08/29/2002 Cold as Ice *

August’s stock market rally stumbled into month end, with moderate weakness throughout and a return of aggressive selling to the technology sector. For the week, the Dow declined 2% and the S&P500 dipped almost 3%. With the airline industry in serious trouble, the Transports sank 5%. The Utilities and Morgan Stanley Cyclical index dropped 2%, while the Morgan Stanley Consumer index declined 1%. The broader market declined, with the small cap Russell 2000 and S&P 400 Mid-Cap indices down 2%. The NASDAQ100 dropped 6% and the Morgan Stanley High Tech index 7%. The Semiconductors were hammered for 10%, and The Street.com Internet index was down 8%. Biotechs sank 9%. The financial stocks were mixed, with the Securities Broker/Dealer index down 3%, while the Banking index was unchanged. With bullion up $5.60, the HUI Gold index surged 14%.

The Treasury market melt-up runs unabated. For the week, two-year yields declined 5 basis points to 2.10%, with five-year Treasury yields declining 12 basis points to 3.19%. The 10-year Treasury yield dropped 10 basis points to 4.13%, while the long-bond saw its yield dip 9 basis points to 4.93%. Mortgage-back and agency yields dropped between 8 and 10 basis points in an extraordinary market environment. The spread on Fannie Mae’s 5 3/8% 2011 note narrowed 1 to 51, while the benchmark 10-year dollar swap spread was unchanged at 52. The yield on December Eurodollars was unchanged at 1.78%. The dollar rally also sputtered this week, as the greenback lost about 1%. The CRB index is on a quiet march. It closed today above 219, the highest level in almost 15 months. The CRB began the year at about 191. Energy prices have been strong, grains quite strong, cocoa on fire, and the metals holding their own.

Broad money supply (M3) surged $41.9 billion last week, with six-week gains now at $128.8 billion. Broad money has jumped $278.4 billion, or 10% annualized, in the 18 weeks since April’s lull. Last week, demand deposits were up $14.0 billion and savings deposits increased $3.9 billion. Retail money fund assets declined $3.3 billion, while institutional money fund assets jumped $16.1 billion. Repurchase agreements increased $8.1 billion and Eurodollar deposits increased $2.1 billion. Repurchase agreements have now increased $32.3 billion over the past five weeks. Outstanding commercial paper increased $5.0 billion last week, with domestic financial sector CP borrowings jumping $9.5 billion. During the past six weeks, domestic financial sector CP has surged $52.1 billion to $1.381 trillion. Today’s Fed data had bank Credit contracting about $2 billion, with loans and leases about unchanged. The ABS market tumult has quieted over the past two weeks, with issuance apparently impacted by the late summer lull.

The news on the economic front is not encouraging. The Conference Board’s Consumer Confidence survey was reported at 93.5, down from July’s 97.4, June’s 106.3, and May’s 110.3. This was weaker than expected (expectations of 97), the lowest reading in nine months, and compares to the year ago level of 118.9. The Present Situation component dropped significantly to 92.0. This was down from July’s 99.4, June’s 104.9, and May’s 111.2. The Present Situation index was reported at 144.5 one year ago, with a peak of 186.8 during July 2000. Expectations declined two points to 94.5, down from May’s 109.7. Elsewhere, the Conference Board’s index of help-wanted advertising in major newspapers dropped to 44 from 47, the lowest level since 1964. This index was at 90 in early 2000. Initial jobless claims of 403,000 last week (estimates of 385,000) were the highest since June 24th. The F.W. Dodge Construction index dropped sharply to 141 from 153, and has not been lower since December 2000. While it receives little attention, bankruptcy filings are also on the rise. Last week’s filings of 31,970 were the highest since early June. The four-week moving average of 30,645 compares to mid-July’s ebb of 26,682. While year-to-date bankruptcies are running up about 3%, last week’s filings were 15% above year ago levels. The Instinet Research Redbook same-store sales report had August sales running down 1.6% from July and about flat year-over-year. A lengthening list of retailers report disappointing results.

The Mortgage Banker’s Association refi application index declined 3%, while remaining up more than 160% from year-ago levels. It is interesting to note that the purchase application index declined 7.2% to the lowest level since mid-May. Purchase applications were up 16.8% y-o-y. Strong July new and existing home sales have total unit sales on a record 6.36 million pace, up slightly from last year’s record 6.21 million.

