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January 19, 2005

Ritual Slaughter?
by Brady Willett

The cost of saving the dollar is to sacrifice U.S. asset bubbles

Peter Eliades, editor of the newsletter Stockmarket Cycles, noted in early 2005, "We have seen the worst opening three days of a new year in breadth in the history of the markets going back to '26". Last week Bloomberg pointed out that the S&P 500 is off to its worst 10-day new year start since 1991 (Gulf War), and Trimtabs recently said that equity funds could see outflows in January for only second time in the last 15-years. Keeping in mind that interest rate/oil fears have recently been rekindled and uncertainty surrounding the Iraq election looms, will Mr. Eliades and others soon be telling us that January 2005 was one of the worst open months to a new year in the history of the markets?

Notwithstanding the limitations of short term forecasts, the speculator cannot help but deduce that these are not ordinary times. Indeed, the sharp reversal in equity market and U.S. dollar trends to begin 2005 are screaming that a change in investor sentiment is afoot. This may be the case not only because oil fears have quickly been rekindled, but also because of the viewpoint that 'old' White House and Federal Reserve Board policies have been exhausted. For example, Greenspan and the Fed are no longer anxious to keep interest rates low to stimulate the economy, but instead growing increasingly concerned about inflation. This outlook sharply contrasts the outlook leading into 2004, or when the Fed was promising to keep interest rates low for a 'considerable period' of time.

As for President Bush, he is still trying to concoct schemes to temporarily strengthen the U.S. economy and stock markets - the latest being to privatize Social Security - but he is also hinting that government spending will remain in check. If Bush is serious about attacking government spending this would not only contrast sharply the supply-side policies he has pushed through during his tenure, but also throw into question the unstated policy of 'benign neglect' with regards to the U.S. dollar.

The implications that rising interest rates and greater fiscal discipline pose to the U.S. financial markets cannot be overstated. Quite frankly, the emergence of 'new' policy mandates from Bush and Greenspan not only threaten to negatively impact economic growth, but also threaten to deflate the asset bubbles the 'old' policy goals helped create. With this in mind, what investors may continue to discover is that what is good for the U.S. dollar is not necessarily good for the U.S. financial markets.

Bulls Ignore Turning Point Speculations

The Wall Street consensus says that stocks will benefit this year because corporate earnings will improve and U.S. interest rates will increase. Repeating this bullish party line verbatim, Donald Luskin adds - as any good bull would - that Bush will 'pull off another miracle' and privatize part of Social Security. The end result, at least according to Luskin, is that a January slump in stocks represents a buying opportunity.

"So, here's the deal. The economy is growing. Stocks are cheap. Rising [interest] rates are good. The political environment is investor-friendly. Are you going to let a little stock market correction scare you? Good. I didn't think so!" Luskin

While Luskin briefly acknowledges that the pace of earnings growth is expected to decline in 2005, his conclusion that 'stocks are cheap' is backed by a review of corporate earnings in 2004. A less rounded conclusion of why stocks might be cheap is difficult to find.

"Stocks are still cheap...Even though S&P 500 earnings were up 23.6% in 2004, stock prices themselves advanced by only 8.9%. That means there's a lot of upside still to be captured - and don't let anyone tell you otherwise."

What Luskin conveniently neglects to mention is that dividend yields are at historically low levels, other valuation matrixes are near extreme highs, and upcoming regulatory and accounting changes (Section 404 and S123R) threaten to negatively impact corporate earnings. As for drawing crude parallels between corporate earnings and stock prices: in 2000 the markets declined and corporate earnings increased. Using Luskin-logic stocks were a buy leading into 2001.

Suffice to say, Luskin and other bulls are aware that the Fed is likely to raise interest rates in 2005, but they conclude that interest rates will not dent economic growth.

Hibernating Bears Begin Salivating

News that Bush may try to cut the government deficit and Greenspan may try to save the dollar (and/or attack inflation) makes steadfast equity bears feel as if Christmas has come early. To be sure, those that don't believe in the 'economic recovery miracle' (Kudlow) have long maintained that the U.S. recovery was temporarily kept afloat by 13-rate cuts, multiple government tax cuts, and - as a result of these unsustainable stimulus policies - multiple asset price bubbles. The bear argument continues that once you take away loose monetary and fiscal policies what you are left with is a housing market ready to implode, an overvalued stock market, a stretched consumer, and - finally - significantly slower economic growth.

