Coping in a Bear Market

0:00Generalised, rather than particularised over production, is a harmful nonsense, and secondly, since we have no access to the staff with which Moses struck the rock, nor a ready supply of manner for the asking, we must realise that production is what creates wealth and consumption, conversely, is what extinguishes it. Thus, contrary to Keynesian and monetarist thinking, stimulating spending of itself says little about whether this would be a force for good or ill, though it may very well manage to induce an increase in the aggregative statistical artefact, which is GDP. What spending does is not to create wealth, but to direct the form of its realisation. Consumption is a vote, not a magic action to distance which generates output automatically, much less investment.

0:47Depending via its generation of price signals tells entrepreneurs what is the overall ordering of preference for goods and services and gives them the starting point upon which they must base their own estimates of the price they can afford to pay for inputs of land, labour and other factors of production necessary for them to contribute towards the delivery of the goods and services most urgently wanted. Once they come to expect they can achieve this with a surplus, a profit in other words, they will compete for those means they judge necessary and in that competition will further will further influence an array of prices of all raw materials, business services, rentals, intermediate, capital goods in the market, and will thus be continuously engaged in calculating and recalculating input to expected output margins. A good part of these costs are associated with carrying the enterprise through time to its fruition.

1:33Goods do not appear instantaneously upon the shelf, no matter how insistent the desire for them, nor how wonderful the technology of Mr Greenspan's blessed inventory management. Here the interest rate as the crucial, if derivative, determinant of the cost of capital on the market plays its role. In a market where the supply of money was fixed, or at least changed so slowly as to make no practical difference, the interest rate would most closely reflect people's time preferences, that is, their degree of impatience in wanting goods today rather than tomorrow. Now this sets us up for what, in distinction to the fallacious Keynesian paradox of thrift, is in fact a paradox of consumption. The more aggressive our demands for current goods, the less surplus we leave over from everyone's current round of labours, or put another way, the less savings we make. Thus, the less of the pool of real capital, and in this case its corresponding monetary form, which can be made available to help produce the goods we want to consume in the future.

2:27From this extra current pressure comes a higher natural rate of interest and so a clear signal to entrepreneurs, through this most vital of prices, that means a scarce and so long duration or thinly margined or more speculative undertakings are all too likely to fail. Thus the entrepreneurial efforts will be more narrowly based on more immediate production modes and in the extreme on simple bilateral exchange or even self-sufficiency. As the last suggests with its echoes of a primitive society this is not a route to increase prosperity. So the upshot is that rather than having a negative feedback leading to a cycle of decline based on too much saving We have one based on saving too little, but of course we don't live in that world, we live in one where Alan Greenspan is merely the most egregious and happily influential player in his belief that he can better set a rate of interest than can the interactions of a myriad of freely acting individuals by slowing or accelerating the swelling of the Fred's balance sheet around its 30-year secular trend.

3:34ran its 30-year secular trend of 6.8% a year growth, an arbitrary number. Thus the vital price signals are confused by the emphatic non-neutrality of money in its injection effects, i.e. who gets it first and what they do with it, and in the amplification of these by today's hyperactive financial architecture, which has a penchant for bringing unimaginable leverage to bear, as Jean was pointing out, on tradable qualities deemed by the herd to be too high or too low in price at any given instant. So relative prices get distorted and they may also be made damagingly volatile and erratic in nature by monetary manipulation. In this manner the rates are distorted by the impact of inflationary credit on financial market asset prices and these feed back very strongly in the John Law spiral of monetised collateral in which we live.

4:23Thus entrepreneurs become confused, people misdirect their labors, and we all keep on misallocating our real capital while piling out yet more credit. That explains the business cycle in its essence, but we've had two new twists in this recent one, which helps explain why it grew to an extent potentially more unbalanced than previously seen. The simple first factor is technological gee-wizzery. Like kids with noses against the toy shop window, we're always impressed by shiny new gadgetry and we lapsed into a syndrome where we steeped ourselves in the trading card mentality and judgment became suspended in favor of novelty and to some extent it still is. Cisco, Intel, Oracle, Microsoft and their ilk still dominate both financial news and daily trading volumes. The second more important factor is the external one. This could be looked upon as the western fruits of globalization or its dark side, dollar imperialism.

