Client Letter January 2005

Ralph Acampora says that the Dow will reach 13,000 in 2005. While we all hope that he is correct, when I read that the NASDAQ is up 22% since November, while the Dow is only up 11% and the S&P up 14%, I start to get nervous, and that makes me want to explore some downside alternatives.

Vernon Smith won a Nobel Prize for economics in 2002. Smith pioneered in the area of behavioral economics, by running class room experiments to study the behavior of market participants. In his famous study, "Bubbles, Crashes, and Endogenous Expectations in Experimental Spot Asset Markets," he ran a series of experiments to study trader behavior and the creation of market bubbles (a market were asset prices rose to levels were their prices were substantially higher than their intrinsic value). For the paper, he ran 22 experiments and found that in 14 of them price bubbles appeared.

The part of Smith's experiment that is now interesting to me was that after a bubble appeared in a trading series, there would be a correction, and then after the first correction, the bubble would usually reappear. The bubble starts to re-inflate, but this time the participants, burned by their previous experience, are more cautious and the values do not become as extreme. "This tendency to bubble decreases with trader experience." Eventually, if they continue to run the same experiment will the same traders, the market becomes educated and from then on the prices tend to get stuck closer to their intrinsic value.

Smith's experiments could go a long way toward explaining the secular (long-term) trends in the stock markets. Our last secular bear was in the 70s, and the one before that was in the 30s. These long cycles could well be explained by a sort of reverse-learning curve. It takes 30 to 40 years for a smart market to forget the lessons of the last bear market and turn stupid. On the other hand, it also may mean that it takes 10 to 15 years, as it did in the 30s and 70a, to kick some sense into Mr. Market.

So if there are smart markets (1977) and dumb markets (March 2000), where are we now? There is evidence that the current market rally is a natural attempt to form Professor Smith's second bubble: strong tech stocks, a decline in the levels of speculative short positions, declarations of the start of a new bull market, etc. If Smith is correct, the market should be smarter now than it was in 2000, so the speculation will not reach the level it did then, and any 2005 peak will be much lower than the levels reached in 2000 and will be followed by another down-leg that may well be worse than the last. In the 1970s, it took three or four bear markets to finally exorcize all of the speculative excesses that had build up in the market in the 50s and 60s.

Mr. Acampora May be right and the market may be headed to a better 2005, but rule number one means that recognition of risk is our "Job One," so we should at least be thinking about Professor Smith's second bubble.

Another area of concern for the coming year is the direction of long-term interest rates. In 2004, the Fed raised short-term interest rates five times, yet rates on 10 U.S. Treasury notes actually fell, beginning the year at 4.25% and closing on December 31, 2004 at 4.22%. Wall Street happily applauds, declaring that this is evidence that the Fed has been successful in fighting inflation. Sir Alan has ridden to the rescue and, finally and forever, banished the inflation dragon so that long-term interest rates will never again return to the levels we witnessed in the 1980s and 90s. Yet, it seems to me that if the Fed wants to control inflation, they have to, at some point, be able to control the cost of shelter, which is, of course, the biggest share of the consumer's budget.

So, if the FED really wants to control inflation, wouldn't they want mortgage rates to rise? Low interest rates have fed the bubble in housing prices. And, it seems to me, it is hard to claim that inflation is low when we are in the middle of a housing bubble.

Because of the trends in the bond market, mortgage rates have remained low. The reason long-term rates did not follow short-term rates as they moved up is not entirely clear, but I suspect long rates are being driven more by the purchase of treasury securities by foreign central banks than by anything the Fed is doing. Recent auctions of treasury securities have seen as much as 60% of the securities going to foreign buyers.

While, in theory, I have nothing against these central banks subsidizing the American consumer's purchase of housing, low mortgage rates are feeding the housing bubble. The longer mortgage rates remain at present levels, the bigger the bubble is going to get, and we all know, that the bigger the bubble gets, the bigger the mess it will make when it pops.

It is not entirely clear to me what is driving the appetite of these foreign central banks for American debt, particularly in light of the falling dollar. But it is possible that Japanese banks, in particular, feel that the easiest way to simulate their domestic economy is to pump up the American consumer.

This disconnect between the Fed tightening and the flat mortgage market suggests that perhaps the Fed is no longer able to control the domestic economy to the extent it was able to do in the 20th century. So, are we to the point that international money flows can short circuit Fed policy? And if we are approaching that point, what is going to happen if the dollar continues to weaken and the foreign buyers of our debt decide to move their money elsewhere?

We could develop a scenario where foreign sales drive the price of our bonds down and long interest rates start to raise rapidly. What is scary about this is that there might be nothing the Fed could do about it. They could try to loosen monetary policy and even drive short-term rates to zero. But as long as the foreign bond holders kept selling, long-term rates would continue to rise. I know very little about how the big boys play interest-rate spreads, but it seems to me that the above scenario could blow these spreads completely out of their historic patterns, and introduce all kinds of stress into the derivatives markets.

The Fed could, of course, purchase the bonds if and when the central banks begin to dump, but they would have to print money to buy the bonds. This could lead to a rapid expansion of the domestic money supply and eventually to inflation and much higher interest rates.