After the Collapse

In the rubble of the Enron collapse, Martin Weiss suggests, the public is finally starting to see the truth – America’s most powerful CEOs lying about their corporate earnings…the world’s most prestigious accounting firms helping to cook the books…brokers and rating agencies knowingly hiding the truth…investors and employees getting wiped out.

The twin towers of the Enron Corporation in Houston were not struck down by hijacked airliners. Nor did they implode in a mushroom cloud of dust and debris.

Strangely, however, ivory-tower economists still don’t get it. They seem completely oblivious that Enron is just one of many accounting scandals that will bust wide open in 2002. Indeed, there are 2,467 other companies that I feel are suspect of earnings manipulations.

Now, hundreds of companies with murky or complex accounting are going to get dumped mercilessly by angry investors. If the company discloses the dirt, investors will sell. If it refuses to disclose, investors will sell even more! The most recent examples: Tyco, Williams Companies, GE, PNC Financial Services, Cendant.

What about the so-called "recovery" so many economists are talking about? It’s a mirage. A fantasy.

I believe dozens of other major companies will fail in the coming months. Big names. One shocker after another. Then, hundreds of companies will soon be writing off up to $1 trillion in "goodwill". Finally, millions of companies in the US and around the world will be struck by debt and deflation.

The key force driving the US economy and stock market is earnings. And right now, I count at least 8 major corporate earnings killers that are about to crash into Wall Street.

Even in good times, three out of four companies that file Chapter 11 never emerge from bankruptcy.

Among the few that do come out, 30% fall right back into bankruptcy, filing Chapter 11 a second time. Examples: Memorex, Cherokee, and LTV. TWA filed three times in the last 10 years!

Wall Street will try to pooh-pooh this. But if you’re in business yourself, you know exactly what happens when a major corporate customer goes bankrupt: You lose when they fail to pay you for goods already delivered … and then you lose again when you stop selling to them in the future.

It will sabotage the pricing power of tens of thousands of companies. When deflation strikes, the simple act of buying now and selling later becomes a treacherous proposition. Even in the best case scenario, profit margins are squashed, forcing companies to cut back on research and development, slash business travel to the bone, severely cap executive expense accounts. And, of course, they cut jobs!

Major companies are swamped with debt to the tune of 156% of GDP. That’s 44% more than a decade ago. It’s also bigger than the debt load Japan faced before their stock market bubble busted back in 1990.

Right now, many companies are so deeply buried in debt that they can’t even THINK about spending money on new plants or equipment.

For every single dollar of stockholders’ equity, Maytag has $5.09 in debt; Xerox, $5.22; Sprint PCS, $12.09; Nextel, $18.52; Ford, $21.00!

How bad is that? Well, even just one dollar of debt per dollar of equity is usually too much. When you start seeing companies with more than double, five times, or even twenty times the debt level they should have, the drag on earnings – not to mention the danger of failure – is literally off the charts.

"Goodwill" write-offs could hit $1 trillion, bashing earnings even further. Goodwill is the same kind of often-bogus, intangible asset that the savings and loans used back in the 1970s to make weak or bankrupt institutions look strong and healthy. By the time the public finally caught on, thousands of S&Ls were down the tubes and the entire industry was threatened with extinction.

You’d think Corporate America would have learned something from that lesson. They didn’t.

How big is the problem? Monstrous! And it shows up when companies are finally forced to write off goodwill and other assets with so-called "one-time charges."

Back in 1989, one-time charges to earnings among the S&P 500 companies totaled around $10 billion. That was considered pretty big in those days.

In 2001, extraordinary charges to the S&P 500 companies reached $360 billion. Can you imagine that? That’s 36 times more than 1989!

And some of the largest write-offs have been the prelude to major bankruptcies:

* In July 2001, Bethlehem Steel took a $1 billion unusual non-cash charge against earnings to write off the value of a deferred tax asset. Three months later, it filed for Chapter 11.

* Excite@Home, the provider of high-speed Internet access, took a $4.63 billion charge against earnings in the fourth quarter of 2000. Nine months later, in September 2001, it was in bankruptcy court.

* Ditto for Enron: The last and final warning of the collapse came in October of last year – a $1.01 billion charge due to investments gone sour.

By the time write-offs are announced, you should be miles away…and if you’re not, it’s your last warning to sell. Get to safety.

Martin Weiss,
for The Daily Reckoning
February 13, 2002

A recession is a time to "repair a company’s balance sheet," says Paul Kasriel in the Chicago Tribune.

Therein lies a tale. Because a recent survey shows that 95% of economists think the recession will end next month. 42% think it’s already over. How many balance sheets got fixed up in the mildest recession in history? Not many.

Corporate bond debt rose 125% in the period 1995-1999, to a total of $2.59 trillion. In the following slump, it should have gone down. Instead, it went up – to $3.39 trillion.

What good is a recession if it doesn’t make the necessary repairs? Where could it lead?

Regular Daily Reckoning sufferers know that we look to Japan for a peek into America’s future. What has been happening in Japan?

"The quicksand of deflation pulls even stronger," says a headline in the Financial Times.

