Rolling correction? Not. What you have got here is a market, which is rolling over onto an unsustainable, unbalanced, growth and credit cycle. Unsustainable,because the more it grows, the more socioeconomic imbalances, not less, accumulate underneath the surface. Unbalanced, because it has finally come to depend primarily on continuous 'growth' in paper and credit for its prosperity and survival. If that doesn't scare you, then you clearly do not even know what you don't know. The fact of the matter is that rolling corrections stopped happening two years ago! What has been happening since, is what I would call centrifugal inflation, a market that resolves on the upside by increasingly focusing its capital resources on fewer leaders, which have a dramatic statistical influence on the indexes:
Note that a rapid deterioration in the advance/decline line began mid 1998. What this means is that most of the market has been deteriorating since. It also coincides with a rapid acceleration in the tech-heavy NASDAQ. Rolling corrections are passe for almost two years hence. Many bulls have long been expecting the market to resolve this by broadening out, though this would be a truly contrarian event! The last time such a divergence became this extreme was in 1973/74, and it resolved in the second worse bear market of the century!
On Friday, April 14 2000, Alan Greenspan spoke about the technology revolution and its implications for the international financial system. His conclusion was spoken in the most neutral manner possible, but has a golden ring to it:
"In summary, then, although information technology by its very nature has lowered risk, it has also engendered a far more complex international financial system that will doubtless bedevil central bankers and other financial regulators for decades to come. I am sure that nostalgia for the relative automaticity of the gold standard will rise among those of us engaged to replace it." - Alan Greenspan.
Is anyone listening yet? He is clearly showing his hand, and it isn't a Royal Flush! In fact, my guess is that the reason he agreed to another four-year term is because he wants to chair the reversion to a gold standard. A guess that is not inconsistent with his gold comments of the past, nor with his ironclad stand against selling or loaning out US gold. I bet that Mr. Green has a golden lining in his dream. We'll see. Anyhow, here is the market leadership today. The leaders that have sucked the capital from most of the rest of the market are compared to the S&P 500 index in each chart. Stock split dates are noted and their P/E ratios are charted as well:
Lest we forget the parent company of CNBC, a market stalwart, and the third largest market capitalization on the board, General Electric Co.
Each one of these seems to be rolling over now, and each one of these is priced between around 40 times earnings (GE and MSFT) and 150 times earnings. These kinds of valuations reflect growth expectations that are simply not possible. For all intents and purposes, these five or six stocks are the markets today. Their cumulative market capitalization approaches three trillion dollars, or roughly 20% of the entire market, and represents an even larger proportion of the main indexes (S&P 500, Dow, and the NASDAQ). If you consider that only 20% of all listed issues were actually up on the year in 1999, the statistical influence from these six stocks alone is probably that much more stunning. So, let me ask you, is this really a bull market or would that be an altogether 'misleading' statement?
You know my opinion. Ok, so let's briefly speculate as to how this market may resolve its divergences?
- Breadth expands giving us a real bull market as momentum investors mend their ways in favor of plentiful and cheaper value stocks.
- These five leaders give way to new market leadership, and new five or ten superstars.
- Everything stops right here, and investors patiently wait for the fundamentals to catch up.
- These five leaders turn around and continue to go higher and higher and higher.
- Internet companies save the poor, which justifies absurd pricing (or has that already happened).
- The above leadership implodes, but does not affect overall market psychology.
- The above leadership brings down the entire market slowly.
- The above leadership crashes down on the rest of the market, the economy, and the dollar.
There are two reasons that breadth cannot expand. The first is that the amount of money the market would need to rise on a broader basis, and the economic stimulus of such an outcome, is inconsistent with the necessary interest rate environment for a bull market. The second is psychological. The valuation disparity between the current leaders and the rest of the market suggest that the rest of the market needs a really new spin to justify the earnings multiples that have dominated the so-called "new economy" stocks. Can you think of one? I can't. In fact, the Internet story has been so climactic that it is going to be a really hard act to follow. So, you might as well eliminate number two above.
