June 26, 2004
We are now well into what is supposed to be the doldrums of summer trading, yet if you sold in May, especially near the bottom, then you have likely missed a small gain. You maybe even getting a bit anxious that by Fall the market will have gotten away from you. The market has churned a lot in the past few weeks, but we now find ourselves wondering whether the S&P can finally take out its old highs (only 20 points away!) and dreaming about the NASDAQ continuing its sneak rally. In the backdrop, we have had all the news headlines that the market is supposed to be afraid of: looming rate hikes, oil prices, inflation worries, terrorism, slowdown in China, etc… In fact, just this week, we got awful news about another beheading of a hostage, this time a South Korean captured in Iraq, and the news about the fringe loonies going on killing sprees in the run-up to the return of Iraq's sovereignty. Yet, the markets, the Nazz in particular, did not seem to mind much at all. It seems cold and uncaring that the market did not at least give a nod to the continued pain and suffering across the globe. So what happened? The market is finally getting numb to it all.
As we have noted, the market is supposed to be a forward-looking mechanism, and it is always making guesses as to what the future holds. Mr. Market spent a good part of May looking ahead to the ominous June 30th date of the Fed meeting and the transfer of power in Iraq and wrung its hands over all the bad stuff that could happen. Not only does it appear that the expected bad news got priced in, but as the date has approached, the market has now convinced itself that June 30th will not be so bad after all. Andrew Bary quotes analysts in "Rate Expectations" (Barron's, 6/28/04) as suggesting that the market has priced in an entire cycle of interest rate hikes: 2.25% by end of 2004 and 3.75% by end of 2005. Moreover, I would not be surprised if Mr. Market told us that it is now looking forward to earnings in July! And well it should. I have heard elsewhere that this particular pre-announcement period has been uncharacteristically optimistic (did I read the ratio of bad to good announcements was around 1.0?!?), and it has caused analysts to actually start hiking earnings expectations at a time when they are usually being forced to face reality and sober up ("Global Pressures on Stocks Ease" - WSJ, 6/14/04). The return of complacency can be seen in our friend the VIX where the "fear index" is once again scraping at lows unseen for at least 10 years.
So, yes, the market has become numb to the pain, and it will take much bigger unexpected negatives to get Mr. Market to do more than roll over and say "wake me when it's done." This probably violates the intuition of some folks. After all, if the world is becoming a more dangerous place and the overall economic outlook is getting cloudier (this week we discovered that durable goods orders came in weak again and GDP growth estimates were cut), then shouldn't the market be responding in kind with another visit to the basement? I would point your attention to the stock market in Israel. Given all the on-going turmoil in this small country, their stock market should be quite dysfunctional. Yet, we see a market that has followed right along global patterns and has been on a remarkable rally and recovery since the beginning of 2003. Essentially, the turmoil becomes part of the operational reality of the economy. The negativity has been priced in and only events that truly impact the economy end up impacting the market. We are witnessing a similar response in our markets and perhaps in most others around the world. The madness in Iraq has been going on so long that it is becoming part of the operational background. We should expect that the market will focus any persisting response on the events that have direct and clear impact on economic conditions.
The Bushies' campaign will likely focus on "numbification." A recent political ad posted on their website, starts with the headline "This is not a time for pessimism and rage." It depicts the Democrats as a bunch of angry madmen who are incapable of seeing the goodness all around, folks who want to dwell on what is wrong. It splices in many angry images, even those of Hitler (!!!), in a jarring view that gives you the impression that these are truly dangerous people. It then ends with a smiling Bushie with blue skies behind him waving happily to his unseen admiring optimists. Even the background music becomes giddy and rosy. It is the typical strategy that the Bushies employ to placate the masses: sure all heck is breaking loose, but continue to look hopefully to the future and all will be just fine and dandy. Essentially: "…Trust us. Leave everything to us, continue your shopping, and don't worry your little heads!" OK, I am being a bit dramatic as I usually do when it comes to this topic, but I will now put aside the rest of my feelings on this most bizarre of political ads. Instead, I will point to the parallel in the markets. Just as in the ad, you can more easily look hopefully forward if you are able to make yourself numb to the madness currently around you. There is always SOMETHING to cause us anxiety, doubt, and worry. But dwelling on these prevent us from functioning well and indeed cripples our ability to see opportunities and plan for the future. The market is no different. It has wanted to rally all year but keeps getting distracted by one negative after another. All the positives it saw last year have already been absorbed, and there have not been enough positives to get it too excited again. Iraq and higher interest rates are two of the biggest loads on the market's back right now. As the market numbs itself to these latest pains and uncertainties, it will move forward in blissful anticipation of a rosy future. I still contend that the positives ahead of us will prove insufficient to carry us much further, but I am sure you are growing weary of such negativity. Let us enjoy being numb for just a minute or two, eh?
