11/21

     WHERE ARE ALL THE BIAS?

Where Are All The Bias?...Was it really a huge surprise that the Fed passed on changing its "bias" at the FOMC meeting last week?  The stock market seemed a bit taken aback as prices promptly took back the ground they had struggled so mightily to achieve over the early part of the day and week.  Stepping back for a moment, the bias in and of itself has little more than perceptual meaning.  Clearly before the next interest rate decrease, the Fed will have summarily changed its bias back to neutral and possibly to a bias of ease.  But a change in bias is not going to change the immediate direction of corporate earnings or trends in the domestic and global economy.  For that matter, an actual change in rate policy will also have no magical overnight effect on immediate fundamentals.  Monetary policy by nature is characterized by lagging real world effects.  The only immediate effect is on investment perceptions.  Corporate revenues, earnings and cash flow don't turn on a dime, no matter how hard investors wish that to be true.  (Of course, as you know, stock prices do not always reflect fundamental reality, both on the upside and the downside.  That we know is true.)

Despite the sell off in stocks, the Fed has a number of good reasons for maintaining at least perceptual strictness.  With unemployment falling back below 4%, there is no question that the labor market is tight.  What has been normal for assumed "structural" unemployment boundaries over the last 25 years has changed.  Simplicity is often found in pictures:

A bit more than the simplistic fact that unemployment is low is that average hourly earnings growth is outstripping current annualized growth in GDP.  Not a situation descriptive of a completely benign inflationary environment.

It's a bit funny that after watching the growth rate in average hourly earnings decline over the last few years, the rate of change in hourly earnings growth has turned up just as the stock market (options) has turned down. For those heavily involved in stock option plans, maybe it's not that funny after all.

Despite the best intentions of politicians far and wide, the impact of the global energy complex on the domestic US economy is simply beyond the control of the Fed.  At the same time, it's the Fed's raison d'etre to respond to those direct effects to the economy such as energy is now imposing.  It is quite interesting to note in the following chart that the last time the price of crude oil was in the mid $30's, the CPI for energy was at and growing at much lower levels than today.

Clearly the last spike up in crude was short lived and perceptually vanquished as Desert Storm rolled across Kuwait.  Today, the CPI for energy acts as if the increase in crude is anything but short lived.  The dynamics are different today.  You may remember the "natural gas bubble" in existence in the late 1980's and early 1990's.  We don't hear that term used at all anymore because the natural gas supply demand balance is much tighter than it has been in over a decade.  Today, the alternative fuel to crude is also expensive.

Lastly, the Fed is more than well aware of the characteristics of credit expansion in aggregate over the last half decade plus.  It's not just oil that is higher.  Despite statistics on real estate inflation that often seem a bit out of step with local experience, the following chart appears more than self explanatory in documenting some of the credit related fuel behind the rise in real estate values.

Remaining perceptually tight at the current time has allowed the Fed to possibly have the banking system do a bit of its dirty work.  As you know, expansion in the liability side of GSE balance sheets and the consumer balance sheet was a strong driver of the consumer economy from mid decade.  Picking up the banner strongly in the last few years (with controversy surrounding the GSE balance sheets) were the banks.  Now that we are almost 18 months into a monetary tightening cycle, the beginnings of overtly visible credit problems are surfacing.  By not coming to the immediate rescue of the banks, does the Fed create a situation where the banks restrict credit as opposed to the Fed needing to tighten further?  Sure it does.

Out Of The Money...We have spoken to you many times of the "Greenspan put".  The thought that Greenspan would ultimately save the financial markets at some point via the liquidity mechanism.  Could it possibly be that the "strike price" of the put is a bit further "out of the money" than the consensus may have thought?  It appears that the Fed is silently promoting the negative wealth effect.  Of course, to a point.  Banks are tightening credit.  A lower stock market is erasing paper wealth as an initial deterrent to runaway demand.  Don't get us wrong.  We're not suggesting that Greenspan is all of a sudden a zealous convert to monetary discipline.  What we are suggesting is that current market circumstances do allow the Fed to perceptually have their cake and eat it also.  Perceptually, it's not the poor Fed's fault that oil prices are supposedly high.  Greenspan didn't put an actual gun to BofA's head and force them to make loans into the telecom "space".  Mr G. can't help it if companies are actually being forced to pay cash in lieu of stock options, given a currently uncooperative equity market.  Possibly the Fed sees itself in a sweet spot of not having to be the direct (interest rate increases) bad guy for its hoped for slowdown in economic growth - the very thing the Fed needed to head off what appeared 6-9 months ago to be the beginning of rampant and blatant inflationary statistics.  The recent Bob Woodward book on Greenspan intimates that Greenspan is one political animal.  Is maintaining the tightening bias for now simply a triumph in politics?

Fall Into The Gap...Certainly today's trade deficit news suggests weakness in US GDP ahead.  The $34.3 billion gap for September was a 15% increase from August and well above expectations.  The voracious US consumer is turning away from US domestic manufacturers with ever more vigor.  And who can blame them?  US manufacturers are caught in a period of rising input costs coupled with the inability to raise prices.  The classic margin squeeze.  The higher the dollar ascends relative to foreign currencies, the more retail pricing pressure grows for the domestic company.  In today's numbers, the US trade deficit with China, Canada and Mexico all set records as aggregate exports actually declined.  The strong dollar policy of the US Treasury/Fed has now become a headwind to the domestic producer.

It appears to us that the Fed believes it can manage an economic "controlled burn".  Possibly the proof in the pudding will come when US annualized GDP falls near, or under 2%.  The following line from the press release of the latest FOMC meeting is quite telling

     "However, softening in demand and tightening conditions in financial markets over recent months suggest that the economy could expand for a time at a pace below the productivity-enhanced rate of growth of its potential to produce."

