Forum Archive Index - October 1999

[Nathan Mercer <nathan.mercer@softwarespectrum.com>]

Interesting reading...

Regards
Nathan




> -----Original Message-----
> From: alert@stratfor.com [mailto:alert@stratfor.com]
> Sent: Monday, 25 October 1999 15:46
> To: redalert@stratfor.com
> Subject: Weekly Analysis October 25, 1999
> 
> 
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> Southeast Asian Nations Call the Shots
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> STRATFOR.COM
> Global Intelligence Update
> 
> Weekly Analysis October 25, 1999
> 
> 
> 
> Whither the American Boom?
> 
> Summary:
> 
> Is the bull market over? Every time the U.S. markets do anything
> but hit new highs, this becomes a chorus. We do not know what the
> stock market will do. If we did, we'd be rich. Our interest is in
> what the economy will do. The markets and the economy are certainly
> overdue for a major correction and a short, sharp recession. In
> some ways the United States needs one for its long-term health. But
> the fact is that, whatever happens to the markets in the short run,
> the core indicators do not point to recession. The financial
> markets remain liquid, with positive free reserves, while the yield
> curve remains positive. Serious structural realignments do not take
> place in this sort of environment. The forces that created the boom
> in the first place remain, it seems to us, in place.
> 
> 
> Analysis:
> 
> For the past few weeks, the burning question in the world of
> economics has been whether or not the United States is about to
> enter a recession. The question has been driven by the performance
> of the American stock market. The performance of the stock market
> is, of course, not identical to the performance of the economy, but
> in the past it has been a decent view of how the economy has
> performed. It also, therefore, is not a bad indicator of how the
> economy might perform in the future. The behavior of the stock
> market, particularly in a country like the United States, in which
> capital formation and the equity markets are tightly linked, is by
> no means a side issue.
> 
> That said, we must remind our readers that while Stratfor does
> economic forecasting, we do not do stock market forecasting. If we
> could do stock market forecasting, we would not be working for a
> living. Nevertheless, since we are interested in the dynamics of
> the international system, the health of the American economy is a
> critical issue for us. As the behavior of the stock markets is tied
> up with the health of the American economy, we cannot ignore their
> performance.
> 
> Let us begin with the obvious. The Standard & Poor's (S&P) 500
> closed Friday, Oct. 22 at around 1300, having fallen from a little
> more than 1400 in July. This drop raised speculation that the bull
> market - underway since 1982, but which began its intense upward
> move in 1995 - may be coming to a close. Last year at this time,
> the index was below 1100. Five years ago, the same index was below
> 500. So, the S&P has given up about one-third of its approximately
> 25 percent gain for the year. In the last five years, the index has
> nearly tripled in value, rising from below 500 to 1400, only giving
> up 10 percent of these gains in the recent losses.
> 
> Based on those statistics, the temptation would be to dismiss all
> of this with a giant yawn. The American stock market has been
> surging for a generation, and roaring for the past five years.
> During that time, we have seen other corrections. For example, in
> the summer of 1998, the S&P 500 fell from 1200 to below 1000, a
> decline of about 25 percent, equaling most of the gains of the
> previous 12 months. In 1996, it fell by 10 percent, from just below
> 700 to just above 600.
> 
> This summer's decline, at its worst, was only about 10 percent.
> What do people expect - a rocket to the moon without any
> turbulence? In fact, it is extremely bullish that pessimism kicks
> in as quickly as it does. Consensus Index, which tracks market
> sentiment, reported bullish opinion fell from 30 percent two weeks
> ago to only 20 percent this week. Market Vane reported a less
> dramatic decline from 29 to 25 percent. These numbers indicate
> investors are not only pessimistic, but the growth of pessimism is
> accelerating and reaching rock bottom levels. When you get down to
> the area of 20 percent, just about everyone able to form an opinion
> has gone bearish or neutral.
> 
> Following contrarian theory these sentiment figures are bullish. If
> everyone is pessimistic, the market can't go down. It can't go down
> because everyone has acted on their pessimism and sold their
> stocks. There is no one left to sell. This assumes that sentiment
> and action go hand-in-hand, an assumption we find fairly
> reasonable. That means we should be near bottom for this down turn.
