Monday, February 15, 2010

Perceived Reality

From the Desk of Joe Rollins

As you know, I make most of my living by keeping up with the stock market and financial matters. Because of that, I tend to think that almost everyone has a fairly good understanding of what is going on with the market and where it stands year-to-date, especially with as much media coverage as there is these days regarding the financial markets. However, in conversations I have with others regarding the economy and stock market, it’s clear to me that it isn’t unusual for people to misperceive the reality of what is going on in the stock market.

For example, I recently had dinner with a distinguished gentleman who has been a client of mine for over 20 years. At one point, he exclaimed to me, “I just don’t understand how you can deal with the pressure with the stock market down so much in 2010!” Since I had a few glasses of expensive French wine under my belt at that time, I didn’t consider it the appropriate forum to discuss the matter. But the more I got to thinking about it, the more it seemed to me that this type of discussion might be something of interest to all of my readers.

It may seem like the stock market has been extraordinarily volatile thus far in 2010; it seems like there are regular moves up and down of over 100 points. However, as of this past Friday, the Standard & Poor’s Index of 500 Stocks is down a total of only 3.3% for all of 2010. I am almost willing to bet that most people reading this post believe that the S&P is down considerably more than that percentage. Given that this same index was up 26.5% for 2009, this small downward movement so far this year was not only predictable, but also reflects a minor correction that could potentially be recovered within a matter of weeks. The S&P enjoyed a massive rally from March through December of 2009, so the 3.3% it is down is truly insignificant.

Why do so many people perceive the stock market to be so bad right now? One reason is because the economic news being reported by the financial press has been overwhelmingly bad. This gives most people the perception that things are worse than they really are. In my February 7th post, “Ding-Dong. The Recession is Dead,” I argued that the economy is better than the public perceives. I received a great deal of criticism from my readers regarding this post, but I believe a good way to gauge how the economy is doing is by visiting your local shopping mall. The U.S. is such a vibrant and diverse country that the economy in one part of the country can be robust while it borders on recession in another region. But combined, there is absolutely no question that the economy is improving now. The only question is whether it will continue to improve at a quick pace or if it’s a slow grind to full recovery.

For the last two decades, I have been arguing that many of the problems that we are suffering through today have to do with decisions made by former Federal Reserve Chairman, Dr. Alan Greenspan. It was always worrisome to me that Dr. Greenspan seemed more concerned with his own image than he was with controlling the economy. After famed Watergate reporter Bob Woodward’s book, Maestro: Greenspan’s Fed and the American Boom, was released, it seemed that Greenspan realized his term was coming to an end and he wanted to cement his legacy with great economic years.

Take a look at the chart below, which reflects the Federal Funds Rate since 1990. This chart, of course, includes the years that Dr. Greenspan was Chairman of the Federal Reserve. The years that led to our current problem are immediately after the terrorist attacks on September 11, 2001. As you can see, the Federal Funds Rate had been moving up during 2000, which was before the large stock market sell-off in 2000. During that entire period, Dr. Greenspan was arguing that he did not need to stimulate the economy even though, in retrospect, the economy was clearly in a recession.

In fact, not until the beginning of 2001 did Dr. Greenspan even start cutting interest rates well into a bad economy. Even though Dr. Greenspan was quite late in trying to stimulate the economy with lower interest rates, you can see the large slide that occurred which was even further accelerated after the terrorist attacks of 2001. You may recall that the country slipped into a recession due to the attacks, but only rested there for a total of three quarters. The country pulled out of the recession quickly due to the Federal Reserve and Dr. Greenspan’s quick actions to cut interest rates and to stimulate the economy with liquidity. However, the problem really began after 2001.

Dr. Greenspan argued continuously during this time period that there was no inflation anywhere in sight, and therefore, he saw no reason to increase interest rates. Not until the middle of 2004 were interest rates edged up, and only at a quarter of a point at each meeting for the following two years until his resignation. You may recall that this was the critical time which led to the financial disaster we have suffered through over the last few years.

As you can see from the chart, the Federal Funds Rate got down to approximately 1% during 2004 and stayed there for almost an entire year. It was during this period that the entire world binged, causing the real estate speculation boom and the leveraging that was the ultimate undoing of Wall Street.

The chart basically shows this process in action. Money could essentially be borrowed at 1% while U.S. government guaranteed bonds were paying 4%, which was a license for high profits. Any successful contractor knows that if you can make money on one house, then you can make a lot of money on 100 houses (not necessarily!). During this time period, some of the Wall Street firms were leveraged at almost 40 times their amount of equity. This is a great recipe for high profits during good times, but it’s a complete and total disaster during bad times.

Frankly, Dr. Greenspan made very critical mistakes. You cannot get a good read on the economy by just looking at things that are in your face. Dr. Greenspan was a notorious reviewer of hard copy printouts and had little computer skills. In fact, he prided himself on the fact that he only reviewed hard copy information, so he could not have been in real time touch with the data.

While he saw no inflation on the horizon – and there ultimately was none – he could never grasp the amount of leverages being built up in the economy due to the tremendously low interest rates that he was promoting. If Dr. Greenspan had been cognizant of what was going on in the real estate market and the number of homes being built and sold due to the low interest rates, he would have clearly moved interest rates up much faster.

The way to slow down the economy is by increasing interest rates and restricting cash flow. The United States would never have become as leveraged as it was from 2004 through 2007 if it had not been for the easy availability of money, high liquidity furnished by the Federal Reserve, and historically low interest rates. As you can see from the chart, during the 20-year period interest rates had never been as low until the most recent financial downturn. Regardless of the accolades given to Dr. Greenspan, the turmoil we’ve suffered was on his watch.

There was a tremendous sell-off in the financial markets in Asia over the last 30 days (10% or so). This sell-off is an example on how investors view things differently. It is anticipated that China will have a GDP growth this year approaching 10%. India may even have a GDP growth of close to 9%. All of Asia is growing tremendously for reasons that are not very clear to Americans. However, Asia is not sitting by and accepting the bubble that could potentially ruin their economy. Why would we sell their stocks when they are doing exactly the right thing?

The financial markets sold off last week when the Chinese government announced that they would restrict liquidity and loans to businesses. They moved up interest rates and increased their reserves last week to slow down their economy and to take some of the air out of the real estate bubble. Those moves by the Chinese government were exactly what they should have done. Does any of this sound familiar as it relates to the U.S. economy? If Dr. Greenspan had taken the same measures in 2004 to slow down the growth of the real estate bubble, perhaps the fall out of the financial crisis in 2008 could have been averted.

As I stated out in my January 21st post, “Why Aren’t Banks Lending?,” it is time for the Federal Reserve to increase interest rates. As you can see, interest rates are now at near historic lows and the economy is recovering slowly but surely. I hope Dr. Ben Bernanke sees this coming and will begin adjusting interest rates upward soon. While this will mean higher interest rates for the entire economy, we need to move prior to a runaway economy and not after it’s already been realized. When interest rates increase, banks will be encouraged to lend again in order to make money for their investors.

We all need to realize that interest rates are at historic lows and have been for some time. This should not persist in any economy, so it warrants an adjustment at the current time. Yes, it will affect real estate, but I really question to what degree. Residential real estate in the United States will recover due to a shortage of supply and demand. My personal opinion is that interest rates will have limited effect on that recovery.

As always, the foregoing are my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

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