Greenspan Interpreted

John Mauldin | Thoughts from the Frontline
February 16, 2001

The Millennium Wave Investor Sentiment Index is 83, down somewhat
The Millennium Wave Sentiment Momentum Index is 42.25, still trending down
The Millennium Wave Sentiment Percentage Uptrends is 29.32, still leaping up!

The Millennium Wave Sector Model is still in Energy Services (RYVIX), with a small profit for a change, but after today, who knows? (comments below)

Greenspan Redux

In an effort to keep my loyal readers on the cutting edge of the investment world, I forced myself to listen to the last two Greenspan testimonies before Congress. I endure this for you, to spare you the pain of doing it yourself, in the hopes of gleaning some tidbit of insight we can use.

I was rewarded. In fact, this is the clearest I have ever heard His Fuzziness speak.. There are a few things he said which are very important.

#1. There was a remarkable exchange with the new Senator from Michigan. She was sticking to the questions her staff had prepared for her (generally good practice for freshman senators when talking to Greenspan), when all of a sudden she thought she had this brilliant insight that would support her position that tax cuts are bad. Basically, she asked, "Do I understand you to be saying that in 2005 we will only have $500 billion in surplus?" getting ready to imply that the surplus was not really going to be enough for tax cuts. (Her staff had to be cringing when she left her script.) Before she could really put her foot in her mouth, Greenspan graciously interrupted and said, "No, Ma'am, I am saying that without tax cuts the surplus will be $500 billion in ONE YEAR. There will be no debt to buy. We will have to do something with that money. Whatever it is will be a huge stimulus to the economy." His implied threat was that he would have to raise rates, cut the money supply or something equally nasty to offset that type of stimulus.

Greenspan plainly said that 5-6 years ago no one could have credibly argued we would be where we are today. No one thought that we could remotely pay off the portion of the debt that is not held by Social Security and Medicare as early as 2005-2006. Then he asks throughout both hearings, as I have done over the past months, what do we do with the "excess" surplus, especially Social Security and Medicare surplus? Put it in a lockbox? Buy corporate bonds? Buy stocks?

These are all good problems, but they are going to be problems, nonetheless. He basically insisted that Congress needs to begin to decide now what we are going to do.

He clearly favored tax cuts. It would provide a steady stimulus, rather than a massive one. It would postpone the problem of paying the debt to a manageable period.

Why, you might ask, is paying off the debt quicker so bad? Paying your mortgage off is a good thing. We all want to be debt free. Let me quickly point out that I think accumulating the debt was bad. I think the size of government should be reduced and the budget and taxes shrunk even more. I believe in pay as you go, and nearly always vote no on any type of local bond issues on principle.

That being said, if we pay the current debt off too quickly, it has the potential to REALLY mess up the bond, equity and currency markets. It makes things very unpredictable. Greenspan thumped his finger on his desk (which for him is the equivalent of pounding the table) as he said Congress MUST figure out the problem of what to do with the surpluses within the next year or so.

The new Senator who bought his seat in New Jersey, Sen. Corzine, is from the financial world and financially astute. He asked Greenspan, why wouldn't we just buy Stock Index funds with the surplus? Greenspan gently reminded him that there were a lot of political questions. Which Index? Which companies? If you buy corporate bonds, which companies get the benefit, and so on. He was clearly worried about the effect the government involvement in the markets, in such a clear way, would have. And he should be. The problem for mischief is enormous.

Interestingly, he noted that in his personal federal retirement account, the money was his and he owned the stocks or debt. I came away with the feeling that he would bless some type of privatization of social security, gradually phased in.

In short, I think a tax cut close to Bush's numbers, and phased in sooner, is in the cards. Further, as I will outline below, I still think we get more Fed rate cuts. This will bring the economy back to a growth phase, if not by the 4th quarter, then in the beginning of next year.

Bush Jr. is going to be luckier than his father. This President Bush gets his recession out of the way early, gets to blame it on the previous administration, gets to cut taxes and claim it boosted us out of problems; we'll see a good economy in 2004, and he'll make the argument that we need to re-elect him for four more years to assure a good economy. It worked for the last guy.

Producer Price Index numbers

The markets looked at the PPI today and decided it might mean that the Fed won't cut rates. Maybe inflation is back. It then proceeded to just go south all day, on top of it being double witching day. Then we bomb Baghdad as well, scaring even more investors. Yuk.

I got a few e-mails from people asking if the low PPI numbers in December were cooked since they are so high this month. Are we going to get any more Fed cuts since inflation may be rearing its ugly head?

The answer is to dissect the PPI numbers, and the best man I know to do that is Greg Weldon. It gets a little technical, but he makes a very important argument you need to understand. Quoting Greg:

"Today's release of PPI was ... horrible, terrible, awful, monumental, and downright disastrous ...... in terms of the FOMC maintaining an aggressively easy tack. Right ??

