Tuesday, February 08, 2005


After two years of economic recovery and stock market strength (our aggressive account averaged a 75.4% annual rate of return since May of 2002), it was natural for the past year to be a bit slow. It was natural for Greenspan to let out the "interest rate dogs".

Several of the worlds economies were close to over-heating. These included Australia, New Zealand, Brazil, China and several more South American and Asian emerging growth economies. (Hong Kong was one of the exceptions.) The unemployment rate in Australia is at a long term low. The rate is a third what it was ten years ago. The low rate is unsustainable without inducing inflation.

Certain sectors of the US economy have been running full tilt. Iron and steel are good examples and , obviously, oil has been too strong.

Two years ago the developed countries of Japan, Western Europe and the USA consumed 40 Billion Barrels of oil per day while all the rest of the word consumed 37 Billion Barrels. The rest of the world has caught up. The developed countries now consume 41.5 Billion Barrels and the developing countries consume 40 Billion Barrels per day.

Chairman Greenspan did an excellent job of reacting to this robust economy which included an unsustainably high growth rate in the USA. By increasing the Fed Funds Rate by one quarter point moves for the past 6 months, Greenspan has engineered a slowing of the economy without killing off the expansion. The economy is still strong, but it is clear that the "interest rate dogs are starting to bite".

Tonight, I read all kinds of looney comments about the current economy. The evidence simply does not support many of the positions taken. For example, many folks see inflation all around. They are like a hunter who sees a grizzly bear and assumes there must be dozens nearby. Yes, the demand for oil has pushed up the price of petroleum products, but the over-all inflation rate is tame. Your inflation rate is a weighted average of the goods you routinely buy and oil is now a relatively small part of our economy.

Many consumer durable goods have dropped in price and continue to do so. For example, TV sets have gone down in price an average of 12.5% two years in a row. Personal computers are down 11% this year. Women's clothing (which for some reason includes children's clothing and luggage) is down another 2% this year and apparel prices have been headed south for ten years or more. Airline fares were down 10% this year before the recent deep cuts by Delta. I paid $159 for a DVD player two years ago and $19 for one last week! The price of many long-distance phone calls have dropped to zero!

How much more inflation hunting does Greenspan need to do? The evidence is all around that the short-term rate "dogs" are starting to bite and to bite hard. One strong piece of evidence is the sharpe decline in long-term bond rates. Over long periods of time, long-term interest rates must mathematically equal the GNP growth rate plus the inflation rate. The 30 year bond rate is down to 4.4.% and the ten year is down to 4%. The best measure of inflation, the price deflator, is running about 1.4% and the US economy grew by 4% last year. Either the economy must slow or the inflation rate must slow or low long rates must stimulate the economy. If long rates are low enough to stimulate the economy six months from now, the stock market must move now because the market leads the economy by 6 months or more.

Certainly those who were afraid they had missed their chance to buy a house at low rates have gotten a reprieve. The housing market has been incredibly strong for 14 years. Private residential construction has increased from the annual rate of 150 Billion to 550 Billion. The peak will be a spike at the end of this long run. Low rates are stimulating the economy and the second leg of the "bull market" is close at hand.

It is not unusual for long rates to decline while short rates go up. It was unusual for long rates to immediately drop as soon as short rates moved up. There is typically an over-lap to the the bond rally and the stock rally. Often times the bond market starts the rally and then "gives a push" to the stock market.

Bonds have made a good run over seven months, during this time productivity has been incredibly strong, low cost imported goods have held down costs and corporate profits have soared. Stocks are now under-valued by 25 to 40%!!!

Note that the interest rate drop has worked its way back down the curve. The ten year and the five year rates have declined in recent days. I can hardly imagine Greenspan raising short rates to 4% if the ten year is below 4% or even raising short rates to 3.5% if the ten year is below 3.5%. Should the stock market take off without further declines in long-bond rates, Greenspan may need to continue to raise short rates later in the year.

A major peak or a major bottom is seldom made until skeptics finally give up. The skeptics must believe that there will be higher highs or lower lows. In 1980 and 1981, when the prime reached 21%, the average investor believed that inflation was not controllable and that rates would go higher. The Japanese economy went though something like 12 years of deflation from a 1991 to 2003. So please don't say 2 or 3% bond rates are impossible.

There are many more signs that the "interest dogs" are biting hard. The dollar has strengthened. Manufacturing and trade inventories have sky-rocketed. European economies have stagnated. Germany, France and Belgium, for example, all have high unemployment rates. China slowed to a "moderate rate of 8% growth". Hong Kong dipped into recession. The US stock market went through a little pull back. Swelling business loan demand for new factories and equipment has moderated. Capacity is plentiful in most sectors.

There is evidence that funds are flowing out of fixed income--into the stock market. Consumers are tired of earning a pittance on savings and money market accounts. For the first time in years, there has been a break in the growth of consumer savings. The fear of another terrorist attack has been replaced with the frustration of losing money. Last Friday when the long-bond rate broke below the "floor" established last March, it did so decisively and institutional managers piled into stocks. Numerous companies have announced buy outs of other companies. No one wants to miss this stock market train as it is moving out of the station and picking up steam.

It is almost time for Greenspan to saddle up his horse and to ride off into the sunset. He will retire next year. I attended several meetings in the early '80s with Paul Volker, Greenspan's predecessor. Mr. Volker fought the hyper-inflation built up in the 70's and won the battle. Mr. Greenspan has served many years and made only a few bad moves. He has done an excellent job. He has hunted down inflation and killed it. In just a month or two it will be time for him to call off the interest rate "dogs". The stock market may struggle a little more while the "dogs" are on the prowl, but the rally in bonds has set the wheels in motion for more money to flow into stocks. When Greenspan puts even a temporary leash on the "dogs" the market will soar.

Other News and Considerations.

It is clear that the US will continue to get more and more of its non-durable goods from over-seas. Non-durable manufacturing has not grown in the US in more than 7 years. More and more furniture and apparel, for example, is being made over-seas.

On the other hand, durable goods orders are very strong. Durable goods such as machinery and airplane manufacturing are capital intensive, high paying industries that have "stayed home". A word of caution here, the construction machinery sector has very high inventories that need to be reduced.

Information technology equipment sales seem ready to run. It is no secreet that consumers and businesses need to upgrade computer and communication equipment to take advantage of many new services.

Several articles about EBAY have missed the point in regard to the price hikes. Successful retailers now-a-days, such as Best Buy, purposefully run off low volume non-profitable customers if they can. EBAY has purposefully thinned the ranks. By charging 60% more for a store, EBAY has assured itself that it will have fewer stores, higher average volumes per store and more profits per store.

The Greenspan interest rate "dogs" do not hurt EBAY. More people will operate EBAY stores in a weak economy.

EBAY and GOOG will hold business conferences next week. GOOG is likely to give an indication of new services to be offered. I think EBAY will have solid earnings growth for many years, however, the biggest threat to EBAY is GOOG. If GOOG offers free hosting of web sites, as I expect they will, then a number of store owners may choose to post their items to a free Google site. Of course these folks would be likely to pay for key word advertising through Google rather than listing and selling fees through EBAY.