A Chicken in Every Pot and A Car in Every Garage

The Daily Reckoning PRESENTS: Allow us to introduce to you, dear reader, Dan Amoss, the newest contributor to Whiskey and Gunpowder and Strategic Investment. In his first essay to be published in these pages, Dan looks at similarities between the Great Depression and the current state of the U.S. economy. Read on…

“A CHICKEN IN EVERY POT AND A CAR IN EVERY GARAGE”

The above quote, attributed to President Herbert Hoover’s 1928 election campaign, epitomizes the mass psychology characteristic of the Roaring ’20s. In a country that had long enjoyed a remarkable period of prosperity, it was felt that the trajectory of the boom’s trend would eventually lead to an eradication of poverty.

The Industrial Revolution brought about a tremendous increase in productive capacity and living standards beginning with its origins in the mid-19th century. But the advent of consumer installment credit in the Roaring ’20s was the mechanism that shifted business into overdrive. Entrepreneurs all along the chain of production, from commodities to retail, geared up for demand that, in hindsight, was short-lived.

A credit-fueled bubble that affected nearly every corner of the economy – encompassing everything from consumer credit, to business loans, to margin debt at stock brokerages – crested the following summer. Alas, historians have thoroughly documented what happened when this euphoria morphed into panic.

With the onset of the Great Depression, priorities for many gradually shifted from return on capital, to return OF capital, to concern that modern industrialized society was unraveling at its seams.

As the panic that engulfed Wall Street spread to the banking community, pain that was previously only felt by those involved in the speculative stock market quickly consumed the business community. Consumers reined in spending, so business owners rationally cut expansion plans and investments in inventory.

Bankers comprised the heart of the capital allocation function of the time period; in the modern global economy, it’s quite another story, as the business of providing credit has shifted toward such institutions as hedge funds, private equity, and government-sponsored enterprises like Fannie Mae. Also taking share from bankers has been the secondary market for credit derivatives, including mortgage-backed securities, collateralized debt obligations, and collateralized loan obligations.

Once consumers had reached the saturation point of installment credit, companies like Ford had the capacity to produce far more cars than the market demanded. Bankers, fearing defaults on their riskiest loans, called them in just as the ability to pay them off had vanished. The combination of falling asset prices (factories, inventories, real estate, etc.) and bank runs was lethal. The country witnessed an enormous number of bank failures in a short period of time.

President Hoover’s interpretation of the authority granted to his office by the Constitution did not square with that of the business and investor communities clamoring for a bailout. The measures he took to clean up the mess left by a burst bubble, in which millions were complicit, were not perceived as radical enough under the circumstances.

In 1932, President Franklin D. Roosevelt was elected in a landslide on promises to take swift and decisive action. The foundation of this recovery involved devaluing the U.S. dollar against its gold backing, and basically amounted to currency debasement and deficit-financed make-work programs. The cost of the New Deal – the brainchild of British economist John Maynard Keynes – was foisted upon future generations.

When confronted with these long-term costs and the necessity of running budget surpluses to pay off debt incurred by his “demand management program,” Keynes casually dismissed this critique with the statement that “in the long run, we are all dead.”

Well, it’s safe to say that we have reached what would be considered “the long run” and, no, we are not all dead yet. The only thing that has sheltered the current working generation from the financial consequences of government debt growth (taxes, runaway CPI inflation) is the fact that America successfully “dollarized” the rest of the world in the post-World War II period.

This is not to say that we will escape unscathed. International accounts will be settled through further destruction in the value of the dollar. It must, and the Fed will do everything in its power to ensure the dollar’s future devaluation. Whether it will be “successful” remains to be seen, but you can be assured that painful consequences will accompany unconventional Fed policy.

Does anyone really stop to think about what would happen to the current economy if Congress enacted a plan to pay off the gargantuan federal debt, not to mention fund the trillions in unfunded Social Security and Medicare promises made?

The consequences of such an action would lead to a second Great Depression. Federal spending that for generations has greased the wheels of commerce cannot be reduced in the face of the gargantuan debt obligations that must continually be paid or rolled over. Widespread default is not an option in the mind of the Fed.

In my mind, the important lessons of the Great Depression lie not in the New Deal’s remedies to its fallout, but in tracing its origins back to the seeds that were sown by post-World War I Fed policies: credit that is controlled by government institutions, rather than the free market, can lead to egregious misallocations of capital. In the 1920s, it clearly did.

What do the Hoover campaign themes of seeking to universally end hunger and promote material prosperity have to do with current market psychology?

The efficient market hypothesis (EMH) basically states that current stock prices reflect all available information, so you are wasting your time attempting to take advantage of extremes in prices. “The market” is lifted to the status of an omniscient capital allocation machine. In theory, it works, but when the human emotions of greed and fear are involved, it’s amazing to behold the irrational pricing that can develop at either extreme.

I can’t think of a better real-world refutation of the EMH than the tech bubble, yet in its aftermath, it is still included in the mainstream of financial theory. For example, the bubble in the stock prices of fiber-optic equipment manufacturers might have been close to accurately pricing in the future growth of Internet traffic, but bubble stock prices were clearly not pricing in the reality that the race to build out fiber-optic capacity sowed the seeds of rapidly approaching profit-margin free fall.

