Falling Down

It’s the end of the world as we know it

and I feel fine…

R.E.M.

“We are about to enter a period of deflation,” wrote John Mauldin recently, describing The End of the World As We Have Known It. “By that I mean a period in which prices in general drop and interest rates get very low. If I am right, the investment strategies that have worked for the last 60 years will need to be changed to reflect the new economic realities.”

It is not often that the end of the world comes. So, when it does, people tend to be unprepared. In fact, of all the world’s peoples none are quite as unprepared for deflation as Americans.

If you expected a period of inflation, what might you do? Mortgage your house…borrow as much as you can…and spend your cash as though it were going out of style. This is exactly what Americans have done – expecting inflation to wipe out their debts and boost up their assets.

U.S. investors still expect asset inflation – rising prices for their main holdings, their homes and their stocks. So confident are they that they have bet everything on it. Take away the value of stocks and residential real estate and there is not much left. And yet, if the Law of Perverse Outcomes is to be honored, they will get not what they expect…but what they deserve: falling asset prices and recession.

These two trends are already underway. The Nasdaq, in very round numbers, used to be worth $6 trillion. Now it is worth only half that much. What happened to the money?

It didn’t go into the Dow, which has also drifted down since March. Some leaked into cash and other assets. But most of the money simply dematerialized.

At any given time, most people who own stock are neither buyers nor sellers, they are holders. Yet the value of their assets is determined by those few who want to either get in or get out. When more people want in than out…the price rises and the holders all feel richer, even though they may own exactly the same percentage of exactly the same business as they did before.

In a bear market, the bids disappear and prices fall. Fewer than 1% of all shares may have changed hands – but price could be cut in half, or worse. Thus, a company might be worth $100 billion one day and only $50 billion the next – even though only a handful of shareholders actually sold shares. The shareholders would have lost $50 billion in purchasing power overnight. What happened to the $50 billion? It simply vanished.

That is what happens in deflation. Money just disappears. The houses are still there. Factories do not go away. Cars. Gold coins. Fast-food restaurants. Movies. Real wealth remains. But the illusions of wealth give way to reality. Deflation is a learning experience.

“In an ideal world,” John Mauldin continues, “deflation should be the norm. In theory, over time competitive businesses should become more productive and able to produce more products for less cost. Prices gradually drop and we all get more bang for our buck.”

More bang for the buck is what economist Gary Shilling expects. His book, Deflation, lists 14 reasons why you should expect falling prices:

1. End of the Cold War led to global cuts in defense spending

2. Major country government spending and deficits are shrinking

3. Central banks continue to fight the last war – inflation

4. The increasing number of people retiring in G-7 countries will lead to reduced benefits and slower growth in incomes and spending

5. Restructuring continues in English-speaking lands and will spread

6. Technology cuts costs and promotes productivity

7. Information via the Internet increases competition

8. Mass distribution to consumers reduces costs and prices

9. Ongoing deregulation cuts prices

10. Global sourcing of goods and services curtails costs

11. The spreading of market economies increases global supply

12. The dollar will continue to strengthen

13. Asian financial and economic problems will intensify global glut and reduce worldwide prices

14. US consumers will switch from borrowing and spending to saving

On at least one of these points, Shilling is about to be proven wrong. The dollar will not continue to strengthen: it will fall, and has already begun doing so. But this, it turns out, will make asset deflation – if not consumer price inflation – even worse.

More tomorrow…

Bill Bonner London, England December 5, 2000

*** Henry Kaufman says the economy faces a 40% chance of recession next year and a 100% chance within 3 years.

*** Reuters reports a “Rising Recession Risk.” And even noted economist Dick Cheney says he thinks the U.S. “may well be on the front edge of a recession.”

*** All this recession talk comes as the economy yields more and more signs of a slowdown. Yesterday, the Conference Board said its index of leading indicators slumped 0.2% in October. Home sales were off less than expected, but still dropped 2.6% in October, as the mean price of a new home rose to a record $218,400 from $204,300 in September.

*** The main cause of recession-thinking, however, is the `reverse wealth effect’ of falling stock prices. Half of all American households own stocks. Some open their statements each month and see how rich they are. Others find out how much money they can afford to spend. In either case, when the statements show a big drop, consumer spending is not far behind.

*** Yesterday, stockholders got a bit of a break. The Dow rose 186 points. But, typical of a bear market rally, relatively few people got much benefit out of it. More stocks actually went down than up on the NYSE – 1440 compared to 1421. And more hit new lows than hit new highs – 123 compared to 119.

*** Meanwhile, over in the land of Big Techs and vanishing dot.coms – the Nasdaq fell 29 points. Intel lost more than $1 to close at $33. Cisco fell $2 to $45. Early last year, I warned that more people would lose more money in these Big Tech stocks than anywhere else on Wall Street. I wasn’t predicting the future – just noticing that there was so much money in them to be lost!

*** Not all the techs and nets went down yesterday. Amazon gained almost $2. And Qualcomm rose $7 to $90.

*** But the big news, again yesterday, was in the currency markets. The dollar index dropped to 113.63 and the euro rose over 89 cents. Currency traders are expecting the Fed to switch to a neutral bias next week – which will be more bad news for the dollar. I wish I had bought those euro bonds when Marc Faber suggested it. But it’s not too late. The euro probably has a long way to go against the dollar.

*** Even Citibank has urged investors to get out of the dollar, warning of a “major reversal” ahead. “If we go into a hard landing [recession], the U.S. dollar is a loser,” said a Citibank analyst. The greenback has been a ‘winner’ for so long, it is shocking to think of it as a ‘loser’. But that is what it is likely to be in the months ahead.

*** The U.S. ratio of savings to income is the lowest it has been since 1933. The trade deficit is the highest it has ever been. And European investors are losing their appetite for U.S. acquisitions. Recent experiences – such as the purchase of Chrysler – have given Europeans cause for second thoughts.

*** Now, with the dollar falling, look for The End of the World As We Have Known It – more below.

*** Gold rose $1.90…to $273 yesterday. Oil fell 80 cents.

*** Interest rates in Turkey spiked up to 1,700% over the weekend…stocks fell 46% in November.

*** The rise of the dot.coms was amusing…but their fall is even funnier. Apparently, there’s even a contest for the saddest dot-com disaster story. The winner gets a $1,500 bottle of Screaming Eagle Cabernet.

*** The British press reports that TheStreet.com has closed its UK shop and told its employees to hit the road. The stock rose to $60 after going public in May of ’99. Now, it’s about $3 – giving the entire company a value about $10 million lower than its cash on-hand. More on this story… maybe tomorrow.

*** Sophia and I went to see “The Seven Year Itch” at Queen’s Theatre in the West End last night. Daryl Hannah does a good imitation of Marilyn Monroe, illustrating what kind of trouble a married man can get into when left on his own in New York in the summertime – if he’s lucky.