Traders Interview: Tony Crescenzi Talks With Eddie Kwong
The smoke from Sept. 11 is clearing, and emerging from it is a picture that, so far, has defied the pessimists and the bears. What are the positive signs? What are the troublesome spots in the economy that still need to be overcome? Trader and bond strategist Tony Crescenzi puts together the macroeconomic, psychological, and technical clues in this interview with TM’s Editor-in-Chief, Eddie Kwong.
What The Markets Are Telling Us
Eddie Kwong: Tony, many events seemed to have been compressed within the small space of two months since that terrorist attack. What do you think the impact of the attack will be on productivity and growth?
Tony Crescenzi: Well, for one, I mean, clearly the events of Sept. 11 have harmed the economy. The travel industry, for example, is about 7% of the economy, and that part of the economy will probably be declining about 20%, and if you do the math, 20% of 7% is a 1.4% hit from travel alone. Now, some of that money will get spent in other areas, a little bit of substitution, but the hit from the travel industry is probably 1.0% of GDP, so it’s very sharp.
But the markets are telling you that things will get better. I think one thing that really has worried the markets recently is that the events would affect the consumer psyche for long periods of time. I felt from day one that the biggest impact of Sept. 11 on the consumer would be on the way it would raise the level of fear and anxiety in the nation. And that fear and anxiety would obstruct normal spending behaviors in consumers and, hence, businesses.
And that has been the case. We saw a disengagement in spending in a lot of ways, but it seems like the high levels of fear and anxiety are abating, and that would allow the normal forces, cyclical forces and monetary and fiscal stimulants to work their magic. And that’s why the markets are starting to behave the way they are, because they believe this main obstruction, this high level of anxiety and fear, is dissipating.
A Revised Outlook
Eddie: Many analysts came out and said very shortly after the attack that this would throw us into a prolonged and deep recession. You expressed that opinion at the time. Has your perception changed at all?
Tony: Well, yes. I felt that early on that we would likely have entered recession. The third-quarter GDP was reported down .4%. The data to date indicates that number will be revised down to a .6% or .7% drop. We’ll find out next week, Nov. 30. And the fourth quarter, it looks like GDP will drop somewhere between 1.0% or 2.0% or so, so the forecast that we had entered recession at that time, I think is still a valid one.
What’s changed, and something I noted back then, is that the economy, I felt, wouldn’t rebound until there was a sense that the crisis was defused. And clearly, with the string of military victories we’ve seen in Afghanistan, I think people do sense the crisis is being defused, also practically speaking, through the airline security bill and various other measures, the financial measures and many of the other measures put into place by the government are defusing the crisis day-by-day. And the fact the coalition against terrorism has stayed together, and luckily, thank God, there have been no other terrorist acts, the public is, in a sense, getting over it. And this mental health is being restored to pre-Sept. 11 levels.
One good example of that is just looking at the topical humor. It returned weeks ago, I had noted. Mud-slinging in politics had come back, which is a good sign, in a sense, because it tells you that they’re less worried about the repercussions on them politically.
Eddie: It just goes to show that the markets are very dynamic and you have to continually reinvent your opinion and outlook. It’s not just the analysis, it’s the adaptation to the “here and now” that’s key.
Tony: Absolutely. The most current information. This is why I always tell people one of the best things they can do is get their hands on as much anecdotal information as they can. Sometimes, the government news is just going to be too late. We’ve yet to see any information from the government, really, that would tell us that things might be set to turn, but what we have seen, and we can look at surveys and so forth, you’ve been able to detect incremental improvements in the way people feel mentally about the way the crisis is affecting them and their personal security. You see it in the way people are behaving and going to restaurants and entertainment venues if you follow these things.
Early on, I was looking at attendance at baseball games, for example, and attendance at Broadway plays. You have to change your way of operating constantly. I have never before looked at things such as traffic flow at restaurants and entertainment venues and so forth as key gauges of the economy, but I felt that’s what was required at the time in order to gauge the level of fear and anxiety in the nation. And I’ve also resorted to following the air traffic and other travel-related data.