5:14Somewhere between the fall of the Berlin Wall and the tequila crisis of 95, a major external shift began. A major external shift began, and this accelerated after the events of the 97-98 Asian Contagion. Foreigners started to build up official reserves, a tendency which swelled to the tune of $400 billion worth of extra seniorage from 1997 to 2000. They also began to accumulate other forms of US debt in an inordinate manner. The figures are sobering. 74% of all corporate bond inflows for the past 50 years have been concentrated in just the last 6, as has 79% of all foreign buying of agency paper. Foreigners have also been rather less than astute in buying 85% of all their US equities in these most overpriced of years, but in fact net equity flows were negative, and even if we add in direct investment, which was often financed with these equity stock swaps, this only contributes $230 billion to America's External Deficit, whereas bonds make up 1.9 trillion gross and 1.7 trillion net.

6:17In fact, 68% of all portfolio and foreign direct investment flows to the United States since the Korean War have been made since the bubble began and they are all essentially bond liabilities. This trend has been absolutely key to preventing America's Ponzi scheme inflationary finance and its yawning trade deficit from igniting the sort of price inflation which short circuits more typical business cycles. It is also clearly America's sword of Damocles. Private foreigners have built up balances in exchange for cheap goods and official foreigners have expanded their reserve bases and hence their money supply on the accumulation of This has helped appreciate their currencies, which while pushing up locally counted export earnings, has also represented an effective channel of taxation on their peoples via the inflation, and that tax has gone to subsidise what we call Atlantic consortium consumers.

7:13For so long as it lasted, with the aid of the odd monetary collapse in those nations along the way, this seemingly costless expansion of credit unfortunately served to tune everybody's production at once to Anglo-American consumers and to the high-tech fallacies of the Atlantic economy. fallacies of the Atlantic business model. Meanwhile, the homegrown credit bubble drove a huge wedge between savings and investment, to the point that, over the last three years for the first time on record, U.S. gross non-financial business investment has not been matched by a combination of household savings and businesses own internally generated funds. The reason this has not torn the system apart in a civil war of consumers and producers battling for goods is a good old Johnny Foreigner has been pleased to provide those goods on Even so, adding the fact that our wonderful corporates have been using much of what they have made in retiring arguably the most expensive equity in history, which is something their 1920s predecessors were not dumb enough to do, and we have had a $1.1 trillion hole blown

8:12in the accounts since the long-term capital management crisis of 1998. But no matter, for an exponential growth in credit extension and financial leverage has helped fill this chasm. If we look at the growth of financial market debt over the last three years, we find an extra $1.20 has been conjured up for every $1 of combined private savings. For a sense of scale, we should compare this to the previous cycle's high of only $0.48 to the dollar and the intervening $0.92 low of $0.28. At the same time, outstanding derivatives contracts, instruments used to cut, paste, bundle, gamble on moves in the underlying economic quantities, have burgeoned from $56 A monetary expansion works essentially by changing prices upwards once more, though Now, this is much more haphazard and random than the homogeneous goods thinkers like standard monetarists and Keynesians believe.

9:28And so it's hardly guaranteed to be of any overall benefit once we jump through Bastiat's window. What is more certain, though, is that it can unlock that portion of productive capacity, which has been frozen up and prevented by the existing costs and refinancing apparatus of its debt load from not repricing its output to better suit the market. Now, unfortunately, this means that firms stubbornly attempting to sell goods at above-clearing prices with shaky balance sheets are being supported at the expense of the nimble, the well-managed and the innovative. Look at Compaq or IBM against Dell for an instance of this. Without the debt machine, the first two long ago would have surrendered the market wholly to the latter. Now, more soberingly, you should look at Japan or Korea or China, where karetsu and kaibol and state-owned enterprises rely upon vast infusions of dishonest money for survival to the detriment of all and look too at what dishonest money achieves through the equity channel in the West.

10:21It is certain that to the extent Greenspan has not simply stored up an even larger financial system crisis, a huge volume of easily mobilized liquidity is available for activation in spending. If the private sector stops the purposeless exercise of piling up more debt with the right hand Given we started this discussion by arguing that too much spending was further weakening an overly prolonged capital structure, there is a significant risk that this will mean increasingly insistent signs of price inflation, and this could possibly be by the late spring as a realignment is sought once more. This can take place even if unemployment rises, unless we shift to a retirement or immobilization of money through private thrift or through extinguishing it by default or deliberate central bank policy.

11:16A GDP may well rise in the absence of this and the hosannas will resound unto the heavens, even though the economy is becoming inherently weaker as spending grows. This is especially conceivable for the services component, which is around five times the dollar value of equipment and software investment spending. Spending. So this means a mere 2.1% rise in haircuts and hotel meals would mask a 10% fall in face recognition technology and human ID chips, which maybe isn't such a bad thing after all. But don't forget, government looms twice as large as capital investment in national accounts also. With Bush about to finance a six-year crusade as well as a host of unnecessary programmes, GDP may well go up, but LBJ, the last man to do likewise, didn't leave the world a better place than when he embarked upon the course.

