The Steve Puetz Letter

In Japan, monetary policy emanates from the demise of the bubble market of the 1980s. In the January 21st issue of Strategic Investment (1217 St. Paul St., Baltimore, MD 21202), Michael Belkin reviews the history: "The Japanese stock market crashed in 1990. By the summer of 1992, the Nikkei had fallen over 60% from its December 1989 high and the worried authorities began a series of market support operations. By pumping public pension money into Japanese stocks through the Price Keeping Operation (PKO) and a variety of tricks, Japanese authorities prevented their stock market from reaching a free-market equilibrium clearing level...

The price/earnings multiple of the Japanese market is now 73 -- higher than it was at the market's 1989 peak. The lower market level and higher P/E represent the drop in corporate earnings stemming from the economic decline triggered by the bubble's collapse. The key point is that valuation and economic fundamentals justify a Nikkei Average level well below 10,000 (compared to the current near 20,000 level). In my view, the Nikkei would have traded below 7,000 long ago if the Japanese authorities hadn't propped the market up artificially. In that case, there would have been a financial crisis in which banks failed and foreign assets were repatriated -- resulting in a margin call on global markets, a collapse in the US bond market and a severe Japanese economic contraction.... The question is: Has the day of reckoning been averted or simply deferred? I would argue that the law of gravity cannot be repealed. The after-bubble liquidation process isn't over until assets get cheap and the inefficient banks, which made absurd and uncollectable loans in the bubble, go bust.... Every policy decision in Japan for the past four years has been designed to prevent the free market from once and for all atoning for the excesses of the 1980s. These policy prescriptions have included:

1) Stuffing public pension fund money into the stock market.

2) Luring foreign investors into Japanese stocks.

3) Changing regulations to allow double-leveraged investment trusts such as 'Nikko Super Hyper Wave' -- which Japanese brokers have marketed heavily and which have enticed Japanese investors back into the bubble and thereby propped up stock prices with leverage.

4) Orchestrating a Yen devaluation, which resulted in huge dollar purchases that kept US interest rates artificially low and pumped up the US stock market speculative bubble.

5) Pretending that weak banks and insurance companies weren't bankrupt by concealing losses through officially-sanctioned fraudulent accounting practices.... The end result of all of these abuses is that the Japanese stock market has become divorced from reality and the bubble has been transmitted to US financial markets through Japan's dollar purchases and the resulting stimulative impact on US credit conditions.... For US investors, the old adage 'Don't fight the Fed' ought to be modified in the current circumstances to 'Don't trust a bubble built on Japanese support of the US dollar.'"

Following is a list of Japanese government interventions into the marketplace and their intended results:

1) The Bank of Japan has reduced short-term interest rates to 1/2 of I% in hopes of stimulating the ailing Japanese economy.

2) The Japanese government has supported the stock market by purchasing stocks with public pension fund money, by allowing highly leveraged stock market transactions to take place, and by encouraging foreigners to invest in Japan. These steps were taken in hopes of stabilizing the Japanese equity markets and preventing a tumultuous collapse in finances and confidence.

3) The Japanese government either encouraged them or looked-the-other-way when unscrupulous financial institutions papered over their ruinous losses. Again, these actions were motivated by a strong desire to maintain public confidence in Japanese institutions.

The unintended side-effects from these government sponsored actions are as follows:

1) Potential Japanese borrowers (individuals and businessmen) have been either too scared or too insolvent to take on more debt. So the low interest rates have done little to stimulate domestic demand. For savers, the low interest rates have been devastating. Rather than accept an interest rate of 1/2 of 1%, Japanese savers have been sending their cash overseas to earn a 7% annual return on US Treasury Bonds. Because of changes in exchange rates, these investors have also gained from the appreciation of the Dollar against the Yen. For the past couple of years, the combined gain from both yield and currency-exchange-rates has been in the neighborhood of 30%. Hedge funds also jumped into this game (the yen carry trade) a long time ago. These early successes encouraged more investors and speculators to jump in -- as they have. Once started, the money flows have become self-feeding. The undesired result has been a massive speculation in US securities funded by low short-term interest rates in Japan.

2) The Japanese stock market has not collapsed to the extent that corporate earnings have. This developed only because of government attempts to stabilize the markets and investors' confidence in them. The unintended final result is that Japanese stocks are now more overvalued than they were in 1989!

3) In a different attempt to maintain confidence, the Japanese government allowed large financial institutions to paper over huge losses. It was hoped that these institutions could some how recover in the interim. They haven't. In fact, the losses have grown larger. An even greater confidence crises looms in the future.

CONCLUSIONS -

In Japan, excessively low interest rates discourage domestic saving, encourage money outflows, and entice international speculators to borrow (especially the hedge-funds). Meanwhile, the depressed economy fails to respond to all attempts to stimulate it. The stock market remains over-valued. And bad loans multiply at the major banks and insurance companies.

In the US, the economy has been propped up by a heavy flow of money from the weak economies of Europe and Japan -- creating the false impression that the US economy is more fundamentally sound than those of its trading partners.

Either directly or indirectly (through US based international mutual funds), the global capital markets have benefited from these international trends and money-flows. In particular, the Bank of Japan, which fueled the 1980s Japanese bubble with low interest rates, has helped create an international financial bubble of greater magnitude during the 1990s. As a consequence, a major financial accident in Japan is likely to precipitate the coming global financial crash.

In the US, mimicking the S&P 500 stock index via index-mutual-funds has become exceedingly popular. Because index-funds are mandated to be fully invested, another disturbing development has occurred -- mutual-fund cash reserves have declined to a dangerously low percentage of their total assets.

Perhaps most perilous of all, there are many money managers who are mostly bullish, but bullish for one reason only -- because the stock market trend is up. They recognize the overvaluation, they understand the inherent dangers of the mutual-fund mania, they know the risks of excessive leveraging, and they control hundreds of billions of dollars worth of stocks. These bullish money managers might better be described as nervous bulls -- bulls ready to sell out at the instant they detect a trend reversal. Hedge-fund managers are equally nimble traders -- reversing trade positions on short notice. And within the past year, mutual fund investors have shown an equally quick reaction to stock market downturns by temporarily halting new purchases.

With all of these nervous and nimble managers, traders, and investors ready to sell once the trend reverses, how can the market possibly accommodate them all at once? It can't, and it won't. Once the selling starts, the Dow will crash to under 3000 within a few weeks. As the global financial system collapses, gold and silver will shoot higher as investors seek safety.