How Unprecedented Fast And Steep Rate-Cuts Stage For Faster Recovery
Eddie: Are we seeing then the potential for more of a “V”-shaped recovery to this recession, as opposed to the dreaded “U”-shaped recovery? I guess you could play devil’s advocate and look at the historical argument. Mark Boucher has said that over the past 100 years of data looking at past stock market/bull markets, that the longest bull markets tended to be followed by the longest recessions, and that the return off the S&P 500 has been negative, or at best flat, after the longest bull markets we’ve had over the past century. So, for us to make a quick recovery, which is what we all hope would happen, that would set a precedent. Do you think that that’s conceivable?
Tony: It’s quite possible. What would make a “V”-shaped recovery possible here, even though history tells us to expect otherwise, is that the Fed has done extraordinary things in respect to cutting the short-term interest rate. The Fed has brought the fed funds rate to below the inflation rate. When the fed funds rate is below the inflation rate, that creates an incentive to invest rather than save because if an investor today would reap the savings rate of just about 2.0%, which is below the inflation rate, arguably, or at least equal to the future inflation rate, and when you subtract taxes, there’s a negative rate of return there.
An investor’s motivation then is to go out and invest in long-term assets like stocks and corporate bonds and in the real economy because their capital is being eaten away by inflation if they simply save the money.
Plus, we also have a very strong banking system. In past recessions, the rebound wasn’t as vigorous in 1991, for example, because the banking system was in tatters. Here, the banking system is very strong and would facilitate a “V”-shaped rebound. The capital is there and the willingness of the banks to lend would be there in a case where they felt the economy was poised to rebound and thereby increase the credit worthiness of their customers. So, that would be a powerful force.
Eddie: Has the Fed ever done anything like this before–made such a drastic cut in interest rates in such a short period of time?
Tony: No, they haven’t. Look at history. In 1990-1991, the fed funds rate got down – was as high as 9.75%, but it took the Fed over three years to bring it down to 3.0%. Sure, that was a big drop in terms of total decline in the interest rate, but it took the Fed three years to figure out that the equilibrium interest rate level was 3.0%. They should have realized that more quickly. The Fed back then cut rates a quarter of point, I think, about 17 times. Here, they’ve cut rates much more drastically and much more often, so this is unprecedented, in terms of the speed with which they brought the fed funds rate down to what is likely to be the rate that motivates the savers to go out and invest.
Eddie: Many people are picking out similarities between our current bear market and the one in 1974. Are we decoupling from that scenario? And what about 1981-82? Can you sort of take us down memory lane and tell us the extent to which we can still use history as a guide?
Tony: Now, going back to the prior recession, 1981-82. That was also an unusual situation. We had an extraordinary situation with respect to inflation. The Fed was wringing out inflation, which had gone to double digits, and interest rates had gone as high as 21%, the prime rate was 21%, and the interest rate level, even though it was brought down slowly but surely, it was not brought down quickly, as it was here. Even as it was brought down, the levels were still inhibiting economic growth because they were simply too high. That’s another case where you can’t make comparisons. We had an oil shock a couple of years prior that had produced the recession, in part because of the high levels of inflation. We don’t have an inflation to wring out, so that means that in this case we were able to lower interest rates faster than they were able to in the early ’80s, and that’s why that recovery was slower because they had to keep rates up for a while to wring out rampant inflation.
So, there, and in 1980, which was the prior recession to the ’81-’82 recession, same story, there was an oil shock the year prior, so the Fed was wringing out inflation by raising interest rates sharply, and they were unable to bring down interest rates. So you’ve got three recessions right now where you can’t make comparisons.
Then go back to the prior recession, ’74-’75. Again, a shock-induced recession related to oil. Again, a situation where the Fed was unable to bring down the interest rate level in the way that they were able to here. So, you can look in more modern times, the last 30 years and point to four recessions where the response by the Fed was slower, where the banking system was in weaker shape.
I should add one other key thing: We were not in the midst of a productivity boom in the ’70s or the ’80s, and that made it less likely that we would rebound vigorously. Productivity booms and busts have averaged about 21 years over the past 100 years according to data from the Fed, and this most recent boom only began in 1995, and those past recessions all occurred during a period of very slow productivity growth, and it’s widely felt that this productivity boom has a ways to go.
What Is Motivating The Fed Today?
Eddie: If the frantic manner in which the Fed has lowered interest rates recently is intended to stimulate investment, does that mean they are looking trigger a recovery in the stock market? About a year ago, you said that the Fed isn’t simply going to lower interest rates to stimulate the stock market. Does that play at all into what the Fed has done here?
