Another big sell-off, but was it healthy?

As US economic growth wavered in Q1, coupled with a few big sell-offs in the equities markets, stocks steadfastly rebounded and repeatedly approached new record highs. Taking into account the vast amount of negative numbers regarding economic data, equity prices fearlessly drove higher, despite predictions by several top economists and market analysts that a recession was near. A key basis point of these bears centered around the inverted yield curve, a unique phenomenon which has been succeeded by a recession every time it develops.

Low and behold, several months and vastly higher heights later, another pair of significant sell-offs occurred. This time however, these bears are missing a significant piece to their pessimistic puzzle. Finally, after years of mismanagement by the FED and US Treasury Dept., the yield curve has begun to normalized. The inversion has reversed, as long-term treasury yields have overtaken the 90-day T-bill rates.



Another issue the bears seemed to dwell on regarded weakness in the US Dollar. Many argued that global equity markets would continue to prosper while US stocks would take a significant hit because of the weakness in profitability between exchanges in currency rates relating to asset levels and market capitalization. Unfortunately, these bears failed to realize the global impact and success of American companies abroad. Giants such as General Electric, United Technologies, and Boeing continue to impress and solidify market share across the globe. Therefore, these revenues made abroad will translate high relative to the USD, failing to impact corporation's balance sheets like pessimists believed they would. In addition, the Dollar has continued to climb against the Yen and made a good comeback against the Euro recently.

Therefore, don't expect a large correction over 5-6% anytime in the near future. The US economy is going strong and stock slumps are supposed to be caused by Bond yield inflation, not computer glitches. This is a natural cycle and valuations are still appealing in the equity markets.

Economic Worries for the U.S. Economy

Despite weak GDP performance in the first quarter of 2008, the equity markets continued their climb today with the Dow closing at yet another record high. All of this came amidst talk of a potential recession, a weak Dollar, and declining markets abroad. With this seemingly unstoppable run continuing, there are still several factors that worry me about the current economy.

First off, let me make it crystal clear that I am still Bullish on the stock market and economy in the long run. However, there are too many factors signaling a struggle ahead. Lets begin with the inflationary pressure on the economy. The CPI and PCE both rose to suggest higher prices across the broad economy. Although prices in commodities continue to increase, I do not see these increases in the CPI and PCE repeating themselves for more then a few months. Commodity prices are being driven by international demand and growth, not domestic. Therefore, rising commodity costs are not being translated into actual inflation for most ordinary Americans except in the form of gasoline.

Another concern I have relates to the Fed's competence and the inverted yield curve it created. Greenspan is out, so I will wait to see how Bernake handles a fragile situation. Many bears argue we have never seen an inverted yield curve without a recession following. This fact is entirely accurate, yet may not be in this unique situation. The Fed mishandled rates in 2002-3 by sending them too low, creating the massive housing boom. Without properly limiting growth and speculation in the housing sector, the expected happened in when the bubble burst. Sub-prime spillover and sharp declines in housing prices and sales are not what worries me though. The drastic lowering of interest rates was overdone compared to inflation numbers. Additionally, it hurt the USD, which dropped steeply between 2002-4.



In an attempt to try and generate a perception of normal inflation, the Fed has increased the amount of money it prints to provide a short-term wealth. This will only worsen inflation in the long run as prices of goods and service remain constant the value of the dollar drops even more. To help control inflation, the Fed keeps focusing on raising the short-term FF rate instead of both the short and long or just the long. This has created the inverted yield curve, which undervalues long-term lending. Why would anyone borrow for the long term when they can get short-term returns at higher rates? Not to mention, it makes the U.S. pay back larger debts sooner rather then later.

Lastly, corporate profit records of late have been derived from operations abroad, not domestically. These profits are good since the companies making them are many of those headquartered in America. But, the income and revenues being attained globablly does not help our economy in terms of GDP, employment, and other factors. When you consider most of the returns on the investments made internationally stay outside the U.S. boarders, it really has no net affect on our country except for aiding to drive the equity markets higher. Also, if you consider the gains of the Euro and Pound against the USD, it makes sense that these companies continue to report record earnings. It must be near impossible for Wall Street to predict income and revenues generate across the world, let alone exchange rates to translate those earnings and sales.

These are just some things to consider in the short-term. Once GDP growth heads back towards 3-4% in the 4th Quarter, you can be assured that a new big rally will begin. Unless, of course, the current rally just never dies. As Larry Kudlow says, "It's the greatest story never told" and I expect many Americans to continue to reap benefits of investing in stocks, mutual funds and ETFs.

Did Alan Greenspan Ruin the Current U.S. Economy?

