If Everything's Okay, What's Wrong?

September 23, 2002

The economy is receiving mixed reviews. From moment to moment, we hear goods news and bad news. The lack of a definitive economic assessment has held the Dow Jones Industrial Index in an anemic limbo for most of this year. Presumably, everything is okay... or, I should say not so bad because consumers have not become depressed to the point of shutting down. Further, residential real estate has been booming. However, there are serious questions about inconsistencies between the media and government assessments and ancillary news.

The Wall Street Journal's front page headlines, "Japan's Central Bank Will Buy Stocks Held By Troubled Lenders." Alone, this process appears a dubious method of solving overall economic woes. More important is a single reference to Japan's "manufacturing-based" economy that is inexorably linked to global consumer confidence. According to the Bank of Japan, there has been a significant slowdown in consumer purchases that has extended to the all-important automobile sector this past month. Thus, we see a contradiction in consumerism represented by a lack of Japanese export sales. Where is the reality?

Moving to the real estate market, we know that commercial leases have slowed to negative growth while occupancy rates have been steadily expanding within major metropolitan areas. It seems clear that residential real estate has been buoyed by a combination of low mortgage rates and a failing stock market. For example, several close friends of mine have recently moved to larger and more expensive homes based upon the fact that their mortgages will be no more...or actually less than their overheads on their old homes. At the same time, they consider real estate "safer" than stocks and more profitable than bonds.

The flaw in this thinking has already been experienced by thousands (if not millions) of Americans who have upgraded and watched home costs rise in unanticipated ways. While my personal experience with friends hardly counts as a statistically sound survey of general experiences, I can glean some lessons that should be obvious. First, a new and more expensive property is assessed at its selling price. This means that local tax burdens are disproportionately distributed between old and new properties. While one friend did see a steady mortgage payment, he did not realize he was more than doubling his real estate taxes.

My other acquaintance discovered that his mortgage went down while his maintenance went up. In the end, the piper is paid for the larger and more expensive homes. On the other hand, those who remain in their homes and refinance have the ability to keep payments the same while reducing principle at an accelerated rate.

It is difficult to fully comprehend the interest rate impact upon personal spending. While the assumption is that extra cash will circulate, there are signs that money is actually being absorbed by "hidden inflation." Consider energy prices. With gasoline up more than 20% over the prior year (pre 9/11), commutation costs have been boosted by a proportional amount. Higher food, electricity, repairs and maintenance along with a host of other rising expenses have captured some of the mortgage savings.

Although saving statistics don't reflect a shift in America's lust for spending and debt, I sense a slowdown in purchasing and a shift in spending priorities. Last week's realization that mortgage defaults are rising and have reached interim highs suggests that the upgrade and/or refinancing hasn't accomplished its objectives. In short, we may see a rough road ahead.

The Technical Picture

Last week, I called attention to 8200 support in the Dow futures and the potential for a head and shoulders formation with an 8200 neckline. This week support was breached and the projection from the head to the neckline represents a 7300 target. This remains 300 points above my downside projection of 7000.

Whether the Dow sinks to 7000 or 7300 makes little difference as long as you are short. Certainly, judicious trailing stops should be capable of capturing a significant portion of this decline should it come to pass. However, technicians are quick to point out that 7300 would represent a first target after a breach of 8200. The second objective would be half as much or approximately 6850.

Such a decline sets the stage for more stock market panic. For the most part, investors who stayed with the "traditional" Dow portfolio faired well in comparison with those who jumped into high tech. From the 11,000 peaks to the 8,000 lows was about 35%. Yes, this is a big hit. But, the Dow was at 1,500 in 1986. From 1986 through 1996 the Dow reached 6550 for a 436% gain over just ten years. That's an average return on initial capital of 43.6% a year, however, it is a declining annual return since profits registered on a climbing capital base.

Then, from 1996 through January 2000 the Dow climbed from 6550 to 11,750 for another 179% gain over four years averaging 44.8% per year on the 1996 capital base. Given these longer-term results, the damage in the index has been moderate rather than extreme. At 7,000, we are still ahead of 1986 by a considerable margin. Thus, pundits of "the long-term" can still cling to their mantra that stocks are a best bet from decade to decade.