That market bears have been selling the above theories for some time should not take away from their validness. Rather, although the Federal Reserve Board has already raised interest rates 5-times in a row the yield curve has flattened, but long-term interest rates - which determine mortgage rates - have yet to move higher. In other words, Fed tightening has yet to impact one of the main drivers of the U.S. economy (the housing market). Moreover, after more than a year of declining credit spreads, a pick-up in IPOs and M&A activity, and unprecedented inflows into hedge funds, the Fed has begun to hint that it is concerned with "risk taking in the financial markets". This is what bears - at least those with a long-term horizon - have been suggesting would eventually happen since late 2003.

Again, it is not as if the bulls do not see Fed policy changes coming. For example, the bullish Luskin is calling for a 4.25% Federal Funds rate by the end of 2005. But while the bears see a day of reckoning the bulls see the world through rose colored glasses.

U.S. Dollar Finds Some Takers, For Now

The December Fed minutes - released on January 4, 2005 - suggested that the Fed is looking to raise interest rates faster than previously expected in order to keep inflation in check and combat "signs of potentially excessive risk-taking in financial markets". Further confirmation of a more hawkish Fed arrived last week when Fed Poole warned that interest rates could rise faster than previously expected. Also last week, ECB President Jean-Claude Trichet signaled that there was no rush to raise interest rates as inflationary pressures had subsided. Following these events expectations are that interest rates will rise faster than expected in America and not rise as significantly in Euroland. Such is why the U.S. dollar managed to rally last week even after a much larger than expected U.S. current account deficit was reported.

Despite the fact that the U.S. dollar rebound could last awhile, the threat the growing/unsustainable U.S. current account deficit poses is not likely to go away. In fact, a stronger dollar suggests that the U.S. current account deficit - which now equals almost 6% of GDP - will become even more of a concern. And although Snow, Kudlow, Luskin, and other supply-side advocates argue that the U.S. current account deficit is simply a sign that the U.S. is growing faster than everyone else, few would disagree that increasing the U.S.'s already unprecedented dependence on foreign capital is an enviable pursuit.

The Dollar Can Be Temporarily Saved, But At What Cost?

The conclusion from most dollar watchers was that a Bush Presidential win translated into bad news for the U.S. dollar. This conclusion has recently been thrown into question. To begin with, and as Kudlow recently noted, Bush's budget deficit may be "shrinking rapidly". Moreover, there is speculation that Bush will pass his first 'tough budget' in February (to note: the February 7 budget will not include Iraq/Afghanistan costs). Suffice to say, if Bush is serious about reeling in government spending and Greenspan keeps raising interest rates until something tells him to stop (i.e. the view of an asset bubble popping), the U.S. dollar could continue to benefit. For lack of a better way of putting it, the U.S. dollar loves sane policy decisions.

If it can be said that the U.S. dollar craves sane policy decisions, then an equally true statement is that the equity market sometimes thrive on insane policy decisions. For example, news that the Fed is going to keep interest rates artificially low is not crazy - it is a reason to dump your savings into stocks instead of money market funds! Similarly, news that President Bush cutting taxes again because Reagan proved that 'deficits don't matter' isn't a reason to plow into Euros and gold - it is a reason to buy stocks because the consumer will be awarded some more money to spend!

In short, if Bush really wants to reduce the budget deficit to appease foreign policy makers/dollar purchasers, and Greenspan really wants to do his best impersonation of Volcker before he rides off to greener pastures, this is, unequivocally, bad news for stocks. However, note the word 'really', because once policy makers take away the punch bowl they may have a hard time explaining and sustaining their 'tough love' beliefs to investors. For that matter, Bush may need to borrow trillions to fund Social Security transition costs.

Conclusions

As the sell off in stocks since the December 4th Fed minutes were released will attest to, stocks do not respond favorably when the Fed is suggesting it will be vigilant against inflation and "risk-taking in the financial markets". Moreover, overvalued stocks - i.e. rising interest rates could make safe bonds look more appealing than risky stocks - respond considerably worse. Such is why Luskin and others note that Bush is about to privatize Social Security: the insane dream of a perpetually stimulated growth through the coddling of asset bubbles can live on...no piper will ever have to be paid so long as more of America's savings can - somehow, someway - be funneled reach the stock market.

Whether or not January 2005 will be remembered as one of the worst open months to a new year is not the real question at hand. Rather, the more important macro question is what asset bubble will implode first as a consequence of increasingly ritualistic anti-bubble policies. Rising interest rates and the threat of greater fiscal discipline are stock market negatives that far outweigh the potential capital windfall from Social Security privatization - and don't let anyone tell you otherwise.

Brady Willett
FallStreet.com

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