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THE BLUE MONEY REPORT.
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The Blue Money Report
"The knowledge of an effect depends on and involves the knowledge of a cause."
~ Spinoza
Welcome to the Blue Money Report
Today's Commentary: 08.05.03 Did I fear some sort of cataclysmic event that would rock the financial world might drag me back early? At the beginning, yes. As the vacation progressed, the chances of such an occurrence happening diminished as the clock that prompts me to rise at what my wife refers to as "an ungodly hour" was simply unplugged. Not to disappoint, the markets continued to embrace a chaos wholly their own.
My vacation did not break old habits of research and mental note taking. It did not halt the spread of good cheer that economic reports delivered in the last several weeks even if the numbers had a sickeningly sweet candy covering. The GDP grew in the last quarter to 2.4% which if you stopped right there, looked no further and believed that this was the turn around number that the economy needed, you would be once again fooled. Without the big boost in military spending, an additive that was (I hope) only a one time aberration, the GDP barely rose above the previous quarter's mark (1.4%) and consensus expectations (1.6%).
This past Friday had Elaine Cho, the Labor Secretary making the rounds and spreading her remarks that the drop in the unemployment number from 6.4% to 6.2% was a reason to celebrate the success of the President's economic policies. Fact is the job market has not gotten better. Workers it seems have stopped looking for non-existent jobs. 500,000 employable Americans have found the job market is such sad shape locally that the pursuit of employment is futile. Those that have jobs the report also noted were making less.
These two lackluster reports will find the person to blame in the office of the CEO with their continued stubbornness to get with the program. Faced with the grim prospect that the economy is still not what they would like it to be as they hear even more desultory information from economists that the old school thinking about how markets react still applies to their business, these folks are standing pat. And who can blame them.
Suppose for a minute that the old school thinking applies. That would mean the tax cut would be spent, dividend yielding stocks will outperform those that reinvest profits for growth and the lack of pricing power will be corrected with an uptick in inflation. That is a heady gamble for any CEO to take. Even more difficult for the company chiefs is the ability to garner enough support to rally behind this thinking.
Suppose for a minute, there is a new way of thinking about how the economy will react to the push the old schoolers have provided. The tax cut, as paltry as it will seem to many will be saved not spent. Inflation will have the desired effect on pricing but as this number moves upward, pressure on mortgages and refinances will slow the only part of the market that has shown any support for the economy during these difficult times.
Its no wonder they are just a little skittish about doing anything. If I was in their shoes, I would probably react the same way. But they may just be looking at something else and arriving at a similar conclusion.
In order for companies to grow which is the desired progress that leads to increased profits for shareholders, money must be raised to increase such things as research and development of new products, the purchase of equipment or even better, other viable companies with good business plans. The problem though is two fold.
Logically, the first question might be where to get the money. The second though is more troubling. In the first much more minor problem, the CEO is faced with limited prospects. As the stock market moves up, even if that has been a more gentle slope recently, the value of the company increases and the debt ratio goes down. If these CEOs were to look to the bond market for help, what they would find is an swirling mass of confusion. More on that later. These folks have reached the limit on what they can do to sustain the false hopes they have been providing of late. Profits cannot continue to rise on the backs of layoffs or stock buy-backs. Sooner or later, you have to increase market share with soemthing they have produced rather than something they produced for far less.
The second question deals with the prospect of sustainability. Sure companies have gotten more lean, learning to fire on all pistons with much less capacity and employees while living an on-demand existence. But any company leader who is worth their mettle understands that this can not go on indefinitely. At this moment in time, the economy is exactly where it should be. In other words the stars are in perfect alignment to allow a recovery to begin. Without basing too much of their decision on the information available from the last tax cut, the quarter following such a move stood alone as improved. If that case carries forward, then we are likely to see the last half of this year improve. The question presents itself as "then what?".
Once they are committed to the belief that global competition is worth fighting, that prices will allow them to continue to grow without increasing the need to borrow heavily to keep up and they can do this for a long period of time, then and only then will we see things improve. But that commitment has yet to manifest itself.
Companies run a risk either way. Expand to grow and gamble that the economy will be better than anticipated in the first half of '04 or the reverse. Pulling the reigns even further in the name of discipline and the consumer may just take that as a sign that maybe they should do the same.
For those of you who do not cook, the title of the this little piece, "emulsification" refers to the suspension of tiny globules of one liquid inside another liquid, creating a mixture that would not normally happen. Spun at high speeds, the resulting mixture such as mayonnaise for example becomes a new entity in itself. The markets are beginning to look like just such a force is at work.
As I said earlier, the economy is ready and willing. All of the tiny little globules of positive economic information have been spun at a high speed creating a rich sauce whose property is far superior to its ingredients. But this mixture is fragile and can break down quickly if not handled properly.
The stock market has recently provided the right environment to break this mixture down. The effect has been similar to leaving the potato salad in the hot sun for too long. Stocks are grouped together in certain ways to provide investors the ability to see how one group might determine the mood of the whole. If one were to follow this logic, then the markets could be in for a world of hurt in the coming months from the financial members of the grouping. The rallies have of the past several quarters have been based on the strength of this sector. But the pressure on rising mortgage rates which effectively slow home purchases and refinances will be the one thing this group does not need.
I'll admit that the actual dollars that are poured back into the economy because of the home equity borrowing is still too fuzzy to determine. I can tell you thugh that the folks who are paid to predict these outcomes are not wholly excited by the prospects of this new development.
With the financials under pressure, the rest of the market's weakness might be easier to see. And if the pension funds begin to look elsewhere, namely the bond market, the increased sell side activity might prove to be all that this market needs to break down the mixture.
I cringe every time I hear someone trot out 1987 as the comparable year to this one. These are obviously old schoolers who do not see the recent swing in bond yields as a natural occurrence to the alignment of all of the economic numbers. The problem is we are not of the old school. We understand that there is no such thing as a risk free investment. We understand that when prices reach historic highs that this is when we should look at the warning sings and perhaps readjust our thinking. And despite all of our recent experience, we continued to pour money into bonds, specifically Treasuries even as we watched the deficits increase and the possibility than billions of dollars of new bonds would be sold.
So when the bottom fell out of the bond market, a move that was described as violent by almost ten different reports that I read or heard, we new age thinkers were long gone. Right? A holder of a 10 year $1,000 bond will have seen the income that should have been produced sliced by 11% or roughly $110. Three years of income gone in what seems like a heart beat. The 30-year Treasuries lost 19%.
When bond prices fall it should go without saying, yields go up. This is an attractive alternative to the prospect of a slow stock market and will likely find pension managers looking hungrily at the prospects of a better return.
All of this will give the FED another headache of its own making. Mr. Greenspan would love to see the threat of deflation go away. The only way to do this is with a steady increase in inflation. This would probably force him to raise short term rates which would negatively impact the stock market and surprisingly, the bond market as well. With two exceptions. The first being TIPs. These bonds tied to the rate of inflation would become the bond of choice among those who are sensitive to income loss. The gamblers in the bunch will find municipal bonds increasingly attractive as budget shortfalls push municipalities to the bond market to solve their short term problems. The later exception will pay handsomely for the increased risk. Neither is enough to hold any part of the mixture together I'm afraid.
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