first majestic silver

A Fallen Cake

April 23, 2001

In an effort to present my thoughts on where we might be in the markets and the economy right now, please allow me to recount an experience I had as a wee lad.

I was about 11 or 12 years old. A birthday party was coming up for another kid who was younger than I, and we were going to have a party for him at our house. Persons who should have known better placed me in charge of baking the cake. (If I recall, I think my parents had to meet someone at the airport a couple of hours away or something, so I was in charge of baking the birthday cake.) I was old enough to be trusted not to start a fire, but I found out there's a big difference between being a non-pyrotechnist and being Betty Crocker.

I had watched dear ol' Mom bake many a cake and things always went swimmingly. I had even helped her make them on numerous occasions, with nary a problem. She reminded me of a few particulars before she left, and then I started in on the cake. It was early morning, the party wasn't until late afternoon. I'd bake the cake, give it time to cool, then frost it -- no problem.

I mixed up the cake batter, poured it in the two pans (this was going to be one of those double-decker jobs like you see on the cake boxes), and then popped them in the oven. I then started making the frosting (this was before the days of canned frosting). Then, like any normal person, I went back to check on the progress of my cakes. I opened the oven door. You heard me right. Just as my little beauties were starting to puff up, I opened the door. I immediately realized what I had done and closed it again. The next few minutes were spent in prayer as I peered through the oven window and kept a close eye on the timer. "Come on! Grow! Grow! This is important!!" They wouldn't.

A few minutes before the time was up, I decided I would poke some air holes in the cakes with a fork, maybe that would help them raise again (I was desperate, and 12.) The cake stuck to the fork and I ended up pulling chunks out of each cake. I replaced them like a golfer's divot, figuring they would grow back. But none of it helped. The cake in one pan imploded, while the other one came out lopsided, resembling a intermediate ski slope . . . with moguls. When I finally pulled them out of the oven, these things were so mutilated and deformed they looked they they had been the object of a mob hit.

I panicked. I was a failure at life. While the cakes cooled, I ate some cookies to calm myself down. What to do now? I decided I would make the best of it. I'd whip up another batch of frosting and use it as a sort of sculptor's clay to hide the imperfections. The top of the cake was going to be seen, so it had to be level. I figured I could use the ski slope as the bottom layer, add some reinforcing frosting to one side to level it out, and then put the frosting-filled imploded cake on top of that. Yeah. Good idea. Everything's gonna work out fine. The divots kept coming out when I tried to frost them, but other than that everything was good. I plastered, leveled, scraped, and sculpted frosting for about an hour. And it really did come out looking halfway decent. I put it in the fridge.

When Mom came home she took a quick look at it, congratulated me, said something about how she knew I wouldn't let her down, and kissed me on the cheek for doing such a good job.

That afternoon, the guests started arriving. The kids played, the parents mingled, we all had something to eat. It was summer, it was hot, the party was outside.

The moment for the birthday cake arrived. Mom asked me to bring the cake out and everyone applauded my accomplishment. I couldn't say anything, it was too late. I had to roll the dice. Everybody was then asked to say something nice about the birthday boy. There were about twenty kids. Kids talk slowly when they're nervous. I kept thinking to myself, "Let's go, let's go! It's hot out here! That frosting's only gonna hold up so long!" Then somebody mentioned something about the cake not having any candles. Mom immediately went inside and got some. "No, no, not more heat," I thought to myself. Like a carpenter trying to find a stud, Mom inserted the candles but had trouble hitting anything solid in the center portion of the cake. When the kid blew out the candles, Mom went to remove them and apparently removed one of my divots in the process, leaving a huge pock mark. "Oh, that's. . . . interesting," she said, not knowing the half of it.

Things degenerated from there. I'd forgotten that when each slice of cake was put on a plate, the entire innards could be easily seen. The shoddy construction was exposed. One slice, which came from the lower side of the ski slope (down near the lodge), revealed itself to be about 75% frosting. The jig was up. I decided to lay low over by the soft drinks. Not wanting to disappoint, the parents continued to dole out chunks of melting, crumbling cake to the kids. The adults didn't eat any. Eventually, the heat and the frosting didn't mix and, of the remaining cake, the top layer slowly slid off the ski slope.

