Prudent Bear Market Commentary

October 20, 1999

Today's reports of stronger than expected productivity gains and less than expected unit labor costs will only incite more giddy chatter of a "new era" miracle economy. Amazingly, a very strong consensus has developed that we live in a period of profound price stability, and that today's "Internet economy" can continue at current growth rates of 5% or better without any worry of developing inflation. Yesterday on CNBC, an economist went so far as to state that with one more 25 basis point interest rate increase next week the Fed would "nail the coffin shut on inflation." Such talk confirms our belief that many brains are suffering from overexposure to the bull market.

Today, there are truly momentous misconceptions about the true underlying health of the economy and the soundness of our financial system. Unfortunately, an historic asset bubble has not only distorted the financial system and real economy, it has worked its magic on perceptions and judgements as well. And although it is to be expected that an euphoric Wall Street would buy into "new era" analysis, we are continually amazed that virtually the entire US economic community has followed. And while the stock market mania has certainly impaired the objectivity of analysis, it is increasingly apparent that some very serious flaws in the understanding of basic economic concepts are at play as well.

Nowhere is this more apparent than in contemporary discussions of inflation. Today, the inflation debate centers almost exclusively on consumer prices. And since a designated basket of consumer goods is showing only moderate price increases, this is accepted as proof positive that Greenspan and the Federal Reserve have mastered the art of price stability. Undoubtedly, however, the great old economists, particularly from the Austrian school, would today scoff at such shallow and nonsensical analysis. Instead of a narrow focus on price changes for a basket of consumer goods, their analysis would center on the general monetary environment as the best indicator of true inherent inflationary pressures. In the past, only stable money and credit conditions would be accepted as conducive to general price stability and sound economic growth.

We subscribe very strongly to the view that excessive money and credit growth invariably has inflationary manifestations that fuel dangerous financial and economic distortions. Importantly, these distortions work to disrupt market-pricing mechanisms, and can develop in various forms and with unpredictable timing. Generally, excessive money and credit creation leads to higher prices of consumer goods, asset prices and/or trade deficits. Of the three, consumer price inflation is the least dangerous, as it is both easily recognized and resolved by restrictive monetary policy. As is patently obvious today, asset inflation and trade deficits are a much different animal, as they are easily, and conveniently, identified as the outcome of anything but monetary inflation. Today, these inflationary consequences are deemed "wealth creation" and the wonderful fruits of a miracle economy. Hence, this type of inflation is particularly problematic as it has great potential to be revered by Wall Street, investors, bankers, businessmen, politicians and the general populace, as well as being susceptible to protracted accommodation by central bankers. This is absolutely the situation today. Over time, escalating asset prices and trade deficits lead to severe distortions to both the financial system and real economy, as we have discussed in previous commentaries. Clearly, the US in the 1920's and Japan in the 1980's are examples of the seductive and destructive nature of asset inflation.

With this in mind, there is absolutely no doubt that we are currently in a very dangerous inflationary environment. Sure, the extent of these powerful forces are not visible in consumer prices, but keep in mind that much of what we consume is produced elsewhere. In fact, imports of goods and services this year will total about $1.2 trillion, as our trade and current account deficits escalate to the largest levels ever.

At the same time, inflationary forces could not be more conspicuous, in the data as well as in ballooning asset prices. The data presents clearly that we are in the midst of the greatest money and credit excesses in history. And, importantly, already gross excesses took a dramatic turn for the worse last year. During the eighteen months ended this past June (most recent available data), total domestic non-financial debt increased $1.553 trillion, or more than 10%. At the same time, our financial system took on unprecedented leverage. Financial sector borrowings grew $1.626 trillion, or almost 30%. Household mortgage debt increased $563 billion, while corporate debt expanded $642 billion. Since June 30, 1998, broad money supply (M3) has increased $662 billion, or almost 12%. Money market fund assets have grown $357 billion, or 30%.

This unprecedented money and credit explosion has had a profound effect, adding incredible fuel to the US financial and economic bubble. Nowhere has this been more conspicuous than in the stock market, where, since the lows of early October of 1998, the Dow Jones Industrials gained 40%, the NASDAQ100 160%, the Morgan Stanley High Tech index more than 200%, the NASDAQ Telecommunications index 170%, the Philadelphia Semiconductor index 240%, and The Internet index 480%. And as we have highlighted repeatedly, residential real estate has been another major asset class to experience exceptional price inflation.

Interestingly, many economists are today caught in a trap. By comparing year-over-year money supply growth, they erroneously conclude that the money supply is now expanding only moderately. We look at the numbers much differently, seeing incontrovertible evidence that an historic episode of money and credit profligacy runs unabated. Importantly, our financial system has been creating truly excessive money and credit since 1995. For example, during the first five years of this decade, total broad money supply (M3) expanded $273 billion, or about $55 billion annually. During the last five years (less the remaining two months of this year), M3 has increased by almost $2 trillion, or about $400 billion each year. Last year, M3 literally exploded, increasing $645 billion, or more than double total growth for the first five years of the decade. And while M3 growth will likely not exceed $400 billion this year, keep in mind that M3 grew by $77 billion in 1994 and $66 billion in 1993. And looking at total non-financial debt, we see growth last year exceeded $1 trillion, and is on track for similar growth this year. For comparison, non-financial debt growth averaged $571 billion during the first five years of the decade. Nowhere, however, has credit inflation run more rampant than in the reckless flood of financial credit creation. Financial system borrowings, after expanding at an average of about $285 billion annually during the first half of the decade, expanded by almost $1.1 trillion last year and are on course to surpass this during 1999. Also, margin debt, having ended 1995 at $77 billion, has surged to $180 billion. How can any serious analyst not recognize this unprecedented orgy of money and credit growth? And how can the Federal Reserve not appreciate that credit excess has fueled a massive asset bubble and bubble economy?