The final question is whether this numbification is truly justified. The terrorists, insurgents, militants, and other associated malcontents will no doubt attempt to increase the pain going into the 30th. Their efforts will as usual prove completely futile in bringing about any real change except to forever scar the lives of so many innocent families. These people have no real political agenda and no real demands. To the world, they have become barbaric killers of the worst kind - people who cause chaos and destruction as bloodsport, people who take pleasure in the pain and suffering of others. Even if their vague goal of kicking the US out of the Middle East were realized, you can bet they will continue to find reasons to kill. For this reason, the US and others have no real motivation to do anything differently. It is truly a sad state of affairs all around. Anyway, I say this because it means that June 30th will be symbolic, but that is it. The pain and suffering in Iraq will continue - indeed, the US is keeping its troops in Iraq for the foreseeable future because it knows that a sovereign Iraq is still a weak Iraq teetering on civil war without continued puppeteering. I have heard that even the symbolism of this transfer will help the markets because it will allow folks to come to closure (read: get numb). Essentially, people can pretend that the Iraq chapter is over. Maybe as far as the market is concerned Iraq is a wrap, but for the people who must deal with the daily realities, the "fun" has only just begun.
And is the market acting "rationally" in the face of further Fed action? This one is harder to get a handle on. The economy is not quite as strong as people would like, so the Fed cannot go crazy and hike up rates dramatically. The Fed is desperately trying to keep this fragile recovery rolling along, so they have gone to great pains to telegraph moves of moderation. In this sense, the economy is like a squirrel - if you want to catch it, you cannot make any sudden moves, otherwise it scurries away to high ground. Ironically, if you do not make any sudden moves, you will likely not move fast enough to catch it! So, the Fed tries tiptoeing on a fine line. It is grateful that the economy seems to be able to eat its nuts without further life-support. The deflation demon that the Fed was bemoaning just a year ago has magically disappeared back into the closet. The Fed is also grateful that the outlook for inflation continues to be mild. This will allow them to bring interest rates back to a "neutral" level slow enough to allow the economy to adjust without too many disruptions and dislocations. But just as I expressed skepticism that the Fed could quickly bring their rate-cutting program to an end, just as I expressed skepticism that deflation was a real threat, I think now that inflation is more of a threat than we are being led to believe. These are hard to analyze of course because perhaps deflation never came because the Fed acted so masterfully. Could be. But if inflation roars, I will feel free to blame the Fed. J
In all fairness, despite all the belly-aching of the bears and Fed-haters, one must at least respect the Fed's performance to date. You can scream all you want about the timebomb ticking away in the economy due to all the cheap money and the huge amounts of leverage, but, so far, we have not met with catastrophe, jobs are trickling back in, corporations are flush with success, the country is not going hungry, and America is still the place of choice for global investment (6/28/04 update - OECD came out with statistics indicating that CHINA now leads the world in foreign direct investment, this does not include financial assets like stocks and bonds). Essentially, the disaster that bears are always fearing has not arrived according to any schedules they have put forth, and the exact mechanism for disaster is far from convincing. As I have stated earlier, I have yet to read one single convincing model that tells us how much debt the economy can safely handle. Instead, the economy continues to surprise folks on that score. Even I am guilty for sounding one alarm too many and seeing the sky fall more than once. So, I will put my own Fed-hating aside for a second and pause to give the Fed credit for sticking to its guns and piloting the ship through stormy waters (at this point, the bears will moan that the storms were created by the Fed in the first place). But as always, be careful out there. Do not let yourself become numb because the storm ain't over yet!