ContraryInvestor - Market Observations

MARKET OBSERVATIONS

THE ULTIMATE PERCEPTUAL MISTAKE?

MARKET OBSERVATIONS - 1/13

We stand corrected...We reported to you on Tuesday that the Fed had literally broken the spigot off of the money "pipe" with the weekly number for Fed credit reported in the January 8 Barron's. Shame on us for not looking at the actual Fed data itself. It turns out that a good chunk of this came in the last two days of 1999. The reporting period for the $18.1 billion in additional Fed credit and $6.6 billion in increased currency included Dec. 30 and 31. We are indebted to "Mr. Moto" for keeping our emotions in check. To see this data yourself, check in every Thursday at http://www.federalreserve.gov/releases/H41/Current/. It's all there in black and white. What this does mean is that the Fed foot has come off of the monetary accelerator in the first week of the new millennium. Clearly, we will stay tuned for further developments.

The Ultimate Perceptual Mistake?...One of the single largest debates between the bullish and the bearish investment communities these days revolves around what is really driving this economy. The bulls would have you believe that we have entered a "new economy" where technology driven productivity growth is catapulting us up to a whole new economic state of enlightenment. Ergo, valuation constraints of yesteryear are bound to collect dust in the annals of U.S. financial history. Our ability to technologically supercharge productivity guarantees above average earnings growth, below average inflation, and moderation(?) in interest rates for the foreseeable future. In a sense, the traditional or historical business cycle has been banished with the confluence of technology and deft Fed policy.

Conversely, the bears argue that valuations do matter, corporate earnings are being "enhanced" through accounting gimmickry and debt driven share buybacks, the public are voracious consumers piling up huge amounts of personal debt and depleting savings, and that ultimately a credit seizure will bring down the whole house of cards. For those of you who have been tuning in to our discussions for many moons, you know our feelings. Rather than rant and rave, we thought we would try to take a look at the very strong possibility that the majority of today's investors are mistaking a "new" business cycle for what is nothing more than the mother of all credit cycles. This time around, it may just turn out to be the ultimate perceptual mistake in that it conceivably could exact an incredible financial toll on the "new era" savings vehicle of choice - the stock market .

The Cycle-Drama...The traditional business cycle in American financial history has been one earmarked by flows of personal savings into business capital investment. Historically, the banking system has played the disintermediary role. That capital base of private savings being funneled into the business economy in turn allowed business expansion and ultimately the expansion of standards of living for the American public vis-à-vis job creation and personal income enhancement. When business expansion was too rapid, prices would decline given the constraint of personal income in limiting consumption and business contraction would follow. The traditional role of the Fed was to step in and be a lender (stimulate) during economic downturns and tap on the monetary brakes (restriction) when it appeared expansion was deemed too rapid. Sounds like something out of Leave It To Beaver, doesn't it? (Hey Beav, whatdaya say we give Greenspan the "business".) A key hallmark of a true business cycle, as significantly opposed to a credit cycle, is that it is largely self regulating. Excessive credit does not distort supply/demand relationships. Excessive credit creation is not used to artificially maintain consumption driven GDP growth.

Alternatively, the U.S. has experienced credit induced expansions many a time throughout its financial history. In roughly every case where credit expansion became excessive, it was not recognized as such until after the cycle had come too an end. In the meantime, it was deemed prosperity. In our view, the hallmark of a credit cycle can be found in the use of debt to create demand. Basically business expansion being driven by debt financed consumption. We are not saying credit is bad and can never be used. It clearly has a proper and justifiable place in any economic system. In fact, it is an essential part of the capitalist economic backdrop. Where it breaks down is when it becomes excessive. When it artificially distorts a natural economic process. How is one to judge when this has happened? Just crack open the history books to find out. We believe the following are keys to the puzzle:

Excess business/capacity expansion. We have witnessed this on a global basis in the current environment.

Despite today's service oriented economy, today's level of total domestic capacity utilization would have passed for a recession in the late 1960's. Today it's described as a key to low inflation within an expanding economy.