Tony: Some of the Fed’s language recently in their statements and in the minutes of their meetings seem to suggest that they’ve become more worried about stock prices and the negative effects of that. I still believe, though, that the Fed, because it’s still led by Chairman Greenspan who is very much in favor of free markets, I think the Fed still would rather see stock prices move up because of expectations regarding corporate profits. The Fed can affect that, of course. By lowering interest rates, they would boost the perception that corporate profits would increase. So, it’s an indirect correlation between the Fed and the stocks. They’re not trying to push stocks up. They are trying to create an environment where investors might believe the factors that cause stock prices to go up will. So, I think the Fed, nearly 100% of the decision is based on what they want to see happen in the economy, and what happens from that is really up to the investors. The Fed doesn’t want to get in the way.
Think about it. They are a group of 12 individuals making important decisions. But as the Fed has said, and Greenspan specifically, “Who are they to put their judgments up against the judgments of millions of investors?” They should not be the ones to make a judgment about where stock prices should be. Millions of investors are.
Eddie: Makes sense. Now what about this fiscal stimulus package that seems to be going to Congress right now. I’m supposing that if that gets passed, it will further give us a boost.
Tony: It should. Now one key that we have to look out for is to what extent the stimulus package is skewed toward investments rather than consumption. The more it’s skewed toward investment, the more investors will be optimistic about the impact of the package because consumption-related stimulus, historically, has proven to have less impact than stimulus related to business investment. Consumption has less of a multiplier effect.
For instance, if a business decides to purchase additional product-enhancing equipment, that purchase will spark improvements in industrial production. It will spark increase in productivity. Increases in productivity lift corporate profits, and as corporate profits increases, that spurs more spending, which, of course, spurs more hiring and income growth. It creates a virtuous cycle.
Whereas, spending doesn’t stop. There is an impact. There is a positive effect, but it’s not nearly as positive because it doesn’t affect productivity as much as business spending would, and that’s a very important element in terms of profits, hiring plans, and hence, it’s called the virtuous cycle.
So what we’re hoping for is that more than half of the stimulus will be skewed toward business investment and the rest toward individuals.
The Signs In Sector Leadership
Eddie: I know that you pay a lot of attention to sector rotation, and the leadership of the sectors is kind of an indication of what phase of the economic cycle we’re in right now. What’s your read on sector leadership? Larry Connors had made the observation that we’re seeing non-recession-type stocks take the lead right now. What do you see?
Tony: The behavior of the various sectors suggests that the investors are looking for an economic rebound. The cyclical stocks are performing well. Companies that have been suffering more than any others, in the basic materials industry, for example, that’s an industry that continues to do poorly in terms of the actual economic performance, yet these stocks in the papers, chemicals and metals have been roaring. They’re above the Sept. 10 levels more comfortably than many of the other areas, and this is an area that I’ve seen no evidence of improvement in the economy yet for them. The transportation areas that you’d expect to do well when the economy performs well are doing well.
And again, these are areas where there are no signs of improvements in the companies themselves. It’s all on expectations. I’m looking at the S&P Rail Index. Currently, it’s at 592, and I’ve got that as low as 460 on Sept. 20. It’s roughly at its highest level in four months. It’s much higher than its Sept. 10 close at this point. This is an area that I’ve seen no real improvement in rail traffic, sure an increase over and above the levels it was at in the aftermath of the tragedy, but these sectors tell you that the market believes there will be a recovery.
This is what creates a little bit of a risk because you know then in these areas where there’s been no economic improvement yet, when the improvement comes, it’s already priced into it, and that makes it tougher to really build on a rally right now without there being some actual evidence of a rebound. So, that’s a reason to be a little bit cautious about buying some trends at present. I think you have a good case in buying weakness simply because the basis for a recovery in the economy is in place with the reduction in fears and anxieties, with the stimulus from the Fed and from the government, and from cyclical forces, like low inventories and low inflation and so on. But buying on strength will require, I believe, more evidence of a rebound before people get too excited.
What Sentiment Says
Eddie: Tony, a bear reading this interview would say, the conditions of extreme pessimism have not yet been met for a bear market bottom to have been made. We saw extreme pessimism in September but it seems to have largely abated. What is more typical at bear market bottoms is a long-term hatred of the stock market. It is hatred that lingers because people have been hurt so badly and it takes them a long while to come back. Are we seeing optimism return too quickly here to play the contrarian card?
