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July 14, 2003
If the U.S. economy does not soon recover …

Patience may well be a virtue, but as Shakespeare once offered, “Who can be patient in extremes?”

With the U.S. economy showing scant evidence of an upturn, U.S. stocks pricing in stellar rebound in profits later this year, and the U.S. housing and bond bubbles threatening to simultaneously burst, the Fed no longer has the luxury of being patient. Rather, Greenspan’s schemes need to generate an economic upturn soon or the Fed risks losing not only near-term credibility, but the long-term battle against deflation.

Incidentally, last weeks reported decline in ‘core’ producer prices (which increases the focus on this weeks consumer prices report), is not the only type of deflation the Fed needs to be worried about.   Rather, with stocks rallying because of numerous nonfundamental reasons*, and rising housing prices supporting cash-out refi records, asset price deflation is as ominous a threat to the U.S. economy as the more closely watched consumer price index. Quite frankly, should either the housing or stock market suffer an unexpected shock, the impact on the already fragile U.S. economy could be extra devastating.  Why?  Because the Fed’s anti-deflation mandate has helped fuel asset price inflation, and, in turn, this asset price inflation has further fueled expectations of a welcomed economic/inflationary turnaround.

Suffice it to say, if you take away the rising stock market and/or the hot housing market, what you are left with is a barely moving U.S. economy that is encountering a steady onslaught of layoffs because of overcapacity. Something tells me that this reality does not read as well without the ‘Nasdaq reaches yearly highs’ banner attached to it.

Will The Fed Ever Target Stocks Again?

In order for the Fed to even begin worrying that asset prices have become dangerously speculative, they must first find or create an engine of growth to replace asset price inflation.  Such is why Greenspan dares not mentioned ‘irrational exuberance’ today, even though by most standards the U.S. markets are more richly valued than they were in December 1996. Until the economy shows signs of life Ebay could rally to $200 a share…the Fed will keep pumping and turning a blind eye to the mania.   

For the onlooker not dared into purchasing stocks and praying that earnings somehow catch up to prices, the Fed’s approach to fighting deflation (by manipulating asset prices) reeks of desperation. One day Greenspan is regularly alluding to a potentially mania driven stock market and the next day - after the markets have already rallied on little else than hopes and dreams - he starts taxing savers and verbally assaulting inflation hawks to try and coax some more upside out of stocks?

In short, the likelihood of the Fed trying to talk down the stock markets anytime soon is about as remote as Japan trying to talk up the Yen. Even though the stock markets may be considerably more risky today than they were in the mid-1990s, Greenspan sees a greater risk to the economy if the asset inflation train stops rolling.

Greenspan on Tap

Tomorrow Greenspan will testify in front of Congress.  In an attempt not to spook equity/bond investors he is likely to offer a dizzying array of incoherent comments that everyone can read and be happy about.  Nevertheless, if Greenspan happens to play the deflation card aggressively, this could mean that the uptick in bond yields following the June FOMC meeting has not been welcomed by the Fed. If Greenspan focuses on the D word the subsequent rally in bonds could be taken two ways: 1) The Fed is going to ensure long-term rates remain low (er) and/or 2) The Fed is worried that the economy is not gaining traction. It is unknown how equities would react to further mention of deflation given that stocks have rallied irregardless of heightened deflationary concerns.

Also due out this week is earnings reports from 12 Dow components and roughly 120 S&P 500 companies, and an array of potentially influential economic reports. While the major reports are noteworthy - retail sales, CPI, IP, etc – the reports for July (yellow) could carry more weight (you may recall that last months uptick in NY Empire State manufacturing set off a magical stock market rally because it was thought to be a ‘leading’ report). Specifically, consumer confidence could be key on Friday.

Date

ET

Release

For

Briefing

Consensus

Jul 15

08:00

NY Empire State Index

Jul

17.0

19.4

Jul 15

08:30

Retail Sales

Jun

0.3%

0.4%

Jul 15

08:30

Retail Sales ex-auto

Jun

0.3%

0.3%

Jul 15

10:00

Greenspan Testimony (2-Day)

-

-

-

Jul 16

08:30

CPI

Jun

0.3%

0.2%

Jul 16

08:30

Core CPI

Jun

0.1%

0.1%

Jul 16

08:30

Business Inventories

May

0.1%

0.0%

Jul 16

09:15

Industrial Production

Jun

0.2%

0.1%

Jul 16

09:15

Capacity Utilization

Jun

74.4%

74.4%

Jul 17

08:30

Housing Starts

Jun

1.830M

1.750M

Jul 17

08:30

Building Permits

Jun

1.850M

1.790M

Jul 17

08:30

Initial Claims

07/12

425K

425K

Jul 17

12:00

Philadelphia Fed

Jul

7.0

7.0

Jul 18

09:45

Mich Sentiment-Prel.