WRONG.

Today's release of PPI is nothing for Fed-doves to get excited about. Was the headline increase a surprise ?? Sure. BUT one must dissect this data before making ANY conclusions. Simply put, the energy markets hold THE key going forward, more so than ever before, as the 'flow' of PPI price pressure is easily discernable. Let's go to the video tape, and weave in the data-autopsy results as we go ...

On the one hand, we have 'Total Crude Materials', which includes actual crude oil, and other energy products, namely natural gas. Total crude PPI has spiked higher, and is making new move highs. Within the huge year-year rise, note

'Energy' --- Up a whopping 25% for the MONTH of January---- after rising 14.8% for the MONTH of December.

---- Subsequently, the year-year rate of 'Energy Crude Materials' PPI increase rose from December's already sky-high 76.0% ... to 110.2% in January.

(Now comes the key point: JFM)

However, stripping out food and energy, for 'Core Crude Materials' PPI tells a markedly different story of pipeline pressures. Indeed, this component of PPI is now DEFLATING at it's most rapid pace to date, pegged in the January PPI report as minus 7.4% year-year, 'down' from minus 5.4% in December."

What Greg argues is that the energy numbers in the "pipeline" for future PPI reports are going to show a much lower PPI, thus giving the Fed plenty of room to cut.

Greg goes on to note that the rise in the core rate of finished goods is partially due to tobacco being up 5.6%, probably from taxes, and from beef and fruits and vegetables being significantly up, which could be seasonal (a tougher winter) and one time events.

Also on the "we need more cuts and stimulus" side is the fact that production "capacity utilization" is down to 80.2%, the lowest since 1992. That is the percentage of what we are actually making of "stuff" (machines, steel, cars, etc.) vs. what we could make if we used every bit of our manufacturing capacity. 80% is not going to send price inflation scares into Fed economists.

Coupled with low consumer confidence (which is at its lowest level in 5 years and down a HUGE 24% in four months), uncertain markets and an economy not yet on the rebound, despite housing starts, I think the Fed is still on the way with more cuts.

But wait, there's more!

Growing Money Supply

Weldon (He really did a great analysis today!) also notes the HUGE growth in the money supply. While Greenspan may be difficult to interpret, the rise in the money supply is not. I won't go into details, but money supply, as measured by M2 and M3, jumped by huge numbers. But M1, basically cash, did not. This, as Weldon notes, is another sign of the deflationary pressures. If the Fed were worried about inflation, they would not be pumping the money supply so powerfully.

What does this mean for bond investors?

The Fed is cutting rates. We are paying down the debt. The supply of long term bonds is going to drop. As the supply drops, the price of the bonds will rise. Don Peters, my favorite bond guru, was in my office this week. He is in the top 1% of all bond timers in the country for the last 20 years, averaging an audited 13.96% in government bonds for the last 20 years and 14.9% for the last 10. Last year his clients (me included) did over 31% in government bonds.

We discussed at length his bond outlook. He thinks we could see another 50% gain, or more, in long term bonds as rates come down. He agreed to do a tape interview in the next month or so detailing his bond strategy. I will transcribe it and put it on the net. In the interest of full disclosure, I am pursuing a relationship with his firm to offer his services to my clients, so my appreciation and agreement with his views may soon have a business bias for you to factor. (I always disclose any business relationships I have with anyone I write about.)

That being said, I think Greenspan's remarks and the Fed actions re-enforce Don's (and my) view that long term rates are headed down.

The money supply and rapid rate cuts suggest to me Greenspan and Company are more concerned about deflation as a problem. I have made the case, and believe it, that a little deflation, is a good thing. Too much, of course, and we become Japan. That would be very bad. But the right amount (which is not much), the "deflationary sweet spot" as I heard it called, means that we'll see lower interest rates, and lower consumer prices; and those on fixed incomes and pensions will be better off, and planning for the business future will be easier, and so on.

The trick is for Greenspan to keep the economy growing fast enough so that debt deflation (paying off business and consumer debt or the outright default of too much business and consumer debt) doesn't happen too fast and push us into a Japanese style deflation. That worries a lot of bears, and is something to keep an eye on, which I do.

Stock Markets and Investor Sentiment

First, let me quote Kevin Klombies, another analyst who like Weldon must have no personal life, because they must live 24/7 doing charts and analysis to turn out all the data they do every day.

Klombies shows a chart of the ratio between the T-Bond futures and the CRB Index futures (Bonds/Commodities) against a 100 week Rate of Change (ROC) indicator for the S&P 500 Index futures. In rough terms he is looking at the broad swings in dominance between bond and commodity prices and the effect on the equity markets. The 100-week ROC is almost down to ZERO. In other words, the S&P 500 Index futures are back to the same level that they were at two years previous compared to this Index. In the entire post 1982 time frame this indicator has never gone negative. We have a very clear break to the upside by the bond/commodity ratio coupled with a level on the S&P 500 Index futures that has marked THE bottom for all of the bear markets over the past 19 years. Very bullish indeed.

