Stocks likely headed for ‘re-bubble’ in 2004
Mortgage rates are holding just below 6 percent, rising on the extraordinary strength of the purchasing managers’ survey for December, released this morning. If the jobs data next Friday are likewise way above forecast, the markets’ assumption about Fed patience through 2004 will be questioned immediately.
It our custom at each New Year to recite our forecasting mantra, which is Peter Drucker’s terse instruction to all: “Nobody can predict the future; keep a firm grasp of the present.”
Discipline is one thing, but temptation another; last New Year’s hunch that mortgage rates would slip into the fives panned out. However, going into a war with a visibly post-bubble economy…well, there’s no fish-in-a-barrel shot this year.
This New Year, the patter of things is so far from normal that it’s enough to state the pattern. The dominant theme for 2004: the Fed is trying – has been trying since 2002 – to raise the inflation rate from slightly sub-1 percent to about 2 percent while simultaneously keeping long-term interest rates low. Though the Fed has never before tried such a trick, everybody assumes the Fed will succeed in “reflating” the economy, but nobody knows how soon, nor after it succeeds, how much rates will have to rise to prevent engineered inflation from rising dangerously above 2 percent, nor does anyone know the risk to recovery when rates finally head up.
I am taken by other unknowns within the large case. All of them are distortions in place, each under tension, unsustainable, related to the Fed’s current 1 percent cost of money, and giving the Fed damned-if-it-does, damned-if-it-doesn’t trouble.
First, stocks: there is an incipient re-bubble underway. There is nothing wrong with the S&P 500’s 26 percent gain this year, or its 68 percent rebound from its post-bubble low, nor its position 27 percent below the bubble peak. However, S&P 500 prices at 20 times forecast 2004 earnings, and Nasdaq at 38 are in the bubble zone. Cash at 1 percent or less creates hunger for yield, and causes discounted future earnings to reach stratospheric present value. A rise in the yield of cash can easily cause a downside lurch as big as an upside over-valuation.
Junk bonds as a class returned 28 percent in 2003. Credit quality is improved, but junk was puffed by the search for yield, especially pension funds’ desperate need to make 8 percent-9 percent annual targets. No high-quality bond investment pays anything like that, which forces the funds to stocks (their portfolios are now 62 percent stocks versus 47 percent in 1990), and junk. Any new credit weakness associated with rising rates and/or a fading economy will make the junk bet a very bad idea.
Home equity line of credit (“HELOC”) balances in the last five years grew from $832 billion to $1.9 trillion, and are still growing about $40 billion every 90 days. Only a tiny fraction of borrowers understand that their HELOC rate floats with prime, which floats 3 percent above the Fed funds rate. When HELOC rates begin to rise, it will come as a shock to a generation believing that 4 percent-interest-only is an entitlement. The same is true for the legion of adjustable-rate-mortgage borrowers, now at the end of a 22-year stretch in which rates rose in only four.
Hedge funds: nobody knows the aggregate value of leveraged assets put in play by investors desperate for returns unavailable in ordinary investments.
Politics. No, not that. It may matter to markets, but most don’t; the economy drives politicians, rarely the other way around, propaganda notwithstanding.
The dollar. Nope: it will fix itself as soon as U.S. rates rise (or foreign ones fall).
A firm grasp of the present: every day that the Fed funds rate stays at this 50-year-record-low 1 percent, more and more of the economy and markets will adjust in wacky ways to a wacky rate. Once in the land of unintended consequences, all roads out are lined with surprises.
Lou Barnes is a mortgage broker and nationally syndicated columnist based in Boulder, Colo. He can be reached at [email protected].
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