Jul

91.0

91.0



*Nonfundamental Reasons For The Rally

Notwithstanding the use of accounting chicanery, as corporate earnings rise so should stock prices.  Such is why – if stock prices were previously ‘fairly valued’ – you could argue that the market should be higher today than they were in Feb/Mar. After all, First Call estimates that 1Q03 profits were up 11.6% (versus estimates of +8.8% on Feb 1), and 2Q03 profits are expected to end in the +8% area.

However, and as is often the case, investors have tried to stretch good news (e.g. profits are not in freefall anymore) into great news.  In order to accomplish this leap of faith alternative methods of valuing stocks arise.

There can be little doubt that the main ‘nonfundamental’ way of justifying recent gains in stocks has been the growing belief that the relationship between risky stocks and safe bonds (see ‘equity premium’) has been profoundly altered. The logic being that when you combine Bush’s reduction on dividend taxes with Greenspan’s assault on interest rates, that stocks must be the highly preferable investment (compared to bonds). The only comment that should be made on this matter is that stocks carry risks while U.S. Treasury’s do not: simply because interest rates are not considered ‘attractive’ – as Japan is well aware – this does not mean that stocks are attractive by default. 

To note: I call the stock/bond relationship ‘nonfundamental’ because one does not have an absolute impact on the other.  To be sure, even if the average stock was yielding a higher after tax dividend return than the 10-year Treasury – which it is not! – this would still not be a fundamental reason to buy stocks.  Rather, stocks are fundamentally attractive when valuations (P/E, P/B, ROE, etc) are below average or at reasonable levels, and the earnings/cash flow outlook for a company is solid. 

With this in mind, consider an article from Glassman entitled “Bubble or not, neglect tech stocks at your peril”. This article begins by referring to legendary investors Benjamin Graham and Warren Buffett.  However, before the article is complete, Mr. Glassman completely ignores everything Graham stood for, and nearly everything Buffett stands for:

“I don't take P/E ratios for tech stocks too seriously…Even with a P/E that is close to 100, eBay, since it is growing so fast, represents good, though not spectacular, value…Yahoo presents a similar profile”

“The best idea to own a diversified portfolio of techs; some will be big winners, the way that Dell Computer (DELL), eBay and Microsoft have been; others will be big losers, but on balance, you should do well over time.”

“Even if this may not be the precisely perfect time to invest in high tech, you should not neglect the sector. If you bailed out during the long and sickening slide, you should get back in.”

To begin with, neither B or G ever took a diversified approach to investing. Rather, each investor bought what they believe was undervalued and likely to offer a no risk return in the future. Period.  Furthermore, B or G never ‘bailed out’ or ever tried to ‘get back in’ to any stock investment.  These investment approaches, even by Glassman’s logic, do not work.

As for Glassman not taking P/Es seriously – a statement that sometimes can make sense even for a Buffett (not for a Graham) – Glassman fails to expand upon what ‘since its growing fast’ means (if anything). Not only are the quality of earnings for companies like Ebay and Yahoo questionable (what with unexpensed stock options helping each company report profits instead of losses) but the most optimistic forward estimates do not show either company as overly attractive (May 28-Word).

In short, Glassman is not unlike Kudlow: he is walking around with a smug grin on his face dying to say I told you so (that stocks would rally) but trying to justify his bullishness by vaguely talking about fundamentals.  Glassman does not invest by the fundamentals – but by his unwavering belief that the markets are always going to rally in the future.

Give the Glassman’s credit for being stubborn enough to hold onto their convictions, but don’t give them credit for being right.  To be sure, Glassman was touting tech stocks as ‘defensive’ in 2001, and he will likely continue touting the Ebay’s even as they inevitably crash back down to earth. That he touts and then mentions someone like Graham - who was a strict valuations (break-up value) investor - is appalling. 

What the Glassman’s need to understand is that the Fed has thrown patience out the window, embraced extremism, and this is only nonfundamental that matters to the markets. And while everything equities related has come up aces with the Fed is rigging the deck, if the U.S. economy does not soon recover …

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