Act III

“Economists say America is unlikely to follow into Japanese-style deflation,” said a recent Wall Street Journal article, “because U.S. leaders reacted to their slowing economy much more quickly than Japanese leaders did..”

Oh?

The question bores most people. But here at the Daily Reckoning it haunts us like an unsolved crime. Spectators, we sit on the edge of our chairs to see what will happen next.

The U.S. economy seems to us to be following a script written in Japanese. With only an occasional improvisation, and a broad allowance for cultural differences, the essential dialog in America 1995-2001 has been very much that of Japan 1985-1991.

The plot was much the same – hotshot new era meets cold realities of marketplace.

The love interest was identical – investors fell head over heels for financial assets, and abandoned all sense of reason or dignity, and made fools of themselves… The first couple of acts were similar…with rising action in the investment markets and a climactic sell- off.

But now, the curtain has gone up on Act III…and our American audience expects a twist. Unlike the dumb Japanese, U.S. investors and consumers will be saved by the prompt action of the hero, Alan Greenspan, they believe.

Greenspan, wielding his rate-cutting sword, has chopped off 450 basis points in 10 months, while it took the Japanese central bank more than 4 years to do so. Bullish economists think his speed will be decisive. We are less sure. But then, we see an economy that suffers from too much credit, not a shortage of it. So we doubt that giving it more credit, more quickly than the Japanese did, will make any difference.

Anything could happen, of course. But the Japanese analogy has worked well enough so far. We’ll stick with it.

Most economists, says Dr. Kurt Richebacher in his latest letter, reject the idea that America might follow Japan with a prolonged period of economic stagnation. But these are the same economists who saw no downturn coming the first place…and who expected lower rates to have already perked up the U.S. economy by the 2nd quarter.

Each month, they push back their estimate of when the upturn will happen.

Now that short term rates have hit 2%, stocks have rallied for a couple weeks, new unemployment claims are down for 3 weeks in a row, and bonds are turning down…these economists, analysts and investors think the worst is behind us.

But, “in April 1992, as the Nikkei appeared to be hitting bottom at 17,000 [from a high of 39,000 a year and a half earlier]” the Wall Street Journal reminds us, “a consensus of a dozen top forecasters still foresaw Japanese economic growth for the following year at between 2% and 3%. It ended up growing at 0.4%. Today, the Nikkei hovers around 10,000 and the Japanese economy is back in its fourth recession of the past decade.”

Most economists have no idea when the market will turn up, because they have no idea why it turned down. They believe lower rates can restore economic activity to former levels. But as pointed out yesterday, rates are already below zero in real, inflation-adjusted terms.

And, as mentioned here many times, while it took the Japanese longer to get there, short term rates in Japan have been “effectively zero” for more than 5 years.

Does ineffective medicine work better because it is administered faster?

There are 3 possible effects from lower rates:

They could do the economy some good. They could do it some harm. Or, they could do nothing at all.

In Japan, lower rates seem to have done as much harm as good. “Plentiful credit is financing stagnation,” reports the Wall Street Journal, “banks use cheap credit to keep ailing companies on life support.”

That’s why, even 12 years after a stock crash, bankruptcies are hitting record highs in Japan. These companies should have given up the ghost long ago. Easy credit has not cured what ailed them…it merely stretched out the period of suffering.

Ignoring the actual experience, economists turn to theory. Since the Hoover administration, they have counted on lowering interest rates and cutting taxes to boost economic activity, thus putting more dollars in the hands of people who would spend them.

But consumer spending does not really make people richer. Consumption is the end result of getting richer…not the means to it. Real prosperity results not from consumption, but from its opposite – forbearance. It is the capital that is not consumed – the savings – that determine how quickly a society gets rich.

Savings can be invested in capital improvements that produce more and better products…and give investors a profit. These profits are the key to everything. They tell us that the effort was worthwhile – that the investment is paying off, making people wealthier. They encourage the business to hire more workers…and spend more on new plant and equipment.The “old economists”, says Dr. Richebacher, knew this.But the new ones seem to have forgotten.

“Ever since Adam Smith published his ‘Inquiry into the Nature and Causes of the Wealth of Nations’ more than 200 years ago,” he writes, “it was undisputed doctrine that there is but one single route towards economic growth and the creation of wealth – through saving and capital accumulation in tangible, income-yielding assets.

