Son of a Bubble

John Mauldin | Thoughts from the Frontline
May 19, 2001

Is the stock market the Little Engine That Could? Have I blown it when I suggested you get out a few weeks ago as the Dow rises another 7% and the NASDAQ is up 10% since then and 30% since the recent bottom? Am I early or am I simply wrong? Is there something really different this time?

Today we will try to answer these and other questions with more than a simple "maybe". Let's review what has happened over the past few weeks and see if anything has changed.

First, let me once again point out that I am not a bear by personality or nature. I believe in trying to take advantage of whatever opportunity the market gives you. I prefer orderly bull markets. I believe we are going into a mild recession, but that we will recover and the world will be just fine. I also believe in market timing and dynamic asset allocation, so if the market is going down, I want to step aside or go short.

First, the bad news. There has been a significant jump in defaulted loans at the nation's credit card companies. Capital One saw its bad loans jump by 33% this last quarter. We are not yet in a recession, so there may be more pain for lenders in the future.

There are numerous sources reporting that banks are reducing their loans to businesses, especially manufacturing and high tech companies. The Fed tells us that 20% of banks are tightening their lending requirements for consumers.

"Not only is consumer debt outstanding at a record relative to disposable personal income, interest payments are also," the ISI Group points out. US consumer installment debt now totals a record 21.7% of disposable personal income, while the payments necessary to satisfy that debt total 3.1% of disposable personal income, also a record. Looked at another way, US private debt now equals a record 147% of America's Gross Domestic Product. ISI concludes, "To be sure, consumers and corporations are the most highly leveraged they have ever been going into a slump." (From the Daily Reckoning)

Further down, we read that: "Charles W. Peabody, the brilliant bank analyst from Mitchell Securities, Inc., observes that revolving home equity and credit card loan growth both peaked in January. 'This may be the first indication that the consumer doesn't have the appetite for more debt.' he writes. 'The big question is whether this diminished appetite is because the consumer is losing confidence, and thus, unwilling to spend or can't spend anymore because his debt service burden is already too high. Either answer bodes poorly for the economy over the next six to nine months."

Dan Denning writes: "The median corporate bond rating stands at BBB, weak investment grade, the lowest since 1981, the first year that statistic is available. Also, just 28% of the junk-bond universe holds the top junk rating, according to Moody's Investors Service, the lowest proportion in at least 80 years, a span including the Depression."

From Greg Weldon: According to today's May Business Outlook Survey from the Philadelphia Regional Federal Reserve Bank ..."manufacturing firms in the region report continued weakness in business conditions this month. Indicators suggest no improvement in demand for manufactured goods, and respondents reported reductions in employment and work hours again this month. The current employment index has remained negative for seven consecutive months."

GM and Ford both reported 16% sales declines in April. Non-Mercedes Chrysler's sales fell 18%. Palm saw its revenues drop by 50%. That is not income, mind you, but sales! Pity the investor who bought Palm at $67 and still holds it at $5.

Now, I use my Palm Pilot every day. It is a truly useful gadget. But mine is 3 years old. I will not buy another of these expensive toys until I lose this one, which I eventually will. But the "new" features on the current upgrades don't make me want to go out and spend $500.

Ditto with computers and other technology. I must not be the only one, as tech sales in many areas are slumping. Dell reports a significant drop in earnings and suggests this quarter will be worse. Company after company reports.

Imports are dropping and that is affecting other countries. Mexico has seen its growth rate drop 5% and lay-offs are starting in the Maquiladora area on the border.

Gas and energy prices are not coming down. Oil is again near $30. Where are the oil production cheats in OPEC when you really need them?

I will stop. All this is just from the last two days, and again I could fill an e-letter with data suggesting the economy is continuing to weaken if I went back for a week or so.

The good news: the Fed cut the rates another 50 basis points. It seems like we are actually going to get a tax cut, although when and how it will affect anything is still up in the air.

It seems to me there is ample reason to be nervous, yet the stock market goes up. The cheerleaders are telling us that investors believe the Fed rate cuts will make a difference in another six months, so therefore the current problems with earnings are temporary and that earnings and the stock market will go up from here. I am sure you have heard more than one talking head or analyst say that investors are looking over the valley.

