January 4, 2003
There is a pot of gold at the end of the rainbow

Welcome back from Holidays, and welcome to what should be a fascinating year.  For investors not interested in buying into dangerous momentum driven stocks, the two most important interrelated items of interest leading into 2004 are as follows:

1) The U.S. dollar
2) U.S. interest rates.

Chances are that if you can predict what will happen to the U.S. dollar/interest rates in 2004 that all your investments will be extremely successful. If you can’t – or choose not to speculate - staying liquid and being extremely selective with your capital is the wisest course of action.

The U.S. Dollar

Judging by the deluge of recent commentaries on the dollar, the consensus is that that a weakening greenback is good news for America.  The logic being that a slumping dollar makes U.S. based industries more competivie at home and abroad (not in China), and that this will help combat the U.S.’s unsustainable current account deficit.

However, a slumping dollar also brings with it potential pitfalls. For example, the weakening greenback is helping to put pressure on dollar denominated commodities like gold and oil.  Moreover, and most importantly, a weakening dollar suggests that investor’s are finding a better return for their capital elsewhere.

In short, one of the fears leading into 2004 is that foreign investment will continue to find a better return for their money and/or that commodity prices will continue to rise (not only because of currency relationships, but also because of the demand picture).

U.S. Interest Rates

Strong economic growth means higher interest rates, and rising commodity prices suggest that inflation is around the corner.  Accordingly, and unless the economic world as we have known it is about to be turned upside down, U.S. interest will rise at some point in 2004.

It is impossible to quantify the impact a jump in interest rates will have on the U.S. economy.  Nevertheless, the housing bubble doomsayers that arrived on the scene in 2002 are not going away anytime soon. Rising interest rates could negate what has been one of the leading drivers of economic growth since early 2002 – the housing market.


Reading Material To Begin The Year

One of the most interesting reads leading into 2004 is Edward Yardeni’s ‘Fearless Forecast 2004’. This research report highlights the bullish point of view by comparing the 1990s turnaround to today’s turnaround. 

To begin with, Mr. Yardeni doesn’t focus on the fact that more people are in the markets today than in 1990 (this limits today’s potential pool of new investment capital). Moreover, he doesn’t pay any attention to the fact that stock market valuations are higher across the board now when compared to the early 1990s. In fact, Yardeni doesn’t even mention that consumers are in worse financial shape now than during any post-recession recovery on record.

Nevertheless, Yardeni outlines the bullish case in greater depth than most, and seems to suggest that the new economy is back in force. As such, he is worth reading simply because his arguments take on a magical tone.  For example, Yardeni sees the Fed raising the Federal funds rate from 1% to 2% in 2004 but envisions stocks trading at higher valuations by year-end partially because of the WiFi backed productivity miracle. Further, Yardeni says the naysayers that say the government is borrowing from the future ‘don’t have children’ – “Those of us who are borrowing are spending the money on our children, not taking money away from their futures.” Apparently President Bush’s tax refunds, which help pay for little Bobby’s Nintendo, are all about securing Bobby’s financial future.


Another interesting read to begin the year comes from Alan Greenspan.  Apparently Sir Alan is still miffed that people think he caused the stock market bubble: 

Fed Members Contradict Each Other

“The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble while preserving economic stability is almost surely an illusion.”

It is one thing for Greenspan to claim that the Fed was braced in the late 1990s to “mitigate the fallout {in stocks} when it occurs”, but quite another for the Fed to smile and say that it was super successful at averting every financial disaster since Greenspan’s tenure began in 1987. To be sure, that the Fed did not wait to react to the Russian debt default, Y2K, and other ‘low-probability risks’ during the late 1990s is largely the reason why stock prices were able to bubble to such fantastic heights. In fact, you could speculate that one of the only reasons why stock prices have not retreated to non-bubble levels today is because of the Fed’s fight against the ‘inevitable’ consumer led recession. 