“Rising capital investment is the one and only component in the economy that pulls up with it everything else that matters in the process of creating growth and prosperity: capacity, production, productivity, output and consumer income…”

Of attempts to induce prosperity by making more consumer credit available he adds, “only in the alphabet does consumption precede production. But that is what every president and every Fed governor has done in America since the Great Depression.” The result? “This country’s economy is geared to rising consumption,” Richebacher quotes Simon Kuznets from a 1961 book, “and our institutions and patterns of social behavior encourage higher consumption per capita…Unless in the next few years the private sector can generate savings and capital formation in a greater proportion to a rising product, the pressure in the demand for goods upon the supply of savings will persist.”

But instead of increasing savings to meet the new capital needs, gross savings plummeted from a 1950s high of nearly 20% of GNP to personal savings rates near zero today. Instead of saving resources, the U.S. economy consumed it.

“Capital has been consumed and misused,” writes Sean Corrigan of Capital Insight. “Everyone would surely be forced to concur that the sooner we cease the first and the quicker we attempt to correct the second, the better it will be for all of us.

“Instead, what do we find? Interest rates are slashed, reserves are injected by the central bank, and the mindless chant. ‘The economy depends on the consumer, the economy depends on the consumer’ is repeated over and over again, as if a farm thrives on the crows pecking at the corn…

“Every extra dollar borrowed by a consumer now puts us all a dollar further from recovery, the debtor a dollar closer to default, and his bank a dollar closer to a bigger loan loss provision than it would have had to face by foreclosing while there was still something to be salvaged.”

Will feeding more corn to the crows – that is, making more dollars available to borrowers, cheaper and faster – rescue the situation?

We will see, dear reader, as Act III continues…

Bill Bonner
November 16, 2001

Lower rates helped people buy a lot of cars and trucks last month. And now comes a report that jobless claims fell for the 3rd week in a row. The bond market, sensing an upturn, turned down…And stocks rose again, in what more and more people seem to think is a new bull market. Plus, the war in Afghanistan seems to be going well.

What do you think, dear reader? Is the worst over? Is it time to buy stocks and sell bonds?

Here at the Daily Reckoning we don’t claim to know. But we don’t mind taking a guess.

New jobless claims are down…but total jobless claims are up – to an 18-year high. And if stock market investors knew what they were doing they wouldn’t have run up prices to preposterous levels in the first place.

We recall also that things started looking up in Japan about 18 months after the market peaked. But here we are, almost 12 years later, and the news from Nippon is worse than ever. “Bankruptcies in Japan soar 11.7%,” reports the International Herald Tribune.

So far, our Japan analogy has proved to be an accurate advance indicator for the U.S. economy. Will it continue? More below…

Eric, what’s new in the Big Apple?

*****

Eric Fry from New York…

– Yesterday’s Wall Street report: Mostly sunny with a few scattered clouds.

– The Dow gained 49 points to 9,872, while the Nasdaq slipped about three points to 1,900.

– Plus signs are becoming fairly routine in the stock market these days. Investing almost feels…well…easy again. Maybe too easy. Once more, we are a nation in love with stocks. Unfortunately, whenever the cold, impersonal science of investing turns into a passionate love affair, Miss Market leaves us crying in our soup.

– The problem begins when starry-eyed investors eagerly overlook their beloved’s shortcomings. Consider Dell Computer – the quintessential “company next door.”

– Dell reported fiscal third-quarter net income after the close yesterday. It was a Wall Street classic – beating the consensus estimate by exactly one penny. Yet “beating the estimates” by a penny still meant that earnings fell 36%. The No. 1 maker of personal computers continues to wage a price war in order to gain a larger piece of what has quickly become a shrinking market.

– Despite the grim prospects for growth, Dell shares have risen about 60% this year and sell for more than 40 times earnings. Sounds like somebody’s lovesick! What’s more, Chief Operating Officer Kevin Rollins says the corporate market remains weak.

– “It boggles the mind to consider that the leading lights of the tech world are still sporting nosebleed- level P/E ratios even after the Nasdaq’s collapse over the past two years,” says Fred Hickey, editor of The High Tech Strategist.