Today, there is evidence everywhere of credit excess-induced inflationary pressures. Outside of the momentous stock market and residential real estate bubbles, we see surging prices for a wide variety of things. In past commentaries we have expounded on the major inflation taking place with media properties, particularly radio and television stations, cable franchises and professional sports teams. In this regard, we recently read that the Cleveland Indians are being sold for a record $320 million, after being purchased in 1986 for $45 million. The NFL's Washington Redskins were sold for $800 million in July. Last month, the NFL awarded an expansion franchise to Houston for $700 million, surpassing the previous record price of $530 million paid last year for a team in Cleveland. Of course, the Houston franchise owners have plans for a new $310 million stadium, with much of the financing provided by local government. Elsewhere, we see the stock market now values the World Wrestling Federation, with revenues last quarter of $76 million, at $1.6 billion. We also see that the average price for an NBA ticket for this season has increased almost 14%. The LA Lakers raised the average ticket price 60%, to almost $82. The average price for a New York Knicks ticket increased 9% to almost $87. For this season, the NBA can boast of six sparkling new arenas. Prices for NHL tickets are rising as well. Toronto, with its new $160 million AirCanada Center, now has the highest price in the league at almost $70, a 65% increase from last year. Higher ticket prices, after all, are necessary as the average NHL player salary has increased more than 50% during the past five seasons.

The Wall Street financial bubble was again very prevalent during the World Series. The prices for 30-second advertisements were between $350,000 and $450,000, up from the average of about $300,000 last year. E*Trade, with its $300 million annual advertising budget, was a major advertiser, as was Fidelity and Merrill Lynch. According to the New York Times, online brokers purchased more World Series advertising than any other industry. Also, according to the Television Bureau of Advertising, brokers, insurance companies and other financial service providers bought $474 billion of network advertising during the first six months of this year, up a staggering 52% from last year. Similarly, the prices paid to rename sporting venues are rocketing. Federal Express recently agreed to pay $200 million to rename the Washington Redskin's stadium. This is inflation in its truest form and increasingly destructive to the real economy.

Yet, these astonishing inflationary manifestations, apparently, do not worry Greenspan or the Federal Reserve. And as the Fed continues to sit back, relax, and watch as this wild party gets completely out of hand, Greenspan's hero status only grows by the day. Certainly, he is deserving of a hero's welcome from the folks at NASCAR. Yesterday, Fox network, NBC and Turner Sports won a bidding war by agreeing to pay $2.4 billion to broadcast NASCAR auto races for the next six years. This huge sum is four times the current contract price. Interestingly, despite all the hype, national ratings so far this year for NASCAR have increased only 1% from last year. But with so many networks competing for programming, and with money so easy to come by, rationality is clearly not the leading determinant of prices. This is the case with the NASCAR contract, with home prices in Silicon Valley, salaries for executives as well as software programmers, and, of course, a hot stock. It used to be that a common definition of inflation was "too much money chasing too few goods." Well, today way too much money and credit is chasing too many things. And just because the world is awash in virtually all basic consumer goods, this does not, in anyway, detract from the fact that unprecedented money and credit growth continues to feed a buying frenzy in real and financial assets. And, importantly, after years of accommodating credit excess, the Greenspan Fed must accept the fact that it has fostered the firm entrenchment of inflationary psychology, particularly in asset markets. This will prove a catastrophic error and not one easily rectified.

Quite simply, the stock market has absolutely run amuck. It has come to be completely dominated by wild speculation and other distortions that make it absolutely impossible to function effectively in its critical role of capital allocation. Today, Amazon has more than double the market capitalization of Sears. Semiconductor equipment manufacturer Applied Materials, with 1999 revenues of about $4 billion, has a greater market value than Boeing with annual revenues surpassing $50 billion. The market also values UPS, this week's star IPO, at more than the entire US airline industry. And Qualcomm, with $4 billion in 12-month revenues, has a value more than one-third greater than General Motors. Let's face it, today's marketplace is no more than one big gambling parlor. And, importantly, it is certainly our view that all the fun and games and b.s. have been allowed, and seemingly encouraged, for so long that the stock market has truly passed the point of no return. As such, we simply don't see how things can return to any semblance of normalcy, except possibly after a crash or significant market washout. Quite simply, too much money has gravitated away from sound investing, choosing instead to join the teeming party of wild speculating. And since the aggressive speculators have profited most from this extraordinary mania, they have attracted immense assets, made converts out of previously prudent investors, and have come to completely rule the marketplace. This is most unfortunate.

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."

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