-->Bubble Revisited

The Daily Reckoning

Baltimore, Maryland

Wednesday, 4 June 2003

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*** Not much chance of deflation. Don't worry about
inflation either, says Fed head.

*** Money supply soars. Mortgage bubble. Home prices rise
on record sales. Record low yields...More
unemployment...and underemployment

*** Poor Martha Stewart...And more!

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"There is a very low probability of deflation," said Alan
Greenspan in Berlin yesterday. (But the Fed chairman hinted
that he might cut rates again, as"insurance.")

"The chances of inflation reemerging in the near future are
quite small," said the same man on the same day in the same
place.

So you see, dear reader, there is nothing to worry about.
Nothing at all. After 30 years of the Dollar Standard, we
have finally reached a kind of monetary perfection. An
economic Valhalla. The Elysian Fields of finance.

Heh...heh...

We can almost hear Eisuke Sakakibara cackle.

Japan's former Finance Minister recalls a similar time,
about 10 years ago, when his dynamo economy seemed to be
getting back into the swing of things after the stock
market tumbled. Back then, he must have been confident,
too. As near as anyone could tell, he and his cronies were
making all the right moves. Interest rates were lowered.
Liquidity was added. Government spending was boosted.
Inflation was low. Bonds boomed...and stocks rallied. Just
like the U.S. today.

But making money and credit more readily available didn't
refloat the Japanese economy. Instead, the extra money
piled up on the decks and capsized it. Rather then throw
them overboard, bad investments and bad companies were
given mouth-to-mouth resuscitation and kept alive. The new
money merely added to capacity - which drove prices lower.

Bonds boomed again yesterday in America. Yields fell to
record lows. Thirty-year treasuries were priced to yield
only 4.36%.

If inflation rates rise significantly, bond investors will
be wiped out. Just as they were in the '70s. But, like
Greenspan, they see no threat from inflation.

On the other hand, if inflation rates slump into deflation,
stock market investors will be wiped out. Consumers will
stop consuming. Borrowers will stop borrowing. Companies
will lay off employees. And profit-making corporations
whose stocks are traded on Wall Street will have fewer
profits to show investors. But, like Greenspan, stock
buyers see no menace from deflation.

Meanwhile, the money supply soars. M1 - cash plus checking
accounts - is increasing at a 30% rate. M2 is rising at
about the same rate. Dollars bulge from vaults and
mattresses all over the world.

Maybe Mr. Greenspan will be wrong about deflation. Or maybe
he will be wrong about inflation. Or maybe he will be wrong
about everything.

While we wait to find out, here is the latest from Wall
Street, brought to you by Eric Fry:

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Eric Fry in New York...

- Poor Martha Stewart; she may be heading off to jail
without a supply of"400-stitch percale" prison dungarees.
TV's Duchess of Decorum is engaged in a very"mussy"
criminal investigation and, rumor has it, faces an
indictment in the near future. Her company's stock, Martha
Stewart Living Omnimedia tumbled as much as 19 percent
after the unseemly news crossed the wires.

- Like sour milk in a crème brûlée, the distasteful news
about Martha Stewart seemed to"ruin everything" for
investors yesterday morning. But like any capable
homemaker, investors wiped the tears from their eyes and
salvaged the day as well as they could. They bid the Dow to
a 25-point gain at 8,923, and whisked the Nasdaq to a 13-
point advance at 1,604.

- Investors also resumed nibbling on government bonds. The
10-year note's yield dropped to 3.33% from 3.41% on Monday.
The dollar advanced slightly against the euro to $1.173,
while gold retreated 80 cents to $366.30.

- Yesterday, we asked ourselves,"How confident - or
nervous - ought the nation's homebuilders feel?" To judge
from the nation's unemployment trends, homebuilders ought
to feel nervous...very nervous. (Making matters worse,
Martha's Stewart's homes might soon be on the market).

- Yesterday, Alan Greenspan, himself, admitted that the job
market has yet to show consistent signs of improvement. Of
course, it's no secret that the nation's employers are
continuing to shed jobs at a furious pace - 525,000 non-
farm payroll positions in the past three months alone. Over
the last two years, 2.1 million jobs have disappeared from
U.S. payrolls.

-"The total number of people unemployed - including
discouraged workers who would prefer to work, but have
stopped looking - is about 9.2 million," the Hartford
Courant reports."And the number of people who are working
part-time because they can't find full-time work is 4.8
million, up 46 percent since 2001, according to the Bureau
of Labor Statistics."

- And the job search isn't getting any easier. The
Conference Board's Help-Wanted Advertising Index - a key
barometer of America's job market - declined three points
in April. The Index now stands at 35, down from 38 in
March. It was 47 one year ago.

