Is the Fed a Short Sale?

by Bill Fleckenstein

I have been in the money-management business since 1982.  Since 1996, I have managed a short-only hedge fund, been a director of Pan American Silver (PAAS), and written a daily market column on the Internet.  As I clearly state on my Web site, my motto is: "Often Wrong, Never in Doubt. " With that disclosure out of the way, I can begin.


When I recently told a friend that I had to spend some time working on the speech that I'm about to give, he asked: "Why do you have to write a new speech? You've been giving the same speech for five years?"  I realized there was some truth to his observation, as my long-term views have been consistent over that period. However, my guess as to the timing of when the "jig would be up" -- as well as my exposures, long or short, in various markets -- has evolved as events have unfolded. Though it's taken far longer to play out than I thought possible, my opinion is that the next year will be the most dangerous period in the last 50 years for the financial markets.


The title of my talk is: "Is the Fed a Short Sale?'.  Today I will share some of the reasons why I think the Fed is incompetent, explain why I think 2005 is the year when folks will realize that, and -- to answer my own question, that yes, the Fed is a short sale -- I'll talk about what the investment ramifications of that idea are.


I'd like to start with one of my favorite economic quotes of all time, and ask if you know who said it: "It is very rare that you can be as unqualifiedly bullish as you can be now." Which one of these two said that?

If you guessed the man on the left, you are correct. That statement was made on January 7, 1973, to The New York Times -- two days after the 1973 stock-market peak, when the market was on its way to declining 50% over two years, and we endured the worse recession since the Great Depression.


I guess a fair alternative title for my talk could be: "An Indictment of Alan Greenspan and What to Do About It." The need to understand the ramifications of the long-term mismanagement of the economy by an all-unknowing Alan Greenspan is so critical to an understanding of what the future holds that I will spend a considerable amount of time today examining his stewardship, through the use of his own words.


First, a quick review of the origins of the equity bubble is in order.  The seeds of that epic bubble were planted long ago.  In 1980,  Congress passed the Depository Institutions Deregulation and Monetary Control Act, calling for the phasing out of Regulation Q, which allowed financial institutions to compete with money market funds. A piece of that legislation was financial cancer: raising the insured deposit maximum to $100,000.00. That seemingly innocuous change spawned “brokered deposits,” the primary driver of the reckless lending practices of the 1980s. Money sought out the highest bidder with no regard as to how it might be used. As a result, we witnessed the funding of overleveraged LBOs and the overbuilding of real estate long after the 1986 Tax Act made it uneconomical to speculate in property. It is hard to overstate the significance of this legislation in creating the excesses of the 1980s, which set the stage for the even greater excesses of the 1990s.


It is important to realize that the 1990-1991 recession was not precipitated by aggressive tightening on the part of the Fed. Yes, rates went up, but not enough to matter. The economic contraction was instead caused by two factors: one, the collapse of credit as banks and the S&L industry were destroyed by the bad loans I just mentioned, and two, the subsequent newfound zeal with which the Office of the Comptroller of the Currency began to do its job. Unfortunately, Greenspan didn’t understand what was occurring, as he made painfully obvious in January 1990, shortly before the failure of Drexel Burnham Lambert and the collapse of the junk-bond market, when he stated, “But such imbalances and dislocations as we see in the economy today probably do not suggest anything anymore than a temporary hesitation in the continued expansion of the economy.”


(Four years later when he reviewed that very period before the Senate Banking Committee, he attempted to rewrite history, patting himself on the back for knowing what he definitely did not.   "In the spring of 1989, we began to ease monetary conditions, as we observed the consequence of balance-sheet strains resulting from increased debt. Households and businesses became much more reluctant to borrow and spend, and leaders to extend credit -- a phenomenon often referred to as a 'credit crunch.'"  Sorry, Al, it didn't happen that way. In fact, it wasn't until October 1991 that he began to use the phrase "economic headwinds" -- his metaphor for the credit crunch that three years hence he would claim, with the benefit of hindsight, to have begun fighting in 1989.)


However, once he finally understood what was happening, as usual, he overdid it -- ultimately cutting interest rates 24 times in a row, to 3%, driving the public (which was only just beginning to focus on its retirement needs) out of money-market instruments into stocks and bonds. In an amazing display of two wrongs making a right, the enormous reckless frenzy of the 1980s, which nearly ruined the banking system and obliterated the savings-and-loan industry, did little apparent damage, and instead gave rise to  a great bull market.  (Remember that tactic. We'll soon see it again.)  The "apparent" success of Greenspan's benign ignorance (which came to be misnamed "the Greenspan put"), i.e., creating and exacerbating problems until they implode--  and then printing money like mad -- ultimately led to the biggest equity bubble in the history of the world.