12:03There will be plenty of government borrowers this year ready to squander proceeds of bank credit creation, even if the private sector becomes more reluctant to play, again an argument at this point against deflation. Initially the improvement in spending will be sold as a renewed golden age. The Wall Street herd will be out in force bad mouthing other currencies like the yen and the euro to forestall the dollar's day of reckoning, and this could take us easily into the second part of the year. But at this point the trade deficit will be widening, internal saving will be suppressed and interest rates will be biased higher if not overwhelmingly so in what would be a mild bear market for bonds. Investment spending too and thus the loop between this and significant corporate revenue and earning enhancement will be largely absent so equities may not wilt but neither are they likely to thrive according to the norms of recent years.

12:52Again in all this the only escape route from an eventual deterioration in the CPI index seems to be the continuation of the US dollar's attractiveness to less high rolling foreigners But with no new era, only sunset industry style growth likely, together with another widening of the trade gap and with portfolios already hugely overexposed, this too looks like a challenge, 6th fleet or no. Now if the Fed does not act to guard against these effects, bondholders will become increasingly uneasy about the impact. The yield curve will steepen bearishly as long bond rates rise fastest, and their foreign holders might compound both the markets woes and the inflationary impact through selling quantities of their now surplus dollars. But then if the Fed does act, or is credibly held to be on the verge of acting, the front end with its unprecedented speculative overhang left from all the interest rate reductions last year will buckle first and will suffer a sell-off led by shorter maturities, again this might hurt the dollar, and might require increasing degrees of Fed aggressiveness

13:50in an attempt to front load the pain and get ahead of the curve as they say. The first scenario may just be to equities benefit, especially those of providers of The second scenario though is likely to be much more malign. It would imply tighter, or at least less easy, liquidity, as well as higher bond yields, and a contraction of both earnings and multiples would then be in prospect.

14:28An outcome along the lines of the first is broadly conducive for diminishing risk premier on corporate bonds and other secondary instruments, the second, because of the quality considerations, would probably favor US Treasuries. If you ask us which way we think the dice will fall, as betting men we can't really say that Greenspan would do anything so politically contentious as tightening, early and causing problems. And now that he's lost the nagging conscience of Governor Mayer, one of the few intellectually rigorous board members, though unfortunately of course a rigorous Keynesian, he has little opposition to look forward to from the placemen and the Bush appointed tyrants on the committee.

15:16Now we should take a quick detour here and pay cursory attention to a wider world and pay a swift abasance to America's numerous and generous offshore creditors in order to estimate their effects on the US cycle. Europe has its problems, Telecom and Techmania did hit, as well as other foolish attempts to emulate the Yankees and the roast beef's worst corporate misadventures. Iberian banks failed attempts at a peso reconquista will hurt, but malinvestment has not been and so widespread, given that much of Europe's extra credit creation was used to buy Anglo-American securities and companies. Moreover, in most European countries, private saving easily covers investment, so a progressive impoverishment should not take place on the Anglo model unless governments abandon all pretence at adhering to their budgetary stability pact and the mantra of structural reform, however anemic.

16:06There also seems to be a firming resolve from the newly confident European Central Bank that the old Bundesbank credo of no counter-cyclical monetary policy might actually work for them, and we should like to think they will continue to be modest in the scale of their reserves additions once the new notes and coins are bedded in. Thus, barring de registe maladroitnes, we might accept Europe to start the year looking worse than the US, but possibly ending up with a much better balanced economy at the end of it. As for the UK, something of a local specialty, as you can hear from the accent, our pessimism should be well noted. Investment goods are in a 20-year slump and broader manufacturing is back at 1996 levels after a 1991 recession-style fall. Private non-financial returns on assets have fallen threefold since the Chancellor and the Bank of England Governor have presided over what they thought was an end to boom and bust policies.

16:57Bigger and bigger government, spreading industrial unrest, collapsing profits, scant saving investment, a huge trade deficit while borrowing a housing bubble in a softening private sector and the labour market looks all horribly reminiscent of 70s and 80s government inspired booms. Japan now seems categorically trapped between its Asian neighbours and the impotent US bully on the weary old ply of currency devaluation. Malaysia has threatened ructions, Korea has voiced complaints, China is flexing its muscles. The hope is that bank reform seems to be edging ever closer and if this is at last accompanied by a ruthless extirpation of the dead wood To recap, the core scenario is an increase in US GDP as the optimists have it, but with much higher prices than most give credit to and with far lower corporate profits except for those companies placed to gain windfalls from the effects of inflation.