Excess credit expansion most inevitably leads to asset price inflation, which in turn increases perceptions of wealth and leads to excess consumption. The simultaneous reaction is a diminution in the perceived need to save.

Clear enough?

An overly-stimulative credit expansion may often start in the banking system, but inevitably spreads to corporations and private households. A credit cycle is marked by credit pyramiding. There is very little tolerance for recessions. The Fed is overly-accommodative in trying to head any business downturn off at the pass by simply monetizing any financial problems - covering up debt with debt. It's no wonder corporations and the public continue to borrow. They are snuggled safe and warm in the Fed safety blanket.

Increasing credit expansion not only reinforces the assumption of wealth, validates consumption and the lack of need to save, but helps to sop up excess business capacity.

Another point of light on our short list is that in a period of excess credit expansion, growth in debt and debt service outstrips growth in GDP. In essence, something north of a dollar in additional debt is needed to produce an additional dollar of GDP. The following chart has a number of ramifications.

Since 1990, GDP growth has swung within a very tight band. It is a clear change relative to the boom-bust experience of the prior three decades. This is partially the case that the bulls present. This is the "new era" of the prolonged business cycle. If this chart is viewed alongside the previous three presented, it just may be telling a quite different story. The period of the no recession (for the most part) 1990's was accompanied by a significant decline in personal savings, a significant increase in household debt (you have already seen our numbers on corporate, government and domestic non-bank financial sector debt that are likewise exploding), and a relatively stagnant level of capacity utilization. Excessive credit has been used to artificially keep the boom bust cycle in check - at almost all costs.

The last characterization of this enlightened period is that the Fed has come to the rescue of each and every financial squall that has appeared this decade with the expansion in credit solution in hand, ready to administer swift monetary medicine. Each time the Fed has done this, the credit expansion increases at a faster pace. The years since the 1997 Asian crisis clearly demonstrate this. The period since LTCM is the fastest 12 month period yet in terms of monetary expansion, credit expansion, margin debt expansion, government agency balance sheet expansion, etc. Quite unfortunately, history has demonstrated that each and every instance of credit pyramiding in America's past has ultimately ended in a liquidity seizure and asset price crash.

It's Different This Time...You bet it is. What's different this time is technology. That's right, technology. (No, we're not long NAZ futures.) We are in the new technologically enlightened period of instantaneous electronic global money transfer. It is different this time. There was nothing like this in the 30's or the 70's. What this may mean is that today we are moving in fast forward motion. Everything happens at DSL speed. A potential breakdown the credit/liquidity structure will happen quickly. Look at the instantaneous global movement of money that precipitated the Asian blowups in 1997. The foreign currency and debt markets moved at lightening speed. No time for reflection and barely any time for coordinated action.

At some point in every credit cycle, debt expansion just hits the wall. The system simply cannot digest additional credit without counter parties to that credit calling a halt to capital risk. Today's world is a bit more complex. Global flows of capital don't allow this to be so simple. Specifically we are referring to the massive U.S. trade deficit. The $1 billion per day we are now borrowing from the foreign sector can and is being recycled into U.S. financial assets. This forestalls credit problems that may be brewing domestically. Foreign economies are dependent on the U.S. economy for their own growth at the moment. The circle of credit expansion becomes global. Again, at some point, the risk is that foreign capital calls a halt to risk lending. It's not something whose solution is completely in the hands of the U.S. Fed.

The incredible credit expansion of the last few decades really has little precedent in U.S. history in terms of longevity and absolute dollar significance. Then again, in prior periods the U.S. did not have a significant non-bank sector that was allowed to create massive amounts of credit without being subject to reserve requirements. Additionally, the banking sector itself was not allowed to conduct off-balance sheet operations (derivatives) in amounts that literally dwarfed its equity account. We believe investors of today have thrown caution to the wind in believing that we have achieved some new type of economic system in this country. They are mistaking the credit cycle of all credit cycles for some type of "new era" economy. Unfortunately, at some point, it just may become the most costly mistake of a generation. Sadly, when this period is perceived as the grand credit super cycle it truly has become, it will be far too late.