New homes were sold at a record 1.017 million annual pace, up 15% from last July, led by booming sales in the Midwest (up 30% y-o-y) and South (up 11% y-o-y). Beneath the surface, however, one can spot potential signs of weakness. Median prices were actually down y-o-y, while average (mean) prices were up only 2.8%. Sales were down 15% y-o-y in the Northeast, and have experienced monthly declines during June and July in both the Northeast and West. And while the West still suffers from a shortage of new homes on the market, the number of newly constructed residences waiting to be sold is up 33.3% y-o-y in the Northeast. The total inventory of homes increased 7,000 to 332,000, the largest inventory since late 1996.

Existing home sales volumes were up slightly year-over-year, with both the Northeast (down 2.9%) and West (down 2.9%) experiencing year-over-year declines. National average (mean) prices were up 9.2% to $208,100, with prices up 10.0% in the South, 9.3% in the Midwest, 9.1% in the West, and 7.4% in the Northeast. Data from the California Association of Realtors (CAR) does not yet indicate weakness, although sales increased only slightly after June’s noticeable slowdown. But price gains are being sustained, with the year-over median price up 21.0% to $323,700. From the CAR: “…most regions of the state recorded double-digit increases in median prices compared to the same period a year ago. It’s a reflection of constraints on the supply of homes for sales relative to demand.” In our view, it’s a reflection of a speculative blow-off in one of history’s great speculative Bubbles.

The Bond Market Association’s (BMA) Research Quarterly makes for fascinating reading (http://www.bondmarkets.com/pr/default.shtml). U.S. new bond market issuance volume totaled $2.5 trillion for the first half of 2002, a 16.8% increase from the $2.1 trillion issued during the same period last year. “Issuance was higher across all sectors, except the corporate market…” “U.S. Treasury gross coupon issuance increased 50.0 percent to $233.1 billion during the first half of 2002…” First-half corporate issuance declined 25.6% to $388.2 billion. Investment grade issuance declined 20.2% to $327.4 billion. Convertible bond issuance dropped more than half, with second quarter issuance of $5 billion compared to Q2 2001 issuance of $25.4 billion. Junk bond issuance dropped 37.9% to $36.6 billion. While the data differs from other sources, the BMA had first half asset-backed security issuance up 6.2% to $237.9 billion. “Municipal bond issuance totaled a record $194.6 billion in the first half of 2002, topping the previous half-year record in the second half of 2001.” Municipal issuance jumped 21.3 percent from the same period last year.

The mortgage finance Bubble is conspicuous in the data. “Mortgage-related securities issuance, which includes agency and private-label pass-throughs and CMOs, totaled $1.01 trillion in the first half of this year, up 51.6 percent from the $664.1 billion issued during the same period in 2001.” Issuance of agency mortgage-backed securities (MBS) increased 38.8% to $637.6 billion. Fannie Mae’s first half MBS issuance jumped 37.2% to $331.0 billion, while Freddie Mac’s MBS issuance climbed 52.8 percent to $240.4 billion. “Issuance in the agency collateralized mortgage obligation (CMO) market increased to $241 billion in the first half of 2002, more than double the $111.5 billion issued during the first two quarters of 2001.” Average daily trading volume in agency MBS jumped 32.1% to $135 billion. The agencies also issued long-term debt in the amount of $453.7 billion, up 6.7%.

“The average volume of total outstanding repurchase (repo) and reverse repo agreement contracts totaled $3.45 trillion for the first half of 2002, an increase of 16.8 percent… Outstanding repo agreements averaged $2.0 trillion through June 2002, an increase of 18.8% from the $1.68 trillion volume during the same period of 2001…In excess of $105.4 trillion in repo trades were submitted by [Government Securities Clearing Corporation] participants during the first half of 2002, with an average trading volume of approximately $850.3 billion.” (Financial historians will look back at these numbers in absolute disbelief!)

While Dr. Greenspan’s Jackson Hole speech today focused on Federal Reserve policy and asset Bubbles, it is not surprising that he chose to avoid any mention of debt issuance data or the expanding real estate Bubble. I hope economists, young and old, students of economic and markets, formal and otherwise, as well as us aspiring Credit and economic analysts, will carefully read and ponder Chairman Greenspan’s speech. It is one for the history books. For one, it rather concisely packages the failed (and hopelessly stubborn) economic doctrine of the Greenspan era. It is essentially an elaborate refinement of the previous “you can’t recognize a Bubble until it bursts” nonsense. Reading through the text, I recalled the childhood game of “Hot and Cold.” After the first couple paragraphs, I was quickly thinking, “Greenspan, your analysis is cold.” As I read further, I thought, “Cold, getting colder, very cold,” to the point of exclaiming, “You’re way off track. Not even close – Cold As Ice!”

