Richard Russell on the Markets

November 26, 2002

The frantic Fed has taken the threat of deflation very seriously. The are seriously afraid that the US might be following the deflationary path of Japan, and they have decided to do what I predicted they would do all along. The Fed's dilemma can be described in three words. The three words are --

INFLATE OR DIE.

It's obvious that the Fed has chosen to act on the first word -- yes, the word is inflate. Part of the Fed's battle against deflation is via what I would call "open-mouth." Almost every day some Fed official tells the press of a convention or a financial gathering that there is no way the Fed will allow deflation to take over in the US. In fact, in a recent speech Fed Chairman Greenspan stated that deflation was literally impossible in the US -- and that if need be the Fed could buy up bonds endless and thereby continue to monetize the debt, which, of course is highly inflationary.

In the face of the Fed's stated intentions, the commodity indices are all heading higher. The price of homes may not still be surging, but they are tending to hold their peak value, despite individual area of weakness.

The most interesting area, for me, is gold. I don't know exactly what the Fed's real attitude towards gold is, but I would guess that they'd like to see gold hold around 320. They wouldn't want the price of gold to decline substantially, since that would be an indication of the dreaded deflation. And they probably don't want gold to head skyward, because in that event even the Wall Street Journal would understand that surging gold would be a tell-tale sign of inflation. So my guess is that the Fed would like gold to sit right here in the $320 area.

But what about the Fed's all-out campaign to fight deflation? After all, a campaign to fight deflation is really a campaign to reinflate. Then why isn't it setting off a steadily higher price for the yellow metal?

Ah, a fascinating question. And I link that question together with the huge surge in gold short sales as seen in the Commitment of Traders. Could the Fed have anything to with the big build-up in gold shorts (and increase in 18,000 gold shorts over the latest two weeks)?

Actually, the week ended November 12 saw a monster increase of 18,000 gold shorts on the part of the Commercials in the latest week, November 19, the Commercial's short position was reduced by just 4,000. Evidently, the Commercials don't want gold to decline, they just don't want it to advance.

In the meantime large speculators have increased their gold long position. I personally will be most interested to see in the weeks ahead whether gold can continue to be held back. Or, let me put it another way -- will the forces of the primary bull market in gold prove to be so powerful that they will overwhelm the Commercials and their efforts to "manage" the price of gold.

It's these "little things" that make the markets so fascinating, at least from my standpoint. Personally, I always put my money on the power of the primary trend. I believe that the primary trend of gold is bullish, and I believe that in due time the primary trend of gold will fully express itself. Furthermore, the longer the primary trend is suppressed, the more powerful the underlying build-up. I liken the primary trend that is held back to a coiled spring. The energy is simply compressed more and more. Finally, when the spring breaks loose the results are both powerful and startling. Which is what I expect for gold somewhere ahead -- maybe a few months ahead, maybe a year or so ahead.

This is why I have labeled the present period the initial phase or "the accumulation phase" of the gold bull market. It's the phase where knowledgeable investors are accumulating gold and gold shares and where the public and the majority of funds continue to ignore gold and gold shares.

As for the stock market, in yesterday's site I made the case for this upside correction in the bear market continuing. So far I believe the buying has been in the hands of professional traders, hedge funds and assorted shrewd individuals.

On November 21, however, I thought we experienced the first sign of institutional buying as volume on the NYSE surged to 2.03 billion shares, while volume on the NASDAQ exploded to 2.4 billion shares. The institutions evidently have decided that they wanted a piece of the action. Some of this volume may also have come from frightened shorts who have been waiting in vain for a sizeable drop in the market to bail them out.

What lies ahead? My best guess is that this advance will continue, probably irregularly, but it will continue. So far, the advance has been characterized by a persistent decline is supply. Fewer and fewer holders of stocks have been willing to sell. This is confirmed by a dramatic decline in Lowry's Selling Pressure (supply) index. On the other hand, demand, as seen in the action of Lowry's Buying Power index, has been more subdued, but it is nevertheless heading higher.

I believe as this market works higher we will see demand for stocks increase. My guess is that this advance will continue right into the first quarter, and somewhere ahead we will see the public (finally) rush back into the market again (and we could easily see what I would call "hopes for the return the techs?").

At any rate, my further guess is that the US economy will at worst tend to hold together while the market is in a rising trend. And all the while we'll be told by the Fed and by Wall Street's economists and strategists (those who have not be fired) that "the worst is over, and we can look for better times ahead."