On the plus side, the generous heapings of frosting led to my hero status with the kids who called it "the best cake ever!" On the minus side, however, that afternoon there was an especially spirited game of Red Rover, during which some minor injuries were sustained.

After the party, Mom forced a confession out of me and I was sentenced to two weeks of yard work.

Al's Loading On The Frosting

Certainly a fallen cake is not exactly like a bubble economy. You want a cake to raise, you don't want a bubble to form. Greenspan's mistake was not in deflating the bubble; it was in allowing in to form in the first place. So while the above is not a perfect analogy to today's current economic situation, I think it does bear many similarities. Alan Greenspan is in much the same spot I was then. The cake he was baking has fallen and there's no way to raise it again. Attempts to do so are likely to make things worse. All he can do is make it appear that he has raised the cake again, just like I did.

Easy money policies have led to America being leveraged as never before, and we arguably still have bubbles in real estate, the dollar, and credit in general.

How much credit is there? This doesn't prove anything, but I'd ask you to take a little test regarding how easy credit has been. Quick, name an asset that you cannot buy with 100% financing. Stocks (50% financing) are about the only thing I can think of. Furniture, boats, cars, electronics, even houses can be bought with 100% financing. I remember back in the '80s when a guy named Robert Allen wrote a book on how to buy real estate called No Money Down. At the time it was scandalous. Not only was it thought to be impossible, it was considered irresponsible. Now, it's ordinary fair. And you no longer have to find a desperate seller to carry the paper; mainstream lenders will offer you 100% financing and sometimes more. My, how times have changed.

People used to save money back then, too. That's something else that's gone out of style. We now have guys like Robert "Everybody Go Buy An SUV" McTeer, of the Dallas Fed, encouraging people to keep spending -- don't save money, spend. I've heard a number of commentators on TV talk about how Japan has problems because their population saves too much. Step back from all economic figures for a moment and ask yourself if that "saving bad, spending good" argument would pass muster with your Grandmother.

While much of this credit has been created outside the banking system, in my opinion Greenspan is still the psychological linchpin.

For the most part, he's now trying to use loads of frosting (artificially low interest rates and massive injections of liquidity) to cover up mistakes he's made over the past five to seven years to make it look like he's baked a good cake. But as I found out, frosting is no foundation. And covered-up sins are eventually revealed.

Ultimately, one of three scenarios seems likely: 1) The guests devour the entire cake and eat so much frosting that things get a little hyper (the inflation scenario), 2) The cake and its frosting start to melt away and collapse before anybody wants to eat it (borrowing stops, leading to the deflation scenario), or 3) Some mix of 1 & 2 (the stagflation scenario, in which prices of commodities rise while financial asset prices fall). Once it gets started, the second scenario, deflation, is extremely difficult to stop. It is also probably the most unpalatable politically, and Greenspan seems to be doing anything and everything to stop it.

Why The Surprise Rate Cut?

Here's my theory. For the money supply to continue expanding at such prolific rates in order to support the debt bubble, borrowing must continue to occur. If it does not, the debt bubble will implode and asset prices will come crashing down.

In our current system, the lending process is what creates money. With Greenspan always willing to come to the rescue in the past (the "moral hazard"), and with the economy fluttering, he has worked himself into a box. Over a period of years he has conditioned people to expect lower rates whenever there's trouble. So you know what, people are waiting for lower rates. They're not borrowing today because they know they can borrow more cheaply tomorrow. But if borrowing does not continue to occur now, the credit pyramid will collapse and we will likely enter into a deflationary death spiral. This is why he must be mysterious, and even misleading, as to when or if he will lower rates further. (Ultimately, continued borrowing will collapse the credit bubble as well, only later. But if you could avoid your death for a little longer, wouldn't you?)

Jumping out of the bushes with a "surprise!" rate cut after stock market psychology had already turned positive, seemed like a clear attempt to manipulate the markets higher, thereby bolstering corporate and consumer balance sheets which are deteriorating quickly and inhibiting further borrowing.

[Please keep in mind, these comments are my opinion on how things are, not on how they should be or how I would like them to be. The entire idea that we have an un-elected, quasi-government official setting artificial prices on money is quite absurd. If there had been a head of the Ministry of Cheese in the old East Germany who announced every few months what the official price for cheese would be, we would have thought that preposterous. But for now, that's what we have.]

Remember Speed?