First of all, it is flawed to place stock market Bubbles at the epicenter of economic analysis. The U.S. equity Bubble was only one (conspicuous) component of the ongoing Great Credit Bubble. It is, moreover, simply failed doctrine for Dr. Greenspan to completely disregard the Credit system when discussing asset Bubbles, especially considering the revolutionary developments and unprecedented expansion experienced over the past decade. Not once in Greenspan’s speech does he use the word “Credit.” There is no mention of lending excess, money or Credit expansion, destabilizing speculation, the overly aggressive financial sector, or the expansive mortgage finance super-industry. No mention of junk bonds, agency debt, mortgage or asset-backed securities, bank loans, or other Credit instruments that provided the purchasing power for the boom now turning bust. After shunning his responsibility for protecting the stability of our financial system, Dr. Greenspan would today like us to believe that it was outside of the control of the Fed to prevent the stock market Bubble. While we would certainly dispute this point, we in the past did write that to get the developing Bubble under control would have required only three phone calls - and they would have been local calls to leading instigators of Credit excess, Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System. A few additional New York calls to speak with Goldman, Merrill, JPMorganChase, Morgan Stanley, and Citigroup could have worked wonders.

These institutions evolved into the core of an expansive and uncontrolled Credit mechanism and Chairman Greenspan had a courtside seat next to the players (the coach or the trainer?). Any analysis that ignores the key role played by the ballooning financial sector and leveraged speculation is a disservice and intellectual injustice. Greenspan goes so far as to state, “It is generally the changing risk preferences of investors, not of corporate managers, that govern the mix of risk investment in an economy… To be sure, managers’ personal sense of risk aversion can sometimes influence the capital investment process, but it is probably a secondary effect relative to the vagaries of investor psychology.”

No way; this is erroneous analysis. An uncontrolled Credit system and monetary excess will reward risk-taking, reckless spending, and destabilizing speculation, while nurturing the resulting financial and economic maladjustments. Monetary recklessness ensures the unstable vagaries of the marketplace, and propels the dominance of speculators over true investors throughout the equity, Credit and currency markets. The responsibility of financial and economic instability lies first and foremost with the accommodative Federal Reserve and the ungoverned financial sector, not “the vagaries of investor psychology.” Have we learned nothing from history?

From Greenspan: “A wave of innovation across a broad range of technologies, combined with considerable deregulation and a further lowering of barriers to trade, fostered a pronounced expansion of competition and creative destruction. The result through the 1990s of all this seeming-heightened instability for individual businesses, somewhat surprisingly, was an apparent reduction in the volatility of output and in the frequency and amplitude of business cycles for the macroeconomy... Economic imbalances in recent years apparently have been addressed more expeditiously and effectively than in the past, aided importantly by the more widespread availability and more intensive use of real-time information. But faster adjustments imply a greater volatility in expected corporate earnings.”

This is especially dangerous analysis. Inarguably, we experienced a confluence of positive new technologies, trade and tax policies that stimulated economic growth. But we would strongly argue that it was profound developments throughout the Credit system that imparted the most serious influences (certainly including distortions) to the real economy. Enormous endemic Credit excesses - with the collapsing technology sector today’s most conspicuous example - imparted wild pricing and spending distortions, creating an extraordinarily risky environment for individual entrepreneurs and businesses. At the same time, unrelenting Credit excess has thus far sustained the general spending boom (when the NASDAQ/tech/Telecom Bubble burst, rampant lending excess simply shifted to the consumer/mortgage sector). Dr. Greenspan makes a grave error when he misinterprets the continuation of the Credit Bubble for an improved environment benefiting from a “reduction in the volatility of output” and more expeditious and effective imbalance rectification. My sense is that, when all is said and done, economists will recognize that during the nineties the de-industrialized U.S. service-sector economy did not repeal the business cycle, but only accentuated and elongated it. No longer would the production of goods and inventory/investment cycles dominate. Instead, the consumption/”service”-based economy became highly monetary in character, with a prolonged Credit cycle sustaining boom-time spending while overriding traditional business cycles dynamics. The downside of the Credit cycle will be commensurate with the upside.

