Wednesday, January 16, 2008

One Factor Auguring a Depression

It seems fairly clear, by now, that Ben Bernanke is very concerned -- almost preoccupied -- with the performance of the stock market. Since last August, his interest rate cuts have repeatedly proceeded for the purpose of saving the market, and despite warnings of potential inflation. The dollar is now at an all-time low against gold and is also very low and headed further downward against key currencies, including not only the euro but also the Chinese yuan, which is moving at a gradual but increasing pace toward becoming a freely traded currency. The low value of the dollar means that dollar-denominated investments perform poorly for international investors. As has been often noted, a foreign investor who entered the U.S. stock market five or six years ago, at the start of its recent and remarkable rise, would have *lost* money because of the contemporaneous decline in the dollar's value. Actual and potential foreign investors are not ignorant of this. They have funded the deficits of the Bush years, buying U.S. government securities because they have believed in the safety and profitability of investments in America. During the past year, however, such investors have become more audibly concerned about the sense of such investments. Steps are being taken -- gradual steps, but significant ones -- toward diversifying away from the U.S. economy. U.S. consumer purchases and government expenditures are founded, alike, on cheap credit. If money becomes less available and/or more expensive, consumers will borrow and spend less, and the government will be less able to afford to hire people, build and buy things, and otherwise stimulate the economy. Money will become less available if foreign investors supply less of it. Rationally, they should be doing so; and over time, by present trends, they will do so. It is not yet clear whether we are now in the opening phase of a massive readjustment to a more realistic world, one in which money is supplied to us based upon our present productivity and competitiveness, as distinct from faith in our future promise. But there is a good chance that that day has arrived. We face unprecedented competition on both counts, as rising economies (especially in Asia) offer seemingly endless supplies of people willing to work hard and live cheap. The market is confident that Bernanke's Federal Reserve Bank will again cut rates, two weeks from now, perhaps by as much as a half-point. (Some are betting on an even greater cut.) Foreign investors are undeniably paying attention. The standard wisdom continues to be that Asia cannot fully decouple its prospects from America's -- that, in other words, if the U.S. sneezes, Asia will catch a cold. But foreign investors cannot be expected to continue to invest where they will realize a negative rate of return. There remain an unacceptably high number of unknowns and negatives in today's stock market. Stocks may not be overvalued in historical terms. But there is a good chance that they are overvalued within a context of troubled times. It is not obviously a good time to cast a vote of confidence in the S&P 500 -- a vote that, essentially, things will return to where they were a year ago. That sort of renaissance seems unlikely in the near term. In short, the market and Fed policy seem to be based upon a worldview that says we have been coping with some difficulties, but that they will ultimately resolve themselves and good times will return. This is bull market thinking: it is the mentality in which everything finally turns out OK. Yesterday's market rout suggested that doubts are now emerging in the bull market mindset. Descriptions of that rout included the key word "panic." Panic is a bear market concept. It is the recognition that companies whose stock you own can go bankrupt, that you can lose your shirt, that the elevator to the penthouse also goes all the way to the basement. The stock market has been extraordinarily resilient despite repeated and growing pressures on multiple fronts. Some unknown portion of that resilience derives from the inexperience of a generation that has known largely good times. Even the recession of 2001 was mild, in contrast to the successively greater hardships known by previous generations, as one goes back in time to 1991, 1980, and, of course, 1933. If the American century were not over, one might expect a continuation of that pattern of successively milder national economic hardships. But this generation, unprecedentedly fortunate in its exposure to hardship, may yet encounter the novel thought that what goes up can go down. Panic remains possible for today's investor. People can reinterpret recent bad news through the bear's eyes. In that event, that grey expanse above us, presently perceived as a set of storm clouds over the economy's forward march, may instead come to be seen as the surface of the ocean, far, far above one's head. In such an event, thoughts go to survival, and standard valuations become rapidly recalculated. The U.S. government, including the Fed, does not presently understand the nation's capital markets, nor does it have the power to fix them. Nobody understands them fully; nobody has that power. Bernanke's consensus leadership style is, moreover, the wrong style for uncertain times. He is a brilliant man -- he is as competent as they come -- but the impression is growing that the Fed does not have the power and wisdom that investors were previously willing to credit to Greenspan's Fed. The impression grows that the Fed is becoming desperate, and that its desperation arises from its impotence. The Fed is behind the curve, and my hunch is that it will not (and could not) get ahead. What it can and apparently will do -- much to the lifelong regret of Bernanke, student of the Great Depression -- will be to alienate the foreign investors whose deposits in our economy have made the bull market possible. It does seem that there will be a wrenching readjustment, and that bear market thinking will come to seem more realistic.