The Tail That Wags The Dog
In early June 2002, Tony Crescenzi chatted with Eddie Kwong
about the current state of the markets and the economy. The theme that
came out of the conversation will be thought-provoking for all stock traders.
That is that the bond market is a powerful leading indicator for the stock
market that is all too often ignored. In this interview, Tony will explain how
to anticipate long-term trends in the stock market by interpreting action in the
bond market. He will also tell you about his new book, The Strategic Bond
Investor.
One additional note
from Eddie: At various points in the following transcript, Tony and I discuss
news and market action in real time as it unfolds during the interview. From
time to time there are off-topic comments have not been edited out in order to
give you some insight on how Tony interprets news.
The Outlook For 2002
And Beyond
Eddie
Kwong: Tony, what’s your big-picture
assessment of where we are right now, both in the economy and the stock market,
since Sept. 11?
Tony Crescenzi:
Well, I think we have two major forces shaping
the economy and another major force shaping the action in the equity markets. In
the economy, we have both cyclical and secular forces helping to lift economic
growth. On the
cyclical front, we have very low inventories. Inventories year-over-year are at
the lowest level in decades. Low levels of inventory are forcing businesses to
raise production, and we’ve seen production rise each month this year. And as
production rises, so do incomes because people work longer hours and workers get
added. As they earn extra income, of course they spend more, and extra spending
results in more production. And hence, income and spending and production. That’s
how you get to a virtuous cycle of economic growth. So the inventory story is
very beneficial right nowsize=2> size=2> and… hold on, there’s a headline right now about Greenspan and the
dollarsize=2>… It’s best
for governments to keep their hands off the dollar… off the
exchange.
Kwong:
We’ve got quite a nice short-term pop going
on…
Crescenzi:
Well, what face=”arial, helvetica” color=#000000 size=2>href=”https://www.globeandmail.ca/servlet/RTGAMArticleHTMLTemplate/C/20020604/wkash06042?hub=homeBN&tf=tgam%252Frealtime%252Ffullstory.html&cf=tgam/realtime/config-neutral&vg=BigAdVariableGenerator&slug=wkash06042&date=20020604&archive=RTGAM&site=Front&ad_page_name=breakingnews”>Putin
said about the India/Pakistan conflict is quite a positive comment… plus the
VIX, which I see Larry Connors had a very nice article in Futures
magazine, I just looked at it today. The VIX was very high, I think the
highest since early February, and I think that was a signal for the
markets…
Kwong:
Yes, he made that statement last week in
the Wall Street Journal, too.
Crescenzi:
Yeah, that’s right. It really is a great
indicator. So back to the economy. We see inventory is likely to benefit the
economy for at least a few more quarters. So that’s the main cyclical force
right now. The main secular force driving the economy is the growth in US
productivity. We see growth for the last two quarters averaging about 7%, and as
productivity advances, historically, it’s correlated with growth in profits.
Kwong:
What does that tell you, based on history?
Crescenzi:
If you look at charts going way back, you see profits and productivity growth
overlapping each other, really moving in lockstep. So a strong growth in
productivity should help profits — in the long run intense income growth, and
hence, the overall economy. So there are very good secular and cyclical forces right now.
Plus, the weaker dollar could have a positive influence on profits going forward.
A 1% drop in the value of the dollar equals a 1% increase in profits for
manufacturers. That’s good news for a big part of our economy.
The Next Bull…How
Long Do We Have To Wait?
Kwong:
What is the typical time frame in which we can
begin to see size=2>the effect of this inventory boost in the stock market? Everybody
is staring at the charts and generally they’re seeing red.
Crescenzi:
It’s had the impact on the economy, and of course
typically, the stock market seems to move in advance of these things, but these
days the problem with equities is that they are being frowned upon as an
asset class simply because people are disenchanted, disillusioned because of
major events such as the busted bubble, 9/11, Enron, accounting concerns, now
the Middle East — worried about a lot of things. But in the long run, of
course, people will tell you that as long as profits keep advancing in the long
run, the stock market’s gains should be consistent with the gains in
profits.
Kwong:
There seems to be a disconnect or delayed-effect because the low
inventories, increased production, and extra income for workers doesn’t seem to
be kicking into the stock market yet.
Crescenzi: It’s just that
right now you’ve got households liquidating assets. We see household holdings of
stocks down to under 40% of the market cap. It was at over 50% a couple of years
ago, so households have liquidated to a very large extent. They’re probably
running out of room and getting under-exposed. So typically we should have seen
a response in equities already. It’s just that households
are liquidating
stocks because they’re disillusioned. But in the end, it may turn out that
they’ve oversold and have become under-invested in the market, and ultimately
that will fuel an advancement. What that will be, it’s hard to see, it’s an emotional
issue. The economics certainly have been very good. There’s very little wrong
with the economy right now.
Kwong: Interesting.
That’s an opinion I don’t hear much these days.
Crescenzi: It’s all moving in a way that should restore
profitability for companies and in the next — for the rest of the year, we
should see the numbers for corporate profits begin to turn. We’ve had six
quarters in a row with profits down, but it’s looking like the estimates
are for the rest of the year to see double-digit growth. That should propel
equities.