Cutting through the new age Fed-speak, does this suggest that the Fed is willing to watch annualized GDP growth fall modestly below 2% before it will act?  Quite possibly.  We're sure there is also some type of corollary with stock price limitations before action is warranted.  What this also suggests is the assumption that the dollar will maintain a certain relative strength against foreign currencies.  Not a given by any means, but a possible outcome.

We know the dollar is over owned globally.  We know our domestic trade deficit is staggering and we risk the potential wholesale global selling of the dollar with each passing month.  What is also true is that the strength of foreign economies is largely tied directly to the health of the US.  Although a microcosm, the downturn in global tech capital spending will be a big drag to the Asian economies.  As you know, so much manufacturing is sourced abroad that the tech slowdown is anything but specific to the Silicon Valley.  As you can see in the following charts, the 50% implosion in the SOX since March of this year has a twin in the performance of the Taiwanese market.  Coincidence?  Of course not.

Just today, the index of western German business confidence fell for the fifth straight month in a row.  Growth in the Euro zone is falling.  The Euro clan is experiencing the same pressures as their US counterparts.  Increasing input costs and lack of pricing power.  We've been arguing for some time that the global economies are tied together more closely today than possibly ever before.  In the current environment, the academic argument for global diversification may have less appeal than at any time in the recent past.  Is the Fed betting on the fact that foreigners will keep their dollar asset holdings intact as opposed to repatriating capital to home fronts that may be suffering their own economic weakness?  In a synchronous global economic slowdown, will the dollar remain the best of a myriad of bad choices in terms of global currency holdings, despite the obvious imbalance in our trade deficit?

The Fed knows that dropping rates meaningfully risks near term dollar strength.  Given the message in today's little trade deficit announcement, a near term decline in the dollar would mean the importation of inflationary pressures pronto.  The Fed may be betting on an acceptable dollar outcome over the intermediate term, but is choosing the dollar over the economy and financial markets, FOMC meeting to FOMC meeting.  In trying to engineer the "controlled burn" soft landing, the bias is just one perceptual tool in the Fed arsenal.  We are convinced that the Fed will not stand pat and let the US financial markets or economy take a swan dive off the high board without an attempted bungee cord save job.  In like manner, were the Fed to give in to blatant moral hazard here and now, the guarantee of an eventual crash landing would solidify.  The next FOMC meeting is December 19th.  It's a toss up as to how the Fed will move.  A removal of the tightening bias seems a necessary precursor to an ultimate rate ease.  If we had to bet, we'd guess they remove the tightening bias at that time.  Remember, the bias may mean very little in immediate fundamental reality, but the perception of movement toward easing may be all this market needs to find its legs...at least for a short while.

Turkey Shoot...You may remember that we discussed the new SEC FD (Fair Disclosure) ruling with you a few weeks back.  Well, this turkey is coming home to roost.  We're guessing that post the Thanksgiving holiday and into early December, the preannouncements should start flying.  Why?  We'll have two months of the quarter under the belt and management's should have a good feel for the "tone" of revenues and earnings.  Secondly, we believe corporate management anxiety is relatively high regarding the new SEC mandate.  Who wants to be the first class action test case?  No one, that's who.  Paranoia regarding disclosure may predispose exec's to come clean as soon as they have reasonable information regarding results versus expectations.  No more banking on a back-end loaded quarter.  We expect preannouncements to begin well before their usual time slot given the testing period of this SEC mandate.  If we were to experience this type of truth serum activity early in December, that may be all the Fed needs to remove the bias on the 19th.  Just a thought.  Don't be surprised.

A Blue Christmas?...And possibly not just because of the potential impact of SEC Rule FD.  Consumer energy prices are up.  Stock prices are down.  Retail sales at Christmas are a question mark at this point.  Will the consumer be willing to bulk up on credit again?  We're going to find out quite soon.  Here's a real flyer.  Another possibly little remembered fact that may delay some buying (of stocks, that is) during December is the change in the cap gains tax law as of 12/31/00.  For holders of stocks purchased after Dec. 31, the long term cap gains tax rate will fall to 18% for assets held for five years or longer.  (Now you know and we know that the thought of holding a stock for five years may seem simply absurd in today's digital world, but in prehistoric financial times, people actually used to do this very thing.  Imagine that.)  So, for any of our true long term investor friends out there, why swoop up any "bargains" before Jan. 1?

Talk To The Hand...We've been simply amazed that the public has not blinked (yet) during the stock market rout really beginning in March of this year.  AMG reported inflows to equity mutual funds have dried up to a proverbial trickle, but still remain positive nonetheless.  Throughout October and November, each week has been a net inflow in aggregate.  A testimony to long term investing at its finest or the hallmark display of the human psychological trait of denial, it's either one of the two.  For perspective, we need to remember that the current NASDAQ decline YTD is one of the worst on record:

Not since the bear market of 1973/74 has the NASDAQ recorded a year-to-date loss as great as we have now experienced this year. (Albeit, last year's parabolic run up does color the picture of normalcy quite considerably.)  In very coincidental fashion, mutual fund investors in the 1973/74 period did not begin selling their mutual funds until well into/after the market had already completed most of its decline.  The 73/74 precedent does speak to the fact that the NASDAQ could easily have another down year next year.  Clearly a decline of the current level being followed up by another year of significant decline is not w/o precedent.  It's happened before.  Then, as now, we strongly believe that the public will be the key to the next leg down in the bear market, if there is to be a next leg down.  It's during the second significant downturn in most "classic" bear markets where anxiety and fear take hold and the public reacts out of emotion.  As you know, though, in 1974 we were facing significantly higher energy costs, the beginnings of the onset of serious inflation,...hmm, maybe we better just stop right here.