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From Misallocations of Resources to Further Misallocation!

"....to combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about ; because we are suffering from a misdirection of production, we want to create further misdirection - a procedure which can only a lead to a much more severe crisis as soon as the credit expansion comes to an end."
- Friedrich Hayek, "Monetary Theory and the Trade Cycle", London 1933

Because of a strong US dollar, a recovery in the stock market, further strength in the US housing industry, disappointing news from Europe, and rallying US government bonds to new 2005 highs, the super-bulls on the American wonder-economy are again out in force telling the world with great conviction "we told you so"! In fact, the more the audience that watches CNBC in the US declines (down 60% from the peak in 2000) the louder the voice of the bullish camp seems to become.

But, let us look at some facts. From figure 1, courtesy of Ed Yardeni, we can see that following a slump post year 2000, global semiconductor sales have rebounded strongly and are at about the level they were in year 2000.

Figure 1: Global Semiconductor Sales and Earnings, 1991 - 2005

 Source: Ed Yardeni, www.yardeni.com

So far so good! But let us now look at the details of these worldwide sales. For one, while sales have recovered - well understood after 5 years - to the previous highs, the earnings of semiconductor companies have not and hover around the level they were at in 1997 - 8 years earlier. In addition, while global semiconductor sales have recovered, we can see from figure 2, that in the US they have hardly moved up following the 2000/2001 slump.

Figure 2: US and European Semiconductor Sales, 1991 - 2005

 Source: Ed Yardeni, www.yardeni.com

Maybe the US super-bulls should take a closer look at figure 2, and if their senses have not been too blurred by their most recent euphoria, also notice that US semiconductor sales are no higher than they were in 1994!

But nor to worry, we know by now that the US economy is a service economy and does not need to produce anything to prosper except printing machines to keep increasing the supply of money (most printing machines are probably imported too). Needless to say that the quality of US services is "the envy of the world", as Mr. Bush, Rumsfeld, Cheney & Co. might articulate and - according to the Census Bureau's Economic Census - with the fastest growth being registered not in "mundane" businesses such as biotechnology, nanotechnology and high tech industries but in high value added and intellectually highly demanding sectors such as lawn care, childcare providers, janitorial services and nail and hair salons!

If global semiconductor sales are up worldwide but down in the US and flat in Europe, where did they rise? Obviously in Asia ex Japan! From figure 3, we can see that Asian Pacific semiconductor sales have doubled to annually almost $ 100 billion since 2001.

Figure 3: Asian Pacific and Japanese Semiconductor Sales, 1991 - 2005

 Source: Ed Yardeni, www.yardeni.com

And while we are at it, for the proponents of the "Great American Empire and Economic Supremacy of the US" we should point out that Asian semiconductor sales, well understood ex Japan, are not only twice as large as US sales but also larger than US and European semiconductor sales combined.

Now, I am not suggesting that semiconductor sales are a perfect economic indicator - although I would rather rely on them than on some forecasts by confused economists. Still, the composition of global semiconductor sales tells us something about the state of the current global economic recovery.

Following the economic contraction and stock market slump in year 2000, the Fed pursued an extremely accommodative monetary policy. Money supply rose rapidly and credit market debt exploded (see figure 4). As can be seen from figure 4, in late 2001 and in early 2002, money supply was growing at annual rates of more than 20%.

Easy money policies and artificially low interest rates led to a credit bubble with the result that since year 2000, total credit market debt has been growing at more than 4-time GDP growth and financed a gigantic boom in home prices, which in turn allowed households to extract equity from their homes through refinancing activity and spend it on excessive and conspicuous consumption.

Figure 4: MZM annual growth, 1984 - 2005

 Source: Ed Yardeni, www.yardeni.com

I am well aware that some observers dispute the fact that there is a housing bubble in the US. These observers contend that for the nation as, a whole, home prices did not rise all that much and that the excesses only exist in selected markets. This is to some extend true but then these observers should also recognize the fact that one of the principal common features of every investment mania or bubble is that the object of speculation is very concentrated. Take the 2000 stock market bubble. The excesses occurred in telecom, media and high tech whereas the rest of the market and in particular the old economy stocks such as home builders, basic and resource shares were inexpensive (as was the entire Asian region with exception of the TMT sector). So, because in a bubble some or - as I would argue - most sectors of the market do remain depressed, this does by no means alter the fact that in some narrow sector a gigantic bubble can exist.

