Matching investment with business cycles (page 2 of 2)

Declining commodity prices led to falling interest rates and, therefore, rising bond and stock prices.

In turn, the combination of these two factors lowered the cost of capital and improved the profits of the manufacturing sector. Hence all major financial manias such as the canal and railroad boom as well as the 1920s stock market and incidentally also the 1990s US stock market boom occurred in a weak pricing environment!

But at the same time, each innovation and stock market boom period preceded financial busts, which led to recessionary periods. Why? During periods of weak prices, monetary conditions remain very accommodative, since there is no inflation. Moreover, the combination of new inventions, rising corporate profits, vibrant financial markets, and easy money is a powerful tonic for capital spending.

Rising stock prices and declining interest rates obviously both lower the cost of capital and by themselves lead to even more investments. Thus, easy money monetary policies bring about, via booming financial markets, massive over-investments and a gross misallocation of capital because the from the innovation arising and expected profit opportunity is so great that it leads to excessive borrowings on the side of consumers as well as businesses.

The downturn or bust is ushered when the over-investments lead to excess capacity and a collapse in prices. This in turn drive down profits and along with them obviously also stock prices, which then weakens the economy even more and reinforce the weak-pricing environment, in which the wave of innovation occurred in the first place.

This is where we stand today. The weak pricing and easy money environment of the 1990s led to a huge stock market and capital-spending boom, which was largely financed by debt and foreigners who bought US real assets, equities and bonds. But, today, the world's most important economic driving force are no longer agrarian commodity prices, as they were in the 19th century, but stocks, which are declining, and caused the bursting of the massive high tech and telecommunication capital spending of the last few years!

And while, an additional injection of liquidity by the FED may cushion the immediate 'shock' to the system, it is obvious that easy money and lower interest rates will only aggravate the excess capacity problem in the high tech sector in the long term, as it will finance further investments. If not in the US, so certainly in countries like China and India, because the multinational corporations will strive to cut costs even more rapidly in order to regain some degree of profitability.

In fact, I would argue that in the current weak pricing environment and, given the ease with which new production facilities can be set up in countries such as China, it is only natural that factories in high cost countries, such as the US, will be closed first. Meanwhile, production in low cost countries will be expanded or be newly established.

Thus, in the present situation, Mr. Greenspan's accommodative monetary policies will remain largely ineffective for the US economy. Corporate profits will continue to slide and disappoint. Poor corporate profitability and negative cash flows will lead to further cutbacks in capital spending and to additional lay-offs in the US.

And when it becomes obvious to everyone that further lay-offs are in the card and that the US economy will fail to recover in the next six months, retail and car sales, and the housing market will finally cave in as well. In this scenario, it is difficult to see why the S&P 500 should now rise to 1,500 by year-end, as Goldman Sach's economist Abby Cohen is predicting.

Moreover, there is a problem with foreigners, who have continued to be record buyers of US equities since the stock market began to decline in the spring of year 2000. If they finally wake up and realize the US economy's dire prospects over the next two years or so, they might begin to off-load their stocks and corporate bond holdings.

If that were the case, then you better kiss good-bye to the strong US dollar and sell it against the euro. Having said all this, I should, however, make the following point. High tech and communication stocks have collapsed already.

So any improvement in sentiment toward high tech, as a result of business not deteriorating much more among the TMT sector, could lead to a strong bear market rally for depressed stocks like Ericsson and Lucent.

On the other hand, financial stocks, which have significantly out-performed the S&P 500 over the last 12 months, are looking increasingly weak. In particular we would avoid consumer finance companies, S&Ls, and sub-prime lenders such as Providian and Capital One Financial Corp, whose loan losses will soar.