Fire and Brimstone Begins to Sound Less Far-Fetched

James Grant, editor of Grant’s Interest Rate Observer newsletter in New York and one of the most eloquent voices on Wall Street, has had very few nice things to say about the stock market for years.

Many years.

So many years, it seems, that his name today is immediately associated with Wall Street’s version of fire and brimstone--plunging share prices, massive bond and bank loan defaults, despondent traders jumping from 50-story buildings, etc.

Yet Grant’s superbly written commentaries in the 1990s, mostly warning of the excesses he perceived to be building in stock valuations, failed to stop even many of his ardent admirer-readers from casting their lot with the roaring bull market. Which is probably a good thing, because following Grant’s advice hasn’t meant just leaving money on the table, but effectively torching it: In place of stocks, Grant has generally favored gold, which at $284 an ounce now has fallen by nearly a third since 1994.

“We have a paper trail,” Grant says of his commentaries, “but it’s not a profitable one.”

Thirteen months into Asia’s devastating economic crisis, however, Grant’s thoughtful and cautionary essays no longer appear so detached from reality. With stock prices in East Asia near 10-year lows, and the region’s economies in shambles, it seems prudent to at least have an appreciation for what can go wrong in financial systems.

Regarding the nearly 8-year-old U.S. bull market, now stumbling perhaps as much under its own weight as under other burdens, the 50-year-old Grant offers no prediction that the latest slide in share prices is the start of something much worse.

“The market can do anything,” he says, with “anything” clearly meant to include rocketing to new highs in the near term. “I’ve learned what I can’t know,” Grant, a great student of history, says with what sounds like genuine humility.

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Even so, he still believes that the U.S. economy is at endgame--the final stage of the wondrous cycle of disinflation and booming financial markets that began more than 15 years ago.

Grant sees the stage being set for a rise in inflation, probably not on the scale of the 1970s experience, but higher than today’s extremely low rates.

This “reflation,” Grant says, will result from global central banks (i.e., the Federal Reserve Board and cohorts) pumping huge sums into the banking system and thus lowering short-term interest rates, to halt what most people regard as a far more serious threat to the world economy: a deflationary cycle that could bring on depression.

Asia’s crisis simply can’t go on for another 13 months without dragging Europe and the United States deep into it, Grant argues. That is what jittery financial markets are saying today, he says, as Russia, Mexico, Indonesia, South Korea and other developing nations fight to stave off financial anarchy.

With sky-high interest rates in much of the developing world, “the needy borrower is being denied,” Grant says. “That is economic growth unfunded.”

Neither can the current global currency crisis continue without far more serious implications for the United States, he says. The dollar, he insists, can’t stand as the only monetary “brand” that investors are willing to own.

The way out, he says, is for central banks in Europe, the United States and elsewhere to make money and credit as easy as possible, to keep the global economy growing.

But wouldn’t lower interest rates be great for U.S. stocks and bonds? Not if investors see lower rates as a desperate effort to stoke the economy, Grant says.

What’s more, if markets begin to see that stoking as eventually leading to higher inflation--the classic monetarist view--the bond market’s reaction would be anything but positive, Grant notes.

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So far, of course, Grant’s theory seems to hold little water. Wasn’t Federal Reserve Chairman Alan Greenspan just saying that the Fed has no intention of cutting interest rates? Would the Fed chairman who warned about the potential for “irrational exuberance” in stock markets when the Dow Jones industrial average was at 6,400 in 1996 now agree to cut rates with the Dow at 8,425, and risk the market at least initially taking it as a tonic?

For Grant to be right with his beginning-of-reflation scenario, something probably must go seriously awry with U.S. markets and the economy over the next six months. But then, that would seem to suit Grant--who has written a book titled “The Trouble With Prosperity: The Loss of Fear, the Rise of Speculation and the Risk to American Savings”--just fine.

Even gloomier is David Tice, the manager of the Prudent Bear stock fund in Dallas and, like Grant, a well-known bear on Wall Street.

Look around, Tice says: Commodity prices are plunging, corporate earnings growth has slowed dramatically in the face of Asia’s woes and increasingly cutthroat competition, and consumer debt has ballooned in the 1990s to fund 1980s-style spending excesses (think 125% loan-to-value home equity loans).

All of these trends bode poorly for the U.S. economy and for the stock market, he insists, because they have the potential to exacerbate the deflationary winds blowing from Asia.

If American consumers and businesses become frightened enough--perhaps because of a continuing slide in stock prices--a deflationary recession, or worse, could ensue in a hurry, Tice insists.

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But wouldn’t the Fed then cut interest rates? It would, Tice allows. But he worries about the Japanese experience: Ever since the real estate and stock market bubbles burst in Japan in 1990, ever-lower interest rates have failed to restore confidence.

(It’s worth noting that in 1992, with U.S. short-term interest rates at 3%, there was growing talk that the Fed would have to cut rates to 1% or less because the weak economy didn’t seem to be responding fast enough.)

Like Grant, Tice favors very few investments today. “I think people ought to batten down the hatches and raise some cash,” he says.

He also likes gold, as does Grant. Other than that, Tice is shorting the U.S. stock market, betting on lower prices. It has been, so far, a terrible bet: His Prudent Bear stock fund has lost 22% this year alone.

Back to Grant: Gloomy as he sounds, he allows for other possibilities. For one, he says, even if he’s right about the long disinflation cycle (which has been great for stocks and bonds) giving way to a reflationary cycle (which would be not at all great for bonds, nor for many stocks), the lesson of the last cycle turn was that it’s a grinding process.

The rising-inflation trend of the 1960s and ‘70s, he notes, began to breathe its last in 1979, when Paul Volcker took over as Fed chief. But investors refused to accept the idea that inflation truly was ebbing until 1982, when stocks’ current super-bull-market was born.

“These cycles take forever” to turn, Grant says.

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Even so, he offers this history lesson: DuPont Co. bought oil giant Conoco in 1981, for $7.6 billion, when many smart people assumed that oil was going to $50 a barrel.

That was, instead, the peak for oil. DuPont, Grant says, would have been far better off in 1981 buying Treasury bonds, which then paid annual interest rates of 15.75% because many investors were convinced inflation would continue to rise forever.

Today, with oil near $13 a barrel, DuPont is seeking to sell Conoco--because there is little faith in oil prices ever accelerating again.

Instead, investors are happy to accept 5.5% Treasury bond yields, on the assumption that inflation is never coming back.

An interesting thought to ponder, even if you think Grant and Tice are living in fantasy worlds.

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Tom Petruno can be reached by e-mail at tom.petruno@latimes.com.