World Report     

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May 2000 by Bill Sterling

Do you remember when the world was supposed to end on January 1, 2000? Do you remember the forecasts of global recession or depression because computers were going to flick off all at once due to the dreaded Y2K bug? Do you remember the scare scenarios of people lining up at automatic teller machines that wouldn't work, then rattling the windows at banks worldwide asking for money?

You should, because it appears that the weird economic and financial dynamics associated with the Y2K scare may account for much of the violent turbulence in financial markets this year. The bad news is that this could go on for a while longer, testing our nerves as investors. The good news is that there are still plenty of reasons to be optimistic.

Here's the story: Governments and businesses took the Y2K story seriously for good reason. There was plenty of buggy computer code around that needed fixing. And in the financial arena, no one wanted to risk a good old-fashioned money panic created by bank customers yanking funds out of their accounts all at the same time. If you have ever seen the classic movie It's a Wonderful Life with James Stewart, then you have seen an old-fashioned bank panic in action. They are not so wonderful.

So, central banks around the world printed billions of dollars of crisp new banknotes to have around - just in case. There was nothing wrong with that, since the money mostly stayed in their vaults. But at the same time, the demand for "just-in-case" money by private financial institutions and individuals rose sharply. Central banks accommodated this by pumping huge amounts of "high-powered money" - fresh bank reserves - into the world's banking systems. Had they not done so, interest rates would have skyrocketed and potentially created just the type of financial turbulence they wanted to avoid.

Coincidentally, central banks also made it clear that they would be in no hurry to raise interest rates around year-end, despite their often-repeated concerns about potential inflationary pressures. As can be seen in Chart 1, the monetary bases of the United States grew explosively around the end of the year.

Millennium Madness

Perhaps not so coincidentally, something else grew explosively: the market value of the most speculative types of technology stocks traded on the Nasdaq market and its overseas counterparts. In the U.S., this was associated with explosive growth in the use of margin debt - good old-fashioned leverage - to finance trading activity. Margin debt in March of this year was up 78% from a year earlier, with most of the growth having occurred since last October - which was precisely when the Nasdaq took off. Signs of frenzied trading abounded.

Anyone with even a passing interest in the markets has been aware of the impressive performance of technology stocks until quite recently. What has been less widely appreciated is the remarkable - indeed truly shocking - degree to which technology stocks outperformed other stocks. As of March 10, for example, the Nasdaq Composite Index had risen by 110% from a year earlier (see Chart 2), compared to a rise of only 9% in the broader market, as measured by the Standard & Poor's 500 Index (S&P 500). To lapse momentarily into statistical jargon, the 101% performance advantage of the Nasdaq index represented a seven-standard deviation event. In other words, relative to historical patterns and normal statistical assumptions, that degree of outperformance could be reasonably viewed as roughly a one-in-a-million occurrence. In other words, it was even more rare then something you might expect to see, say, once in a millennium.

To be sure, there had been a great deal of positive news about technology associated with the ongoing growth of the Internet and for the potentially revolutionary impact of e-commerce. That said, such news had been building for several years and it is difficult to point to any fundamental information about technology trends in recent months that would justify a one-in-a-trillion market event.

Millennial Moves

In fact, the only truly shocking economic data one can point to in recent months is the surge in high-powered money, which by our reckoning was almost a four-standard deviation event in the U.S. and a seven-standard deviation event in Japan. With hindsight, it looks as if the folks in charge of the world's money pumps may have fallen asleep at the switch around the time of millennial festivities.

Focusing on the U.S., the issue now is that the liquidity surge has helped turn a strong economy into a booming economy. Domestic demand grew at an astonishing 8.0% annual rate in the first quarter of the year, while inflation rose at a 5.8% annual rate for the first three months of 2000. No one on Wall Street is talking any more about "Goldilocks growth" - not too hot, not too cold. Instead, it is widely anticipating that the U.S. Federal Reserve will be shifting to a more aggressive monetary tightening in coming months as its strives to tame the boom.

The fact that this is widely anticipated should be comforting since one can argue that it should already be fully priced in the markets. That said, the history of aggressive Fed tightening is replete with financial accidents, even when such moves were anticipated. The market fireworks of 1994 come to mind in this respect.

The problem when hyper-liquid markets become less liquid is that price moves can become discontinuous, resulting in huge volatility. In a market where one fund manager alone controls $100 billion of assets, the result of a single individual's impact on market prices can therefore be enormous.

Research by financial economists has shown that a change in volatility is often a leading indicator of market declines. The logic is simple: If markets become more volatile, investors will demand higher returns to put up with the risk. The only way to be assured of higher future returns is to take prices down. Since by some measure, intra-day volatility in the U.S. market has reached a level not seen since 1937, risks have clearly risen. And if the surge in Nasdaq was primarily related to the Y2K liquidity surge, as opposed to fundamentals, a correction back to even the top of its historic ratio with the S&P 500 would imply a Nasdaq index level of about 2,500, or a third lower than the level at the time of writing. There is no guarantee that this will happen, but there is also no guarantee that it will not. The message from the high-volatility markets is: caveat emptor.

New Economy Inflation Outlook

So much for the bad news. The good news is that we believe there is little reason to fear a sustained surge in inflation that could usher in a long-lasting bear market. Instead, we are more concerned about the near-term effect of the medicine the Fed will use to stop inflation in its tracks.

Not only can the Fed be counted on to curb inflation, we expect that it will be assisted in this by the fact that roughly 40% of growth in recent years has been from New Economy industries, where costs have tended to fall even as demand has surged.

To get technical again, such industries tend to be characterized by declining costs - which is not quite what most of us learned about in our basic economics classes. As shown in Chart 3, in industries like semiconductors and telecommunications, increases in demand may usher in lower prices - not higher prices - as firms benefit from economies of scale.

A great example is the pharmaceutical industry, where the cost of the first pill may be $350 million, due to fixed research and testing costs (see Chart 4). But once that fixed cost is paid for, the cost goes down dramatically as more units are sold. Likewise for software: It's very expensive to produce a new software product, but each additional copy of software costs next to nothing.

The bottom line is that once the Fed wrings excess liquidity out of the system, the stage should be set for continued growth in the range of 3 to 4% with low inflation. That's not a bad outlook.

For now, we remain cautious and have taken advantage of the recent rally in markets to reduce our equity position in the C.I. International Balanced Fund. We are now running our balanced funds at a target of 45% equity and 55% fixed income. We are also running above-average cash positions in the C.I. Global Equity Fund.

It's a very simple view: Don't fight the Fed - especially when the Fed is dealing with a genuine Y2K problem.