Juiced Up

BY RANDALL W. FORSYTH

Reprinted from Barron's

March 29, 2004 Copyright (c) 2004, Dow Jones & Company, Inc.

It's a tough call which had a more sudden reversal of fortune last week, Richard A. Clarke or the stock market.

Less than seven days ago, Clarke was an obscure former bureaucrat who had toiled in the White House for a decade as the counterterrorism coordinator for Presidents Clinton and Bush. But after appearances on 60 Minutes and before the 9/11 Commission, his name suddenly was on everyone's lips. And much to the delight of Mr. Clarke and his publisher, his new book, Against All Enemies: Inside America's War on Terror, couldn't stay on bookstores' shelves.

The question of whether the Bush administration was guilty of malign neglect about the threat from at Qaeda – as Clarke now contends -- or that it had stepped up the efforts of the Clinton administration to bring bin Laden and his henchman to heel - as Clarke stated back in 2002 -- there is sufficient blame for both administrations to share for their failure to perform the most basic function of government, to protect their citizens from attack. But that the blame game is being played in Washington, in an election year -- well, does that surprise anybody?

Why waste time dealing about something ever so mundane, such as the clear and not-so-far-in-the-future danger that Medicare will be bust in 2019? That's some seven years sooner than previous projections, not even counting some squirrelly projections about how much the new prescription-drug benefit will cost. (And speaking of counting, do those commercials from the Department of Health and Human Services touting the new drug coverage, presumably paid on the taxpayers' dime, count as ads for the Bush re-election team and their GOP congressional cohort'?)

The dispiriting spectacle in D.C. can hardly be held responsible for the stock market’s rubbery legs of late. Internecine squabbling instead of tackling the crucial problems confronting the Republic? Yeah, that's another shocker. No less unsurprising but even more disquieting have been the troubles around the globe, with Israel's elimination of the founder of Hamas and the disputed election in Taiwan only the latest additions to the litany of woes. But it ain't news that the end of history, with its promises of permanent
peace and prosperity, has not arrived.

From the standpoint of the stock market, the revival that began a bit over a year ago has produced excesses that trouble the graybeards, and we don' t just mean the liftoff in the likes of Yahoo, Amazon and eBay back to bubble valuations. A bubble is more substantial than smoke, which is what the market appeared to be going up in. That is, according to no less an authority than AM New York, a newspaper distributed free of charge and apparently aimed at Gothamites not in the habit of picking up a daily paper. Last Monday's lead story, chosen no doubt with its readership's interests in mind, was headlined, "Pot goes public." It seems that Amigula, which bills itself as "the world's first marijuana company" and trades on the Bulletin Board under the symbol AMJL, wants to make the leap to the Nasdaq or the Amex. The company has contracted with 50 Canadian growers to provide medicinal marijuana and is looking to raise $7 million in equity financing for the venture. Heady stuff, to be sure, but hardly symptomatic of a sober approach to the market.

By midweek, the market could have used a lift, from whatever source, as the declines in the Dow Industrials, the Nasdaq and the Standard & Poor's 500 from their highs extended to the 5% correction territory. Some tech sectors had been hit even harder, with the SOX, the Philadelphia Semiconductor Index, down three times as much from its peak. Fittingly, sentiment indicators started to show the strain of the retreat of the past couple of weeks. Notably, Investors Intelligence found the bulls in its polling dipped below the 50% mark while the ratio of bulls to bears fell under the 2-to-1 level, readings not seen since the market really got the bit in its teeth last spring.

All of which set things up for Thursday's blastoff, when the Dow jumped 170 points, its best-one day showing in six months, while the Nasdaq surged 3%, its biggest move to the upside since July. The market tried to build on those gains Friday, but faded at the end.

So why the sudden change of heart on the part of investors'? Woody Dorsey, who pens the Market Semiotics advisory out of Castelton, Vt., had been calling for a "March massacre" for months. (And if you're keeping score at home, Woody also presciently called for the market to bottom in October 2002 and "the best equity rally in years" starting in March 2003. And now? Woody thinks "this market has gotten this correction out of our system." The market's fear of geopolitical uncertainty had produced almost a "minipanic" in stocks, he adds, but failed to give a meaningful boost to Treasuries or gold, the usual beneticiaries of those jitters.

From here, Woody looks for the market to bounce back for a couple of months and then, as the cliche goes, sell in May and go away. "Bush and Kerry will be a dogfight, and the market will be concerned about that," he says. (The market's big concern is that one of them will win.) Woody's work points to a "minicrash" ahead of the election, say September, then a rally into year end.

But that's about it. "We've had a one-way market for about a year, a lot of it liquidity driven, which you can see in the commodities." Now, Woody says, look for "asset dissonance," where everything doesn't add up, with lots of back-and-forth action. By early 2005, however, he looks for the market to be back on its "slippery slope."