Number three would require new investment principles altogether, since these valuations have generously priced over five years worth of fundamentals looking forward. It would require almost no leverage in the market, immovable faith in the global economy, and extreme patience. Yeah right.
Number four is not impossible, but a very unhealthy status quo. Number five is a pipe dream, which leaves us with numbers 6, 7, and 8. Number six is also plausible, but unlikely. The real debate should center on the likelihood between the two last and most probable outcomes.
If you favor a slow deflating of this bubble, you have to refuse to accept the fact that a number of unhealthy economic imbalances have developed over the past five years. You also have to refuse to accept the fact that bubbles have never deflated slowly before, and you have to refuse to acknowledge the fact that the market probably surprised you on the upside like everyone else. When I talk to people who expect this thing to unravel slowly, methodically, and peacefully, I ask them why is it that the market is allowed to surprise them on the upside, but not on the downside? Hope is a f-o-u-r letter word.
There is a Golden Lining on the horizon
First, let's illustrate a little perspective. The Fed.'s relationship as a central banker to the global economy has taken the role of that of the relationship between US banks and developing nation banks in the 1980's. The solution then was to stay accommodative and hope that the borrowers make healthy economic policy reforms.The same holds true for the United States and the global economy today. Stay accommodative (lend more) and hope that consumers and businesses, in a free market economy, put the credits toward fixing economic imbalances, rather than exaggerating them. As in the first case, which has resulted in catastrophic currency shocks in Mexico, South America, Asia, and Eastern Europe, they have again misunderstood human nature.
What is the damn solution? For a paper money system to work, an independent monetary authority needs to have control of the nation's aggregate money supply in the name of the economy, while the central bank's main interest ought to reside with aggregate credit conditions and credit quality. The problem is that central banks have tried to stay independent, and theoretically have, but in reality, they have not. It is an impossible feat.
A central bank today, thus, faces a conflict of interest. In its role as lender of last resort, should it solve this problem like all the others, by lending more and more easily to keep the economy solvent, or should it focus on underlying credit quality? It clearly should focus on credit quality, but when that means collapsing a credit "cycle," it threatens its own survival, especially when the underlying imbalances build up to destabilizing proportions. I have said before that when this thing is all over, we, being human, will try to figure out what all went wrong and fix it, after the crisis as usual, but first, interesting times ahead.
Pessimists think that the darkest sides of the history of human nature have been marked by important socioeconomic shocks like these. Optimists believe that we're still in a new economy where historians need not apply! Nevertheless, what I predict will come out of the whole process is the recognition that extended general asset "inflation," or deflation for that matter, ought to be included under a stable price policy, which is by far the most favorable environment for sustainable and "efficient" long-term socioeconomic growth. That point, which separates generally rising prices from an "inflation" problem, is where the nature of rising prices distorts the economic process of resource allocation. This is why we consider inflation to be bad in the first place. To be sure, it is a qualitative assessment, but what isn't.
The authority that governs a nation's monetary system needs to be completely independent of politics and self-interest, so as to avoid even having the means to perpetrate unhealthy survival tactics. The independent body needs to have a keen focus on potential socioeconomic imbalances that threaten long-term sustainable growth, and the tools within its mandate to deal with them as creatively as possible, without the typical human postponement of the inevitable. Possible? Not likely, but absolutely necessary? Yes.
Every member on the board of governors of the Federal Reserve System is human I think, and simply not capable of what is necessary to stay independent of their environment. They are all citizens, whose families probably live, in high regard within their communities. They have a lot to lose from a capsized economy. I cannot imagine that a computer or alien could do a much better job, and I am sure we will one day develop our financial infrastructure to become more immune to the systemic risks inherent in any free market system comprised of "irrational" participants.
