Markets Lower as North Korea Adds to Crisis of Confidence

* Markets overnight have taken another step lower, as concerns over a brewing conflict with North Korea is roiling markets. So now, we can add Korea to the list of reasons why US equity markets are lower. This is despite the fact that the widely disseminated data suggest that the US’s economy is on a path to recovery. What is surprising is the fact that the common view suggests that the sell-off in equity prices is just a correction in the recovery from the recession of 2008-2009. This blog has never been about embracing the common view, but rather, to discern what is really going on.


In response to the lead off paragraph of my blog yesterday, a reader writes in with the following:


“I disagree with the assessment that Bush’s and Paulson’s dire predictions caused the meltdown. There were a great many causes and those dire predictions only made the market drop when it did. It would’ve dropped anyway. I am fully convinced that we would be more or less where we are now in the stock market today, with or without those dire predictions. We might even be lower, since TARP wouldn’t have passed, more financial firms might have gone to ruin and the economy and housing sector might be deeper in the toilet.” (end of readers comment)


You are right, we were screwed no matter what, it is just a matter of how we got to where we are/were. But I have to tell you, that when you have the president of the US saying the house of cards is ready to come down, that does affect people. Not that George Bush’s statements were the cause of the downturn in 2008, but his speeches kicked off the crisis in confidence. I bring this up because commentators, to this day, spend a considerable amount of time blaming the Lehman bankruptcy as the kick-off for the great collapse of 2008. Most trading desks had to spend just one day unwinding their Lehman trades, and some money was lost, but it was not as big a deal as it is continually referenced to be.


What is transpiring today is a reflection of the global (lack of) confidence. This is the basis for equity prices, and corporate plans to hire people and spend money in pursuit of business expansion. The rally from the lows of 2009, represents an elimination of the negative confidence which was embedded within the economy. Despite the almost 100% rally in stock prices from March of 2009 to April of 2010, confidence is still suffering. Today we have the release of the Conference Board’s (CB) Consumer Confidence readings for April, and this shows a modest up-tick in this reading. If I look at the long data series for the Conference Board’s consumer confidence index, recent readings in the upper 50s to low 60s, during our supposed recovery, is not higher than levels seen during the recessions which occurred since this data was accumulated in 1967. The good news is that this is up from a 2009 level of 25, which is dramatically lower than the previous low of 43, in December, 1974. This measure combines the results of a survey on consumer’s expectations and current conditions. A look at the CB’s expectations survey only, shows that the confidence is not as low, relative to lows seen during previous recessions. This buttresses the point that the current conditions component of the CB survey is still scraping along the bottom, at levels consistent with previous recessions. So here is the divergence, while expectations are not so bad, current conditions suck.  And this is occurring during a time period when the stock market rebounded by almost 100%. 


Clearly, the CB survey corresponds with the chronically high unemployment rate, which is still hovering around 10%. And my take-away is that while stocks have rallied over the last year, this will go down in history as a false rally, which was fueled by the hope of zero percent interest rates, $1.7 trillion of new money being printed, and massive deficit financed stimulus spending. Collectively, all the administration’s efforts to revive confidence in the nation’s prospects were through quick and expensive fixes, without solving underlying problems which led to the downturn.


Let me suggest a basic concept which the government should be doing to remedy the current economic malaise. I start off with the vantage point that much of the economic boom of the 2000′s revolved around an inflating housing market, and economic activity in support of housing. With housing in a down-turn, it is imperative for the government to find alternative activities to redeploy our unemployed labor force. To that end, the government should be doing what they can to encourage green related businesses to develop in the US. It is ironic that the government offers a 30% direct tax credit for those people who install solar panels in their homes, yet I am told that the entire solar panel manufacturing industry is in Asia. Why can’t we produce those domestically? While they are at it, the government can offer tax credits for the development of certain green related businesses. I do not spend my days thinking of things which the administration should be doing, but they should be focusing on activities which cause structural shifts in how our economy is organized, and not focused on giving states more money so they do not have to fire public employees. The latter is a stop-gap measure, while the former will put the economy on better long run footings.


* Gold is meandering around the upper 1100s, while stocks are sinking. The gold/S&P ratio is now up to 1.15, and has broken above the recent 1.10 resistance level. The longer term graph of this ratio shows that it has been in a persistent uptrend over the last 10 years. In 1980, when gold had its last hurrah, this ratio achieved a level over 7.0. If the markets were to return to this type of valuation, then you can do the math: stocks down by 80%, with gold unchanged, or gold up by more than 600% with stocks unchanged. I know, picking the highest gold/S&P valuation is not the way to look at a likely outcome, or long run equilibrium level for this ratio to return to. If you divide the period from 1975 to date, (the period for which Bloomberg data is available), there are 3 distinct time periods:


1>    The 1970s to 1980, during which time inflation and issues with the dollar were in vogue, this ratio ranged from 1.0 to 7.4.


2>    From early in 1980 to 2000, this ratio went from 7.4 to 0.2, as the Fed’s inflation fighting resolve put more weight behind paper currency, since they were policing the markets against inflation, and by extension, currency risks.


3>    Since 2000, this ratio has been on the rise, and is last at 1.15, up from 0.20. Clearly, we are in a new trend towards higher gold/S&P valuations.


My view of the data is that the data corresponds to different time periods, and the circumstances surrounding gold’s ascendency or decent into irrelevance, has to do with the environment. The current environment, which is a period of printing money and a proliferation of credit, is leaving open questions about the viability of fiat currencies. For the moment, I will chose to ignore inflation as a factor which will support gold, instead relying on the linkage that inflation would serve to undermine the fiat currencies which will in turn, underperform gold.


Nonetheless, despite the fact that gold is not taking off into the stratosphere yet, I am encouraged by its relative performance versus equities.