During the tenure of Alan Greenspan, from 1987-2006, the U.S. economy grew significantly. Although these gains helped solidify America as the unquestioned global leader in finance, production, and wealth, it came with a stiff price. We are only beginning to realize the affect of Mr. Greenspan's focus on short-term monetary and fiscal policies that dominated during his last four to five years.

There is certainly no question that Mr. Greenspan maintained stability in the economy from his entrance during Reagan's Presidency to the end of Clinton's. However, the effects of Greenspan's economic policies are certainly being felt. Outsourcing, weakness in the U.S. Dollar, an inverted yield curve, high inflation and repercussions from an unnecessary housing bubble are all presently hampering the American economy.

Despite obvious flaws in Greenspan's policies, he won't get all of the blame. Natural factors, decisions of other leaders, and actions taken by other countries or parties outside of Greenspan's control played a significant role. But, these outside factors surely could have been combated in a more effective manner by our former head of the Federal Reserve.

The 2008 election is critical to the importance of our free market, capitalistic economy. Some Democratic Presidential and Congressional candidates such as Hilary Clinton are proposing protectionism to try and combat outsourcing and trade deficits. This type of legislation will surely put our economy into a slump. Any economist who completely dismisses outsourcing as at least a minor problem does not view economics in an objective light. However, outsourcing really stems from our protectionist approach to the U.S. Dollar in the late 90s and early part of this decade. High costs for merchandise in the U.S. force countries who import American goods to look elsewhere for goods of similar quality and value. Part of this outsourcing problem cannot be directly tied to Greenspan, who has limited control over the wage inflation and more importantly benefits received by U.S. workers. Labor Unions, health care costs, and a variety of other issues compound the actions of Greenspan to intensify the outsourcing effect. Nevertheless, Greenspan's continuous use of short-term methods to boost the U.S. Dollar or maintain its high levels against other global currencies are linked directly to our current outsourcing problem.

Along with outsourcing, Greenspan's short-term bolstering of the strength for the U.S. Dollar has contributed to its current struggles. Money supply was not properly utilized to preserve a stable Dollar, as it has shown with the decline against the Euro from 1.12USD/1E to .75USD/1E. The Dollar's substantial drop has occurred during times of economic prosperity across the globe, including both the U.S. and Europe. A weak dollar hurts the wealth of the nation and also disrupts tourism and travel overseas. Over-tightening and protectionist measures on the dollar generally hamper the economy, as evidenced by our rapid growth in the late 1990s, followed by the recession of 2001-2.

Current threats of recession are also correlated to Greenspan's poor handling of the Fed's interest rate control. Following the recession in our economy, the Fed made multiple, massive rate cuts. These cuts were detrimental for two reasons: they caused the housing bubble of 2003-6 and created an inverted yield curve for treasury bonds. With interest rate cuts in 2002 and 2003 to ultra-low levels, the Fed produced a housing boom that is still affecting us today. By over-cutting, Greenspan generated too much liquidity for the marketplace, thus ensuring heavy asset investment of all sorts. The problem with this massive amount of liquidity was that it was coupled with extremely low interest rates. Housing was the obvious choice for investors and the immediate boom that followed was one of unsustainable proportions. I thought that the Fed was supposed to curb growth in order to control volatility, peaks and troughs, and ultimately enable growth longevity. Apparently I was wrong.

Another key consequence of cutting rates too low was the mishandling of temporary debt vs. long-term debt. One of the main reasons the U.S. Treasuries are considered sound investments is not only because of the "guaranteed return", but also the decency of that return. However, when Greenspan cut rates, they targeted long-term rates in too many cases. This poor action spawned an environment where short-term rates actually exceed long-term returns. Why would an investor tie his capital up longer if he can't get a higher rate? While Sen. Clinton preaches her worries about China and other countries controlling high amounts of U.S. debt, she need not look further to blame then our own Federal Reserve and Treasury Department. Now, America needs to pay off China & Co.'s borrowed money faster then normal. This is the type of action that creates political instability. In addition, the theory of the inverted yield curve suggests there will be a significant slowdown or potential recession. Investors in long-term yields are demanding lower rates because they fear the economy will plummet and those rates will actually decline even more as GDP growth and inflation fall. But, what happens if inflation doesn't decline like was previously expected? So far, inflation has actually been prevalent as evidenced by the commodity gains and our economy might enter the dreaded environment dubbed "stagflation".

As if his horrible policies weren't enough, Greenspan came out not long after the huge February correction and predicted a recession was "likely". Despite his retiree status, Greenspan sent more fear through the minds of consumers, investors, and businesses alike. Conveniently, after the stock market (and economy to an extent) rebounded and stayed its upward course, Greenspan came out again and denounced his previous prediction.

Hopefully that was the last we will hear from Greenspan, unfortunately, I wouldn’t count on it.