As benignly academic as that process sounds, historically, these kinds of transitions have often been significantly stressful for the human race. Not because of the change itself, but because change like this requires a crisis to initiate it.
For anyone who doesn't quite grasp the ponzi-like nature of our current economic system, it might come as shock to realize one day that the "lend more money" solution has negative consequences for everyone. Thankfully though, the new interactive NASDAQ casino presents the public with a much-needed escape from dealing with daily nuances like this. We tend to really put our minds to work only when facing a crisis. So as long as central bankers also have something to lose from economic depressions, and so much to gain from economic booms, they cannot be independent, and the 'temptation' to postpone ever growing consequences rather than dealing with them will persist.
So what kind of mechanism or infrastructure can we develop, which can keep up with the changing definitions and uses of money, is not afraid of the truth, and is accountable to the underlying "quality" of economic growth rather than the "apparent" quality of economic growth. The infrastructure would have to be independent not only from the Government, but from the voting population. Are you beginning to understand the difficulty in developing such an invincible human infrastructure? These are only some of the dynamics that have throughout history favored that credit and currency is assigned a real value, such as gold or real estate. Almost any easily marketable commodity would do, but gold has a few physical advantages to most of them…it's pretty, easy to measure, to assess, carry, and difficult to counterfeit, especially at today's prices.
In fact, for those of you who, from time to time, have questioned why we have ever bothered with such a primitive notion as a gold standard, will learn the hard way very soon I suspect. Any talk about a more sophisticated central bank usually means building a larger one, so I have yet to hear any truly new ideas for our juxtaposition. That is, "how to allow a free market economy to grow at its optimum long term rate, without allowing it to kill the goose that laid the golden egg."
Sorry folks, but this is exactly why gold has always reclaimed its role as a monetary reserve historically. Each time it has been abandoned in search of faster growth and prosperity, it has been reclaimed in the name of stability. We have abandoned it 30 years ago now, in favor of a two generations long ponzi-scheme, which appears to be reaching its climactic limits.
I am sure that gold will once again reclaim its position as an unbiased, disciplinary monetary standard once more, unless the Internet can be expanded into outer space. For, there are few buyers and lenders of last resort on earth. Of course, once stability is achieved and growth is needed again, another, more sophisticated system of money will attempt to displace it. Remember, for every Yin, there is an equal and opposite Yang.
So what can we expect to happen now?
To answer that question, we need to understand what kind of imbalances a stock market crash threatens to expose:
- Poor savings habits and stock market dependence will expose the vulnerability of the consumer's balance sheet.
- The sudden evaporation of capital gains tax receipts will expose the true nature of the government's budget surplus.
- The same will expose the real contribution to many a company's recent earnings gains.
- The lack of incentive to buy US assets will expose the Yang of the Balance of Payments problem, and the vulnerability of confidence in the US Dollar.
- The sudden contraction in collateral will expose the vulnerability of the banking system's credit quality assumptions.
- The unbridled issuance of overpriced stock certificates for the acquisition of other companies will become a long-term deflationary problem for the stock market.
- The incessant "buy the dips for the long term" and "new economy" chorus from Wall Street will undermine its own medium term credibility.
- The cyclical contribution to 'productivity' will finally be calculable.
- The wage inflation that has been financed with stock options will finally become visible.
- Once and for all and whether or not, there has been a deliberate gold market manipulation!
What will the FED do now? Lower interest rates as they did in 1987, 1991 and 1998? Maybe, but the questions are can they, and how will the investing public react if they do?
Mr. Greenspan has regularly repeated that the FED doesn't target stock prices. OOPS. Has he just put his foot in his mouth? Surely he will look that way if he lowers rates. Additionally, what would that do to the Dollar and inflation? Houston, I think we've got a problem.
If he does, it has got to be a clear sign of desperation at this point, and the likelihood of a repeat 1998 performance in the stock market is therefore highly unlikely. Maybe we'll finally get that gold market we've all been waiting for. I certainly hope so.