At some point, probably during the first quarter, while the public is rushing back into the market, the primary bear trend will reassert itself, and a new blood bath will greet the latter-day stock-buyers.

Question -- "Russell, just in case you're right in your analysis, what should we do about it?"

Answer -- Do just as I've been suggesting. I think there's enough "oomph" left in this advance to indicate that disciplined subscribers might try their hand. What I've suggested is buying the Exchange Traded Funds known as the Diamonds (DIA) traded on the Amex. These are traded just like any other stock, and they are valued at 1% of the Dow.

The Diamonds have a huge advantage over mutual funds in that they can be traded all during the session like any other stock. Furthermore, Diamonds are not subject to the ridiculous taxes that can be generated by mutual funds and their trading. As a matter of fact, I believe the mutual funds will be abandoned en masse once the retail public realizes the many advantages of ETFs.

For those subscribers who don't want to play "beat the bear," my advice is simply to stay on the sidelines and watch the show. The higher this counter-primary trend advance climbs, the more dangerous it will become. But the higher it goes, the greater the urge will be to join the parade. My recommendation -- either buy the Diamonds now or forget it. Don't buy them weeks or months from how when the market looks best and when the market is most dangerous. Remember, the more enticing the market, the more dangerous the market.

The Dow has now rallied for seven consecutive weeks, and under normal circumstances it "should" be due for a rest. The Dow did rest Friday, but there was very little give to the market, and down volume was actually equal to up volume and breadth was positive. I took Friday's action to be bullish.

Valuations for the market continue absurdly high with the S&P selling for 34.80 times earnings (of course based on "core earnings" valuations would look even worse) while the dividend yield on the S&P is a mere 1.70%.

The Confidence Index has climbed from a frighteningly low 68.5 to a currently still very low 73.0. The bond market continues to be very wary of credit conditions, but just a little less wary.

The VIX has come down form a recent October high of just under 50 to Friday's close of 26. Thus, the prescient option-writers are less and less nervous about this market.

The true (common stocks only) advance-decline ratio for last week was -- Nov. 18 minus 4.75; Nov. 19 minus 4.90; Nov. 20 minus 4.49; Nov. 21 minus 4.10; Nov. 22 minus 4.05.

What more can I tell you? Just don't know.

See you Monday (be glad you're not a turkey).

Russell

The piece below by the indomitable Stephen Roach of Morgan Stanley is "must" reading. It's amazing that Morgan Stanley "allows" him to write this kind of analysis. Hats off to Morgan.

Subject:
Fed Squeezing the Shorts in Vain attempt to lift the economy - Roach

Read the last paragraph. For the Fed, the stock market HAS become the 'economy,' and monetary policy has devolved into good old fashioned market manipulation not as some extreme exception, but as a matter of course. This cannot last.

Bear Trap?

Stephen Roach (New York)

The US stock market is flashing yet another in a long string of recovery calls. The S&P 500 is now up 20% from its October 9 lows, little different from its two preceding rebounds - 21% recoveries off both the September 21, 2001 low as well as off the July 24, 2002 low. In each of those two earlier instances, there was hope that meaningful cyclical revival was at hand. Yet those hopes were ultimately dashed by double-dip scares. Is the current rally in the stock market any different from the two that preceded it? Or is it just another bear trap - a rally that fails in the face of the unrelenting dip-prone tendencies of America's post-bubble business cycle?

My fear is the latter - yet another rally that falls victim to lingering weakness in the US economy. While I'm straying a bit off my perch as an economist, that's not my intent - even though our warm and cuddly strategists have been making economics calls for as long as I have been at Morgan Stanley. Instead, my purpose is to suggest that just as the past two rallies missed the looming double-dip scare, the current one could be guilty of the same oversight. As I see it, the US economy remains stuck in a sub-par growth channel, at best - with real GDP growth averaging around 2%. There will be quarters when the economy exceeds this bogey - the first and third quarters of this year, for example, with growth rates of 5.0% and 3.1%, respectively. But there will also be quarters when the economy falls short of this threshold - the second and fourth periods of this year, with growth rates of 1.3% and an estimated 0.7%, respectively. In the former instances, a seemingly vigorous economy will appear to be on the road to self-sustaining recovery. In the latter cases, the economy will seem to be hovering at its "stall speed" - easily toppled into renewed recession by just the slightest shock.

