Sunday, March 27, 2011

1999 Or 2008 All Over Again?

On Sunday morning, I watched an interview on CNN's State of the Union with Candy Crowley (see video below or click here to watch it). The interview was on the US economy and the guests were two two former directors of the Congressional Budget Office, Alice Rivlin who's now a Brooking's expert, and Doug Holz-Eakin, president of DHE Consulting, LLC.

Not surprisingly, both Ms. Rivlin and Mr. Holz-Eakin were talking about cutting spending, especially entitlement spending, but they also addressed the impact that the crisis in Japan and the Middle East unrest are having on the global economy. At one point, Candy Cowley asked about the recovery in the US economy. Here is part of the exchange taken from the show's transcript (added emphasis is mine):
CROWLEY: Alice Rivlin and Douglas Holtz-Eakin, thank you both so much for joining me.

You know, every time we watch the stock market, the analysts say, well you know, the oil did this and, therefore, the stock market's done that. What is the net effect of what's going on in the world -- I know the markets don't like things that aren't settled, but what about just every day living, you know, in America, looking for a recovery that is still sluggish?

Japan, has that affected the recovery at all? And how about Libya and the Middle East in general on oil?

RIVLIN: Well, nothing is going on is good -- Japan, Libya, whatever, the high price of oil and gasoline, all of these create uncertainty and to some extent a drag on the economy, especially the price of gasoline and oil.

But none of it is major yet. Your intro emphasized all the things that might be bad, but the good news is the economy is perking along, not fast enough, very weak hiring, very weak in housing, but the rest of the economy does seem to be coming back slowly but steadily.

CROWLEY: But what -- can you really have a recovery with -- in a housing market, we keep saying the housing market hit bottom. Oh, the housing market has hit bottom. So now we've gone to the lowest ever in new home sales which are the most important, because they provide jobs in building, et cetera. Can you really have a recovery without a recovery in the housing market?

HOLTZ-EAKIN: There are two pieces to the housing recovery. The first is construction of new homes. And there we've seen the housing market go from just a really drag on the economy to about neutral. It's not adding or subjecting from growth at this point. The second piece is the value of homes, which affects deeply how families feel about their futures and their ability to spend. And there I think we're about to see the worst end. But until both of those start moving north, we're not going to see a really robust recovery.

CROWLEY: Because it undermines consumer confidence, right?

HOLTZ-EAKIN: Absolutely.

CROWLEY: And what about hiring and gas prices? Isn't there some connection there? If I'm a business and suddenly my energy costs have come up whether it's a business that involves trucks or a business that involves heating or air conditioning in the summer, doesn't -- isn't that a drag on hiring people?

RIVLIN: Yes. For some businesses, it is. The main effect is that consumers who have to buy gasoline will spend less on other things. So it's a drag from that sense. And for some energy intensive businesses as well.

But we don't have as many of those as we used to. We're not as dependent as an economy on energy.

HOLTZ-EAKIN: I think there are three lessons on the oil and gas front. Lesson number one is we have oil at $140 a barrel in 2008. And it went down not because we somehow discovered a lot more oil. No, it went down because we went into a massive global recession. As economies recovered, it was inevitable that prices were going to rise. And this was utterly foreseeable.

Second piece is that Libya's not really the concern. That's not what markets are pricing. It's the broader Middle East. Libya is 2% of oil supplies. That's not our problem. It's what happens in the rest of the Middle East.

And the third is, something like this is always going to happen. There is always some piece of bad news out there. So, the key should be to build an economy that's growing more robustly, it's more resilient to bad news that inevitably will happen. And there we could do better.

We've seen calls for more pro-growth strategies this week from Eric Cantor, for example, and it really is time to get a strategy that is about having the economy grow faster.

CROWLEY: And so what I take from you is, yeah, around the margins this isn't great for the economy. However, when you look at the current state of the economy, the sluggishness of recovery, what worries you most?

RIVLIN: What worries me most, and I suspect Doug as well, is our looming debt crisis. We've got to get past this squabbling over the federal budget for this fiscal year. That's just a squabble. But what is really important is that we're moving into a period when we will have debt rising rapidly because of the retirement of the baby boom generation and high medical care costs. And we've got to do something about that. It's got to be bipartisan, and we've got to do it soon so that we reassure our world creditors that we're on the job.

CROWLEY: Doug, can you just -- I think people know intrinsically the debt is a bad idea, and when they hear trillions and trillions, it's an even worse idea. But can you connect debt to my life, to the life of the viewers?