In late 1994, the Fed tightening caused the implosion of the carry trade, bankrupted Orange County, and helped trigger the collapse of the Mexican peso, all of which posed a grave threat to Wall Street and the banks, so Greenspan bailed them out.  In doing so, they spiked the punch bowl rather than remove it.

This triggered a new round of speculation, both domestically and globally, that ultimately began to unwind in the summer of 1997 when the bubbles in Southeast Asia burst, beginning with Thailand.  While many countries were seriously hurt by the "Asian contagion," the U.S. was not. In fact, the net effect was to add more fuel to the stock-market frenzy raging here in America.  


The Russian default in 1998 caused a chain reaction that culminated with the implosion of Long Term Capital.  The reason for the LTCM bailout was the stock market, not the bond market,  as was professed. As former Goldman Sachs CEO and now Senator Jon Corzine told BusinessWeek: "We were most concerned about the equity book. " And as David Komansky, former CEO of Merrill Lynch, described it: "The whole potential scenario of unwinding their equity portfolio under a forced environment could have had extremely negative consequences on the market."  This is why the Fed decided to get ahead of the curve, in a panicked attempt to change market psychology.


On October 15, 1998, with only 45 minutes remaining in a trading day in which all index options and options on futures were due to stop trading, the Fed precipitated one of the biggest moves in history, as the S&P futures exploded 4.9% in four minutes, thanks to a surprise 25 basis-point rate cut.  The chaos created by the surprise rate cut caused a systems outage at the CBOE, forcing them to halt trading and hold a closing rotation for index options, for the first time ever.


The next bailout was essentially a pre-emptive strike on a problem that in fact needed no bailing out, namely, the year 2000 date change. That succeeded in blowing the top off the stock market once and for all,  as the Nasdaq rallied 80% in roughly four months, before peaking on March 10, 2000.


So what was going through Al's mind while the epic stock-market blow-off was ending? On March 6, 2000,  four days before the Nasdaq peak of 5,048  in a speech in Boston that was eerily reminiscent of his January 1973 prediction, he said: "The fact that the capital spending boom is still going strong indicates that businesses continue to find a wide array of potential high-rate-of-return, productivity-enhancing investments. And I see nothing to suggest that these opportunities will peter out anytime soon."


He went on to further display his keen grasp of the upcoming collapse: "Indeed, many argue that the pace of innovation will continue to quicken in the next few years, as companies exploit the still largely untapped potential for e-commerce, especially in the business-to-business arena, where most observers expect the fastest growth. . . . It appears to be only a matter of time before the Internet becomes the prime venue for the trillions of dollars of business-to-business commerce conducted every year."  I guess you could say that yes, Al did embrace the Internet.


He did, however, make one prediction that I will agree with: "When historians look back at the last half of the 1990s, a decade or two hence, I suspect that they will conclude we are now living through a pivotal period in American economic history."  Of course, I'm sure we disagree about what those future historians will actually conclude about his stewardship of monetary policy.


About a month later, in April 2000, he once again provided those future historians with data by which to judge his grasp of the financial world at that time. When asked before Congress if an interest-rate hike would prick the stock-market bubble (which of course had already peaked), he answered: "That presupposes I know there is a bubble. I don't think we can know there's a bubble until after the fact. To assume we know it currently assumes that we have the capacity to forecast an imminent downturn in prices."


(Not seeing the bubble while it was occurring and unwinding, and repeatedly denying it was even possible to see one, didn't stop him from implying in January 2004 that he'd seen it all along, and had a policy to solve it. "There appears to be enough evidence, at least tentatively, to conclude that our strategy of addressing the bubble's consequences rather than the bubble itself has been successful.")


By February 2001, almost a full year  after the stock market peak, just as in 1991, he still didn't understand what had transpired. Quote: " Moreover, although recent short-term business profits have softened considerably, most corporate managers appear not to have altered to any appreciable extent their long-standing optimism about the future returns from using new technology. A recent survey of purchasing managers suggests that the wave of new on-line business-to-business activities is far from cresting. Corporate managers more generally, rightly or wrongly, appear to remain remarkably sanguine about the potential for innovations to continue to enhance productivity and profits. At least this is what is gleaned from the projections of equity analysts, who, one must presume, obtain most of their insights from corporate managers. According to one prominent survey, the three- to five-year average earnings projections of more than a thousand analysts, though exhibiting some signs of diminishing in recent months, have generally held at a very high level. Such expectations, should they persist, bode well for continued strength in capital accumulation and sustained elevated growth of structural productivity over the longer term.  . . . As I pointed out earlier, expected earnings growth over the longer-run continues to be elevated."  The economic and stock market weakness that we had experienced in the prior year he blamed mostly on "inventory backup" and "the rise in the cost of energy."