> 
> There are some other reasons for being, if not optimistic, then at
> least not pessimistic. The first is the liquidity of the banking
> system. The Federal Reserve Bank, which controls America's money
> supply, has a measure called Net Free Reserves. Net Free Reserves
> is a measure of how much surplus cash is kicking around in the
> system, once all of the credits and debits of the system have been
> totaled. The actual number is not all that important - especially
> as it bounces around and is revised and never really settles down.
> However, whether this number is positive or negative is important.
> A positive number means there is liquidity in the economy. A
> negative number means liquidity is drying up. This has become an
> extremely boring indicator, because it has been generally positive
> for a generation. But then, so has the stock market. Serious bear
> markets tend to correlate, for obvious reasons, with Fed policies
> that pull money out of the economy, creating credit squeezes. The
> Fed has not given us a serious credit squeeze in nearly a
> generation. It is not giving us one now. That argues against a
> serious bear market.
> 
> There is another argument closely linked to Net Free Reserves: the
> shape of the yield curve argues against a bearish turn. The yield
> curve is a display of the cost of money borrowed for various
> periods of time. For example, at closing on Oct. 21, three-month
> U.S. Treasury Bills carried a yield of 4.96 percent. The yield on
> six-month bills was 5.03 percent. Ten-year treasury notes yielded
> 6.18 percent and 30-year bonds yielded 6.35 percent. Prime
> corporate bonds were yielding more than 8 percent.
> 
> Interest rates may be trending upward, but the yield curve remains
> positive. During the late 1970s, yield curves were negative. Short-
> term rates were higher than long term rates. This was bearish. With
> short-term rates high, investors looking for safety could abandon
> the long-term bond markets and, with them, the stock market. Money
> markets provided safety, liquidity and higher rates of return.
> Long-term rates higher than short-term rates are bullish,
> encouraging long-term investment and capital formation.
> 
> Two factors create negative yield curves. The first is the Fed. It
> has tremendous influence over short-term rates and much less
> influence over long-term rates. When the Fed wants to drive up
> interest rates, it can drive up the short-term rates, but the long-
> term rates may not follow. This can create a negative yield curve.
> 
> The second is borrowers' fears of locking into long-term rates. As
> instability and uncertainty develop, borrowers increase short-term
> borrowing and decrease long-term ones. Theoretically, investors,
> seeing opportunities at the short end, should pile their money in
> and bring down the short-term rates. The Fed can override that
> tendency; also, in an overheated economy, demand so outstrips
> supply at the short end that rates go up anyway.
> 
> That just hasn't happened yet. The economy is certainly hot, and
> the Fed has tightened money. But the yield curve has not flipped
> negative. This indicates that the financial markets can still
> accommodate the demand for money from businesses, without causing
> distortions in the yield curve. It also means both speculators and
> investors in the stock market - tempted though they might be to
> find other, safer havens for their money - don't have anywhere to
> go. The bond markets carry substantial risks should interest rates
> rise, and the short-term markets are relatively unattractive on
> both an absolute scale and psychologically.
> 
> In our view, the foundations for a bear market are not yet in
> place. Investor sentiment is too negative, the financial system is
> too liquid and the yield curve is positive. At the same time,
> several serious clouds hover on the horizon.
> 
> The first is simply time. The current economic expansion has been
> underway for a generation. It took a downturn in 1991-92, costing
> George Bush his job. Even if we accept that the United States is in
> an unprecedented long-term boom - which we do - there ought to be
> more downturns within that boom.
> 
> Recessions are healthy for long-term growth. They originate in
> rising money costs as businesses expand and consumer demand
> quickens.  As the cost of money rises, competition among businesses
> for scarcer and more expensive money increases as well. Weaker
> businesses, with lower rates of return on capital, cannot afford to
> borrow and end up either cutting back operations or going bankrupt.
> More efficient businesses can borrow. This clears the field and
> channels money toward more efficient businesses. Recessions may
> hurt, but not having them can result in the Asian disease.
> 
> From the historical record, we are overdue for a short, sharp
> recession. Indeed the Fed seems to be nudging the economy in that
> direction, in increasing interest rates; but it has not moved the
> Net Free Reserves negative. However, the markets are not acting as
> if a recession is near. The cost of money is rising, but not to a
> culling level. The yield curve refuses to flip negative. Such
> behavior usually indicates that a recession is not imminent.
