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A View from the Bear's Lair

March 22, 1999

As expected, it was a wild and particularly challenging week with "triple witching" options expiration. Today (March 19), the Dow traded as high as 10,085 but closed at 9,904. For the week, the Dow rose 27 points and the S&P500 gained about ½ of 1%. The economically sensitive sectors outperformed, with the Morgan Stanley Cyclical index gaining 3% and the Transports about 2%. The small cap Russell 2000 was unimpressive, as it traded unchanged for the week. The tech stocks were very volatile as the NASDAQ 100 gained 2%, the Morgan Stanley High Tech index and semiconductor index gained 3%, and the Internet index surged 10%, bringing its gain for the past month to 33%. It was, however, a bearish day in the tech sector and we would expect selling to continue next week. Now that option expiration is out of the way, we expect many stocks to trade more based on deteriorating fundamentals. The financial stocks were also very volatile and declined today as the bond market lost about ¾ of a point and the yield moved back above 5½ %. For the week, the S&P Bank index declined 1% and the Bloomberg Wall Street index ended unchanged. With the tech stocks, the bond market and financial stocks all looking vulnerable, next week could be interesting.

In an environment where America Online trades with a larger market capitalization than General Motors, Boeing, and Caterpillar combined, it really should not be too surprising that the financial markets ignored yesterday's trade data. And with Dow again hovering near 10,000, there was certainly no time for the media to deal with a pesky economic report. We, however, will give this data some deserved attention, as it is certainly quite meaningful in providing important insights into the dangerous dichotomy that has developed between current US excesses and the global economic crisis.

First, the January trade deficit is indisputable evidence of a situation moving rapidly from bad to much worse. The record $17 billion January deficit was $2 billion more than estimated. The deterioration in the trade picture is absolutely alarming, as the January deficit grew 21% from December, and an astonishing 70% from January 1998.

Exports of goods fell for the third straight month, declining more than 2% from December and 5% from January 1998 levels. Looking at goods exports by region and country, here we find disturbing evidence of the breadth and depth of the global crisis. Exports declined in every region. Not surprisingly, exports to the Pacific Rim posted an 8% year-over-year decline in January, as exports to Japan declined 10%, Hong Kong 12%, Taiwan 12% and China plummeted 36%. The drop in exports to China is noteworthy, as it was one Asian economy where exports had been growing. Exports to Eastern Europe also a posted disturbing fall, with a year-over-year decline of 44%, compared to a 14% decline in December. January exports to Russia were down 66%. Western Europe also showed startling deterioration, as January goods exports declined 37%, with weakness seen in almost all countries. Latin America posted a decline of 10%, with exports to Argentina down almost 19% from last year. OPEC countries, suffering acutely from the collapse in oil prices, imported 34% less from the US in January than the year before.

And while exports decline, we are seemingly unable to sate our appetite for imports. Total January imports were almost $94 billion, fully 22% greater than exports. Imports rose 2% from December and were 5% greater than last January. Providing significant stimulus to our neighbors, imports from Canada grew 8% from last year, and were 6% higher from Mexico. Imports from Europe grew 5%, although imports from Eastern Europe declined 25% and Latin America 7%. Imports from OPEC declined 24%, the result of the collapse of oil prices the past year. Noteworthy, January oil imports were priced at just over $9, the lowest price since 1974. Since January, however, the price of crude has moved sharply higher, and this will only add to our already enormous trade deficit going forward.

This year's trade deficit will likely surpass $200 billion. This compares to $170 billion in 1998, and $100 billion in 1997. It is simply hard to fathom such a dramatic deterioration in our trade balance in just two years. It is even more incredible that no one, not even a member of the Federal Reserve, seems to have the slightest concern. In fact, it is now commonplace for the bulls to place a positive spin by explaining our huge trade gap as a sign of the profound health of our economy. Well, we refuse to accept this "new era" analysis and will stick to our understanding of economics and history. With this knowledge, we have a much less sanguine view of our runaway trade deficits.

Today, we literally flood the world with hundred's of billions of dollars, as we import inexpensive products and consume 'till our heart's content. Indeed, today we so enjoy a truly magnificent arrangement where we trade "paper dollars" for hard goods. No need to save, apparently, as our financial system simply creates all this new money and credit that we can then use to buy products from the toil of our trading partners. This is much a dream come true as we have low-cost foreign labor manufacture much of our consumption needs, allowing our economy to focus on entertainment, media, leisure goods, high technology, retailing, stock trading, and a booming service sector generally. With seemingly little need to manufacture, there is no need to invest in manufacturing capacity. Instead, we can use our resources to build restaurants, shopping malls, office buildings, casinos, hotels, health clubs, theme parks, and professional sports venues. And despite a ballooning debt of $2 trillion owed to our foreign creditors, much the true financiers of our prosperity, we presume that the dollar's world reserve currency status forever immunizes us from a currency crisis. This complacency is much misplaced. Instead, we should heed the painful lessons learned by many countries that have seen their currencies and economies implode.

Well, unless the principles of economics no longer apply, it is only a matter of time until we will pay a severe price for straying so far away from sound economic policies. The bottom line is that we are on a course that will ensure an inevitable dollar crisis. While today the dollar has the "luxury" of Asia being locked in depression, and a weak Europe sinking into recession, we, nonetheless, see the initial inklings of dollar trouble. Clearly, the dollar performs most unimpressively against the yen, and this despite a Japanese economy and financial system truly at the brink. Today the dollar trades at 117 versus the yen, after trading above 145 in August. We also suspect that our excesses are beginning to impact the credit markets. While the bulls like to repeat to themselves how today's high real interest rates ensures an imminent bond market rally, a more insightful analysis would see higher real interest rates as increasingly necessary to keep our foreign creditors from selling their ever-growing inventory of US securities.

It is also important to recognize that the current global situation is completely dysfunctional. The US booms while much of the rest of the world suffers the worst economic crisis since the Great Depression. We don't claim to have all the answers and do not presume to know how this all plays out. We do, however, see a situation that is coming to a head. It is simply not realistic to assume that we can continue on the current path of flooding the world with dollars and consuming the efforts of laborers from the rest of the world. Too many are seeing few rewards from the current arrangement. Not surprisingly, animosity is growing and stress is escalating in relations with our trading partners. A trade war is developing with Europe. Tension is also high with China, and now our politicians are now taking keen interest in trade issues, which greatly increases the likelihood of trade wars. While bullish euphoria runs unabated on Wall Street, a much darker bear market mood has developed throughout much of the world.

Here in the US, with these halcyon days of Dow 10,000, many are inclined to fantasize about the US as an "Island of Prosperity." Unfortunately, the reality is that we have become a huge debtor nation. And as much as it is counter to today's social and political perception, we are going to have to accept that our creditors may have great difficulties at home, but they now have considerable power over our finances. To this point, our creditors have been extraordinarily generous, not unlike a credit card company that regularly raises the credit limit, thus providing the means for additional buying by the cardholder. But sticking with this credit card analogy, there comes a point where the credit card company is doing itself as well as the borrower a big disservice by extending more credit. Indeed, there comes a time when the lender questions the creditworthiness of the debtor, and the sensibility of "throwing good money after bad." We fear that our trading partners may someday actually begin to seek something other than "paper dollars" for all the goods they send us. We also would not be surprised if our creditors begin to expect some repayment of the massive debt owed. Times are changing and it is hard for us to see how these developments could be too bullish.

Goldschläger and Goldwasser are liqueurs containing pure gold flakes.
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