Drunk Teenager Takes Foot Off Gas

Today's headline refers to the US economy, of course. More specifically, the Baby Boomers who are driving it and the crazy, old man who is their Sugardaddy, Alan Greenspan. With real interest rates basically at zero, it will be interesting to see how this plays out. "Greenie" is betting that with enough time, the overleveraged American consumer will be able to right his fiscal ship and sail through potentially stormy waters intact. But just like the weather, the financial environment can be treacherous. Especially when you have built a massive, historic house or cards that is susceptible to the calmest of breezes. And the wind that has been blowing from the oil-producing nations is more than a mild one. With the price of oil and the price of war increasing daily, it seems only a matter of time before the negative effects on the US economy become apparent. Yet, at this juncture the catalyst that will cause growth to turn negative is not apparent. Typically, the Fed would play this role, hiking rates to a level restrictive enough to contain speculative activity. But the will to assume this unpopular task is not present, quite understandably so. The "maestro" sees or at least senses that real interest rates of the historically typical level of 2-3% could very well kill the economy, just as it has gained "traction". Personally, "traction" is something the US economy will likely be in, rather than something it will gain, if anything but perfection lies in the immediate future. But Greenspan has little choice. If he raises rates to a rational level, all of those zero-down, interest-only, adjustable-rate mortgages would probably quickly seek the level of their worth: zero. So as distasteful as it may be, the most prudent course of action may be exactly what the Fed chief is doing, following the markets on the way up the yield curve. The question is how long can that game go on before something gives? Will Fannie Mae have to be recapitalized, will the Japanese or Chinese tire of loading up on US dollars with a questionable future value, will Chinese property speculators not rush for the exits simultaneously or will the radical Islamists pull off another stunning strike against the West? I am sure that there are more risks out there and that it will be one other than those previously mentioned which will mark the turn in our fates. This vicious circle goes something like this: oil prices are rising and price pressures are picking up, this is putting pressure on rates upward, the Fed is following this increase in rates, but is being extremely careful not to get ahead of the market and set off a debt crisis in one of the aforementioned areas. Of course, this begets more increases in oil prices, bond yields and the need for more rate hikes, which pressures those burdened with overactive debt appetites to go on a diet, but as long as they can borrow more, which they still can, the game continues. Until it reaches some point where it cannot continute any further. This point is unknowable in real time, but not completely unrecognizable. With an upward sloping yield curve, it seems likely that we are not there yet, but with just a few unexpectedly outsized rate hikes, we could get there. With the bond market having tested multi-year highs and failed, it seems only a matter of time, probably months before the cracks become obvious.

It is that very same bond market, which has been rallying of late and will probably continue to do so in the short-term. Don't be surprised to see its wilder cousin, the stock market, follow suit and rally for a while. Both of these markets are due for a little relief, after a choppy first quarter. But the longer term fundamentals of both leave little room for optimism. A 2% stock market yield and a 4.5% 10-year note yield hardly seem like enough to compensate for all of the risk. A position which market participants obviously do not share, but if they do embrace it, watch out below! A bond yield of 5.5% seems likely and, if so, what Fed Funds rate would be required to keep pace with it? 5.5% or higher seems like a logical answer. This would probably kill the economy, but if Alan Greenspan has retired by then, what does it matter? Oh! I forgot! Some of you actually have bills to pay, children to educate, retirements to fund and gas-guzzling SUV's to pay for and fill up! So look for a brief respite here, followed by a big growling grizzly who will start waking up from his multi-year hibernation as the bear market returns in force, with 2006 shaping up to be an interesting year (translation, the stock market is going to go down big!). So if you can handle a 25% decline in the bond market and a 50% decline in stocks with a 25-50% decline in real estate values, depending upon the zip code you should be fine. If not, it may be a good idea to head a jump on the crowd and start saving some of those pennies while they are still plentiful. The problem is that I am convinced that the authorities are going to fight the market mechanisms which are trying to correct the excesses in the markets. So instead of a short, sharp shock, it may turn into a long drawn out bloodletting, which could extend well into the next decade, or even longer. Nobody can know. But it seems likely that the virtuous circle that we have enjoyed for almost 25 years now, will become an equally vicious circle once that it turns.

Look for the high beta stocks (EBAY, OSTK, TZOO) to be especially vulnerable. And the financial stocks will probably experience one of the most brutal bloodlettings in history with declines of 90% being the norm. ( I am referring to the 'quality' companies, the second tier and below will probably cease to exist at some point.)The Chinese and Japanese have a lot of our dollars to tide them over this rough spot, while we have debts and more debts. Many, of which, will end up not being paid. For now, cash is king. Eventually, gold will become the most desired asset, but there is probably a lot of pain and volatility left before we get there.