Greenspan: “As might be expected, accumulating signs of greater economic stability over the decade of the 1990s fostered an increased willingness on the part of business managers and investors to take risks with both positive and negative consequences. Stock prices rose in response to the greater propensity for risk-taking and to improved prospects for earnings growth that reflected emerging evidence of an increased pace of innovation. The associated decline in the cost of equity capital spurred a pronounced rise in capital investment and productivity growth that broadened impressively in the latter years of the 1990s. Stock prices rose further, responding to the growing optimism about greater stability, strengthening investment, and faster productivity growth.”

Almost without exception, extraordinary asset price gains (inflation) are the manifestation of some underlying disorder within the Credit system. With the explosion of money and Credit experienced during this boom, there should be no confusion as to the true source of asset inflation and the stock market Bubble. This dynamic has been repeated throughout history, with John Law’s infamous early 18th century experiment with paper money expansion one of the most colorful. As always, Credit excess begets additional excess, with especially seductive manifestations that few are able to recognize and even fewer in positions of authority willing to stem come the powerful euphoric tide. It is then not helpful (and likely disingenuous) for Greenspan to focus on esoteric concepts such as “equity premiums,” the “cost of equity capital,” and the “greater propensity for risk-taking” as causes, when they are clearly the effects of monetary and Credit excess. Indeed, the destabilizing distortion to risk perceptions (hence risk-taking) is precisely one of the paramount dangers of Credit-induced asset inflation.

Greenspan: “Looking back on those years [the nineties], it is evident that increased productivity growth imparted significant upward momentum to expectations of earnings growth and, accordingly, to price-earnings ratios.”

This is not evident at all, and it is certainly not a key issue. Money flooded into the stock market – much of it purely speculative bets on rising technology and index mutual funds. This torrent of speculative flows was not the making of productivity-induced earnings growth expectations, but was in response to others making significant easy money. Many wanted a piece of the action, while the history of markets teaches us to expect no less. But the bottom line is that there was too much money sloshing throughout the system, with limitless leveraged speculation and Credit availability inundating the marketplace with risk-seeking finance. The booming junk, syndicated bank loan, and CDO markets left their footprints all over the technology Bubble, just as the agency, MBS, ABS, and CMO booms are today fueling the mortgage finance Bubble. The notion of productivity growth, if it actually exits, has nothing to do with monetary excess and assets Bubbles. Yet it does conveniently confuse the issue.

Greenspan: “Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely an illusion. Instead, we noted in the previously cited mid-1999 congressional testimony the need to focus on policies ‘to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion.’”

As the brilliant Henry Kaufman has stated: “The Fed missed its timing.” A true bout of tight money (not just somewhat higher short rates), having squeezed the aggressive lenders, and punished the speculators and assertive leveraged players, would have nipped the Credit Bubble in the bud. This process was actually begun in 1994 (Greenspan admitted as much during Fed meetings), but systemic stress (including the Orange County bankruptcy) and the Mexican collapse proved more painful than the Fed was willing to tolerate. Post-Mexican bailout, the leveraged speculating community became too large and their holdings only more critical to the system. It became “growth at any cost” and the speculators were the key to financing it. Financial excess was handsomely rewarded, and the securities/speculation-based Credit system became dangerously emboldened. There was no turning back for the Greenspan Fed. It is today a true disaster, as policies “to mitigate the fallout” from the stock market Bubble and to “ease the transition to the next expansion” really only fuel greater Credit Bubble maladjustments and heightened financial fragility.

Greenspan: “Bubbles thus appear to primarily reflect exuberance on the part of investors in pricing financial assets. If managers and investors perceived the same degree of risk, and both correctly judged a sustainable rise in profits stemming from new technology, for example, none of a rise in stock prices would reflect a bubble. Bubbles appear to emerge when investors either overestimate the sustainable rise in profits or unrealistically lower the rate of discount they apply to expected profits and dividends. The distinction cannot readily be ascertained from market prices. But the equity premium less the expected growth of dividends, and presumed earnings, can be estimated as the dividend yield less the real long-term interest rate on U.S. Treasuries. ”

Geez, talk about barking up the wrong tree. Greenspan seems to go out of his way to create analysis that confuses the issue, while completely avoiding the central role played by Credit excess in fostering self-reinforcing booms and destabilizing asset inflation. But it gets worse.

