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
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
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
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
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.
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
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
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
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
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.