At some point, if people have reasons to be confident —
there has to be a catalyst, though, maybe some type of peace between India and
Pakistan — after all, fear of fallout from nuclear bombs caught between those
two countries is a valid concern. The problem is for everyone. And similarly,
these warnings over these potential terrorist acts that we heard from the
Government a few weeks ago are still being digested by individuals. Once a
period of calm passes, God willing, I think we’ll begin to see the markets begin
to behave in the way they did before they began to decline in March. We have to
remember the recent decline began when the Israelis moved into the West Bank. So
I think there’s a connection there between tensions in the Middle East and
equity market performances.
Foreign Money Exodus
Still a Concern?
Kwong: To what
extent does the recent weakness that we have
seen in the market have to do with the foreign money coming out of the market?
You mentioned this in our previous conversation a few months ago. What’s your
take now?
Crescenzi:
I have a table to show the levels of investment
by foreigners over the last eight years in stocks and corporate bonds to show
how enormous it had been.
Right now, I think there’s
no question that in 2000, net foreign buying of US equities was about $175
billion. In 2001, it was about $120 billion. In the last 12 months, it’s about
$80 billion. So we’ve already seen a net reduction in purchases by foreigners of
$100 billion. We know what that feels like. It’s not like we’ve had sharp
liquidations from the foreign investor. We have to remember that the same
theories about foreign liquidations being tossed around now were being tossed
around in 1999 and 2000, before the bubble busted.
People said that when the
equity market faltered that people who had invested in mutual funds would
liquidate positions in large amounts. It never happened. You didn’t see mass
liquidation. That theory was for institutional investors. Here, people are
trying to say that institutional investors abroad, and again, most of the net
foreign buyers from institutions — people are trying to say that
these institutions will be big sellers — but it’s hard to imagine they would
be. There are too many reasons to continue investing in the US, particularly our
high levels of growth in productivity. That makes for a very good investment
environment. We’re still growing. We’re stronger than most of the world. We have
low taxes, low regulations — a very good climate for investing.
Kwong:
We’re probably best place in the world for
their money in the sense of where else are they going to put their money,
right?
Crescenzi:
Right. Japan? That’s not an option. And even
parts of Europe, with an unemployment rate at 9% and a Central Bank there that
does not permit growth to exceed the rates of growth that we see here because
they are afraid of inflation so much. So I think they will continue to stay with
the US market. Of course, they can reduce their investment somewhat. There will
be periods where there are bouts of liquidation but not large-scale
liquidation…
One important point, from
1985 when the dollar posted its last major high, between 1985 and 1982 when the
dollar posted its last major low, the dollar lost 50% of its value. Yet during
that period, the S&P gained 115% and with dividends reinvested, it gained
166%, so the dollar can decline and stocks can rally at the same time, again
because it’s beneficial to US companies because it makes our goods more
attractive to buyers so we are going to sell more goods throughout the
world. And that’s good news.
We’ve already seen exports
rise five of the last six months, up at a 7% annual rate. The previous twelve
months, exports fell 16% in the year prior, so we’re already seeing a positive
impact from the dollar having weakened and the increasingly positive
impact going forward, so investors should be thinking about buying companies
with high levels of export sales or capital goods stocks, for example.
Those depressed stocks should benefit from increased sales. Those stocks should
benefit from increased sales. Forty-three percent of all US exports are
in capital goods. So the Capital Goods sector will improve and, of course, in a
bet on the Cap Goods sector, you have to bet that US demand for goods will pick
up, and I think with profits likely to pick up with the economy doing well, it’s
a fair bet to make right now with prices down.
Kwong:
One thing I recall from conversations that you
and I had shortly after Sept. 11 was that a large percentage of the gross national product was based on the travel industry and
then we saw the impact right off. Have we passed
through the riskiest part of that phase?
Crescenzi:
Yeah, I think we’ve already seen airline
companies hire back a fair number of workers. The industry had lost about
100,000 jobs. They are likely to continue to add workers back. I mean you can
see they’re trying to raise prices and having difficulty…face=”arial, helvetica” color=#000000 size=2> that‘s
face=”arial, helvetica” color=#000000 size=2>an indication that the demand
factors are better. It’s just security issues are key.
Kwong:
I would imagine it’s a very sensitive sector
right now because a lot of things could trigger…
Crescenzi:
That’s why they’re weakening again. If you look,
there’s been a loss of clients since tensions heated up in the Middle East and
with tensions with Pakistan and India, it’s the same thing because people feel
that could disrupt the War on Terrorism and therefore hurt the airline stock.
But traveling is up, it’s just business travel that’s a bit soft still. It’s an
area of good pricing power for the airlines so, like I say, they will continue
to have problems for the rest of the year because of security concerns. I think
it’s not until the end of the year when certain other security measures get
implemented.