Our Investor Sentiment numbers sure indicate that few people are looking at the bad news. You have to go back more than ten years, to early 1991, to find numbers that are as high as we are today. Interestingly, we were in the middle of a recession at that time. But even more interesting is that in May of 1990 we see almost the same pattern as we do today, and a few months later we were in the last recession we have seen. Will that pattern repeat? Is it possible that investors could again be wrong today as they were back then?

Our Sentiment Uptrends number has started rising, as you would expect. It is back to 24.5, up from below 22. Interestingly, this number almost always goes on down to the mid-teens BEFORE we see a bottom in the markets.

Timers in Trouble In Denver

I just came back from a meeting of the interestingly named Society of Asset Allocaters and Fund Timers Inc. or SAAFTI. This is a meeting of Investment Advisors who believe in active management. It was interesting as usual, but I spent a lot of time talking to other timers, looking at their systems and track records.

My general impression? Those timers who use historical pattern recognition of some type or another are not having good years. This was only a small comfort, as we are also down for the year, since we went short last month. Many timers who have had remarkable records over long periods of time have not been able to figure this market out. In theory, this is exactly the type of market in which market timing systems should be shining.

Interestingly, the only timers I found who were showing success were those whose system is relatively new or have dynamic systems that can change over time. These work in volatile markets but tend to have problems in other types of markets.

As I came back on the plane, I meditated on this apparent anomaly. Why do so many previously successful systems seem to be having difficulties? What is different about this period?

I have written about the NASDAQ Bubble before. Briefly, it is my contention that the broad markets did not participate in the run-up. In early 2000, 80% of the broad market was either down or flat. The bubble was concentrated in the techs and the Internet, but their incredible rise made the Old Economy Indexes like the DOW and the S&P 500 appear to be healthy. The Bubble was concentrated in Microsoft, Yahoo, Amazon, Intel, Cisco, Lucent and their kin. 80% of the rise in the NASDAQ came from 20 stocks.

Son of Bubble

Lots of writers are focusing on the growth of late in the money supply. When I look at a chart of the growth in the money supply over the last few years I see an interesting pattern. In late 1998 and throughout 1999 the Fed grew the money supply at an annual rate which topped out at almost 9% (as measured by M-2). Even in the face of rate hikes, the money supply grew. Where did this excess money go? It did NOT go into inflation, as I wrote throughout that period.

Many analysts contend that it went into the stock market, and primarily into the tech stocks. Greenspan, in pumping up liquidity for Y2K, inadvertently pumped up the stock market. I think we can all agree that the NASDAQ went to ridiculous levels. Is there anyone credible who will now contend that it was not a bubble? Of course, there were legions of cheerleaders during 1999 and into 2000 who told us that large cap stocks at P/E ratios of 100 should be the norm.

When Y2K turned out to be a non-event, Greenspan applied the brakes, money supply growth went back to less than 6% on an annual basis (I am looking at charts so I don't have exact numbers.) This tightening, coupled with the previous rate hikes, took the air out of the stock market bubble, and $5 trillion dollars went "poof".

It is clear to me that the wealth effect made consumers happy and ready to spend. The negative wealth effect of that disappearing net worth has cut consumption back.

Greenspan knows that the consumer is the backbone of this economy. So even as he cuts rates, he is also once again growing the money supply at an 8% annual rate. On shorter term measures the growth is in the low teens, as he is really putting the pedal to the metal.

Question: is the growth in the money supply once again showing up in the stock market?

Dr. Ed Yardeni, chief analysts of Deutsche Bank, thinks so: "The message is loud and clear: The Fed folks believe that the negative equity wealth effect they helped to engineer over the past year has gone too far. A rebound in stock prices is now welcome. The Fed's welcome wagon is stocked with lots of bottles of champagne, and the speculators are drinking the liquidity with gusto. The bubbly is bringing back irrational exuberance fast. "

We are not seeing the growth in money supply give us real inflation -- YET. Inflation is up slightly, but nothing to ring alarm bells. It is nothing like it would be if the money supply were growing at this rate in the 1980's. I read a lot of writers who worry about inflation, but then I read another analyst who shows inflation is not really heating up, and that what we are seeing is just another statistical anomaly.

