Sunday, December 16, 2007

The mess that Greenspan made

In 2001 Greenspan started slashing rates and began devaluing the dollar. This was done to try and sidestep the recession that should have followed the bursting of the tech bubble. Despite investors losing a large portion of their investments (which BTW adjusted for inflation they are still heavily underwater) the plan was semi successful. We had a mild recession in 2001. Unfortunately life isn't quite that easy. You can't just turn on the printing presses and escape the consequences of a bubble bursting. Japan tried this approach when their bubble burst in 90. It's now 17 years later and the Nikkei is still nowhere near all time highs. Japan also tried to prevent any pain in their banking sector just like the Fed is doing today. Just like Japan we are going to go through a long drawn out bear market unless the Fed allows the market to correct the imbalances. That is not a popular scenario unfortunately. So my guess is they will compound the problem again.
When Greenspan cut rates not only did he not stop the deflation in the stock market but in the process he created another bubble in real estate and credit. As we know bubbles are unsustainable and they will burst. In the first chart we can see the housing sector topped in the summer of 05. It has clearly been in a bear market since then. The housing bubble was in my opinion a large contributor to the incredible growth we've seen since 03. Unfortunately once that driver of growth failed we have seen a domino effect of failing sectors following housing down the bear path.
Out of the 06 bottom the Fed really started to pump the money supply to compensate for the deflating real estate market. From that point we can see the last major leg up in the stock market and what a leg up it was. Two runaway moves higher divided by one minor and short lived correction in Feb. and Mar. Sadly the cost of this borrowed prosperity was a devaluation of our currency to levels never seen before in history. Since this is also unsustainable it had to come to an end and it did come to an end in July of this year. At that point no more currency devaluation was going to lift the markets. The only thing it was now accomplishing was higher and higher inflation (the government finally this week published inflation numbers that vaguely represent what we have all known for sometime).
So now let's look at the progression of what's been taking place. First the housing bubble, the driver of this prosperity, collapses. Once the free money from refi's and home equity dries up and the devaluation of the dollar has run it's course we start to see the domino effect. Next go retail and of course if retail is declining the the transports are going to follow. That's exactly what has happened. The semi's also followed retail down. Even though the Nasdaq has held up better than the general market it is being held up only by a few large caps like AAPL and GOOG. The internals are actually much weaker in the Nasdaq than the general market. With the semi's in a bear market it won't be long before the last remaining large cap tech succumb to gravity.
Now for the sector that made the credit bubble possible, the banks. We see the rise as housing drove the economy into 05. We also see the banks start to falter right before the housing bubble burst. Then we see the meteoric run during the Fed's all out currency devaluation. Now we are seeing the result of the bursting of the credit bubble. The banks who failed to heed the warnings when greed was running rampant are now paying the price of that hubris.
The only question now is will the Fed let the market run it's course and clean out the excesses so we can start to rebuild or will they try and hold everything together like Japan did and draw this out for years to come. At the moment it looks like they are headed down the wrong path.