August 18, 2003
September 2003

The exciting bond market dump is either a signal that the U.S. economy is about to recover strongly or a signal that the U.S. economy (stock market) is about to fall off a cliff. 

The Recovery Scenario

As strange as it may sound – especially to any investor sweating the ongoing bond market debacle – rising interest rates can be good news for stocks. For example, supposedly the stock markets have not collapsed following a sharp rise in long-term rates is because just a few months ago investor’s were terrified of deflation.  Today, with interest rates, commodity prices, operational profits, and the price of gold all gaining in unison, it is difficult for the deflation hawks to catch any air. Thus, no deflation automatically means good news for stocks?

I don’t necessary buy the recovery argument. Remember, the equity markets originally rallied – so we were told - because investor’s were expecting a strong post-Iraq economic bounce. Furthermore, when this economic bounce failed to materialize, stocks supposedly kept rallying because Greenspan coaxed interest rates lower (and Bush passed his dividend tax package).  Thus, have stocks ever actually displayed an ounce of fear towards the threat of deflation?  No.

Accordingly, and if you can follow my train of thought, why should stock prices applaud something – the death of deflation – that they have never booed?

In short, the recovery scenario is grounded on the belief that interest rates are rising because economic activity will continue to pick up.  The dramatic rise in interest rates isn’t alarming equity investors yet because inflation would be good news given the alternative (deflation).   

Off the Cliff

Given the amount of media coverage on this issue – that rising interest rates will pierce the housing bubble which will in turn pummel the U.S. economy – there is few new points to unearth. However, last weeks demise of CCM is further proof that extremely volatile financial markets, in this case bonds, nearly always leave behind road kill.

“This was a big national company - this just doesn't happen. Nobody, not even the employees, were expecting this.” Gene Cisneros, a retail mortgage broker

If more parties are to publicly admit that their interest rate bets went wrong the cliff could draw close quickly. However, even if there isn’t any more CCM’s, the ‘cliff’ argument ties in directly to the recovery theme: as bonds continue to anticipate an economic recovery higher interest rates make it more likely that such a recovery is likely to soon stall.

I favor the ‘cliff’ argument, but since the Fed isn’t going to hike rates until (unless) the economy is on fire, I realize that this scenario is grounded on the expectation of blow-ups that only time – not policy – can combat.

1987?

With interest rates spiking and the American dollar supposedly a sitting duck, there have been a wave of alarmists hunting for comparisons to 1987 and today. In fact, this month alone (August) there has been no less than 7 separate (feed) articles comparing today to 1987. 

I lump-call these individuals ‘alarmists’ because most of the ‘this is 1987 all over again’ opinions leave out the fact that stock prices plunged by more than 20% on Black Monday primarily because the markets failed, not necessarily because financial markets other than equities warned of the bust.  To be sure, when trades are not being cleared, portfolio insurance schemes are imploding, and traders/firms can not figure out how much capital/leverage they have, stocks prices crash due to lack of buying. Such a scenario, while possible, is not likely today as system upgrades to all exchanges, circuit breakers, and plunge protection members stand ready to stop it.

This is not to say that the alarmists are crackpots – only that the most important market negative (woefully inadequate trading technology) should at least be given mention as one of the causes of Black Monday. 

Incidentally, if you are going to have a stock market crash you need some sellers. Say what you want about the so called ‘stupid money’, but this pool of capital continues to trust Wall Street with their chips. Before the 1987 Crash less than 20% of American’s owned stocks while today the total is above 50%.  Why are 50% of Americans going to wake up tomorrow scared to death of the deficit or a 4.5% 10-year yield if their broker tells them to sit tight?

Point being, the crash alerts are early. Unless a Freddie is caught napping, or another Enron X 2 lurks, keep your crash goggles locked on the dollar and first week of trading in September (sometimes the action in the so called ‘smart money’ - which will return to the tables in Sept - can forecast future equity volatility trends). The second the U.S. dollar starts its next leg lower I’ll crack out my crash pom-poms, but probably not before. 

Anticipation Killed the Cat

With the Luskin’s writing inane statements like ‘It’s a Great Time to Buy’ and the Russell’s warning that disaster lurks, what should not be forgotten by the doldrums watcher is that investor’s do not always feel the need to take an extremist viewpoint.  Quite frankly, until some new economic information arrives or the bond bust turns into a complete meltdown, the immediate future for stocks is unknown -- September’s smart money bets may presage what the stupid money does, or does not do in October.

And yes, whatever happens tomorrow, it will appear to have been obvious after the fact.



 

Date

ET

Release

For

Briefing

Consensus

Aug 19

08:30

Housing Starts

Jul

1.810M

1.790M

Aug 19

08:30

Building Permits

Jul

1.810M

1.800M

Aug 19

09:45

Mich Sentiment-Prel.

Aug

92.0

91.5

Aug 19

14:00

Treasury Budget

Jul

-$53.0B

-$42.0B

Aug 21

08:30

Initial Claims

08/16

395K

NA

Aug 21

10:00

Leading Indicators

Jul

0.6%

0.4%

Aug 21

12:00

Philadelphia Fed

Aug

11.0

10.0

a