September 11 turned out to be a convenient scapegoat for all "New Era" pundits.  In the wake of that tragedy, prior pronouncements and errors seem to have been forgotten, as all our economic and stock market problems were blindly pinned on that event. The excuse for the continued weakness was pre-Iraq-war jitters. Finally, in the spring of 2003, the combination of the fall of Baghdad, 13 rate cuts (which heretofore had not been good enough), two tax cuts, two rounds of tax rebates, and one tax refund was potent enough to give us the rally that peaked earlier this year, as well as the bounce in the economy that began sputtering last year just as the stimulus stopped.



The real engine of the better times we have seen in the last 18 months has been the housing bubble, which has been fueled not just by lower interest rates but also by extraordinarily lax lending standards, an attendant consequence of the bubble in real estate. ( I'm sure that everyone in this room regularly receives countless emails regarding the easy money available for real estate.)



All these factors have naturally fed on themselves -- allowing people to live beyond their means (and/or speculate on more real estate), as they have serially extracted equity from the increased market appraisal of their homes, while simultaneously increasing their overall level of debt.  It's what I refer to as "use-your-house-as-an-ATM-to-live-beyond-your-means."


Of course, this only sets the stage for an even larger problem when home prices begin to decline, as has recently begun, most notably in Las Vegas and Southern California -- two of the hottest (and most speculative) markets in the country.

Not surprisingly, the man who didn't see the equity bubble does not see one in housing, either. In a recent speech, he explained why real estate is structurally incapable of a bubble. Quote: "Houses aren't as prone to bubbles as stocks, because high transaction costs and a seller's need of shelter are significant impediments to speculative trading. While some buyers have bid through offering prices, they have contributed only modestly to overall house-price speculation. " I'll let  all of you be the judge of whether or not you think his views jibe with what your eyes have seen taking place in the real estate market.


In essence, the Greenspan Fed has attempted to bail out one bubble with another. In an epic replay of the 1990-1991 game plan that I said we'd see again, the Fed is now "all-in." And, while it's created the illusion that all is well, in reality, all they've done is ensure that the ultimate adjustment to these two bubbles will be far worse than it would have been, thanks to all the leverage that's been added as the country has attempted to speculate its way to prosperity.



From a stimulus standpoint, the cupboard is bare. Monetary policy can't be loosened, nor can fiscal policy, and the ATM is now empty.


Wait a minute, bulls will say. The Fed can cut rates and Bush can cut taxes. To which I would answer: Be serious. With inflationary pressures as they are (even as understated as they are, thanks to hedonic adjustments and substitution), even this band of refugees from the pressmen's union wouldn't cut rates. Likewise, given the size of the deficit and, more importantly, the fact that people have noticed it's out of control, even the Bush administration can't produce big tax cuts. Besides, he's already been re-elected. Why bother with that now?


Nevertheless, even if the powers that be wanted to be even more reckless, I don't think they could pull it off, because there is finally a new sheriff in town: Uncle Buck. Historically, when countries have been unable or unwilling to discipline themselves, eventually discipline has been introduced via the foreign-exchange market, as the currency of the out-of-control country was abandoned. These countries have almost always had large external imbalances for which they depended on foreign creditors to help (allow) them to live beyond their means. Today, we in America are that country, and we are headed for a currency crisis.


Currency crises take a long time to gestate, and the glaring imbalances never matter for very long periods of time, until they finally DO matter. Then, they are the ONLY THING that matters. These crises are not just a function of mathematical macro imbalances in the budget deficit, trade deficit, savings rate, GDP growth, inflation, interest rates, or net indebtedness. If they were, one could know precisely at what point they might happen.

Rather, psychology,  in terms of the perception of the problems, both domestically and by foreigners, plays an enormous role in determining when the jig is up.


I have long believed that when the economy and stock market started to sink once again that the Greenspan Fed would be seen as the dangerous menace that it is. I also have felt that the recognition of their incompetence would exacerbate the unwinding,  as folks became frightened upon realizing that the last decade had been a façade, and that people were now on their own to face and try to conquer the economic imbalances that have been created. The change in psychology that will coincide with these events is what I refer to as "the next time down." In an environment like that, the decline in stocks, housing prices, and the dollar would negatively impact the economy, and they would all feed on each other. I will leave it to your imagination to decide exactly how ugly things may get.


