Partying Like It’s 2003
National Investor

            Those of us who occasionally (or chronically, as the case may be) who decide it’s appropriate to warn one and all of looming trouble for investors often like to draw comparisons to what we perceive as similar periods in the past to make our point.  For a long time, the end of the “Roaring 20’s” has been invoked as a period when speculation was rampant and risk- in normal times, a viable and necessary component of judging markets-was merely a nasty four-letter work to be shunned.  Recently, it’s been fashionable in some circles (including ours) to look back to the 1970’s and its cocktail of inflation, anemic economic growth and jeopolitical headaches.  For those who want to isolate the stock market and its lofty valuations, you can’t do much better than to point back to 1987 and the great bust that started in early 2000.

            We can’t help here, though, having an increasing fascination with how uncannily similar the behavior of most markets are now, though, with a more recent year-2003.  Then, you might recall, darn near everything moved higher; and you needed to try pretty hard to LOSE money.  But as we investigate the causes of these respective bullish environments as well as the fundamental and financial backdrops, they are radically different. 

            There in lies the story….

            Back in 2003, we were coming off the most gut-wrenching time for stock market investors in particular since the 1973-74 bear market.  To boot, credit conditions were horrendous; and although the Federal Reserve had been lowering short-term interest rates, much of the lending community was still “holding back” somewhat, stung by strings of high-profile business failures the previous couple years.  Ultimately, though, the Fed’s relentless pump priming worked its magic.  Pretty much everything responded as desired (though, in some cases such as where energy prices are concerned, a bit more than had been planned on!)

            The investing public is behaving as if 2007 is 2003 all over again; as if they believe that anything and everything is destined to rise in price.  The nasty hit that all the markets took several weeks ago is already treated as but a distant, fleeting inconvenience; with that impertinent interruption out of the way, the party can continue.  And continue it has stocks continue to rise with the Dow Industrials, China and other bourses setting new nominal records.  Bonds refuse to buckle.  Commodities are again red-hot, having come off their won early-year swoon.  Led by soaring nickel prices, base metals in particular have ben surprisingly strong.  Gold is flirting again with the $700 per ounce level.

            The foundation, though- and we use the term loosely- of these two different “expansions” provide sharp contrasts.  Looking quickly at them, we can come to no other conclusion than that the 2007 version of things will shortly run into choppier waters.  Let’s look at a few of these contrasts:

            THE “CARRY TRADE”.  Back in 2003, the Federal Reserve was doing most of the heavy lifting, goosing both the economy and financial markets by ultimately driving the federal funds rate down to 1%, and by flooding the world with dollars.  Though the Fed has still maintained a healthy level of liquidity, rates have risen; and may yet rise further.  Once this reality sinks in, it will take some of the starch out of the bulls on its own.

            More recently, it has been a yen-fueled carry trade that has been a big force behind rises in a number of asset classes.  Japanese officials, though, have ever so slowly started to crimp the free flow of the yen.  They are clearly mindful that they cannot tighten too quickly; however, neither will the flow of yen remain unlimited as was the flow of dollars back in 2003.  Japan’s central bank head Toshihiko Fukui recently acknowledged that being too complacent where the carry trade is concerned could create “harmful effects” if markets became too distorted as a consequence.

            Thus, at present, we must judge the “benefit” of the carry trade as something less that what existed in 2003.

            STOCKS’ STARTING POINT.  In 2003, stocks were coming off their worst period since the 1970’s.  The Dow bottomed near 7200, the Nasdaq near 1200.  For at least a while, there was no place to go but up.  Similarly, corporate earnings had contracted sharply due to the recession of that time. 

            Now we have pretty much the opposite situation.  Stocks are at their highest levels of this cyclical-and liquidity-induced-bounce.  As for corporate earnings, they are in the process of decelerating sharply.  This year will see a dramatic reversal of a string of several years worth of double-digit earnings gains.  According to Thomson Financial, full-year profits for 2007 will rise at less that a 7% year-over-year rate.  With the direction of the over all economy being South rather than North, there will be little in the way of fundamental underpinnings for continued advances.

            INFLATION.  So sick were the economy and financial markets in 2003, there was talk regularly that the U.S. was in the process of sinking into a Japanese-style multi-year deflation.  This fear, in part, was responsible for the Greenspan- led Fed cutting interest rates as much as it did and keeping them low for so long.

            Now we see the fruits (or consequences, if you will) of such an unchecked monetary inflation.  Prices-even according to the government’s suspect numbers are rising faster than the Fed’s supposed comfort zone.  The dollar is, as a consequence, flirting with new all-time lows versus the euro.  This puts the Fed in a tight spot; raise rates and virtually guarantee a recession, or don’t raise them and invite even higher inflation, if not a currency crisis.

            A LOOMING CREDIT CRUNCH.  Of all the factors we can point to, none catches our attention more than this stark contrast.  Back in 2003, we were coming off of a credit crunch.  It was one that chiefly affected corporate America, and came about due to (primarily) bust-ups among Internet and energy-related companies.  The much larger consumer market was not only relatively unaffected, but evidenced very liberal credit availability.

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