As Ben Bernanke makes his first appearance before Congress, it is useful to ask just what his reputational legacy be.   My bet is that he will soon be the most despised Fed chairman in modern history.  

Ironically, this will be his fault.  Rather, he will simply be the “fall guy” for intractable problems created by the Bush Administration and departed Alan Greenspan.  History helps teach us why this may be so. 

During the 1960s, William McChesney Martin would forever establish the Fed’s independence.  He steadfastly refused to accommodate the financing of the Vietnam War with easy money – and wound up having as much to do with Lyndon Johnson’s fall as any massive war protest.

In the 1970s, Arthur Burns was as shamelessly political as Martin was deeply principled.  To get his benefactor Richard Nixon reelected, Burns turned the Fed into a 24-hour “printing press.”   Part dope, part dupe, he thereby set the stage for a virulent double digit inflation and wound up leaving almost as shamefully as Nixon.

In 1979, Paul Volcker was conscripted by President Carter to clean up Burns’ mess.  He would not only be the tallest chairman in history.  He would also be its most doctrinaire.  Under the Monetarist banner, Volcker set monetary growth targets to purposely trigger the most severe recession since the Great Depression.  His mission – ever so painfully accomplished at Carter’s expense– was to wring every last drop of inflation out of the economy.

Enter the “Maestro” Greenspan in the booming 1980s.  Greenspan quickly won the public over with a sharp burst of liquidity that minimized the damage of the 1987 Black Friday stock market crash.  A decade later, he worked the same magic for the 1997-98 Asian financial crisis and forever established himself as the ultimate crisis manager.  Today, however, Greenspan, together with President Bush, have left Ben Bernanke in one of the most difficult positions ever assumed by any Fed chairman. 

The Housing Bubble: It is no small historical irony that after purposely pricking the speculative stock market bubble in 2000 with a series of punishing rate hikes, Alan Greenspan refused to face the recessionary music.  Instead, in a post 9/11 ultra-easy money panic, he created what is now a far more dangerous housing bubble. 

In this easy money era, Jiminy Cricket consumers used serial mortgage refis to turn their homes into ATMs, spending far beyond their wage incomes.  Now, with “spent up” demand for housing and mortgage rates rising, Bernanke’s Fed can no longer depend on this stimulus.  Meanwhile, corporate investment is far more likely to migrate offshore than into the domestic economy so as to take up the slack as the bubble bursts. 

The Budget Deficit: If former Treasury Secretary Paul O’Neil’s biographer is to be believed, Greenspan privately opposed the Bush tax cuts but pliantly and publicly went along with the President.  Now, tax revenues are running at about 18% of revenues at full employment output and expenditures are running at 21%.  That's a clear "structural budget deficit" that can only be addressed by raising taxes or cutting spending. 

As inexplicably as irresponsibly, Bernanke has already removed himself from that fiscal policy debate.  The Bernanke Fed will, however, have to choose whether to accommodate these large budget deficits like Arthur Burns did or turn down the screws like William McChesney Martin and Paul Volcker.  Renewed easy money will certainly begat inflation while any further tightening will surely accelerate the recession’s arrival. 

The Trade Deficit: The Fed-inspired housing bubble together with the Bush tax cuts and war expenditures have not only stimulated the domestic economy.  They have been the primary catalyst for annual double digit GDP growth in China.  China’s hyper growth has, in turn, helped sharply drive up oil prices while China’s “beggar thy neighbor” dollar peg has flooded the U.S. with cheap imports. 

“Helicopter Ben” has nowhere to run or hide here either.  Further Fed rate hikes will firm up the dollar and make U.S. exports less competitive.   An easy money reversal would drive the dollar down and trigger inflation.

The Bottom Line: Knowing as he must that the Fed alone cannot solve the mounting problems facing the U.S. economy, Bernanke’s optimal strategy should be to inoculate his own reputation from the beating it is going to take once the recession begins, inflation spikes, and the dollar starts unraveling.  He could do so by leveling with Congress right from the get go.  Firmly stating that the Bush Administration and Congress must come to grips with the “twin deficits” and begin practicing fiscal responsibility would be an excellent start. 

Hedging Your Bets With Matt Davio:  Good, Bad, and the Ugly

I wanted to keep this week’s column short and sweet and work off four simple charts that appear in the written version of this podcast – one good, two bad, and one really ugly.

First off – there is the Gold Chart.  In this chart, Gold continues its stairstep to heaven with two nice touches on the 50-day moving average since September of 05.  This is a really bullish chart; and although gold looks a bit stretched by the various stochastic technical indicators, a nice steady pullback to the 530 range before another bullish move up would be healthy.

The second chart is that for commodities.  It shows an even better picture of the budding inflation than the gold chart.  This inflation has been building in commodities since bottoming in March of 03 as the Iraqi started.

I don’t know how anyone can deny inflation when you look at GOLD, oil, and all the commodities.  Regardless of what hedonic numbers the government throws out to disguise these effects, inflation is pervasive and growing.  These are the good charts I see out there, even with Oil and Energy and Metals taking a well deserved break this week as the current momentum players are taking profits and going short for a spell.

Now to continue to the Bad.  The Standard and Poor’s Index or SPX has not yet broken in my eyes.  However, it does appear to be putting in a broadening top pattern. The SPX broke the 50 dma and is not looking healthy to me.  You see the touches up to 1295 highs and around that head you see two solid shoulders.

However, on the plus side, the SPX continues to hold the 1250 range and has since we began the fall rally in October. So until 1245 can be broken on the bottom end, we remain in the range.

I also think that this last week’s work by the SPX indicates that we may yet have another push to new highs in the SPX before we break lower. I would suggest a run up to around 1350 before the highs may be seen.  However, if we close under 1245 all bets are off and we will be heading back down to the 1170 range.  Personally, I don’t feel great urgency to be short right now unless we were to break that 1245 range, but I would definitely be a seller of the next “breakout” of the SPX up to 1350. 

Finally, the ugly chart must be viewed.  This is the Nasdaq 100 or NDX  The NDX broke the 50dma solidly this week and looks to be leading the market down as we begin the next leg of rotation.  This chart shows clear weakening by tech stocks and to me all solid rallies up to 1700 on the NDX should be sold.

More broadly, I must say that volatility has picked up. A sea of change is upon us as all asset classes that have been moving in concert are finally starting to break down and move in different directions providing opportunities in the markets we really haven’t seen in over 4 years. It is inevitable that volatility returns from the ultra low levels that we have been witnessing over the past 4 years. I think that this is again an exciting time to be active as a market player.

Peter Navarro is a business professor at the University of California-Irvine, and can be contacted at pn@peternavarro.com. Matt Davio is a managing partner at the hedge fund, Red Rock Capital Fund, and be contacted for hedge fund services at redrock@peternavarro.com.

DISCLAIMER: This newsletter is written for educational purposes only.  By no means do any of its contents recommend, advocate or urge the buying, selling, or holding of any financial instrument whatsoever.  Trading and investing involves high levels of risk.  The authors express personal opinions and will not assume any responsibility whatsoever for the actions of the reader.  The authors may or may not have positions in the financial instruments discussed in this newsletter.  Future results can be dramatically different from the opinions expressed herein.  Past performance does not guarantee future performance.