I have never felt that it was possible to know the exact catalyst to precipitate that change in psychology. However, I have felt that it was completely knowable that at some time, the dollar would crack under the weight of these imbalances. The biggest ramification of a currency crisis for most Americans will be a rise in interest rates as foreign lenders will demand more compensation to help offset currency losses. Each of you can decide how high rates might go, and what the ramifications of higher rates on our leveraged consumer will be, as your guess is as good as mine. However, I guarantee you that higher interest rates will result at some point, from a declining dollar.


To give you some idea as to the size of the problem, consider this:  Though comprising less than 40% of world trade, approximately 70%  of the world's currency reserves are held in dollars, as a result of foreigners' willingness to "overweight" them.  In addition, we keep asking them to increase their dollar holdings, currently to the tune of roughly $600 billion annually, which works out to roughly $1.5 billion per day.


As with all big numbers, it's hard to grasp what an extra $1.5 billion each day means, so think of it this way: If you spend one dollar every second, it will take 33 years to spend a billion dollars. Therefore, we're asking foreigners to accumulate an additional 50 years' worth of one-dollar-per-second spending each and every day.  That's why psychology matters so much. Foreigners need to be optimistic and confident regarding America to overcome all the math that suggests they are making a bad bet.


Obviously, Warren Buffett feels the same way about the dollar and the potential for damage to the stock market, as he is currently sitting on $43 billion in cash, $20 billion of which is held in foreign currencies and based on recent filings, he added to that position again in the third quarter. He has been outspoken regarding the dangers of a dollar crisis, going so far as to write an article for Fortune in October 2003, in which he stated: "Through the spring of 2002, I had lived nearly 72 years without purchasing a foreign currency. Since then Berkshire has made significant investments in -- and today holds -- several currencies. I won't give you particulars; in fact, it is largely irrelevant which currencies they are. What does matter is the underlying point: To hold other currencies is to believe that the dollar will decline."


As often happens, the catalyst to change psychology seems to come out of left field, though it was in plain sight all the time. In the case of the dollar, George Bush's re-election may have been the catalyst to begin tipping over all the dominoes. For the last year, given our huge imbalances, I couldn't understand how mounting geopolitical friction, such as Iraq, appeared not to affect the dollar.


It's almost as if foreigners had been expecting Bush to lose, and when he didn't, they became scared and have begun voting with their feet, based on stories I have heard concerning Middle Eastern and Asian selling. And, why wouldn't they, with the administration now almost openly cheering for a lower dollar, as we saw in Greg Ip's Wall Street Journal  story last Wednesday:  "Bush Policy: Talk a Strong Dollar, But Let It Slide."  


When you think about that viewpoint, plus the fundamentals, combined with a Fed that is willing, as the Dallas Fed stated in May 2003 to pursue "essentially the classic textbook policy of dropping freshly minted money from a helicopter," the only real question is how low will the dollar go?


As the dollar declines, that decline will "write the news," and all the long-ignored problems I have discussed will be used as more reasons to sell dollars. The Fed, the dollar, the stock market, and the economy are all on borrowed time, as I believe 2005 will be the year when the façade comes crashing down. Therefore, you should make plans accordingly.


So what do I think you should do? When confronted with the challenge to give public investment recommendations based on my views, I always try to suggest the idea that has the best risk versus reward as I see it, and also requires the smallest expenditure of mental capital, from a day-to-day standpoint.


For that reason, though I and my fund are short tech stocks, and will one day also be short financial stocks, I don't think that short-selling is a good idea for most people, as in addition to the risks, the tactics required to be successful at it are quite laborious and time-consuming.


And, while I own the euro, as well as Canadian and Australian dollars, I think the better risk-reward idea for most people is to own precious metals (or precious-metal stocks -- I own Pan American Silver and Newmont Mining). I say this because at the end of the day, most currencies are just battles of wits amongst unarmed opponents. They are only "relatively" attractive versus each other, and not genuinely attractive on their own.



Gold is the only currency that has no central bank spokesperson whining that its price rise has been "brutal."  It's also the only currency that is not the liability of some issuing country.  When I say gold, I also mean silver, so for those of you willing to accept more risk, I think that silver will do even better than gold.  If events play out as I expect them to, gold will ultimately rally far more in percentage terms than will foreign currencies.  At a large conference such as this, there should be no shortage of information on the various ways to best express a long gold or silver idea. Just be sure that somehow, some way, you have some exposure to gold.


On a cautionary note: Please remember as you consider the size of the investment you may want to make in gold and silver, or anything else, for that matter: The goal of Mr. Market is to get you bullish at the top, bearish at the bottom, and confused in between. Given the recent rise in the price of gold, the way I would think about it is as follows: It's a $4.30 stock that could easily drop to $4, but is probably headed to $8 to $10, and possibly higher.  If you plan for volatility, you won't be disappointed.