This analysis is little consolation for investors who ventured away from the "old market" in favor of the NASDAQ. Having hashed over this in several previous Reports, there is no need to rub salt in wounds. My overall point is that a substantial downside in the traditional sector still exists and represents a very dangerous threat to our economy.

Once again, I express my hope that projections and analysis are wrong. Perhaps there is a silver lining and I simply don't visualize it...yet. But, having been enticed into the last technical "bear trap," I am not inclined to sway from my perception that stocks remain in trouble.

The Interest Rate Connection

Imagine a 30-year long bond trading under 4.80%. That's what we have. The outpouring from equities into bonds has obviously accelerated and is finally flattening the yield curve. Now, we will see if Fed Chairman Greenspan's strategy of reducing long-term rates can sufficiently stimulate the economy to turn investor sentiment around.

Interestingly, Mr. Greenspan's approach has already become entangled in a paradox. Just as rates reach their lowest levels, banks are tightening up their lending parameters. So, even with loose money, the price is high and the situation is tight. As indicated by the credit market, struggling companies include former big names like AT&T, Sun Micro Systems, Ford, General Motors, and even IBM. With Moody's and Standard & Poors jumping on the "quality" bandwagon, good ratings are becoming increasingly difficult to obtain. Consequently, the commercial paper environment has been less than friendly.

It is no coincidence that banks are measuring clients by Moody's and S&P when making loan decisions. When you see the triple "Bs" you know yields are going to be fat. It is possible to get 6.5% all the way to 10% on issues that would have been considered "safe" just a year ago. The paradox extends to tax-free issues where backing is becoming questionable. For example, several states have issued tobacco bonds based upon their huge settlements with the cigarette manufacturers. However, as tobacco sales slump and adjunct business slip, the anticipated cash flow could easily be compromised.

Issues that depend upon real estate projections could hit a brick wall if home upgrades and acquisitions flat line or, worse, decline. Payback based upon growing tax bases face the same difficulty. What if there is little or no growth?

Strategically, I abandoned our profitable longs in T-notes under the same uncertainty many analysts faced. How low could (can) rates go? Obviously, safety is taking on new meaning based upon a continuing demand despite falling rates. Greenspan may have appeared to be taking a firm stand, but he realized that no action was sufficient to weigh upon any yield over 90 days.

The scale of T-notes versus Eurodollars distorts the relationship slightly when viewed side-by-side. Notice how the T-note slope has remained consistent while short term rates reflected by Eurodollars have flattened and may actually be responding to prognostications of a fourth quarter pop by either the Fed or simply the demand for money.

There was more room for the long-term rates, but wouldn't it have been nice to spread the yield curve? Of course, there would have been considerable suffering while waiting for the notes or bonds to catch up.

With the Treasury retiring 30-year debt, our government has condensed the time frame for financing operations. When the curve was steep in favor of short-term rates, this made sense. But, as pressure builds between the private and public sector, this situation could change. Essentially, there is no way to lock down costs exceeding two decades. By the same token, there is no way to lock in yields.

I have been seeking an opportunity to sell Eurodollars. Earlier attempts met with failure since the stops were too close for intra-day volatility. While I do not foresee a collapse in principle value (i.e., rocketing short-term rates), I cannot see further upside potential and I believe the Fed will be forced to address price index issues.

One pleasant development has been the halt in rising oil and grain. This stall could give the economy enough reprieve to ward off a preemptive Fed move against inflation. Favorable Midwest weather coupled with cooler Northeast temperatures have affected energy, harvesting, and early winter wheat planting.

The weather map shows ideal conditions with a low pressure system generating rain across much of the winter wheat belt followed by a high pressure center that should clear out the rain and provide drying over the next several harvesting days. So wheat can get into the field while beans and corn can come out.

The boogieman is unstable conditions in the Gulf of Mexico. Hurricane Isidore is threatening to move north into Florida or track north west to come up the U.S. midsection.

Frankly, the harvest is well underway and I am not sure the storm can make landfall in time to adversely effect yields. Still, farmers are looking for some dry weather to complete their harvest tasks and the high coming down from the Northwest may not hold long enough to help. The position of Isidore could take her to Cuba. There goes sugar!

The term “carat” comes from “carob seed,” which was standard for weighing small quantities in the Middle East.