The current situation reminds me of the movie Speed. If memory serves, the plot (if you want to call it that) was that if the bus Sandra Bullock somehow ended up driving was slowed below 50 mph, it would explode. As oddball and hair-brained as that plot was, that's what we've got now. We can't slow down for a while and then speed back up. If borrowing does not continue at its torrid pace, the credit bubble will collapse. Bob McTeer plays the part of Keanu Reeves by telling us, "Dudes, don't stop borrowing and spending or this thing's gonna blow!" It's really quite ridiculous and surreal that we've ended up in such a situation, yet here we are.

The Markets Will Rule

But the markets ultimately control things. Greenspan, the GSEs, leveraged speculators, etc., can all appear to control things in the short run, but the markets will have the final say. The long-term bond market is becoming very shaky, perhaps worrying about inflation or perhaps money moving out of bonds and back into stocks. Whatever the case, long term rates, including mortgage rates, may very well have finished their move down. Mortgage refinancings have been going gangbusters of late and have helped sustain the economy and consumer lifestyles. Low mortgage rates have increased home prices and led to large cash-out refi's to the point where home prices are at all-time highs while homeowner equity is at all-time lows. If mortgage rates start moving up meaningfully, homes prices are likely to come down. Perhaps sharply in some areas (the San Francisco Bay Area comes to mind). This will lead to precisely the consumer balance sheet deterioration Greenspan was trying to prevent. People will scale back spending. Consumer spending represents about two-thirds of the economy (or so they say, I don't know how it's possible to come up with such accurate figures). The economy will turn down. And heaven forbid if people should actually start saving money.

If we're not there already, we will soon be at the point where anything Greenspan does will lead to serious problems.

The housing index appears to have started a downtrend while inflation is trending up. Credit card and home loan delinquencies are also on the rise. The effects of higher energy prices, caused at least partly by past easy money policies which led to misallocations of capital, have yet to fully work their way through the system. Nobody seems to care if we inflate, but long-term rates don't like inflation.

What Now?

Does all this mean the stock markets have to head down immediately? Nope. Heck, it doesn't even have to mean I'm right. That's just my view of things. For the time being, investors seem convinced that the worst is over. Perhaps they're right, who knows. Or perhaps they have convinced themselves that everyone was too bearish, that things couldn't get any worse, and that lower rates and easy money will save the day. It may end up being self-fulfilling in the short term. Add to that the numerous companies who are taking their "big-bath" quarters, and the comparisons will start getting very easy for a few quarters. We may be back to playing the "beat the estimates" game. This psychology can be very strong once it gets rolling. We have come down extremely far, extremely fast on the Naz. Drawing a simple trend line from the top, one can see that we could go up quite a ways and still be below the trend line.

The piece with Richard Russell in Barron's last weak was a good read. Especially notable is how much respect he has for a bear market, how violent the bull rallies can be, and how long the entire process can last. He's been around a long time. There's nothing saying he has to be right, but there's nothing saying the worst is over either.

We're all guessing.

My guess is that Greenspan is leading investors into exactly the wrong areas at exactly the wrong time. I am staying far away from the financials, homebuilders, and retailers. Especially risky would seem to be Freddie Mac and Fannie Mae. Lower real estate values could be devastating to these highly, highly leveraged institutions. I've seen many articles suggesting these are good, safe companies. I couldn't disagree more.

But for the time being, we may have a bull inside of a bear. This latest move has been extremely strong, the comparisons will get easier, and if the psychology stays, it could last a while. The confidence of the last decade is not likely to be destroyed in one year. It will take time (assuming we're still in a bear market). We could rally for months. Maybe even to the end of the year. Now that I've said that, things will probably crash tomorrow.

Alternatively, much of last week's action may have been due to options expirations. Perhaps we even had the opposite of one thing that occurred during the '87 crash. Then, many people wrote far out-of-the-money puts, figuring it was easy income and they'd never be worth anything. They then had to cover those positions as things moved down, which led to further selling, etc. This time, some of that may have happened with people writing calls that they thought would be worthless, so higher prices led to higher prices and so forth. The beginning of this week may give us some indication as to whether this move is real, or options related.

Currently, I'm too much of a ninny to be on the short side of such a powerful move, and have too much respect for The Bear to go long in any meaningful way.

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