> 
> In showing no indications of imminent recession, the financial
> markets are telling us that the traditional calendar for the
> business market does not apply. They are not saying the business
> cycle is dead. They are saying traditional post-war theories of
> timing don't apply.
> 
> Another cloud on the horizon, perhaps a more serious one in the
> long run, is the rise in commodity prices - particularly in oil
> prices. Stratfor has argued that one of the foundations of the
> generation-long boom was the collapse of commodity prices across
> the board to record low levels. The decline in commodity prices
> reduced the cost of production for industrial countries
> dramatically, tilting the advantage from producers to consumers.
> The rise in commodity prices indicates two things. First, that
> demand for commodities by expanding economies like that of the
> United States has finally raised prices. Second, that as commodity
> prices rise, the advantage might tilt back to producers, and
> consumers might start experiencing significant inflation once
> again.
> 
> This should be bearish. But here again, the bearishness is
> mitigated. Going into this summer, one fear was deflation. All of
> Asia was suffering from deflation caused by excessive, inefficient
> industrial capacity and extremely low consumer demand. This was
> compounded by banking systems and financial public policies, which
> were driving prices downward. Deflationary pressure appeared to be
> spreading around the globe. The oil price bounce is, in a perverse
> way, a positive factor. By counteracting deflation, it could
> actually help stabilize the system.
> 
> On balance, therefore, the Stratfor view is this:
> 
> * The United States is undergoing a short-term correction in a
> long-term bull market of unprecedented proportions. Speculative
> fever, extremely high price earnings ratios and the appetite for
> profit all argue for a pause in the bull market. At the same time,
> sentiment figures indicate that a great deal of the enthusiasm has
> been beaten out of the market. We are continually startled by how
> quickly sentiment turns negative at the slightest correction. We
> find this lack of confidence in the market quite bullish, as it
> provides a self-correcting balance.
> 
> * The foundations for a mid-term recession lasting a year or so are
> simply not yet in place. They could materialize fairly quickly,
> particularly if the Fed wants to impose a recession, but they are
> not there now. The Fed is maintaining liquidity in the financial
> system and the yield curve is positive. Interest rates are rising,
> which may cool growth, but the market is not behaving as if a
> recession were near at hand.
> 
> * The rise in commodity prices should be a negative. However, given
> the deflationary threats and fears of this summer, the rise in
> commodity prices may even be a positive sign, if it doesn't get out
> of hand. With the Asian and European economies sluggish at best, we
> do not see the rise as a significant threat.
> 
> * There certainly ought to be a recession some time in the next 36
> months, and we would not be surprised to see it sooner rather than
> later. This is based on the timelines of previous economic
> expansions. We see this expansion as extraordinary, but it will not
> abolish the basic laws of capitalism. Under these laws, pruning
> back the economy is, in the long run, a positive development rather
> than a negative one.
> 
> In short, the United States appears to remain on the path it has
> been pursuing for a generation. It is quite likely that the stock
> market will take a serious break from the past five years of
> growth. Indeed, we may well be that we will not again see such a
> sustained and intense bull market as sustained and as the one from
> 1995-1999. That is not the same as saying that the U.S. economy
> will crash. We simply do not see the evidence.
> 
> It is important to understand the dramatically unexpected pattern
> that has developed in the global economy. Rather than moving
> together, it has fragmented along geographical lines. Asia, the
> United States and Europe have all pursued radically different
> economic paths, sometimes behaving as if they were living on
> different planets. Even within geographical regions, there have
> been differences. Germany's economic performance has been very
> different from the United Kingdom's. Japan has behaved differently
> from South Korea.
> 
> The fragmentation of economic activity into geographical elements
> is based on the fact that, economically, what goes on within a
> nation remains more important than what goes on between nations;
> Japanese domestic economic structure and policy determine Japan's
> fate. The U.S. economy has operated under its own power for the
> past several years, and it will continue to do so. In our view, it
> may not expand as it did in the past. It may even make a cyclical
> contraction. But there are no structural shifts evident to us that
> would indicate the expansion begun in 1982 is coming to an end.
> Cooling off is not the same thing as crashing.
> 
> 
> (c) 1999, Stratfor, Inc.
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