Prudent Bear Market Commentary

Today was day 43 in what continues to be an historic period of absolutely destructive speculation. With today's 3% rise, the NASDAQ100 joins the Morgan Stanley Technology index, the Semiconductors, the NASDAQ Telecommunications index, and all the Internet indices in more than doubling in price during the year. And although Qualcomm has attracted most of the attention, there were many wild moves today as the small cap Russell 2000 rose 2% and the AMEX Broker/Dealer index surged 6%. Once again, there were big jumps in many stocks with short positions. So far this week, the Dow has gained 1% with the S&P500 posting a small gain. Economically sensitive stocks have been in heavy demand with the Transports rising 2%, and the Morgan Stanley Cyclical index jumping 3%. The Morgan Stanley Cyclical index now has a 1999 gain of 22%. The Morgan Stanley Consumer index is largely unchanged for the week, while the interest-sensitive Utilities have declined about 1%. The small cap Russell 2000 has jumped 3% and has now gained 22% since the lows of October 18th. The NASDAQ100 has also increased 3%. The Morgan Stanley Technology index and the Semiconductors have posted 1% advances, increasing year-to-date gains to 111% and 100%. The Street.com Internet index has advanced 3%, increasing 1999 gains to 185%. The NASDAQ Telecommunications index jumped 4% in the past three sessions. The financial stocks have been mixed with the S&P Bank index unchanged and the Bloomberg Wall Street index rising 2%. Recent economic reports overwhelmingly support our view of a desperately overheated economy turned white-hot by historic money and credit growth and a concomitant stock market melt up. Not surprisingly, yesterday the Conference Board reported a big jump in consumer confidence for November to the second highest level in history. Reported at 141.4, it is less than one point below the all-time record of 142.3 posted in the midst of a booming stock market back in October of 1968. (Interestingly, the Dow peaked at 985 in November of 1968 and then sank to a low of 662 by May of 1970.) The gauge of current economic conditions surged to 181.5, a new record, led by continued strong gains in perceptions of job availability.

Yesterday also saw what we view as a key report of stronger than expected existing home sales. Many see a slowing housing sector playing an important role in fostering a so-called "soft landing." Our view is the exact opposite. As such, existing home sales jumped 6% from November to an annual rate of 5.09 million making it virtually certain that 1999 will be the fourth consecutive record year of home sales. At $169,400, the average price was $2,400 higher than October and $10,300 greater than November last year. Annualized transaction dollars were $862 billion, 9% above last November, 31% greater than 1997 and 45% above 1996. Importantly, the inventory of unsold homes dropped to 4.3 months, the lowest since the record low reported in December of 1994. For comparison, the inventory of unsold homes ended November of 1998 at 5.7 months. It is our view that economists and homebuilders alike have failed to appreciate the boost in housing demand that will be wrought by more than $2 trillion of perceived stock market wealth created over the past 9 weeks. With inventory levels exceptionally low and demand strong and virtually certain to strengthen, the surprise will be higher home prices and resurgent new home construction. That is, until the stock market bubble is pierced.

And quoting an article titled, "Condos, Homes Continue Dramatic, Upward Spiral," from Sunday's San Francisco Examiner, "South Bay housing prices have been on a dramatic, upward spiral since the explosion five years ago of Silicon Valley's high-tech industries. The price increase has been exacerbated by a shortage of homes for sale and strong demand from well-compensated, high-tech executives and workers. As prices have soared to astronomical heights in towns closest to the heart of Silicon Valley, buyers have moved into outlying towns or once-shunned urban neighborhoods in their quest for affordable housing." The article highlighted results from a recent survey of price changes during the past six months in Santa Clara County. Strong price gains were prevalent in all communities and in all classes of dwellings. Examples include a 30% increase in condo prices in Saratoga and a 22% gain for condos farther out in Gilroy. Single-family homes rose 15% in Los Altos, 15.6% in Sunnyvale and 17.4% in Saratoga, and these gains in just the past six months and from already extreme levels. We have little doubt that additional housing inflation in Silicon Valley and elsewhere is being stoked by recent stock market inflation.

We can't help but to think back to November's 3.6% decline in single-family housing starts, and the accompanied comments from the National Association of Home Builders, and be convinced that homebuilders are not well prepared to match what we expect to be a significant pickup in demand. "NAHB's most recent survey indicates that builders anticipate some additional slowing of single-family production in coming months, and many builders will take the opportunity to work down backlogs of orders that have built up during the year…" It was also "noted that shortages of skilled labor, finished lots and some building materials have caused significant delays in production schedules during 1999. "Just as industrial production is today rising as manufacturers scurry to rebuild depleted stocks, scant housing inventory is one in a growing list of factors that will put additional stress on an already stretched and dysfunctional economy.