Greenspan: “If equity premiums were redefined to include both the unrealistic part of profit projections and the unsustainably low segment of discount factors, and if we had associated measures of these concepts, we could employ this measure to infer emerging bubbles. That is, if we could substitute realistic projections of earnings and dividend growth, perhaps based on structural productivity growth and the behavior of the payout ratio, the residual equity premium might afford some evidence of a developing bubble. Of course, if the central bank had access to this information, so would private agents, rendering the development of bubbles highly unlikely.”

While this analytical goose-chase clearly has enormous potential to keep scores of economists and Ph.D. students occupied for years to come, what a waste of time and effort. The foundation of asset Bubble analysis rests squarely with the study of lending, money and Credit creation, financial institutions, debt structures, and speculative market dynamics.

Greenspan: “As I noted earlier, the key policy question is: If low-cost, incremental policy tightening appears incapable of deflating bubbles, do other options exist that can at least effectively limit the size of bubbles without doing substantial damage in the process? To date, we have not been able to identify such policies, though perhaps we or others may do so in the future. It is by no means evident to us that we currently have--or will be able to find--a measure of equity premiums or related indicators that convincingly presage an emerging bubble. Short of such a measure, I find it difficult to conceive of an adequate degree of central bank certainty to justify the scale of preemptive tightening that would likely be necessary to neutralize a bubble.”

Well, I would suggest we start with sound money, and not let Bubbles get started. And for indicators of asset Bubbles, I would suggest monitoring broad money supply, studying Credit growth by sector, and paying especially careful attention to whatever area is the current hot trade/sector on Wall Street. And the key to protecting the stability of the financial system and economy is to punish financial speculators early in their endeavors instead of sheltering and rewarding the aggressive.

Greenspan: “In conclusion, the endeavors of policymakers to stabilize our economies require a functioning model of the way our economies work. Increasingly, it appears that this model needs to embody movements in equity premiums and the development of bubbles if it is to explain history.”

Contemporary economies and financial sectors are incredibly complex and evolving. There will be no answers found in models. The great Hyman Minsky saw how stability would be over time destabilizing. “Fine-tuning” and policymaker endeavors to rid the economy and markets of the downside of cycles, only nurtures destabilizing risk-taking, speculation, Credit excess, cumulating maladjustments, and resulting financial fragility and structural distortions to the real economy. There is no way around these economic facts of life (as much as they are not conducive to modeling!). Wed stabilization policy goals with a monetary system lacking either sound backing by a relatively stable commodity (gold/precious metals) or limitations as to the amount of (electronic) “money” that the Fed and financial sector can create, and there should be no surprise that such a system is acutely unstable. What’s more, it is difficult to imagine such an unharnessed system not nurturing inflationary manifestations, including asset Bubbles. When this type of monetary “regime” is the lynchpin of the global financial system, we should expect nothing less than the continuation of the spectacular booms turned bust that have afflicted the likes of Japan, Mexico, Korea and SE Asia, Russia, Argentina, Turkey, Brazil, telecom, the Internet, and others.

It is clear that Dr. Greenspan is adept at crafting reasoning that deflects responsibility from him and Fed policies for the great hardship that has and will be suffered by so many. More troubling, he is determined to espouse only more outlandish disinformation and erroneous/dangerous analysis. To blame “investor psychology” for the U.S. Bubble is ridiculous.

Greenspan has developed into the grand master of spin and instantaneous historical revisionism. This is a great disservice to the public interest and is unacceptable from the Chairman of the Federal Reserve. We have in the past invoked the fable of the “Emperor with No Clothes.” Well, it is past time to admit that Greenspan is a man of intellectual nakedness. Can the economic community please cease with the mindless kowtowing and instead commence with an open debate of these critical issues? Today’s speech leaves no doubt that Dr. Greenspan is more interested in protecting his reputation than the pursuing the knowledge and analysis necessary to help protect the public welfare. Must we wait for some type of collapse or crisis to begin the learning process? The “Emperor” should step aside. But, regrettably, it is more a case of Greenspan as economic dictator. It is time for an intellectual “uprising” to cast aside the failed thinking and obfuscation from the Greenspan era and usher in a new period of analytical rigor, open-minded impartiality, and intellectual integrity. In this regard, we have an incredibly exciting opportunity. There is much work to be done.