HOLTZ-EAKIN: Sure. If we continue down the path we're going down, in the good-news scenario, what we see is interest rates start creeping up and then elevate sharply.

That means that, if you want to buy a car; if you want to buy a house; if you want to send your son or daughter to college, it's a very expensive proposition.

It also means that the place you work can't invest in the upgrades it wants to and it really can't start giving you raises because they're carrying costs of their debt. So you see an economy that starts to stagnate, where you don't increases in the standard of living, and everyone suffers from that. And it goes on for a long period of time. That's the good news scenario.

The bad-news scenario is we see 2008 all over again, where credit freezes up and we get a sharp recession. Neither is something we should mess with.

CROWLEY: I was going to ask you, I mean, can you -- if the crisis remains a crisis and Congress can't get its act together nor do something about it, which I'm assuming is for you all cutting spending, perhaps raising taxes, some -- you know, combination thereof, could we have a worse recession than we have just experienced?

RIVLIN: Yes, we could definitely have what's called a sovereign debt crisis. We used to think that only happened to small countries on other continents, but it could happen to us as well.

That means we would not be perceived as able to get our act together and pay our debts. And our creditors would lose confidence in us. And when that happens, things go south very fast. We could have a big spike in interest rates, a big fall in the dollar and be plunged into a worse recession than the one we're climbing so slowly out of right now.
Let me comment on this exchange. First, as I stated above, given their background and ideological views, it hardly surprises me that Ms. Rivlin and Mr. Holz-Eakin are sounding the alarm on US debt and entitlement spending. But to claim the US might suffer a sovereign debt crisis is simply ridiculous. The US is the largest economy in the world by far, it prints the world's reserve currency and the risk of a US sovereign debt crisis lies somewhere between zero and zero. All the doomsayers will tell you otherwise but that's a fact.

As far as entitlement spending "run amok," we need some perspective. These aren't pension liabilities of state plans where it's difficult to cut benefits, they're entitlement programs that are based on current spending and are subject to political decisions. If they need to be cut or reformed, and if there is political will to do it, US Congress will take action.

Ms. Rivlin also dismissed rising energy prices, stating that "we're not as dependent as an economy on energy." That may be true but oil prices still matter. Rising gas prices are going to hammer consumer confidence and are ultimately deflationary, not inflationary for the economy, something that analysts keep omitting.

That brings me to Mr. Holz-Eakin's comments on housing, interest rates and another sovereign debt crisis. On housing, Mr. Holz-Eakin sounds more sanguine than others, stating that new homes construction is no longer a drag on the economy and that the he sees an end to the drop in home values. But others aren't convinced that housing is stabilizing. Diana Olick of CNBC recently wrote a comment on why housing is going through a double dip, citing these reasons:
  1. Supply supply supply. Too much. Can't overstate that.
  2. Foreclosures. Banks are pushing properties through the foreclosure process at a really rapid pace now. I'm also hearing they may be ramping up sales ahead of any settlement with nation's attorney's general over the so-called "robo-signing" paperwork scandal. More foreclosures on the market means more supply and more price pressure.
  3. Gas prices: See yesterday's blog post. It's real.
  4. Mortgage applications. They are way below historical norms. All cash buyers in February rose to a record 33 percent of all buyers of existing homes. Many many Americans simply can't qualify for a mortgage anymore at a reasonable rate.
  5. FHA: Next month the cost of an FHA loan goes up yet again. FHA loan volume dropped 26 percent in February month to month.
  6. Consumer sentiment: Awful. No confidence in this market. Only the investors are out in droves, looking for and getting bargains. We need them, but we need real buyers as well.
Mr. Holz-Eakin also noted that they see "interest rates start creeping up and then elevate sharply". If that happens, it will kill any recovery in the housing market. But I just don't see rates rising sharply for two reasons. First, the Fed's policy remains reflate and inflate at all costs to avoid a prolonged period of debt deflation. They will continue with quantitative easing (QE) which will cap long-term bond yields. Second, without a robust housing and more importantly jobs recovery, the risks of deflation remain elevated. I simply cannot understand all these doomsayers who see hyperinflation on the horizon. Why? Because oil prices are rising again? Again, if they rise too high, too fast, it's ultimately deflationary for the US and global economy.