Kwong:
Then the risk factors of flying
decline…
Crescenzi:
The new people that are trained, the new
equipment that’s supposed to be in place I think by November, to detect bombs. A
lot of things that will make people feel more secure won’t be in place until
later in the year. So I think these issues will continue. The one good thing is
that energy prices have stabilized. Of course, I can see some companies have very
high fixed cost and this is one fixed cost that’s very
positive.
What The Yield Curve
Says About Stocks Now
Kwong:
Right now I want to touch on another one of
the points you just made last time we talked. We have a yield curve right now
which is very favorable to the stock market. In fact, I was looking at it the
other day and it is as steep as it was in 1994. We had nice run-up from
there.
Crescenzi:
That’s right. The yield curve has been
steepening. You’re right. It’s the steepest it’s been scolor=#000000 size=”2″ face=”arial, helvetica”>ince 1994. That then was on a declining trend. Let’s go back one
more period here. The last pattern in this we saw, it steepened from late 1989
until 1993 and of course that was because the Fed was cutting interest
rates during much of that period, and it helped the economy to emerge from
recession and eventually enter a period of strong growth. So the basic point is
that it’s steep because the Fed is accommodative and…
Greenspan’s just made this
statement, “This economy is showing resilience in the face of shocks.”
Kwong:
Greenspan
must have been listening to our conversation.
Crescenzi:
He said this recently. It’s interesting. I
wonder because of the weakness of stocks if he wants to sound positive today.
This is a comment he’s made before. So, yeah, the steepness of the curve
suggests the Federal Reserve’s policy stance is designed to aid the economy, and
it’s obviously very positive.
Kwong:
And you don’t necessarily see a kick to the
stock market right away, but from what I’ve seen, even when you look back at
different times through history where the yield curve steepens, it was against
the backdrop of very, very depressing events in the world, in politics, in the
economy throughout the world, yet somehow the economy responded to the favorable
environment that the Fed was creating, as did the stock market
eventually.
Crescenzi:
Well, that’s right. Sorry, hold it.
(Editor’s note: Tony now turns to some further breaking news on Greenspan.)
Greenspan’s now saying,
“The US is more sensitive than others to asset changes.” Let’s
take that positively. That means he recognizes that the stock market drop is a
problem potentially because our economy is more sensitive to it. That’s a positive. It
means he is telling us, “We’re going to support the economy because we realize
there is a negative influence here because of the recent drop in stocks.” So
that’s caused a little uptick in the S&Ps right there…
Just generally, I think
this yield curve has been one of the better indicators for decades. The yield
curve has been known to predict events as early as six months in advance, whereas
the stock market is somewhere around nine to 12 months, although these days I
don’t know if they’re predicting anything, it’s just pessimism. But the yield curve started steepening
a while ago.
Tony’s New
Book
Kwong:
I think that one thing that is very important
to the average trader/investor is an understanding of the big
picture because most people are just focused on their price charts…and they’re
reading the newspaper every day and they’re hearing all the horror stories out
of the Middle East. I want to talk about what you teach people in your new
book. Tell me about it.
Crescenzi:
The title is The Strategic Bond
Investor. I wrote the book with the idea that other bond books that exist
are too technical. That they confuse investors and they are too technical for
the average investor, especially those with very little knowledge of the bond
market. What I wanted to do was try to write a book that discusses simple things
in the bond market that people could understand and use when they make
investment decisions, simple things such as: How do you watch the Fed? What’s
the best way to keep an eye on the Fed so that you can make decisions about what
they might do next? So Fed watching is a key area, and a chapter on the Federal
Reserve.
I also talk about the yield curve — and how you can use
the yield curve, which has proven to be a better indicator than the stock market
and many other key indicators on the economy and the financial markets. How do
you use it to predict what’s next? I outlined that because that’s a very
fundamental thing I find absent from most bond books. They tell you what it is
and they get technical about it but they don’t describe what you can do with
it.
And also I lay out in the Appendix, for example, all the
major economic indicators released on a monthly basis described, how they are
computed, and how they affect the market. I think that’s a very useful tool
because we know economic numbers have a big impact on the markets and basically
show how interest rates have a very powerful influence on stock prices and on
everyone’s personal life, including when an individual household goes to obtain a
home mortgage.
Kwong:
Now even though your book is called The
Strategic Bond Investor, will it be of interest not just to bond traders, but
to the average trader like me and other members of our site?
Crescenzi:
That’s right, because they can use this
information to have a better understanding about how the bond market affects the
stock market, how economic news affects the markets, how they can use the
information, the market intelligence that you can get in the bond market and the
interest rate futures market, how to track bond market sentiment to glean
messages which are good for all markets because obviously the bond market has a
big impact on the stock market, so movement in bonds is instrumental to movement
in stocks.
One should have an understanding of what moves the bond
market and why it’s moving so they can understand what might be next for stocks
because to me, the bond market is the tail that wags the dog when it comes to
economic performance. Interest rate levels are key to economic performance.
Economic performance is key to stock prices.
Kwong: That
statement you made has a lot of impact. I think I’ll use “tail that wags the
dog” as the title of this interview. Thanks, Tony.
Crescenzi:
Thanks, Eddie.