- Not surprisingly, therefore, the average search time for
re-employment has been on the rise for seven consecutive
quarters. The average search time stretched in April to a
17-year high of nearly 20 weeks - that's up from about 12
weeks in early 2001.

-"Clearly, businesses have been busy laying off workers
and scaling back already greatly reduced plans to hire,"
says Conference Board Economist Ken Goldstein."If the
overall economy remains weak heading into the third
quarter, a return to job growth earlier than the fourth
quarter doesn't seem likely."

- These grim employment statistics issue forth from an
economy that emerged from recession 16 months ago,
according to the nation's fully employed economists...And
yet, the housing market booms.

- So far, generation-low interest rates and easy bank
lending practices have combined to support housing prices.
But job growth would be a welcome addition to the mix.
Unfortunately, unless the hundreds of thousands of laid-off
autoworkers and manufacturing employees can find gainful
employment as economists, the housing market may run low on
eager and capable buyers.

- Making matters worse, high-paying manufacturing jobs
continue to disappear at a rapid clip. According to the
Bureau of Labor Statistics, there were 62,429 mass layoffs
in the factory sector in April, up from 50,897 in April
2002.

- However, there is a ray of hope on the horizon - you see,
we ALWAYS try to look on the bright side of things here at
the Daily Reckoning, even if we don't always find it. The
number of ANNOUNCED layoffs by U.S. employers fell 53
percent in May, the lowest level since November 2000,
according to outplacement firm Challenger, Gray &
Christmas.

- Maybe there's hope for the housing market after all.

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Back in Baltimore...

*** House prices are still rising. In the first quarter,
they rose at a 6.4% annual rate - the smallest rate of
increase since 1999. Home sales are hitting new records. So
are home mortgages. Fannie Mae says this year's total is up
42% over last year - to $3.7 trillion.

*** Home prices and apartments are rising in Argentina,
too. But they've got a long way to go. A colleague reports
he just bought two very nice apartments in one of the best
areas of the city - one for $169,000, and another for
$200,000. In Paris or New York, apartments like these would
easily sell for up to $2 million each.

"Argentina won't be this cheap for very long," opines our
friend Leif Simon - who, as editor of Global Real Estate
Investor, has spent time scouring the Argentine market for
bargains in the wake of their currency's collapse. Leif
says he has seen first-hand that prices have started to
rise...and believes Argentina will see as much as 100%
advances over the next three years.

*** Editor's Note: If you're at all interested in buying
deep-value property in Argentina, you may benefit by
participating in a"conference call" scheduled this
afternoon at 2:00pm EST, organized by the Diligence group.

Participating in the call will be Dr. Steve Sjuggerud, who,
if you've been following his comments here in the Daily
Reckoning, you may know has been following the Argentina
situation very closely for the past 3 years. Lief Simon
will also be in on the call, as well as Paul Reynolds, the
head of the top residential real estate firm in Argentina.

They'll be talking to the directors of a company that owns
over 50 developments in the capital city of Buenos Aires.
(It owns all 6 of the major shopping malls in the city. And
almost all of the residential and office towers there,
too.) Millennium Partners, a consortium of some of the
world's best investors, bought a $150 million stake in the
company...the shares of which can still be purchased on the
NYSE for under $10.

This conference call is, of course, reserved for Diligence
members. But if you're interested in participating -
remember it's today at 2pm EST - please follow this link.
You'll also learn more about the work being done by the
Diligence group:

Deep Value in Argentina
http://www.agora-inc.com/reports/DIL/WDILD616

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The Daily Reckoning PRESENTS: Is a long-trusted indicator
in the bond market signaling economic recovery...or are
investors just"groping for yield"?


BUBBLE REVISITED
by Eric Fry

"Yield spread" sounds like something you might smear on a
toasted bagel, but only if you were really hungry. It's
not.

Yield spread is simply the mathematical difference between
a specific kind of bond and a treasury bond of the same
maturity. For example, the yield spread between a 10-year
corporate bond yielding 5% and a 10-year treasury note
yielding 3.5% would be 1.5%, or"150 basis points over
treasuries."

Generally speaking, yield spreads narrow ("tighten") during
strong economic times and widen during recessionary times.
That's because fixed-income investors become more confident
in low-rated credits during boom times than when times are
tough...and Treasury bonds lose their safe-haven appeal. As
a rule of thumb, therefore, most investors consider
tightening yield spreads to be both a coincident indicator
of economic growth and a harbinger of growth to come.

Lately, yield spreads have been tightening. So...is this a
harbinger of growth to come? Or is it merely the result of
yield-hungry investors buying up riskier bonds in a"grope
for yield"?

ContraryInvestor.com offers a compelling argument in favor
of the latter interpretation. In other words, just because
yield spreads are tightening, don't think that economic
recovery has arrived.