Far from sneering at drugs and their extracurricular uses, the markets and the economy should face the facts that they're booked, big time. That is, on the monetary equivalent of steroids, most notably in the form of 1% money. Oh yes, half-trillion-dollar deficits don't exactly retard the economy (at least until you have to pay for them). In that context, last year's numbers, featuring an 8%-plus annualized expansion in U.S. gross domestic product in the third quarter, should be viewed in the same vein as Barry Bonds' 70 home runs a couple of years ago. Juiced, big time.

A federal-funds rate of merely 1% can work magic, mainly by the second-oldest game in town: borrow short and lend long. Borrow at 1% to buy bonds at 4%, multiply by 50 times, and you're on to triple-digit gains. Oh, did I mention that was risky? No matter, everybody's doing it, as the chart on the previous page, provided by Jim Bianco of the eponymous and ever-informative Bianco Research, shows. Leverage used by the big government securities dealers has gone out of sight, dwarfing the uptick in stock-market margin debt.

Boring as running a bulked-up bond position may sound, it sure can pay off, at least if you're as sharp as the guys and gals at Goldman Sachs. Goldman last week posted earnings of $1.3 billion for the quarter ended February, its best three-month showing ever. That's even with a dip in investment-banking revenue and a relatively modest uptick in advisory services -- you know, what Goldman does to help Michael Eisner keep Disney out of the clutches of Comcast. What really took off was trading -- over $2 billion in revenue in fixed income, currencies and commodities, up 85% over the prior quarter. Equity trading revenue clocked in at $1.7 billion, up 42% in the quarter. In the process, Goldman increased its risk by about 25% in the process, notes the Gimme Credit newsletter.

It isn't only Wall Street wizards who play these games. Seven out of every eight dollars General Motors made last year came from its finance operations, not making cars. Much of that came from mortgage lending and refinancing, which is aided and abetted by leveraged players in the mortgage market. And borrowers and lenders are getting more creative to leverage to the max, switching to adjustable-rate mortgages, interest-only loans, zero down payments. Now there's even a proposal to make private mortgage insurance, which lets home buyers get away with putting next to nothing down, tax deductible.

Of course, the point of pushing the funds rate down to 1% and holding it there was to get the economy growing. On that score, Mark Turner, chief investment officer of Pentagram Investment partners in Boston, observes: "All the cheap credit that the Fed has helped to create has found its way into not into productive investment, but into more speculative bubble-like investments. Unlike the asset bubble of economy of the late 'Nineties, which focused narrowly on stocks, this bubble indulges real estate and commodities as well as stocks."

A possible and unexpected result of the Fed's cheap-money policy, Mark posits, is a sharp global deceleration -- yes, deceleration -- in global growth brought about by the surge in energy prices. At the minimum, the surge at the gas pump has absorbed a good chunk of this year's tax refunds. OPEC, for its part, is mulling whether to rescind its output cuts slated for April 1, out of due consideration for the world economy. Not that the cartel might want sell more of its product while demand is high; that never entered their minds.

But there are signs that other central banks are trying to disentangle themselves from the effects of the Fed's money-for-next- to-nothing stance. China's monetary authorities last week tightened policy, raising rates and increasing bank reserve requirements. The Bank of Japan's governor also voiced hope that it could end its policy of flooding the markets with liquidity as soon as deflation is defeated. Both countries are captive to Fed policy -- China by pegging the exchange rate of the renminbi, Japan by resisting the appreciation of the yen -- which forces the central banks to buy dollars by the carload. (By contrast, in Europe, where the euro has taken the brunt of dollar depreciation, the European Central Bank may be ready to let its key rate fall.)

Even some Fed officials are beginning to talk of a time when they will have to lift the funds rate from the sub-basement. But events may stay their hand. The rise in energy costs may indeed slow the economy, doing the work of dearer money. Tighter Chinese monetary policy, if it succeeds in cooling that overheated economy, also may take some pressure off commodities. Looking ahead to 2005, Washington may actually be forced to do something about half-trillion-dollar budget deficits. Whoever is elected probably will want to get the dirty work out of the way in an off-year for elections.

And could all those less-than-positive prospects for '05 be creeping into the collective mind of the market, the ultimate discounting mechanism?

What the Fed's policies have yet to produce is, of course, jobs. And what Wall Street economists have yet to produce this year is an accurate forecast of the monthly employment report. They’ll try again with March's numbers, due out Friday morning, which they're guessing will show a 100,000 increase in non-farm payrolls. You'll recall that their forecast for February's tally was off by about that much -- 21,000 instead of 120,000. Whatever the actual numbers, the Fed won't nudge up rates until Americans really begin to feel that jobs are becoming more plentiful. So enjoy the juice.