– Prior to Y2K, he explains, “The world bought too much of everything that was technology-related: too many servers, too much disk space, too much broadband capacity and too much semiconductor manufacturing equipment. Over the next couple of years, these excesses will have to be worked off in the midst of the deepest recession in decades.

– “The third-quarter results were the worst I’ve ever seen,” Hickey continues. “Just look at the year-over- year sales declines for these industry leaders: Intel down 25%; Compaq down 33%; Sun Microsystems down 43%; EMC down 47%; Motorola down 22%; Texas Instruments down 41%; Lucent down 28% (with a record $8.8 billion loss); and Nortel down 45%. The worsening worldwide recession ensures that fourth-quarter results will not be any better.”

– It is possible to love stocks too much.

– A recent study by Richard Bernstein, chief quantitative strategist with Merrill Lynch, entitled “Truly Unbelievable,” found that a record 71.5% of fund managers are bullish. “Wall Street continues to believe that the current environment represents the best time to buy equities in the last 16 years,” Bernstein says incredulously.

– One eminent member of the bullish contingent is Robert Stansky, manager of the Fidelity Magellan Fund. “The pieces are falling into place for an economic recovery and a market rebound,” Stansky said in a recent report. Of course, Stansky gets paid a lot of money to find reasons to like stocks…no matter what. Fidelity Magellan is down about 12% so far this year.

– No one can say with certainty, of course, whether Stansky and the other three-quarters of all fund managers who are bullish are right to be optimistic. But we can say that when so many market participants hold the identical view, Mr. Market’s usually getting ready to throw us for a loop.

– For example, “even when dividends ‘didn’t matter,'” says the Fleet Street Letter’s Lynn Carpenter, “they brought total bonus returns that nearly matched the capital gains over a tremendous bull market run.”

– Lynn explains that even when there wasn’t a soul in the market expecting to build wealth by investing for oft-maligned “income” – reinvesting your dividend yields on the S&P 500 from 1983-1998 would have upped your return on $10,000 by an additional $41,000. The straight capital gains on the index in that boom was only $47,500. “You read that right,” says Lynn, “And that was a bull market. Dividends work hard, even when they work quietly.”

– “This is a bear market (yes, still),” Lynn continues. “This rally may hold, but likely not. In fact, it would surprise none of the old hands in the market to see a replay of the 1970s. And if dividends were the underrated secret of the ’80s and ’90s – in the ’70sthey were as powerful as learning to split the atom.”

– Finally, one more Wall Street “superstar” hung up his cleats this week: Henry Blodget, Internet analyst extraordinare. Blodget made a splash on Wall Street a couple years back by setting a $400 price target for Amazon – the notoriously profitless e-enterprise was selling for about $100 a share at the time. Amazon, to the chagrin of short-sellers, hit Blodget’s price target within a matter of days. But it has been falling ever since. To paraphrase Churchill: Never in the field of financial endeavor was so much lost by so many because of one Wall Street dummy.

– Was it moronic or an act of genius to make that call? Maybe both. Certainly it was moronic securities analysis, but from a career advancement standpoint, pure genius. Weep not for Mr. Blodget, however. He will receive a $2 million parting gift.

– Henry, we will miss you.

*****

Back in Paris…

*** “Refined, elegant…’The Wind Spirit’ feels like a private yacht,” writes Oxford Club chief Julia Guth. She’ll be leading a panel of “highly qualified financial advisors” on a cruise of the Pacific Coasts of Costa Rica and Nicaragua, January 18-26, 2002. January may be just the right month for you to relax in high style off the coast of paradise…if you’re interested in joining the cruise…

“Like Floating On A Five Star Boutique Hotel”

*** Raskolnikov might have been a tech investor.

*** We went to see a stage production of Dostoevsky’s “Crime and Punishment” on Wednesday night. I will resume the story for you, dear reader, since it may hold a useful lesson. The lead character, a student named Raskolnikov, thought it was a new era in Russia, and believed himself to be a new, superior man – a Russian version of Nietzsche’s Ubermensch. He murdered an old woman and stole her jewels.

*** Why not? The laws that govern other humans should not apply to him. Alas, his crime haunted him. Sleepless, tormented, he finally confessed. He got what he deserved, not what he expected…