Historically, yield-spread differentials widen during tough
economic periods, because there is often an accompanying
flight to the perceived quality and cash-flow safety of
U.S. Treasurys. This naturally bids Treasury prices up and
yields down.

Over the past few years, the fixed-income markets have
witnessed some very wide - even extreme - spreads between
the yields on Treasury securities and those on main-line
corporate and high-yield debt. The yield spread between
Moody's Baa-rated corporate debt and the 10-year Treasury
peaked late last year at a level not seen since the early
1980s.

However, the spread between Moody's Baa note yields and 10-
year Treasury yields has contracted by 75-plus basis points
since late last year. Over the last six to seven months,
yield spreads between what is considered risky debt and
safe U.S. Treasurys have continued to contract...during a
period in which U.S. Treasury yields have also continued to
decline to levels seen maybe once in a generation.

Which brings us to a very important question for those
trying to read today's financial markets. Does the"yield-
spread" contraction truly signify a better economic
environment ahead? Or are investors - shocked by the low
absolute level of yields available in safe fixed-income
investments - simply"chasing yield" in higher-risk
securities?

What do we look for when trying to get a sense of whether
collapsing credit spreads are correctly forecasting an
economic recovery, anyway?

Consumer spending patterns are a good place to start. If
indeed the economy is shaping up, consumer spending on
discretionary items should also improve. Unfortunately,
recent retail spending and retail-sector corporate reports
leave little to be cheerful about.

But in addition to watching consumer spending, we should be
keeping a pretty sharp eye on commercial lending
activities, too.

A recent commercial-bank survey of senior loan officers
revealed that these officers have significantly relaxed
their standards for making loans relative to their 4Q 2002
responses. But the big question for banks is whether they
are relaxing corporate lending standards because they
genuinely believe that corporate credit quality, and
general economic conditions, are improving...or instead -
as we're tempted to believe - because the pressure to grow
their top lines is so great, they're willing to lend more
freely just to achieve some growth in their own businesses.

Commercial-bank lending to corporate borrowers peaked on an
absolute dollar basis in February 2001. As you might guess,
it took the bankers a little time to get comfortable with
the idea that the party on Wall Street and in the real
economy was ending. Since then, it has been straight
downhill in terms of bank-sponsored corporate loans
outstanding. Total corporate loans outstanding have dropped
by 14%-plus, or $156 billion.

On a year-over-year rate-of-change basis, this cycle's
contraction in commercial-bank corporate lending has no
precedent in at least two-plus decades. But if the
tightening of credit-market yield spreads really
foreshadows an economic recovery ahead, we should at least
be seeing bank lending to corporations beginning to turn
up.

As the Fed and the U.S. non-bank credit system throw the
liquidity levers into hyper-drive, the yield curve is
flattening - not an environment in which the banks can
simply coin money by buying bonds with their deposits and
then take the rest of the day off. In essence, by
accommodating supercharged liquidity in the system, the Fed
is forcing the banks to lend if they want to grow their
revenues...And yet, corporate lending is falling!

The biggest reason of all why yield spreads are contracting
may be that mom-and-pop America is simply starving for
yield. Diligent savers across the U.S., dependent on
interest income for their living needs, have seen their
incomes destroyed over the last three years. And because of
the need for adequate absolute return, folks are clearly
"reaching for yield" in the current environment.

Inflows to American bond mutual funds help explain a lot of
what is happening with credit spreads. As of this writing,
$63 billion has come into bond mutual funds so far this
year - a record figure. Meanwhile, equity funds have taken
in only $2 billion, and money market funds have seen a $29
billion outflow.

Like equity-fund managers, bond managers also feel
performance pressure - in this case, one basis point at a
time. The higher bond prices go in the short term, the more
these managers will surely feel the pressure to become more
fully invested.

Clearly, it's taken the public a good while to"find" bond
funds. And they are doing their best to pile in at what are
multi-decade lows in terms of yield. Main Street is chasing
yield with what seems like little regard for credit quality
or longer-term interest-rate risk. In addition to the
accommodative environment fostered by the Fed, Main Street
is also feeding the bond market monster.

Add to the mix that foreigners are still financing the
massive U.S. trade deficit by snapping up dollars. And in
many cases...like, say, Japan...they're ploughing them into
U.S. Treasury bonds.

The resulting situation in today's fixed-income market
bears an uncanny resemblance to that of stocks in late '99
and early 2000. After all, everyone chasing an asset in
simultaneous fashion is what usually characterizes a mania,
right?

If these parallels hold, tightening credit-market yield
spreads won't be helpful at all in predicting an economic
recovery. But one thing they may help to predict is a
bubble top - this time in credit-market debt.


Warm regards,

Eric Fry,
The Daily Reckoning