How low can global markets go?

At the same time, Jim Cramer of Street.com fame writes that we ought to 'quip moping about last year's market meltdown' and that since 'Greenspan has taken his foot off the break and begun to force interest rates down, you want exposure to the stock market. ...This is the lowest risk, highest reward environment possible. You have the Fed - and history totally on your side.'

The fact, however, is that the economy has just experienced one of the steepest decelerations on record. Yet economists dismiss this slowdown as an inventory correction and out of 54 economists recently surveyed, 52 are looking for a powerful rebound in the second half of 2001.

And despite the record inflows of more than $300 billion into equity mutual funds in 2000 and the concentration of this money into loss-making high tech funds, individual investors are more optimistic than ever, according to sentiment surveys.

Moreover, note that the $300 billion inflow into equity mutual funds in 2000 vastly exceeded total equity mutual fund assets in 1990, which were then less than $200 billion. People talk about the great US productivity miracle, but the enormous trade deficit suggests differently as does the record number of flight delays during the year 2000.

And finally, in Robert Mugabe's Zimbabwe, where the economy is falling apart and where the budget deficit is projected to rise to 29% of GDP this year, the stock market has recently soared to all time highs. So, what should an investor do in such a bizarre environment?

It may be that 'you have the Fed - and history totally on your side.' But is it 'the lowest risk, highest reward environment possible?' We have our doubts on both counts. It is true that in the past, Fed rate cuts led to rising stock prices most of the time, which averaged after the second or third rate cut between 15% and 17.5% for the subsequent twelve months period.

However, there are a few differences between past and present conditions. Just consider the two periods of previous rate cuts, 1973 to 1975, and 1981 to 1982. The great US bear market of 1973 to 1974 began for most stocks already by 1968, and for the 'nifty fifty' stocks in January 1973.

The first rate cut occurred on December 19, 1974, in the midst of a very serious recession and after stocks had been so badly devastated that they were 30% lower than they had been in 1964 - ten years earlier. The Dow Jones Industrial had a p/e of seven, was valued at less than book value and at a discount of 66% of replacement cost, and had a dividend yield of more than 6%.

In the 1981 to 1982 period, the situation was similar, except that prior to the first rate cut, Paul Volcker had increased the Fed Fund rate from less than 5% in 1977 to close to 20% in 1981. The subsequent three rate cuts took place between November 1981 and July 1982, when the economy was in one of its worst Post-War recessions (the unemployment rate touched 10.5% in 1982).

Also, over the previous 15 years, the Dow Jones Industrial had declined by 9% and was in real terms (inflation adjusted) down 70%! It sold for seven times depressed earnings and had a dividend yield of 6.3%. Equity mutual funds then had more than 11% of their assets in cash and their total assets ($40 billion) were no higher than they had been in 1970, because throughout the seventies mutual funds had been plagued by net redemptions.

Thus, in these two periods (1973/75 and 1981/82), there was a very depressed stock market and the economy was in the midst of a recession, when the rate cuts took place. Therefore, rate cuts in this sort of condition acted as a powerful catalyst for a market rally.

The rate cuts of 1987/88, 1989/90, and 1995/96 also produced stock market rallies in the subsequent 12 months, but these were more muted. In addition, I have to point out that these rate cuts came at a time of 'still' reasonable stock market valuations, and when the stock market capitalization as a percent of nominal GDP never exceeded 100%, compared to 150% now.

Hence on all previous occasions of FED interest rate cuts, with the exception of 1998, the US stock market valuation was far more reasonable than it is at present. Of course, the bulls will point to the 1998 rate cuts, which came at a time of high valuations. They will argue that even though the market may now be expensive by historical standards, it will rally as it did between 1998 and March 2000.

The difference, however, is that we are, unlike in 1998, not in the midst of a high tech boom, but in a phase of a bust. Moreover, we are not dealing with an inventory liquidation, as everybody seems to think, but with the dynamics of a capital spending downswing, which is characterized by excess capacity, weak pricing and decelerating, or more to the point, declining corporate earnings.

And because high tech has been driving the economy since 1998, FED easing could be fighting a losing battle against disappointing or poor corporate profits among high tech companies. It should also be noted that the NASDAQ is still valued at more than 100 times earnings, which is roughly twice as expensive as it was in 1998.

But even if the bulls are right about both the FED and history being on your side, we are, given the high stock market valuation and deteriorating economic conditions by no means in 'the lowest risk, highest reward environment possible.'

Quite to the contrary, we only have Mr Greenspan on our side, a desperado, whose judgement has to be seriously questioned, since his monetary policy created history's biggest-ever stock market bubble. That aside we have, in my opinion, the highest possible risk and lowest possible reward environment on our side.

I should just like to emphasize that low risk entry points into markets arise only after a long lasting and severe bear market, followed ideally by a lengthy base building period, and amidst very low volume, which indicates that all the speculative excesses have been purged. That we are not in such an environment ought to be clear to everyone.

At present no one knows how the economy will perform six, let alone twelve months from now. Personally, I am extremely skeptical of the current consensus, which calls for renewed growth starting in the second quarter of 2001, since all economists failed to forecast the current slump.

In fact, I am leaning toward the view that the first few months of this year may look somewhat better than expected, but that the second half will reveal weakness across almost all sectors of the economy. Deflationary forces are very powerful at this point and could lead to several years of disappointing corporate profits.

This will be true not just for the high tech sector, but also for most of the large multinationals around the world, as competition from companies in emerging economies intensifies, and as patent rights come increasingly under pressure. Excessive monetary easing by Mr Greenspan, however, is preventing deflationary forces and could lead to some kind of stagflation.

In particular in the United States, deflation may not occur through an adjustment in the domestic price level, but through a sharp decline in the US dollar. So both the US dollar and US equities remain vulnerable to further setbacks.