When the powerful emotions of greed and the fear of being left behind combined to produce jaw-dropping rallies, sell-side analysts responded by publishing ridiculous discounted cash flow models in order to justify current prices. Remember the “click count” and “eyeball” methods of valuing triple-digit Internet stocks that ultimately crashed and burned?

A principle of financial theory that withstands the rigors of real-world experience is that the value of any stock is equal to the sum of future free cash flows generated by the underlying business. These free cash flows can be used to pay dividends or to repurchase shares and must be discounted back to the present time using a “reasonable” rate in order to arrive at a current value for the stock. This is where it gets really tricky, with wild swings in stock value resulting in changes to the discount rate.

For individual investors, the important thing to take away from discounted cash flow (DCF) models is that future sales growth (or contraction) rates, costs of production, overhead, competition, and the availability of financing are all huge, unpredictable factors in the DCF calculation. Take an unreasonably optimistic view of these future assumptions, and voila: instant mathematical justification for bubble valuations.

Approaching the peaks of bull markets, investors tend to aggressively bid up the prices of those stocks with the most egregious assumptions about future sales and earnings growth and tend to ignore threats to those assumptions, including competition, inflating expenses, and, often, the ready availability of financing. Due diligence often consists of A) my neighbor just made a fortune in this stock, B) the chart shows that it’s a clear path to riches, and C) I’ll get out before the top by selling to a “greater fool.”

Consequently, in the early stages of bear markets, investors tend to flock toward safe havens with rock-solid balance sheets and business models with more predictable assumptions, like consumer staples.

While traditional safe havens may continue to fall in price, you can be reasonably confident that they will fall less dramatically than the most speculative stocks and aren’t going to flame out to $0. This, combined with solid grounding in macroeconomic trends, can in fact lead to profits in an otherwise choppy, downtrending bear market.

Regards,

Dan Amoss
for The Daily Reckoning
May 10, 2006

P.S. Maybe “a chicken in every pot and a car in every garage” was a good enough aspiration for the economy of the Roaring ’20s, but it looks like a campaign slogan for the new millennium should be modified to “convenient, tasty food delivered to every doorstep and unlimited cheap oil to fuel multiple cars in every garage.”

Editor’s Note: Dan Amoss is the latest addition to the team at Strategic Investment, and he will also be contributing work to Whiskey and Gunpowder. Whiskey and Gunpowder is a free e-letter, which covers resources, oil, geopolitics, military history, geology and personal freedom.

Gold shot up $21 yesterday. People are starting to notice.

The globe is lop-sided. Everywhere we look, things are out of kilter, like a house of mirrors, where nothing quite looks the way it should. We have to check our glasses to make sure it isn’t us.

And, yesterday, we also felt…deserted…alone…abandoned by our friends.

Stephen Roach, chief economist at Morgan Stanley, threw in the towel. He was the last bear standing on macroeconomics matters, according to the Guardian (The Guardian editors do not spend much time in the woods).

Like us, for many years, Roach lamented and bemoaned the “unbalanced” world economy, which he saw becoming more and more unbalanced as time went on. But recently, it seems that it is Roach himself who has become unbalanced; yesterday, he imagined balance being restored by the coordinated efforts of bureaucrats at central banks all over the world.

Actually, the relationship between East and West is not so much imbalanced as it is parasitic. One side makes; the other side takes. One saves; the other borrows. One grows rich acting poor; the other grows poor believing itself rich.

In the West, people live beyond their means and expect to continue doing so at least until the Second Coming. Their top economists tell them that they have nothing to worry about, no day of judgment. Savings? Who needs that? We have something better – credit!

But where does the credit come from, without a pool of savings from which to draw? Well, it comes from the East – where people do save. Here, the Wall Street Journal weighs in with some facts. Developing nations already hold reserves – mostly in dollars – of $2.9 trillion. China, Russia, and Saudi Arabia are laying in huge supplies of capital – earned from the export of oil and manufactured goods. Most of this money was once owned by Americans; now, it is owned by foreigners. Every day, more than $2 billion, net, shifts further from one end of the teeter-totter to the other – from the chunky spenders down to the skinny savers.

China, Russia, and Saudi Arabia may not be the world’s most developed nations, but they weren’t born yesterday. And, what they don’t know between them – about mismanaged economies, political corruption, incompetence, and worthless paper money – is probably not worth knowing. Sitting there, surrounded by trillions of dollars, they are likely to wonder what each one is actually worth. And then, they are likely to turn their gaze to the country that issues them – and wonder again.

“What is behind the dollar?” they will ask themselves. Just faith, comes the answer. But faith in what? Is it in the financial future of the United States? Talk about unbalanced; no nation in the history of the world has ever had such a big gap between what it earned, and what it spent. U.S. public and private finances are out of whack, and on the evidence, becoming more and more out of whack with each passing day. What faith can you have in its paper currencies? Its notes? Its bonds? And then, the foreigners turn to the Middle East and wonder even more.

