). And, while Mr. Poole may state that it is the “fundamental responsibility of the central bank is to control the amount of money that is created,” the Fed has and continues to shirk this critical responsibility, much to the delight of King Wall Street. As such, it is now the investment banks, the powerful money center institutions, and the equally powerful GSEs that largely determine the amount of lending and security issuance, hence money and credit creation. It is Wall Street that partners with the GSEs to create virtually endless amounts of mortgage finance that fuels higher home prices and increased consumer home equity (additional collateral to borrow against!). It’s Wall Street that partners with the aggressive consumer lenders, particularly the non-bank finance companies, whereby creating vast quantities of securities that provides unlimited funding for further consumer lending and consumption. It is Wall Street that creates sophisticated structures and vehicles that “transform” the most risky of loans into asset-backs, mortgage-backs and other marketable securities. Wall Street is the derivatives market that holds immense influence over present financial markets. It is, as well, Wall Street that partners with the likes of GE Capital Services and other business sector finance companies that create the fuel for a runaway “investment” boom. It is Wall Street that is behind the enormous expansion of commercial paper, repos, and other money market instruments. It is Wall Street and the leveraged speculators that determine the degree of leverage in the financial sector, hence the demand for securities and credit market liquidity generally. It is Wall Street that determines which companies and industries have access to funding – the allocation of our nation’s resources. And it is Wall Street, having forged managerial control over vast pools of assets, that lavishes the great reward of higher stock prices to those company managements (possessing huge stock option packages, of course) that “toe the line” in perpetuating the boom. Importantly, it is Wall Street and not the Fed that today holds the helm of the “money spigot,” hence determining the rate of economic growth. Of course, Wall Street pursues only one goal: the perpetuation of the financial and economic boom. Increasingly, and most unfortunately, this is reminiscent of the infamous S&L debacle from the late 1980’s and early 1990’s. While the S&L problems were apparent in the early 1980’s, no one had the courage to step in to stop the reckless lending boom before it got completely out of hand - no one was willing to put a “stop-loss” on the mushrooming fiasco, clean house of the reckless, incompetent, irresponsible, and fraudulent before it became a systemic risk and enormous taxpayer bailout. Not the politicians, certainly not Wall Street, not the Fed or the bank regulators. Instead, a dysfunctional system was allowed to grow tremendously and disastrously. Then, there were hundreds of individual S&Ls and banks whose ill-advised lending were fueling unhealthy regional booms. Although there were many indications of unsound lending and improprieties, and increasingly poor asset quality at many institutions, the day of reckoning was delayed while a dysfunctional boom expanded exponentially. Today, there is unequivocal evidence that the current system is dysfunctional – that truly enormous amounts of unsound loans are being extended and very poor quality securities issued. Evidence abounds of an ominous deterioration in the quality of assets throughout the financial sector. This boom, unlike the S&L debacle, is endemic to the entire financial sector and U.S. economy. And, like before, no one is willing to stop the party, as a momentous and dysfunctional boom grows exponentially. While ignored by the bullish contingent, we will highlight recent data on corporate debt quality that is quite disconcerting. From a recent report from Moody’s Investors Service - US Corporate Credit Quality Continues to Slide - “The decline in the credit quality of US corporations, particularly of speculative grade industrial companies, continued its two and one-half year decline and is not likely to improve in the immediate future.” “Moody’s downgrades of credit rating for US corporate borrowers outpaced upgrades by a margin of 2 to 1 in the first half of 2000. The rating agency cited equity buybacks and debt-financed M&A for difficulty in the investment-grade sector while difficulty accessing capital and softer earnings weakened credit worth at the lower end of the rating ladder.” Quoting John Puchalla, senior economist at Moody’s: “Greater use of debt in capital structures is negatively affecting US corporate credit worth compared to the very strong levels of the mid-1990s, and this has helped widen credit risk premiums on corporate bonds…Not since the 1991 recession year have upgrades been so few relative to downgrades among high-yield US corporate issuers.” “By sector, Moody’s reports that downgrades outpaced upgrades by 2 to 1 among industrials, with 159 downgrades worth $269 billion, and 71 upgrades valued at $115 billion. ‘In addition to equity buybacks and debt-based M&A, the industrial downgrades reflect increasing tolerance of corporate managers for greater risk as they try to satisfy shareholder demands. The result is the highest use of debt in capital structures in seven years.’ The debt-to-net worth ratio of non-financial companies stands at 81%…compared to a low of 70% in 1997.” Monday, the Wall Street Journal covered the Moody’s report and quoted their outstanding chief economist John Lonski: “There has been an erosion of corporate credit worth that investors ought to pay attention to.” Taking the other side of the argument, the Journal quoted Robert DiClemente, chief U.S. economist at Citigroup’s Salomon Smith Barney: “You’re always worried about debt, but so much of this debt expansion is being poured into investments in capital expansion that is driving productivity gains, so it may be more likely to produce profits, rather than financial stress.” Not surprisingly, the first big wave of defaults is coming from the junk sector. According to the Los Angeles Times, Moody’s “projects that (junk bond) defaults in the 12 months ending 2001 will total more than 8% of bonds outstanding, up from 5.4% so far this year.” So far this year, 65 issues have defaulted, compared to a record 108 defaults last year. The previous record was 88 defaults in 1990. “Many recent defaults stem from a period of easy money in late 1997 and early 1998, when corporate earnings were strong, foreign money was pouring into U.S. debt markets, and investors generally let down their guard,” according to analyst John Lonski at Moody’s. In the first quarter of 1998 alone, $30 billion in low-rated bonds were issued. Many junk deals that shouldn’t have been done at all are now coming undone, Lonski said. ‘It’s payback time,’ he said.” We agree completely with Mr. Lonski – not only will it be payback time going forward, but it should also be recognized that the most problematic loans are made during “a period of easy money.” We watched the post 1987 crash “easy money” period fuel real estate bubbles that culminated with the S&L and banking crisis of the early 1980s. This led to a historic “easy money” period in the early 1990s that fostered unprecedented financial system leverage and the severe credit market disruption in 1994. This crisis culminated with the Orange County bankruptcy and Mexican collapse, with the subsequent Mexican bailout. The next post-crisis period of easy money – “reliquefication” - fueled the terminal stage of credit and speculative excess throughout SE Asia, Russia, and emerging markets generally. The Fed was forced to respond to this series of inevitable busts by lowering interest rates and accommodating the greatest period of “easy money” in history – a virtual unending “reliquefication.” Unprecedented money and credit growth for the past two years has fueled an economic boom and a massive technology/Internet/Telecommunications bubble. Moreover, money and credit excess powered a great asset bubble, particularly in financial assets and home prices. In this regard, it is now our view that the great technology speculative bubble is in the process of coming undone. It is also our “hunch” that this problematic situation is, as the same time, quietly responsible for another period of heightened credit system liquidity – “reliquefication” or “easy money.” Sure, a return of ultra-easy credit conditions may work to help mitigate the destabilizing forces and allow a more gradual unwind of problematic speculative positions and imbalances throughout the technology sector. However, this is an unmitigated disaster as continued egregious money and credit excess only fuels unsound booms elsewhere. For one, we suggest looking specifically to the consumer and mortgage-lending sector. In fact, it almost appears that “the die is cast” on a final wild speculative boom in consumer and mortgage finance. Clearly apparent in second quarter data, finance company managements are more than willing to lend with reckless abandon to meet Wall Street’s aggressive earnings expectations. With liquidity and speculative fervor returning to the credit market, there appears, for now anyway, considerable demand for high-yielding asset-backed securities. And, as evidenced by the phenomenal performance of these stocks, Wall Street, as always, is right there to cheer and handsomely reward the leading instigators of credit and speculative excess. With the Fed asleep at the wheel, our analysis finds us in the midst of an historic consumer debt bubble, with credit excess-induced housing inflation providing rising collateral values that fuels additional borrowings from credit cards, auto loans and leases, and margin debt. This enormous credit growth is increasingly making its way into income growth, which adds further fuel to rising home prices and spending generally in a self-reinforcing process. And, actually, as long as enormous credit growth fuels higher home prices and income, this Ponzi scheme plays well. Rising home prices rise keep mortgage defaults low, over-exposed credit card borrowers happy to borrow against home equity to stay current on credit card balances, and the consumer borrowing and spending binge runs on – the monetization of real estate inflation into trade deficits, rising wages, and higher prices generally. Mr. Greenspan may see consumer credit as “very desirable,” but to make such comments in the present environment is astounding and, quite simply, irresponsible. Interestingly, the debate continues as to whether this, the greatest of bubbles, will end in ugly deflation or a great inflation. Well, in the longer run, we believe this historic credit and asset bubble will likely end in a devastating deflation, at least in financial assets and home prices. However, our analysis continues to lead us to expect in the short-run a continuation of overheated economic conditions and even greater inflationary manifestations. We have for some time expected that the Federal Reserve would come (belatedly) to recognize that the US was in the midst of a dangerous credit bubble with endemic asset inflation, dangerous imbalances and distortions, and heightened inflation risks generally. We expected that the Fed would respond by aggressively raising short-term interest rates. This would then, in our thinking, precipitate dislocation and forced deleveraging in the acutely over leveraged credit system and stock market. We must admit that we our confidence in the Federal Reserve was in error. Never in our wildest dreams did we anticipate that “New Era” thinking would gain such a strong foothold with adherents at the very top of the Federal Reserve System. Moreover, it is beyond us that such thinking has taken precedence over historic money and credit excess, endemic real estate inflation, outrageous financial speculation, and unheard of trade deficits. The facts speak for themselves. The Greenspan Fed is a disgrace, and we are compelled to shout “THE EMPEROR HAS NO CLOTHES!!!”