18:06We see the Fed as being slow to react politically and tied by what is likely to be a continued upward march of unemployment and worried also about adding their impetus to the market's own imposition of increased debt service levels. Given its world view, it will be bamboozled by low factory utilization and a possible double dip in its precious inventory cycle. Greenspan's last speech showed that he was still irresponsibly trying to promote the The Monetization of House Price Inflation to support consumption, but how far this can run has to be questioned. In sum, we currently hold that the vast monetary stimulus will push up prices even amid stagnation in output and cost of living indexes will deteriorate. Before too long the yawning hole left by the evaporation of bubble tax revenues and their replacement with bust expenditures at every level of government will take effect not only to add an underlying offer to bonds but to begin to remind people of the bad old days of the 1980s. However, it is conceivable that the ongoing fall of income, in the sense of

19:05a remunerated flow of valued goods and services wrought by the distortions of the boom, will mean that the inflationary currents become in essence hidden ones. The lack of earnings visibility as the current vogue has it, and the political and financial impediments to entrepreneurial activity may, and we emphasise the may, be too much for businessmen to respond The Central Bank has not gone to mere liquidity just yet, preferring instead to hold it on account and bide their time. If this occurs, consumer prices could still rise, and they will certainly outstrip producer prices, but they will not rise as fast as we have in our main scenario, and may even decelerate. Of course, this would give the central bankers greater leeway to remain lax for longer, and fixed income strategists would be sharpening off pencils and projecting even more lows in bond yields. It would be too late then for us to argue that we still have an inflation in a technical and that in an honest world prices would have fallen to bring labour materials and factors of production all back into balance or that we are already sowing the seeds of the next boom, bonds would have gained significantly at the expense of equities and pessimism would abound.

20:06So far this does not appear to be the case. Not only is money supply still growing and the weekly MBA housing purchase index making new highs, but there are signs of life in non-energy commodities such as metals and DRAMs and even freight futures. Futures, though we should be wary that some of this is due to restrictionism, not demand. Asian export volumes too have begun to level off after often precipitous falls. But conversely it is true that industrial production and capacity utilisation were yet lower in December, albeit barely, and that production has now declined for 15 straight months, wiping out two years' gains and losing the biggest percentage since the slump of 1982 in the process. Core intermediate goods prices fell faster in the last six months than at any time in in the past 28 years. The core crude price is at the bottom of a 14-year range.

20:52NEPM prices are up from a 52-year low barely, and the Philly Fed's version of these is only just recovering from its October 33-year low. Orders may have done somewhat better, but as companies such as Tyco reminded us only this week, orders can be cancelled, and in some categories such as non-defence capital goods, the highest of high order goods, we are still languishing at 1995 levels. If therefore there is still no great demand for producer goods, as these aggregates may be suggesting, there is likely to be no payment to production workers or suppliers and, once credit led spending exhausts both itself and further free capital, if you like Jean's burn rate for the whole economy, the spiral into the depths well inside the production frontier would become all too real a possibility, as consumer goods too began to lie unutilised at the price and the process of voluntary postponement of purchases set in.

21:43Hayek's secondary depression could then be given an outing. It would be a shame if it does that the Fed has already expended so much ammunition trying for the mirage of a soft landing that it might be forced to resort to some real monetary crank methods to solve this problem given the crushing indebtedness which obtains across all sectors. We need then to see clear signs of reversal in these numbers together with the restoration of corporate revenues, profits we can wait upon for a short while, which might signal that the productive structure is lengthening or at least broadening once more. Drawdowns in institutional money funds would also be another signal of an end to a scramble for liquidity in favour of the activation of these balances. But until then, we are unfortunately in limbo, and we must invest with even greater than usual levels of deliberation. In the end, this episode may simply come down to what we all know in our hearts as the crux.

22:32After a truly spectacular boom and bust, will secularly expensive bonds win out over historically Or in other words, will the damage done to the system spare us from inflation's ills, even at the expense of a depression? This is what we, traders, speculators, entrepreneurs, must attempt to gauge in the coming weeks and months. And as acting men and women, we of all people should know that as the data change, so must we. That is the way to cope in a bear market, but it is of course also the way to cope in a bull market.

23:11Thank you for watching.