Tony: You know, one thing, it’s true, you mentioned people will remember the most recent experience in stocks, and between the recent drop and the drop in 2000, the busted bubble, the equity risk premium is no doubt higher. Investors are attaching more risk to stocks than they would have two years ago. But that’s what will keep it in healthier shape, and there will be no excess.
One sign of that, just as an example, margin debt has been cut in half from its peak set in 2000 right before the market caved in. It was at $280 billion. It’s down to about $144 billion or so currently, and there’s been no sign in any increase, so I think the speculative fervor is gone, and it’s a good thing, in the sense that there will be less fraud, so the prices you see you can pretty much trust that they’ll stay within the confines of a normal range without the risk of a huge move, barring unforeseen events.
Eddie: I guess further shocks are certainly possible, and we hope they don’t happen, but it appears we’re on the right track right now.
Tony: It is. Everything has converged to a point where the elements are now in place for a pretty quick rebound next year, starting slowly at the start of next year and getting more vigorous with time. And I think the primary influence will be the lower levels of fear and anxiety will further dissipate, all of the cyclical forces, the Fed, the fiscal stimulus will converge and produce a strong rebound. And the strong banking system will help permit that.
Indicators To Watch Going Forward
Eddie: What indicators or quantitative measures should we be watching over the next several months? I suppose one indicator would be the stock market itself.
Tony: Yeah. Right now, you mean just to gauge the economy? Or the markets? Or both?
Eddie: Both.
Tony: All right. Well, to gauge the market’s mood, one thing I’m looking at is the spread between the corporate bonds and treasuries. I quote it often, and it’s on their website, Standard & Poor’s Speculative Grade Credit Index measures the performance of junk bonds relative to treasuries. You can also just look at AMG data on inflows into junk bond funds, which recently posted the biggest increase since January 2001, because the more money that flows into junk bonds, which are about the riskiest financial assets, the more that tells you that investors are becoming less risk averse. That’s a sign that they see strength coming in the economy, so that’s a key indicator.
I’m still watching things like steel production for an actual improvement in the economy. There’s been a slight improvement. It’s just not been substantial yet. This is put out by the American Iron and Steel Institute. It’s available on Bloomberg – Raw Steel Production and Capacity Utilization is released every Monday. So, steel production to gauge the industrial sector, and whether there’s a rebound in manufacturing activity.
Consumer Spending, of course. You want to gauge retail sales every Monday – it’s 2/3 of the economy. Any analysis of the economy requires a close look at that. You can get information from Wal-Mart, Federated, JC Penney, Sears, K-Mart and Target on a regular basis. You can call Wal-Mart every Monday at 9:00 a.m. ET and know what sales were like through Friday. How more current can you get? So, I do that.
We should also continue to watch air travel. Air travel will tell you a great deal about the public’s level of fear and anxiety. Also, watch the news, watch to see if Afghanistan continues to be the top story or not. The newspeople know what the people are interested in. And the less time spent on terrorist-related news, the more that indicates that the public is just not interested. And also, the news organizations put out polls on whether people are concerned about it. I follow the news polls closely for information on the public psyche. If people are having trouble sleeping at night, is there depression? I’ve been citing things like that as evidence that things are changing recently.
Eddie: By the way, how’s your book coming along?
Tony: They want it by Dec. 14, and it looks like I’m on track for that. This week, with Thanksgiving, I expect to get a lot done.
Eddie: What’s the book about?
Tony: It’s for all investors, not just bond investors. It’s got basics about the bond market and how to use information from the bond market to make forecasts about the economy, the stock market. It’s got a section on the yield curve, and how you should use the yield curve to make forecasts on stocks and the economy. Real interest rates are also an important thing. Just a lot of little basics that I think people don’t use. It’s not just for bond guys. That’s the whole idea. How you can become a better Fed watcher, credit ratings, how they’re defined, how they come up with them, which is important for stock plays, too, because they have credit ratings on companies, obviously. There will be something in there for everybody. It’s like a handbook on all the economic data, how they come up with each report, the methodology, how it affects the markets, both stocks and bonds, how it affects an individual. It’s a handbook that I think people will find useful on those numbers.
Eddie: Well, we look forward to seeing in early next year. In meantime, have a great holiday.
Tony: You too, Eddie