ContraryInvestor - Market Observations

MARKET OBSERVATIONS

NOW OR NEVER ?

MARKET OBSERVATIONS - 3/7

Nothing Succeeds Like Excess...This teflon bull market just continues on and on (at least until today). Setbacks are usually brief. Reaction to Fed commentary short lived. In his Humphrey Hawkins testimony a few weeks, Greenspan pointed to the "wealth effect" as being responsible for a good deal of the imbalances and consumption excess we are witnessing today. Greenspan went so far as to say that the stock market was boosting real GDP by 1% annually over the last five years. Initially, the markets seemed to react a bit more soberly (than usual) to these comments, but in "new era" style, either forgot or completely dismissed Greenspan's implied warning in a few short weeks. Who can blame them? Investors have come to count on Alan to "save the day" under almost any circumstances over the last few years, regardless of anything he may say. It's a case of watch what I do, not what I say.

Over the last few weeks, equity market participants have chosen to focus on the inverted yield curve and "softer than expected" employment report as reasons to believe that once again, the economic and financial market nirvana of a soft landing can be achieved. Hallelujah - just in the nick of time. Forget the recent GDP number. Forget the blowout strength in auto sales. Forget the surge upward in mortgage apps and housing/construction activity. Forget the surely temporary spike on oil prices. After all, by historical benchmarks the yield curve is telling us that the US economy is in for a bit of a slowdown. (Funny how the bulls cite historical parameters when it's "convenient".) Additionally, the employment number is telling us that the bond market is right. We're cooling off. You know what that means. It must mean that Greenspan is closer to the end of monetary tightening than the beginning. And you know what that means - BUY NEW ECONOMY STOCKS!

Oh, were it so easy. In yesterday's speech at the Boston College "New Economy" conference, Greenspan again commented on the wealth effect:

"While recent gains in productivity have helped keep inflation from rising, those same gains in productivity are feeding expectations that corporate profitability will accelerate. Those expectations, in turn, lead to gains in stock values that engender consumer spending, which is pushing demand for goods far beyond the economy's ability to supply them. That wealth effect creates the kind of "imbalances" that have to be corrected by the Fed."

Let's think about it for a second. If (and so far this is a a big if) Greenspan wants to target the "wealth effect" as a problem fostering economic imbalances, he needs the stock market to go down and stay down. Not just for a few days. Not just for a few weeks. We as well as many others have criticized Greenspan and the Fed time and time again for wanton credit creation and moral hazard. In reality, most individual investors haven't a clue as to the ramifications of money and credit creation or subtraction. They do, however, understand interest rates. (They may not actually understand the underlying mechanisms, but can directly feel what they mean to adjustable rate mortgage payments, credit card interest payments, etc.) So far the Fed has used its interest rate lever with little effect. We've seen some anecdotes of slowing, but they are few and far between as well as shallow in retrenchment.

Is it now time for the Fed to pull another set of tools from its arsenal to directly attack the "wealth effect" (also known as the stock market)? To maintain any semblance of credibility, our answer is yes. (That does not necessarily mean it will happen. The tools or the credibility.) What may be more telling in trying to answer the question of moving the attack on the "wealth effect" to a new plateau is that increasing the Fed Funds rate as a mechanism of induced economic slowdown may have lost its punch in the "new era" credit environment in which we find ourselves. It's been twelve months now that the Fed Funds rate has been "put up":

And the economy is accelerating. What certainly seems to be happening is that in today's world, the Fed is controlling only a "portion" of the money/credit creation mechanism. The ability of corporations to borrow in the money markets has opened up a whole to outlet for monetary growth, accelerating in the last decade. The ability of today's non-bank financial institutions to create credit is without precedent in modern times. The larger the non-bank financial economy has grown, the lesser the Fed's ability to control money and credit in the aggregate. It just may be that Greenspan and friends are not fighting the last war, but are fighting the war in the rearview mirror - with "yesterday's armaments" (the Fed Funds rate). Maybe it's simply time to employ some different tools.

If Greenspan is truly serious about moderating the wealth effect, it's time to seriously consider margin requirements and reserve requirements. As you may know, the Fed has not changed margin requirements since 1974. Greenspan has gone on record saying that increasing requirements would hurt the little guy. After all, the "big boys" can go offshore for money (skirting domestic margin requirements) and the little guy can't. Nonetheless, what Greenspan clearly needs to change are expectations. Margin requirements and the ability to change them come in a number of flavors:

1) Regulation T - margin requirements of brokers and dealers

2) Regulation U - margin requirements of "non-brokers"

3) Regulation X - requirements on borrowers of securities credit

4) Margin setting on stock index futures contracts

Maybe it's changing one. Maybe it's effecting change in a few. Maybe it's a small change in all. We believe the fact is that any tightening "change" in margin requirements would engender a perceptual change in speculative attitude. If Greenspan isn't just paying lip service to wanting to reign in the wealth effect, he needs to send a clear message to market participants. Another 25 basis point rate hike is not going to do the trick.

Another potential weapon in the Greenspan tool box is the ability of the Chief to influence/mandate change in member banks' lending activities - specifically credit activities related to securities lending. The following chart clearly argues that there is little fear among banks and that maximization of lending relative to total capital is the order of the day.

Our last observation is that if Greenspan decides to stay on his course of gradually raising short term interest rates in trying to tame the "wealth effect" bull, he risks severely injuring both the stock market and the real economy in the long run (it seems apparent from recent action that the "old economy" stocks already get it). If he decides to increase his focus on slowing the wealth effect (stock market speculation), it seems time he pulls a new tool from the tool box. Undoubtedly the real economy will suffer if the market blows, but just what do you think will happen if the market blows and real rates are already significantly higher than they are today?

(As you know, all of this is simply idle chatter if the market bolts violently in a southern direction over the near term. Remember, before getting too worked up over today's action, let the market show us where it's going next. If we are truly headed into Bear territory, it's only the appetizers that have just been served. The main course awaits. Undoubtedly, not many bulls will make it to dessert.)

The Sultans of Swing...Are China and Taiwan again headed for Dire Straits? The Taiwanese elections are March 16th and the inauguration a few months after. As you know, China has made repeated "noises" regarding their demands that the Taiwanese negotiate over reunification. Of course the US issued its obligatory outrage at China's belligerent outbursts, citing "incalculable consequences" should China attack Taiwan. As you may remember, in 1994, the Chinese shelled the Strait of Taiwan. This time around, at least for the US and its markets, the Chinese have much more powerful weaponry - significant US dollars holdings. Imagine the bang that would go off if China ever decided that financial retaliation (dumping US dollars) was the most suitable form of response to the US. Sort of gives a whole new meaning to the term "modern warfare". Of course CNN would cover the financial shelling live from a hotel rooftop in downtown Manhattan.

Technical Knock-Out?...We've blown through the Dow '00 lows with today's action, although any conclusions drawn from this observation are suspect given the eye-popping $40 billion "reduction" in the value of PG and its significant influence on this narrow average. Tim's super chart work below says there are plenty of "channel cats" swimming in the pond. Price gapping has been violent. Volume has been violent. Investor actions are clearly being driven by emotional violence. Do you really expect all of this to simply quiet down? We're very close to taking out the '00 SPX lows. Today's 160 point NASDAQ reversal is yet another of the NASDAQ's intra-day top ten range days. We don't expect anything to quiet down. In fact, we'd bet you that the biggest index record price change and volume days lie ahead. Maybe directly ahead.