Mr. Holz-Eakin also stated that he sees "2008 all over again, where credit freezes up and we get a sharp recession." But to see 2008 all over again, you need a catalyst, perhaps a major sovereign debt crisis. The doomsayers will tell you look no further than Greece and the Eurozone, but as I wrote in my last comment, I'm not buying the drama. There are serious structural problems in the Eurozone, but to claim that a major European default is a "done deal" is way too easy. Importantly, when everyone is on the same side of the trade, shorting the sovereign debt of European periphery economies, then I start questioning the merits of that trade.

It's also worth keeping in mind all the macro events that rocked markets over the last year or so, starting with Dubai, Greece, PIIGS, and more recently Japan. In every case, markets were able to climb the wall of worry and head higher. This doesn't mean that it will continue or that some serious sovereign default or geopolitical crisis can't rock the global financial system again, but it speaks volumes to the amount of liquidity out there ready to soak up any major macro event.

This brings me to my final point on another bubble forming in the stock market. Earlier this week, Dave Kansas of the WSJ reported that Red Hat Jumps Higher After Strong Earnings:

The remarkable return of hot 1990s-era hot stocks continues (think JDS Uniphase, Ciena, Micron et al) this morning with Red Hat.

The open-source software company is surging more than 13% out of the gates following strong fourth-quarter earnings after-the-close yesterday afternoon.

Oppenheimer (Outperform rating): “While we were pleased to see the company deliver strong results across the board, we were particularly impressed with RHT’s ability to deliver over 30% billings growth and over 20% growth in cash flow from operations ($95.0 million).” Oppenheimer says, and backs an outperform rating.

Robert Baird raised Red Hat to outperform from neutral.

As Matt reported earlier, Micron is jumping more than 6% after reporting its own earnings.

Among other highfliers, JDSU and Ciena are up about 2%. Maybe it is the 1990s again.

Semis, networking stocks and materials have been on fire following the earthquake disaster in Japan. Earnings have been strong but there is a lot of hot money flowing into these sectors too, making them very volatile. It all looks and feels like the reemergence of the tech bubble, a point covered by Jameson Berkow of the Financial Post, Bootup: Experts warn of Internet bubble 2.0:

Today in technology: With a number of new web firms expected to make public stock offerings this year, observers are growing concerned the market could be headed towards another bubble; Canada’s first offshore wind farm project wins a key victory in the regulatory process; the inner workings of the computer hacker group known as Anonymous are exposed and Research in Motion Ltd. along with several other Waterloo, Ontario-based tech giants are looking to recruit more Canadian talent.

Is Silicon Valley ‘on tilt’ again?
Noted financial commentator Paul Kedrosky used a poker metaphor on Friday evening to explain why the Internet industry is about to do the same thing it did back in the spring of 2000, when the first dot-com bubble burst and an estimated US$6-trillion in shareholder value vanished. He offers a Top 10 list of reasons why that could soon happen again, among them being the extreme popularity of conferences such as South by Southwest (SXSW), or the fact that private valuations are approaching public valuations (i.e. privately-held Facebook has reached valuations as high as US$65-billion).

Steve Blank, a professor at Stanford University’s engineering school and at UC Berkeley’s Haas School of Business, has gone so far as to publish New Rules for the New Bubble. Unlike the last Internet bubble, writes Mr. Blank, the next one will involve “real” companies with real revenue and masses of real customers. Facebook, LinkedIn, Skype and Groupon are all examples of firms expected to launch IPOs in the next year or two, and all have displayed an ability to earn money and maintain a strong customer base. “But like all bubbles, these initial IPOs will attract companies with less stellar financials, the quality IPO pipeline will diminish rapidly, and the bubble will pop,” Mr. Blank cautions.

I would also caution people to avoid chasing stocks that run up too high, too fast. There is a lot of liquidity spurred by hot money, hedge funds and banks engaging in high-frequency trading, mutual fund flows, pension flows, sovereign wealth fund flows, and last but not least, retail investor flows (they're always the last ones to the party and typically get slaughtered). Tread carefully, these markets may appear easy but if you become complacent and ignore risks, you'll get killed.

I will however tell you that I feel like we're heading towards another 1999 rather than another 2008. Call it a gut feeling but I look at the stock market every single day, tracking unusual volume and which stocks and sectors are making new highs. I also study the quarterly holdings of top hedge funds and mutual funds. Right now, I see the "Risk On" trade. Will it last? Will it be in tech or so will it be in some new bubble like renewable energy? Who knows? All I know is that the liquidity party will continue on Wall Street for the foreseeable future, which is why I continue to advise people to keep buying the dips.

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