This seemingly schizophrenic character of economic recovery is the essence of the post-bubble business cycle. Restrained by the headwinds of excess debt, sub-par saving, excess capacity, a massive current-account deficit, and the lack of pent-up demand, there is a compelling case for a persistently sub-par recovery, in my view. And that's basically been the case over the four quarters of this year. According to our latest estimates, real GDP growth will average just 2.5% over the four quarters of 2002, literally half the cyclical norm. Moreover, after stripping out an 0.9 percentage point lift from the inventory cycle, our estimates suggest real final demand growth has averaged only 1.6% over the same period - one of the weakest demand recoveries on record. This weakness hasn't appeared out of thin air. It's precisely what the model of the post-bubble business cycle would predict. Moreover, to the extent that the bulk of the inventory lift is in the past, there's good reason to believe that prospective GDP growth will settle out somewhere in-between this year's pace of output growth (2.5%) and final demand growth (1.6%). Hence, my belief that 2% is a reasonably good approximation of the underlying sub-par growth that can be expected, for as long as the above-noted headwinds continue to howl. In my mind, that's probably for another couple of years.

Therein lies the problem for the US economy and the latest rally of an ever-hopeful stock market. Sure, the high-frequency data are pointing to yet another fillip in the real economy. Ted Wieseman documents these trends in detail elsewhere in today's Forum. But this is precisely the pattern that was evident after the shock of 9/11 as well early this past summer. And yet in both instances, those seemingly classic cyclical rebounds quickly morphed into full-blown double-dip alerts. As long as America's post-bubble headwinds continue to blow, I continue to believe that it will be exceedingly difficult for the US economy to mount a self-sustaining, vigorous cyclical recovery. The saw-tooth pattern over the four quarters of 2002 is likely to be the rule, not the exception, in this post-bubble era. Dick Berner has argued persuasively that since policy stimulus has now shifted into high gear, a growth payback can be expected in 2003. I certainly agree with his assessment of policy, but I continue to have grave doubts about the ability of these policies to achieve traction in the real economy. As I have stressed for some time, the three sectors where policy normally bites - consumer durables, homebuilding, and business capital spending - all seem to be in a zone of excess that is unresponsive to variations in interest rates or taxes (see my October 25 dispatch, "The Limits of Policy"). The model of the post-bubble business cycle allows for precisely this type of muted response to policy actions, as the authorities get increasingly frustrated by "pushing on a string."

Meanwhile, I think the Fed finally gets it. The "it" in this case is deflation. A remarkable speech by Fed Governor Ben Bernanke says it all (see his November 21 address "Deflation: Making Sure 'It' Doesn't Happen Here" posted on the Fed's Web site). This speech, on the heels of the larger-than-expected 50 bp monetary easing of November 6, leaves little doubt in my mind that the Fed has gone into a full-blown anti-deflation drill. Sure, Mr. Bernanke couches his remarks with the predictable caveat that he feels the chances of deflation are "extremely small." Alan Greenspan has said precisely the same thing in recent days. But Fedspeak is always laced with a profusion of caveats that would make Wall Street disclaimers look brief by comparison. The bottom line is that the Fed has mounted a full-scale assault against deflation - precisely what their own playbook suggests. Indeed, as the Fed research staff recently suggested in its thinly-veiled references to the "Japanese experience," as the odds of deflation rise beyond a trivial threshold, I believe the central bank needs to treat this possibility as its central case (see Ahearne, et. al., "Preventing Deflation: Lessons from Japan's Experiences in the 1990s," International Finance Discussion Paper No. 729, June 2002). Fed actions and rhetoric leave little doubt in my mind that this threshold has now been breached.

Which takes us full circle to the perils of sub-par growth in this post-bubble business cycle and their related implications for the stock market. If I'm right on the 2% underlying growth call on the US economy going forward, this anemic pace is well below America's 3-3.5% potential growth rate. Consequently, it would result in an ever-widening "output gap" - with utilization rates continuing to decline in both labor and product market markets. In English, that spells rising unemployment and further downward pressure on an inflation rate that is already closer to outright deflation than at any point in half a century. In my view, the Fed can't even afford to flirt with such risks. By launching a full-scale frontal assault on deflation, it has finally put its cards on the table: By catching the "shorts" by surprise, the Fed is attempting to lift the real economy by playing the time-worn equity wealth effect. Sadly, we've been to this well all too often in the past seven years. Why should this rally be any different from those that have ultimately failed in the past?

China is poised to become world's biggest gold consumer.