In Mesopotamia, the Americans’ war against “nobody-in-particular” is also lopsided. The Untied States is the world’s only superpower, and probably the most powerful nation that ever existed. Against the most sophisticated fighting force ever assembled, the “nobodies” on the other side can launch no planes, field no tanks, assemble no armies, and dispatch no ships. An estimate from the Pentagon is that they have no more than 10,000 partisans, most of them neither seriously armed, nor seriously trained, nor seriously led.

Still, it is an incredibly expensive war – but only on one side. The United States will spend about $120 billion this year alone; the enemy, whoever he or she may be, spends peanuts. Yet, despite the imbalance, “nobody-in-particular” seems to be winning.

That these imbalances will eventually be resolved, we do not doubt. But they are likely to be settled more or less as they were created – by agile individuals and flat-footed official intervention.

More news from The Rude Awakening…

————–

Eric Fry, reporting from Manhattan:

“Americans love an underdog. We love pulling for the little guy. In fact, we’ve been pulling for the little guys for seven straight years… So maybe it’s time to bet on the new underdogs: the big guys.”

For the rest of this story, and for more market insights, see today’s issue of The Rude Awakening.

————–

Back to London for more opinions on various subjects…

*** Resource Trader Alert’s Kevin Kerr shares his thought on copper becoming a “precious metal.”

“All that glitters is not only gold; it’s copper, steel aluminum, you name it,” says the commodities guru. “Surging metals prices of all kinds are making some of the nonferrous metals the first choice for thieves over the more traditional ‘precious metals.’ Thieves are stealing wire, pipes, even rusty old cars to sell to scrap metal recycling businesses.

“All of this is due to the skyrocketing costs of metals, such as copper. Copper, at more than $2 a pound, is about double what it was a year ago, while aluminum prices have gone up about 50% in a year. Zinc and lead have nearly doubled in price over a year…and the list goes on.

“So, it turns out we’re talking big money after all. At today’s prices, it doesn’t take much copper to add up to a hefty sum. For example, a chunk of partly compressed copper wire (without insulation) that measures about 6 by 8 by 12 inches is not a lot. But at 75 pounds, it’s worth $150.

“I was visiting the DR HQ in November of 2005 when I read that Baltimore police officials reported the theft of about 130 aluminum light poles, each about 30 feet tall and 250 pounds. Elsewhere, thieves have stolen manhole covers, luggage carts and parking meters.

“Though steel isn’t getting nearly the price copper does, in one report I read that some enterprising thieves have been stealing and selling junk cars, calling up a tow truck service posing as the vehicle’s owner. The thieves ask the towing company to pick up the vehicle and bring it to a metal recycling company, where the thief, meets the tow truck driver and says it’s his car. Also, about a month ago, a man was taking metal power boxes from the CSX rail line, according to police reports.

“Now if that doesn’t prove physical demand is behind this, what will?”

Kevin will be appearing on CNBC’s Kudlow and Company today at 5 p.m. (EST) to help everyone out in TV land better understand the commodities market. Be sure to tune in.

*** So far, we are enjoying this 21st century. Except for the World Trade Center, wars in Afghanistan and Iraq, and the new conservatives – what’s not to like?

True, so far, the new millennium has not been kind to investors. Stocks are down – especially after inflation is taken into account. So are most other investments. Housing has done well for most people, but you have to live somewhere. The only way most people can release the gains in their houses is by leaving the country, dying, or borrowing against them. Of the three choices, most have chosen the third, which is why the next few years of this century promise to be more disagreeable than the first six.

We approve of “rebalancing, ” but the world economy is not a wheel. You can’t put it on a rotator and rebalance it by adding lead weights. Instead, it is made of millions of individuals, who have made financial decisions based on what they saw before them. When the going was good…they went. Americans took advantage of loose credit conditions to go deep into debt. Rebalancing requires them to end up less in debt, which means they will have to do something that will be unpleasant for most of them – reduce spending.

Cutting consumer spending will also turn out to be unpleasant for America’s policy makers and officials, for it will mean a slowdown in the U.S. economy…possibly a very severe one.

What will people do? Where will they turn?

*** Last night, we went to the theatre. Maria’s drama school performed the Man of La Mancha.

We had never seen the play. We were prepared for the music, but not for the rough handling of the whore, Aldonza, by the mule drivers at the bar. Not when our own daughter was playing the part. We wondered how other fathers must feel when their children perform in front of a crowd. We know how we felt: like stopping the show! Nobody treats our little girl like that!

But, we reminded ourselves that it was only theatre; they were only acting. And we let the show go on.

It is a touching story. Don Quixote sees Aldonza in a way no one ever had…

“Oh, pure virgin,” he calls to her…as the bar breaks out in laughter. Of course, Quixote is unbalanced and hallucinating. The world is not what he imagines – or even what he can imagine. But people are infinitely complex…like truth itself. And in Aldonza, a tough, hard-swearing prostitute, is hidden a pure virgin, too. It brought a tear to our paternal eye when the dear girl came out.

After the curtain went down, we went backstage to congratulate the cast, but we still haven’t quite forgiven the mule drivers.