Looking at figure 5, courtesy of Goldman Sachs, the uneven distribution of housing price gains in the US is visible. The biggest price gains occurred on the east and west coast and in particular in California, Florida and New England.

Figure 5: Home price Changes since Year 2000

 Source: Goldman Sachs and Freddie Mac

The US housing bulls also take comfort from the fact that since 1952, the value of household real estate holdings has never declined. Again, this may be true, although we must take into account that every year the stock of homes is increasing. Consequently it is only natural that the value of household real estate has a rising tendency (see figure 6).

Figure 6: Market Value of Household Real Estate

Source: www.thechartstore.com

Still, whereas the value of household real estate has never declined in nominal terms, it has declined in teal terms and for selected markets on numerous occasions. Figure 7, shows that following strong real price gains in 1971/72, 1979/80, 1986/87, inflation adjusted prices declined in 1971, 1974, 1981/82 and in 1990/91. Therefore, following the extended period of real price gains we had since 1997, it is more than likely that prices will decline at least in real terms at some point in the future.

Figure 7: Inflation-adjusted Annualized Home Price Gains

 Source: Bridgewater Associates

In addition, whereas it is possible that for the entire nation, household real estate assets never declined in nominal terms, in selected markets we had numerous vicious real estate slumps. In the early 1980s Texas properties totally collapsed. In the early 1990s New England properties went through an unpleasant slump. And even the Golden State of California, with all the pluses that the bulls are now advancing in its favor, had three years of declining prices between 1991 and 1994. In fact it took until 1998 for prices to recover to the 1990s highs (see figure 8). In Asia, we know all too well that property prices can decline violently something that seems to escape the perma housing bulls in the US!

Figure 8: Annual Home Price Changes, California vs US, 1976 -2004

Source: Goldman Sachs and Freddie Mac

The point, however, is this. Ultra easy monetary policies after 2001 fueled in the US an asset boom, which was particularly noticeable in the housing industry. This housing boom created wealth, illusionary wealth I might add, which allowed American households to boost their consumption at a faster rate than their personal income gains. What ultra easy monetary policies failed to boost was capital spending in terms of net capital formation (capital spending that exceed depreciation) and "real" industrial production, as I have demonstrated in the case of the semiconductor industry (see figure 2). To what extend the US economy can continue to expand based on inflating home prices remain to be seen, but as Hayek would say, faced with a misdirection of production in the late 1990s, the Fed created further misdirection in the housing industry between 2000 and today, which will eventually lead to a much more severe crisis as soon as the credit expansion comes to an end.

Turning our attention to figure to figure 4, once again, we can actually see that following the burst in money supply growth in 2001 and 2002, MZM growth has recently almost come to a standstill. In fact, MZM is expanding at the slowest rate in ten years, which would suggest to me that money has already become much tighter. Certainly, dollar strength and some weakness in commodities as well as slower growth in foreign official dollar reserves do all support the notion that money has become tighter. Therefore, unless the Fed starts to print money once again, the housing market may shortly begin to weaken somewhat, as has already happened in Australia, and in the United Kingdom, where following some unease in the property market retail sales disappointed.

But would printing money by the Fed help this time around? Hardly! Long term US government bonds have rallied while the Fed pushed short term interest rates up, because the bond market loves nothing more than tight money which would deflate the economy and asset prices. Conversely, another round of ultra easy monetary policies would lead to renewed dollar weakness, some inflationary pressures for consumer prices and weaker bond prices. So, it is likely that nationwide home price increases will shortly moderate and that in some areas (California and Florida - see figure 4) prices will even come down regardless of the Fed's monetary policies.

The stock market rally I expected for April unfolded in May but now the oversold position we had in late April has been replaced by an overbought condition. In addition, the market faces significant resistance between 1200 and 1230. Therefore, the upside potential seems rather limited at this point.

Bonds are now also grossly overbought and are likely to weaken in the period directly ahead. In the meantime, the Euro has broken down, whereby bearish sentiment on the Euro is now almost as high as bearish sentiment was for the US dollar in late 2004. Therefore, I would expect at least some stabilization of the Euro around current levels. Moreover, if investors begin to discount that the Fed may refrain from further increasing rates, a strong rebound in the Euro and renewed dollar weakness should not be ruled out.

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