During this recent run-up, investors are telling themselves they are smarter this time. They have learned their lesson. "We will not invest in worthless dot-coms. We will invest in real companies with real earnings and sales." So we are seeing a growth in the price of Old Economy companies. GE goes for a P/E of 40. IBM is at 25. MMM is at 26. Microsoft is at 37. Cisco is at 36. All are in historical nosebleed areas.

What is Gold Saying?

Today, as I sit here, gold jumps up $14 to $287. Part of this is a short squeeze, and part of this is a for real rally that could go on up to $300 or more before the central bankers once again push it back down. I think it is coming, as there are real concerns about inflation. The concerns come not from the actual inflation data, I think, but from the realization that the money supply growth could eventually turn into inflation.

Just as Greenspan recognized in early 2000 that if he kept up the growth in the money supply he would re-ignite inflation and therefore he slowed things down, I think that he will realize the same thing again.

The trick, of course, is to know when he decides he needs to slow things down. Will the old Gold Bug side of Greenspan emerge and therefore tell him gold is signaling problems? Does he pay any attention to gold anymore, as he did in his younger days?

Fighting the Fed or Fighting History?

Conventional wisdom tells us not to fight the Fed. Common Sense tells us not to fight History. Right now, History and the Fed are at odds. As long as the Fed is pumping the money supply, it seems to me that the market has a real chance to go higher or at least march sideways.

But for how long, fellow traveler? That is the question. How long can Greenspan continue to grow the money supply without inflation coming back just as we go into a recession? How long before you start hearing that most dreaded of all words - stagflation?

I don't think Greenspan will let it go that far. Right now, he is trying to keep the consumer happy and hoping that the economy will turn around before inflation becomes a problem. If he cuts rates enough, I think he hopes he can lower the growth rate of the money supply at some future point without causing a problem.

But if inflation starts to comes back, will he decide it is better to suffer a small recession than risk inflation and a potential devastating recession?

Last Minute Bulletin

That old mind-reader, Greg Weldon, literally just sent a special bulletin to answer my question. It seems the Fed may be starting to slow down money growth. Quote:

"... the 3-month rate of M-2 growth has slowed, from 12.6% on April 26th ... to 12.0% as of last night's report.

... the 3-month rate of M-1 growth has slowed, from 7.6% on April 26th ... to the 5.4% reported last night. These are only subtle signs of slowing ... relative to the continued expansion in most all other more medium-term rate-of-change indicators that we monitor ... but they are signs nonetheless. The point: signs of slowing money growth could cause the growth in debt to come down hard on the back-end of the economic recovery ... assuming there is one."

Is this a trend reversal, or just a statistical blip? We will have to wait and see, as you can bet the Fed will not send out a press release on this one. If it truly signals a slowdown in the money supply growth, the days of this rally are numbered. If it is a blip, then we could see the market continue to go with the Fed and fight History. In the short term, I would bet on the Fed. In the long-term? Bet on History.

We will watch the money supply growth numbers carefully over the next weeks and months.

Gold?

As I wrote a few weeks ago, there is the real potential for a gold rally, and we seem to be in the midst of one. Enjoy it. I know many of you are waiting for a rally to lighten up on gold and gold stocks, which many of us bought in anticipation of a Y2K problem. You may get a chance. On a pure technical basis, Kevin Klombies tells us that there is some more room in this run.

Bonds

Briefly, the action in bonds is as odd as the stock action. Long-term rates went to 5.90% this week before dropping to 5.76%. A lot of this is influenced by currency fluctuations, especially the Yen. Some of it is a concern about inflation. I still think we could see some more volatility but it is my belief rates will drop substantially as we head into a recession. More on this next week. Now is a good time to begin to accumulate a good long-term bond portfolio.

Traveling to New York

I will be in New York (Manhattan) the first part of the week speaking at a hedge fund conference. I will share with you what I learn, if anything, next week. I will have some time to speak with clients or prospective clients. You can call the office at 800-829-7273 if you would like to meet.

I am tempted to sign this "Your bubble-headed analyst" but will resist, as a few of you will point out that it might be true.

Your "Still wondering where the growth is in his personal money supply" Analyst,

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