Greenspan's Catch 22

In the late 1990s, numerous economists and strategists distinguished between the 'old economy' and the 'new economy'.

'Old economy' companies were companies that made some money, had reasonable stock market valuations, and a relatively high earnings visibility. 'New economy' companies, on the other hand, were engaged in new and unproven industries, in which were the pace of technological innovation was extremely rapid and, therefore, also obsolescence.

Moreover, all the profits and some more had to be reinvested in research and development. New economy companies were also characterized by very high valuations (in March 2000, NASDAQ at 5000), and almost no earnings visibility.

Well, we now know what happened to the then popular buzzword 'new economy', but to be fair, there is indeed a new economy in the world. It is just different than what the visionaries had anticipated.

The new economy is characterized by the rise of China, India and to some extend also Russia as global economic and geopolitical players. Out of the blue and certainly totally unexpected to the American visionaries that spent their days counting irrelevant eyeballs in order to value Internet stocks, China has overtaken the US in many markets such as for steel, iron ore, copper, not to mention in the production of appliances and consumer electronics.

But more importantly the 'newest economy' is characterized by seemingly endless bubbles, courtesy of the man who has done more to destroy the value of paper money than any one else in the 200 year history of capitalism: Mr. Alan Greenspan.

The destruction of paper money as a store of value - the most important quality paper money should have - occurs only in one way and that is through increasing the quantity of paper money at a higher rate than real GDP growth.

At times this excessive money supply growth will lead to real wages rising strongly, such as in the 1960s, or to commodity and consumer prices soaring, such as in the 1970s. But, excessive money supply growth can also lead to the most dangerous form of inflation and this is asset inflation, which at times will boost equity prices to lofty levels (Kuwait in 1980, Japan in 1989, Taiwan in 1990, NASDAQ in 2000, etc) and on other occasions boost the value of real estate into cuckoo-land (Tokyo in 1990, Hong Kong in 1997, and now in the Anglo Saxon countries).

The reason asset inflation is so dangerous is that central bankers - usually unemployable in any other capacity - not even as waiters - only pay attention to consumer price inflation. Therefore, when consumer prices do not rise much, for example because of international competition (as is now the case), they print money like water.

So, with the entry of China and India into the global economy we had low consumer price increases around the world - although higher than the statisticians in the US are under political pressure computing, calculating and doctoring - and this led Mr. Greenspan to create, after he fueled the NASDAQ investment mania with easy money, another gigantic bubble: the housing bubble!

How to spot bubbles

There are many ways to recognize a bubble. One of the most reliable indicators that an investment mania is underway is always very high volume. In the case of US housing it is the number of home sales as a percentage of households that show how speculative the market has become.

Annual home sales as percentage of households is now at all time high. I am not suggesting that US housing cannot get even more over-heated but very clearly we are in housing not near a low such as was the case in 1971, 1982, and 1992. Moreover, since 1994, housing stocks rose actually more than the NASDAQ had risen between 1994 and 2000.

Now, there are several interesting development in the housing markets. In Britain home prices are no longer rising and turnover is down. In Australia, in many markets home prices are already down and in the US, on record home sales in March, stocks of homebuilders failed to make a new high.

Usually if a new high in a physical market is not confirmed by the stocks in the respective sector - that is if there is a divergence in the performance between physical and financial market we call it a non-confirmation.

If the non-confirmation occurs following a long term up or down trend it frequently leads to a very sharp reversal whereby an uptrend is followed by a collapse in prices and a downtrend is followed by an explosive upward move.

There is another reason to be negative about US homebuilding stocks. Homebuilding companies have traced out a Head and Shoulders top, which is an important reversal pattern. I must stress that there are occasions when prices break out on the upside from a Head and Shoulders formation, but usually they will not rise significantly above the 'Head' of the Head and Shoulders pattern.

Thereafter they reverse very quickly and break down almost vertically. But there is another reason I am inclined to think that the housing boom is nearing its end: International liquidity (FRODOR) has been diminishing.

FRODOR is a creation of my friend Ed Yardeni and stands according to him for 'Foreign Official Dollar Reserves of central banks' and is 'the sum of U.S. Treasury and U.S. Agency securities held by foreign central banks'.

It is probably the best available measure of world liquidity because foreign central banks tend to transmit and to amplify U.S. monetary policy globally (emphasis added). The yearly growth rate of FRODOR is extremely pro-cyclical. It tends to rise during global economic expansions and to fall during recessions.

When FRODOR expands asset markets including stocks, commodities and real estate tend to perform well while the US dollar tends to decline. Conversely, when FRODOR growth decelerates, asset markets come under pressure while the US dollar strengthens. Also commodity prices and oil demand correlate very closely with the rate of change in FRODOR.

Since the takeoff in commodity prices in 2000 coincided with the takeoff in homebuilding stocks I assume that shrinking global liquidity will not only have a negative impact on industrial commodity prices - including oil - but also on other asset markets such as housing.

Now, I admit that it is always possible that Mr. Greenspan will ease once again massively - if the economy weakens. That should almost certainly be the case if home prices begin to weaken since housing inflation was driving consumption or more appropriately put over-consumption in the last few years.

But this might be one of the rare moments in financial history were 'printing money' becomes totally ineffective because any easing move now would hurt the bond market.

Why would that be so if the economy weakens? Because commodity prices would soar and the US dollar tumble as investors would once and for all recognize that paper money under the guardianship of central bankers is no longer a store of value but a recipe for impoverishment due to paper money's loss of purchasing power.

Needless to say that if the Fed engages one more time in 'printing money' the decline of the US dollar will lead to soaring import prices, accelerating consumer price inflation and higher interest rates. Hardly a favorable environment for the highly priced and highly leveraged US stock and real estate markets!

Short in May and go away

I do admit that my expectation, a month ago, of an April stock market rally was plainly wrong (there was a rally but it only lasted for one day and pushed the Dow up by 200 points).

Still, stocks around the world were from a near term point of view somewhat oversold and rallied in the first two weeks of May. I believe that a better shorting opportunity has now arisen and that the stock markets will again weaken in the second half of May and in June. I strongly feel that for the most stock markets new 2005 highs will be very difficult to achieve.

For the S&P 500 there is strong resistance between 1195 and 1230 and numerous stocks have already broken down and inflicted serious technical damage to the entire market.

So, I would use any strength to liquidate stock positions around the world. The risk reward ratio remains unfavorable. Moreover, based on the deceleration of growth in FRODOR I would avoid all industrial commodities including oil.

Lastly it will be fascinating to watch whether the 'newest economy', which is characterized by bubbles everywhere and was the creation of the destructor of the value of paper money, Mr. Alan Greenspan, will last for much longer than the 'new economy' of the late 1990s!