Perceptions are Changing

It was a decisive week for the bearish view, with losses for the dollar, credit markets and stocks. For the week, the Dow and S&P 500 dropped about 2%. The Morgan Stanley Cyclical index and the Utilities shed 3%. Performing better, the Morgan Stanley Consumer index and Transports declined about 1%. The small caps outperformed, especially with this afternoon’s late buying, with the Russell 2000 dropping less than 1% for the week. Technology stocks also had a relatively good week with the NASDAQ 100 and Morgan Stanley indices losing about 1%, lowering their year-to-date gains to 24% and 29%. Semiconductor stocks actually gained 2% this week, increasing 1999 gains to 41%. Internet stocks, however, came under selling pressure with The Street.com Internet index declining almost 6%. Financial stocks were also weak, with the S&P Bank index declining 3% and the Bloomberg Wall Street index dropping almost 4%.

It was another disappointing week for the dollar bulls. The greenback sunk another 2% against the yen, increasing losses for the past two months to almost 8%. The dollar closed today below 115 to the yen compared to almost 145 on July 31, 1998. This has been a virtual disaster for speculators in the "yen carry" trade. The dollar has also declined about 6% against the Euro during the past two weeks, and lost 2.5% this week against the British pound. Certainly, there has been a major shift in perceptions as to the long-term health of the dollar that, in our view, is likely related to the belated recognition of the unstable and parlous nature of the US financial and economic bubble.

With a weak dollar and plenty of evidence of a problematic overheated economy, it was another poor week for US credit markets. The yield on the 30-year bond rose 8 basis points to 6.1%. The five-year Treasury note was hit harder, with yields rising 10 basis points to 5.79%. In what is unfolding as an ugly bear market, year-to-date losses on the 30-year bond now stand at 10.6%. Bonds have now dropped for six straight months, the longest losing streak since 1973, according to research group Ryan Labs Inc. Although there was a slight narrowing in spreads earlier in the week, today spreads generally widened for mortgages and corporate securities as fears continue of the coming onslaught of issuance. Certainly, the market is also increasingly fearful of the potential for major dumping of positions by an increasingly impaired leveraged speculating community.

Faltering credit markets, though, are not just a US phenomenon. In the UK this week, yields rose to the highest levels since September on news of faster than expected economic growth. Two-year yields rose 25 basis points this week, extending their streak to 12 straight days of higher rates. Throughout Europe yields are near 13-month highs. Ten-year German bund yields rose 13 basis points this week, while 5-year note yields rose 23 basis points. Yields also rose sharply in Australia, New Zealand and Canada.

It was certainly a decisive week in economic analysis. This week’s data left little doubt that the US economy is in a dangerous unstable boom and that higher market interest rates have not at all tempered the excesses. Today’s report had June Personal Income growing a stronger than expected 0.7%, the largest increase since November. This is consistent with yesterday’s very strong 1.1% increase in the Employment Cost Index, the largest rise since 1991. Let there be little doubt that taut labor markets are demonstrating inflationary biases. Also today, Consumer spending rose at a 4% annual rate. This continues an 18-month stretch of at least 4% growth, the longest pace of such strong consumption increases in more than 25 years. Additionally, the Chicago Purchasing Managers index was reported today at above 60, indicative of a very strong and strengthening Midwestern-manufacturing sector. Both production and price components demonstrated exceptional strength. This report is likely a harbinger of a strong National Association of Purchasing Managers report Monday. The manufacturing sector has certainly bounced back quite strongly from last year’s slowdown.

Also today, June new home sales rose a more than expected 3.1%, to an annualized 929,000 units. For comparison, a record year last year saw 886,000 new homes sold, with 804,000 sold in 1997. Before last year’s record, the previous high was 819,000 units in 1977. In June, new home sales increased almost 13% in the West and almost 7% in the South. The average selling price was $196,500, up from May’s $185,100. Many have expected that higher mortgage rates would slow the housing boom. Indeed, this week, Freddie Mac reported mortgage rates rising to 7.7%, an increase of 50 basis points in two months, but the boom continues. In this regard, this week the Mortgage Bankers Association stated that 20% of current borrowers are using adjustable rate mortgages, double the number three months ago. Back in October, only 8% were using adjustable rates. This is a good example of how our financial system is perpetuating the credit bubble despite higher long-term rates. Yet, this is clearly a dilemma for the Fed that has been hoping that higher market rates would temper the economic boom. Obviously, things are not working out this way and this only heightens the pressure on the Fed to raise short-term rates. And, unfortunately, few borrowers that are currently taking advantage of initial attractive adjustable rates recognize the considerable additional interest rate risk they are accepting in this most unsettled environment. A boom in adjustable rate mortgages, at what can be argued are current artificially low short-term rates, only increases systemic risk down the road.

Yesterday on CNBC, a bullish money manager stated that stock markets only decline with higher inflation and sinking corporate profits. Since, as he argued, the CPI is not rising and corporate profits are strong, the stock market is destined to move higher. Well, we just don’t think he had his facts right. Markets have been around for hundreds of years and they decline for a myriad of reasons, usually, however, because perceptions change and people try to convert gains into hard cash. Actually, the ingredients that he states as ensuring a continued bull market are exactly the major factors that precipitated the two greatest stock market bubbles in history, the US boom in the late 20’s and Japan in the late 1980’s. And if one looks at Japanese data back in late 1989, at the peak of the Japanese bubble, one will see strong GDP growth, corporate profits that were expanding at about 10%, and stable consumer prices. Things could not have looked better – at least on the surface. And, of course, virtually everyone was bullish at the top. With this in mind, today we thought it would be informative to include a pertinent paragraph from Charles P. Kindleberger’s great book, Manias, Panics, and Crashes.

"As the speculative boom continues, interest rates, velocity of circulation, and prices all continue to mount. At some stage, a few insiders decide to take their profits and sell out. At the top of the market there is hesitation, as new recruits to speculation are balanced by insiders who withdraw. Prices begin to level off. There may then ensue an uneasy period of "financial distress." The term comes from corporate finance, where a firm is said to be in financial distress when it must contemplate the possibility, perhaps only a remote one, that it will not be able to meet its liabilities. For an economy as a whole, the equivalent is the awareness on the part of a considerable segment of the speculating community that a rush for liquidity – to get out of other assets and into money – may develop, with disastrous consequences for the prices of goods and securities, and leaving some speculative borrowers unable to pay off their loans. As distress persists, speculators realize, gradually or suddenly, that the market cannot go higher. It is time to withdraw. The race out of real or long-term financial assets and into money may turn into a stampede."

Speaking of insider selling, several top America Online executives this week sold a block of 4 million shares, raising more than $400 million. Chairman Steve Case sold 1.5 million shares and President Bob Pittman sold 1 million. This week Bill Gates filed to sell 3 million shares of Microsoft stock, or more than $250 million worth. So far this year, he has sold 15 million shares, this after selling $1.8 billion in 1998. Fellow Microsoft founder Paul Allen also filed to sell 1 million Microsoft shares. Interestingly, this week Paul Allen’s Charter Communications, the country’s fourth largest cable company, announced it is planning to do an initial public offering of almost $3.5 billion. It is certainly our view that the game is changing and that the smart money will be working to trade paper for others’ cash, exiting the great US stock market mania.