And it is not just domestic factors that are increasing the risk of problematic bottlenecks and inflationary pressures going forward. Apparently fueled by strong orders for exports and increased consumer spending, the confidence level of French Manufacturers surged to a five-year high in December. Bloomberg quoted a French executive who stated, "Our orders books in France have never been so high." Indeed, indexes of orders, both foreign and domestic, jumped to 11-year highs. In Germany, a business survey also showed improvement, with confidence rising to the highest level in 18 months. In the UK, the boom continues with today's report that housing prices increased again at more than a 13% annual rate, the most rapid increase since the late 1980s. Importantly, it was reported yesterday that Euro zone M3 money supply growth again accelerated, expanding at a rate of 6.2% versus the target of 4.5%. Equally alarming, total credit growth surged to 8.5% from 8% in October, while private sector credit growth jumped to 11% from 10.5%. Although credit growth is seemingly off the radar screens of the Federal Reserve, we strongly suspect that such credit excess does not go unnoticed by European central bankers.

In Asia, there are increasing signs that an industrial boom has taken hold. In Korea, industrial output surged 3.6% in November as output ran 26.8% above year ago levels. Exports were 39% above last November while domestic wholesale and retail sales jumped 15.4%. November capital spending rose 66.2% from last year. The Korean economy is now on track to record its strongest rate of growth in 10 years. In Thailand, automobile production has surged 108% for the first 11 months of the year, led by strong exports and a 44% increase in domestic sales. November Hong Kong exports jumped 10.3% from a year ago, the strongest gain in more than two years. Having now largely recovered, the Hong Kong economy is currently expanding at about 5% and expectations are that this pace will only quicken for next year. With our expectation of even more extreme demand for imports here at home, we expect economies to surprise in Europe and in Asia until the US bubble is broken.

Sometimes we feel like we are living on a different planet than the guests that pontificate on CNBC. Yesterday a bullish money manager noted that although everything looks wonderful, there are two issues that could next year provide potential potholes for the bull market. The first was the presidential cycle and the second was the potential for too many IPOs. Well, in the grand scheme of things, his two factors don't rank very high on our very long list of potential problems. Instead, we think he and the vast majority of market participants are missing the two key issues for 2000. First is the overheated economy that we suspect is in the process of further dangerous acceleration. This is certain to create massive demands for capital and require immense security issuance in a rising rate environment. And despite all the bullish propaganda, the current environment has created an absolute tinderbox for inflation - a system more prone to rising prices than at anytime since the late 1980's.

The second negative factor for 2000 is the momentous financial free-for-all that has unmistakably moved to a new degree of catastrophic speculative and credit excess. As for the melee that runs hopelessly out of control in our credit system, M3 has now expanded $230 billion during the past 14 weeks. And while most analysts pin responsibility almost solely on Federal Reserve Y2K operations, the simple fact remains that, as has been the case for some time, egregious credit excesses emanate directly from our overzealous financial sector. Importantly, since the beginning of September, financial sector commercial paper borrowings have increased $147 billion to $1.13 trillion, an annualized growth rate of 45%. Of this, $59 billion has been issued in just the past three weeks. Certainly, non-bank financial institutions continue to be responsible for much of these borrowings, as they balloon their balance sheets with mortgages and other financial assets. However, for several months bank credit has been expanding rapidly as well. So far this quarter, bank credit has expanded at a 15% annual rate. Consumer loans have expanded at 11%, Commercial and Industrial loans 13%, and Real Estate loans at 21%. Yet this excessive growth pales in comparison to security loans. This category of lending surged to $158 billion last week from $108 billion at the end of October. In fact, of the $155 billion increase in bank credit since the end of October, two-thirds has been to real estate and security loans. This is the absolute essence of asset inflation and a dangerous bubble. We have absolutely no doubt that this is a fiasco in the making.

Increasingly, we see the marketplace beginning to discount the likelihood of higher inflation. Commodity prices now appear to be firmly in a bullish pattern, and this goes beyond this year's doubling of oil prices to the highest levels since the end of the Gulf War. Quietly, the Goldman Sachs index of industrial metals prices has gained more than one-third this year, with copper rising 40% since May lows, palladium and aluminum at record highs and strong gains in nickel, zinc, and tin. Today silver gained more than 3%, the largest gain in three months, and copper closed at 19-month highs. Gold has also gained almost $10 over the past two weeks. We hear chemical prices are moving as well and equity investors are taking notice. So far this week, Dow Chemical has gained 10 points, with gains as much as 10% for the like of Phelps Dodge, Union Carbide, Praxair and Air Product and Chemicals.

So, at the minimum, we now have strong inflationary pressures in housing, oil, chemicals, industrial metals, and medical costs. Going forward, we see import prices as key. Keeping in mind that we will soon be importing an astonishing $100 billion of goods monthly, any general price pressures will have considerable effect on our overall inflation picture. One thing is certain, the period of declining import prices has ended and any expectation of reduced inflation over the coming months is no more than wishful thinking by the bulls. Much more likely, prices will surprise on the upside and this will be particularly unwelcome news for our financial sector that is massively leveraged in financial assets. And with the Fed falling further behind the curve each passing day, it is only a matter of time until reality must be faced. Interest rates are likely going substantially higher and rising rates will be acutely problematic for a system with unprecedented leverage and $28 trillion of interest rate derivatives. Moreover, we are in the midst of the greatest stock market speculation in history, with unknown but certainly massive underlying leverage. To any serious analyst, the stock market is a disaster waiting to happen. Candidly, we are dumbstruck with the public's perception that things could simply not be any better. But then again, the bulls have developed one powerful propaganda machine. This is one perilous mania.