Paying absolutely no regard to the Fed’s ongoing rate cutting campaign, Greenspan’s true colors are seen within footnote number 9 (which was not covered in any depth by the media):

“Even if imbalances still persist in our current environment, the business decline that began in March 2001 came to an end in November of that year, according to the National Bureau of Economic Research. We experienced tepid recovery until the second half of last year, when GDP accelerated considerably. Hence, when the next recession arrives, as it inevitably will, it will be a stretch to attribute it to speculative imbalances of many years earlier.”

Needless to say, it is not very often that Mr. Greenspan uses a colloquial word like ‘stretch’.  Regardless, is it a ‘stretch’ to assume that if speculative imbalances in the U.S. housing market are close to bubbling over that the Fed is not at least partially responsible for allowing these imbalances to reach dangerous levels in 2002/2003? For that matter, is it a ‘stretch’ to conclude that the Fed has not endorsed an irrationally valued stock market as being a safe place for savings (versus negative returns on money markets) when considering that the Fed has continued to cut interest rates even, in Greenspan’s words, ‘the business decline has come to an end’?

Suffice it to say, it is laughable that Greenspan wants to blame the next recession on some yet to be determined cause. In fact, the next recession – which baring calamity does not appear to be in the cards until at least late 2004/2005 -- will likely occur because of the Fed’s explicit and continuing endorsement of asset inflation and consumer leveraging. Indeed, and by Greenspan’s admission, the Fed is willing to keep its foot on the pedal so long as traditional inflationary pressures remain at bay. This stance has compelled the consumer to margin the escalating value of their home and shift funds from savings into stocks. 

If this speculation – that the Fed endorses bubble prices in assets – seems like a ‘stretch’, consider what Fed Bernanke recently noted: 

“This literature suggests that even with the overnight nominal interest rate at zero, a central bank can impart additional stimulus by offering some form of commitment to the public to keep the short rate low for a longer period than previously expected. This commitment, if credible, should lower yields throughout the term structure and support other asset prices.”

How is it that the Fed, as Greenspan suggests, is unable to do anything about rising asset prices, but, using Bernanke’s suggestions, is also able to support asset prices at will?

The logic of Bernanke: If a 0% Federal Funds rate doesn’t do the job we will tell investors that short rates will be lower in the future than they currently expect, we will ramp-up the printing presses and/or buy U.S. Treasuries. 

The logic of Greenspan: When bubbles pop we will claim ignorance. No one will notice, ourselves included, that the easy money policies we used to avert any softness in the economy created the bubbles in the first place. 

Conclusion

After reading Yardeni, Greenspan, and Bernanke, the investor either accepts the world presented before them or they run for cover. Opting for cover – in this case gold/silver – is the safe long-term choice (even Yardeni speculates of $500 an ounce gold in his footnotes). However, unless a calamity in the U.S. dollar/interest rates arises gold may not be the most profitable choice in the near term. 

The perplexing point worth remembering is that 2003 was a good year for stocks because of a convergence of unique factors, not necessarily because stocks were strictly undervalued by traditional measures to begin the year.  Indeed, the perplexing point to remember is that in 2003 the Fed widened its attack against deflationary ghosts because of the limitations of zero pound interest rate policy, and that Bush wanted to write as many checks as possible in his reelection bid. Why is this perplexing? Because the Fed and President were so successful at reigniting the U.S. economy and stock markets that it is difficult to predict how the U.S. economy/stock markets will perform once this stimulus ebbs.

Even so, and make no doubt about it – the stimulus will ebb. To be sure, even Yardeni is scared of this reality: “Down the road, the bubble in the financing of our homes could be a serious problem.”

2004 will likely prove to be a fascinating year because despite all the uncertainty – U.S. interest rates and the U.S. dollar could adjust slowly enough not to immediately damage the expansion - one asset is unlikely to stop shining no matter what the outcome: gold.
 

BWillett@fallstreet.com




 

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