(Klombies service is a daily charting service at $40 per month. For samples e-mail Kevin at krk@krk-imra.com)

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Note: Last week, I quoted some stats from Yardeni and a few of you wrote or called and made me realize I was not clear (shock!). Let me try again: one year ago the percentage of stocks in the S&P 500 which had very low Price to Earnings ratios (P/E ratios) of between 5 and 10 was 20%. Generally, to value investors, a low P/E ratio is something you look for when you are trying to find a stock to buy.

I have been pointing out for almost a year the transition to value investing from growth investing. During the last year, the number of stocks with very low P/E ratios in the S&P 500 dropped to just 7%. That means value investors began to buy those stocks, and their prices went up. The point is that the shift to value investing is quite clear. You should be making the shift as well.

If you are determined to be invested in mutual funds in these volatile markets (and I am still saying we should be cautious, but some of you feel you MUST invest in something) then look into quality small cap value funds like Meridian Value (MVALX) or mid-cap value like Dreyfus Mid-Cap Value (DMCVX). These are Morningstar five-star rated funds with powerful records whose only "slips" came in the years when growth was king. When value is the order of the day, they have done very well. For those of you with 401k's, I would be choosing long term bonds or value funds.

Investor Sentiment is still bullish.

Lately, I can almost guess what the large institutional sentiment numbers will be. When the market is up, they are high. When the market is down, they are low, or their percentage of the total market is down. They are being very cagey buyers. They are buying value. They are betting on the "Greenspan Put". Namely, they know that the markets are up an average 17% one year later after the third rate cut, which will happen soon.

Let me jump out on a limb. Today's PPI number's obviously spooked the market. But Weldon is not the only economist/analyst to see through the headline number to the real story underneath. The big boys will let the market drop and then come back in next week and buy the value stocks.

Remember last December when I was so nervous when the markets dropped and our timing system was long? I openly worried about someone calling a bear market and not sending me an invitation. Our sentiment numbers were not as strong and were dropping, and Sentiment Percentage Uptrends was low. We had several potential sell signals on the horizon. Today, the market is just as volatile, and my stomach is not doing the acid tango. I look at our sentiment numbers, and they tell me this market wants to go up. The key is going to be finding a bottom for the NASDAQ. When that happens, we will go up. Is it today? Maybe, for the short -term.

Sector Rotation Model

We are still in Energy Services with a small profit, but after today, that probably vanished as well. I repeat that I think investors should wait until the economy evens out to start actually using our Sector Rotation model as an investment system, but one day, we are going to have fun with this. For right now, the pain would be too much. I think this latest trade will end up losing as well. I am glad I only have a very small amount of personal money in the model to test our systems and make sure we can execute the trades correctly. I am down almost 20% in less than 2 months, as I told you I would be.

Gold is Bombing Out

Let me get this straight. Spot Gold is at $254 and we bomb Baghdad and gold "skyrockets" to $259? A whole $5? Boy, how did I miss that trade?

Gold is telling us that inflation is not a problem. I am confused when the dollar drops against the Euro as it has and gold just keeps dropping. We were supposed to see some bounce when the dollar dropped. That is what all the conventional wisdom said. I know there are many of you who still think inflation is the problem. Look, even my good friend, Dr. Gary North, "Dr. Inflation Is the End Of World" during the 70's and 80's is now a deflationist. I have a hard time seeing how gold does much of anything useful investment wise in a period of dis-inflation or outright deflation.

Gold may also be telling us that in an era where investors can move into stronger currencies at the speed of an electron, the usefulness of gold as an inflation hedge may be waning. Most of you know I am an ex-gold bug. It saddens me when I see gold go down. I know many of you hold big gold stock positions. Doug Casey says now is the time to back up the truck and buy. I hope he is right, because I have too many friends with too much money in gold and gold stocks. I hope they get a chance to make something. I think I will pass for now, though. I like bonds better. I just have a hard time seeing $400 gold next year.

Mea culpa

I got a letter from a reader who went to his scale, weighed a dollar bill and determined that it only takes 881 railroad cars to carry $1.6 trillion. I haven't had the heart to tell my son his Dad was wrong. But it does illustrate why I use computers for my investment models

I also got an irate letter from a reader in Arlington, Texas. It seems she points out that it was not my idea to take my bride on a weekend Valentine retreat. She contends that she set up the reservations, picked me up (or rather dragged me away from the computer) and paid for the weekend with her own money. She points out my old boy Texas male ego trying to pretend to be a romantic needs to be put in the shop for an overhaul. (sigh)

Have a great weekend and next week,

Your expecting the markets to bounce analyst,

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