Ben Shalom Bernanke is probably one of the smartest people on earth. A summa cum laude from Harvard, PhD from MIT and ex-full time professorship form Stanford, prepared him well to sort out the economic mess inherited from another summa cum laude economist, Alan Greenspan. However, no matter how bright or knowledgeable he may be, today he is a prisoner of history and can only watch as events unfold on his watch. In our public presentations (the next one is tomorrow), we spend time explaining why this is the case. One of the key findings we show is how the combination of Paul Volcker and Alan Greenspan may have largely determined the economic fate of the world over the last 20 years and a few more to come. Let’s try to summarize why as briefly as possible:
After the US suspended gold convertibility in 1971 (incidentally, Nixon imposed this one exactly like Chavez did on January 8th –completely on his own), which resulted in the collapse of the Bretton Woods system, the US economy entered a severe inflationary spiral that kept growing until Paul Volcker, appointed Fed chairman in 1979, started one of the longest and harshest campaigns ever seen to reduce inflation by sending the Fed Funds (FF) rate as high as 20%. After two recessions, one of them quite nasty (1982-83), Volcker turned the Fed to Greenspan with an economy that had become incredibly more efficient, generating higher GDP on much less liquidity.
However, barely 2 months after Greenspan took over the Fed in 1987, the stock market in its rush to discount the good times to come, grew extremely high and crashed by 22%. The steepness of the fall brought the US economy near systemic collapse, so in addition to reducing the FF rate, Greenspan was forced to bail out the largest US stock market intermediaries and to publicly stand behind them. After markets completely recovered, Greenspan started increasing rates again, perhaps causing the 1991 recession. That’s when he must have said “No more” and over the following 15 years proceeded to bring about the largest increase in absolute liquidity the world has ever seen.
From August 1990 until he left the Fed in 2006, Greenspan kept the FF rate on average at 4.2%, 50% lower than the 8.8% average that was necessary to transform the inflationary, post gold-standard US economy into a lean growth engine (from Aug. 71 to Aug. 87). The low rates brought a mountain of liquidity to finance the massive consumer demand that luckily found a timely counterpart in China, India, Eastern Europe and the rest of the economies whose exports to the US, whether manufactured or extracted, rose astonishingly high over the past 15 years. To top it all off, currency carry trades, financial derivatives and other intricate leverage schemes multiplied Greenspan-fed liquidity, leading to the asymptotic price behavior we have seen over the last four years in all commodity charts, from oil to cooper, to iron, to gold, etc.
THE CRUCIATUS CURSE
However, by dropping rates to 3% by April 1992 and to 1% by June 2003, Greenspan sowed both the technology bubble and the housing bubble. The first one eventually wiped out 70% of NASDAQ capitalization, but these huge losses were quickly reversed by the second one. Now that the housing bubble is exploding, it will eventually wipe out multiple times the amount of capital originally saved, but the larger problem is: this time a precipitous FF rate drop won’t save the American economy from crashing. In fact, if Bernanke doesn’t wait until markets endure a large enough correction before he starts cutting the FF rate, dollar purchasing power WILL implode. For a taste of what would happen, just consider how fast the Yen has strengthened since Feb. 27 (5% up) as Yen-Carry trades unwind. Soon, Bernanke will have no choice but to watch personal consumption erode and unemployment climb, just as he watched production fall apart without even telegraphing the possibility of a rate cut to the markets.
HOW BAD CAN IT GET?
This week, the world’s eyes will be fixed on the February employment numbers (Friday at 8:30 AM). As you know, since December, we have been waiting for unemployment to start rising sharply at some point this quarter or next as confirmation of the start of the recession. Well, so has everyone else, especially since last week’s Initial claims for unemployment benefits rose to 338K and the four-week average rose to 2.547 million, a sure sign of creeping employment weakness. Should February Nonfarm Payrolls decrease sharply below 100K, all hell will break loose. Should they not, we may see a steep rebound from the losses being experienced at the moment.
In the meantime, quite a few numbers are coming out this week that will keep volatility rising. As you can see on the SPX chart below, after the market broke through the top green line last fall, 1360 became support, but as the market broke that green line again last week at 1400, 1360 became support again (top dotted red line). However, if news surprises keep popping up like today’s announcement on New Century’s federal criminal probe and HSBC massive charges (old news), the SPX may drop straight through 1360, but hopefully rebound at 1330 (mid dotted red line).
Finally, this week, if no major hedge fund blows up or more bad news comes out, the SPX should stay between 1330 and 1400. Yet, should we get bad employment numbers on Friday or should the Yen-Carry Trade continue to unwind, the SPX correction could take us below support at 1270 (the bottom green line). In any event, we doubt the SPX reaches below 1150 (bottom dotted red line), that would represent a 20% correction or what is called, the start of a bear market.
THE PATRONUS CHARM
If you are one of our Portfolio Vital clients or have been following our bulletin’s advice, your 10-year and 30-year treasuries have just returned some very handsome profits. Last week, the price of the 4 5/8 percent treasury due February 2017 rose 1 12/32 to 101, or $13,750 per million of face value. Last night long-term treasuries went up even further and yields are presently at 4.45%, but we believe they may drop further in the weeks to come, so If you haven’t done it yet, consider switching a good part or your portfolio by to long-term treasuries now.
THE GOBLET OF FIRE
In a few months, once a majority of the bad news has been discounted, we will start switching out of long-term treasuries and back into the markets. If you are one of our clients by then, your investments will benefit from our timing, operational precision and low costs. We believe diversification can only become optimal if besides choosing the right asset classes, you choose the right time to enter them. In other words, diversification without market knowledge doesn’t work or works very slowly at getting you were you want to be financially before you are too old to enjoy it. If you have any questions, please bring them to Hotel Tamanaco presentation tomorrow. Hope to see you then!