"We are already in a deflationary spiral," the FT quotes Takatoshi Ito, professor of economics at Hitotsubashi University. "This makes debtors’ balance sheets much more difficult to manage, so they join the ranks of non- performing-loan companies. They lay off workers, further depressing aggregate demand, thus creating more deflation and so on."

Prices fell 1% in Japan last year – excluding fresh foods. What does deflation do to companies with a lot of debt?

"Deflation destroys cash flows and because many companies can’t pass this on through lower wages, they eventually go operating-cash-flow negative," explains David Atkinson, managing director of Goldman Sachs in Tokyo. Even with interest rates at virtually zero, he adds, this inevitably leads to default.

In Japan, as in America, the central bank responded to the economic slump with lower interest rates. But the Bank of Japan found that it couldn’t create "money" when it was most needed. Prices have been falling in Japan for the last two years – despite the central bank’s vigorous inflationary efforts.

Why can’t the government just "print money?" Because money is only valuable as long as the myth behind it remains intact. It is only useful as "money" so long as people believe its supply is limited. At the first sign of just "printing" money, interest rates would shoot up, people would dump the currency…and whatever advantage a government hoped to gain by printing money would be overwhelmed by the disadvantage of high interest rates and a "run" on the currency.

Central banks can and do destroy their currencies; it’s their job. But they have to do so in a measured way…so the illusion of paper money is preserved.

Meanwhile, back in the land of sushi eaters…"If somebody can produce a price rise, but no interest rise hike," says Atkinson, "I would like to see them do so. That would be a kind of miracle."

Here in the U.S. people are counting on a miracle too. They expect higher stock prices, higher consumer prices and higher interest rates. But no one believes that high interest rates will cut off the recovery…not even in a nation where corporations and individuals carry more debt than ever before…and where – in the recession that barely happened – few balance sheets were repaired.

Eric was out late last night. I know, because I was out with him for the first part of the night. Still, our steadfast reporter on Wall Street brings us the news…

******

Eric Fry, reporting from New York:

– The battle between fear and greed continues to rage. Yesterday, fear won again, as it has been doing so often this year. Gold rallied and stocks fell.

– After an early morning sell-off that pushed the gold price below $300, the metal reversed course to post a modest 50-cent gain to $301.30. Meanwhile, the stock market failed to hold onto its gains. The Dow dropped 21 points to 9,863, while the Nasdaq fell 12 to 1,834.

– Fear has paid very well this year. Thus far, in 2002, gold has rallied more than 8%, while the XAU Index of gold shares has jumped more than 22%. And numerous individual gold stocks have fared even better. Harmony Gold (now the world’s second largest unhedged gold miner) has climbed more than 45% in 2002. The stock has soared a spectacular 72% since John Myers recommended the stock in the November edition of Outstanding Investments!

– By contrast, the returns on greed year-to-date have been very disappointing. The Nasdaq Index, for example, has tumbled about 6%. But 2002 is young, of course. There’s still plenty of time for greed to triumph over fear and for Abby Cohen’s bullish predictions to come to pass and for James Cramer to become a celebrity again.

– There’s still plenty of time for gold bugs and short sellers to return to the investment doghouses they’ve been inhabiting for most of the last two decades. Then again, who’s to say that stock market investors won’t spend a few years in the doghouse, just like their Japanese counterparts have been doing? Financial markets are nothing if not cyclical.

– And financial celebrity is as cyclical as the stock market. The kinds of stock market personalities who make the newspapers at any given time can reveal more about the state of the financial markets than 1,000 brokerage reports.

– During the mid-1980s, the correctly bullish Robert Prechter enjoyed modest fame for his "Dow 3,000" prediction. By the late 1980s, stock market bears like Joe Granville and the short-selling Feshbach brothers grabbed most of the headlines…for a while. (Of course, when the Feshbachs bought a Lear jet in 1990, a stock market rally became all but inevitable).

– As the market rallied throughout the early 1990s, successful stock-pickers like Warren Buffett and Fidelity’s Peter Lynch became folk heroes. By the late 1990s, it seemed that everyone associated with the stock market became a kind of celebrity – from Alan Greenspan to Abby Joseph Cohen to Maria Bartiromo to the temporary dot-com billionaires too numerous to mention.

– So where are we today? Who are today’s financial famous? Well…let’s see…former Enron CEO Kenneth Lay is a pretty well-known guy. And today’s minor celebrities include some of the short-sellers who have been profiting from the bursting of the great millennial bubble market.

– My friend Jim Chanos, while no stranger to the press, has been garnering a lot more ink than usual lately as "The Guy Who Called Enron."

– "When Jim Chanos and his friends go on spring break, there is no time for golf. Or the beach. Or fun of any kind," says Newsweek magazine. "Unless your idea of a good time is sitting in a conference room talking about lousy investments. Each February, Chanos, a veteran Wall Street investor, picks up the tab to bring 20 of his professional-investor buddies to a luxury Miami hotel. Most of the group specialize in ‘short selling,’ in which they bet on stocks to fall, so most of their picks are companies they see heading for hard times. At last February’s gathering, Chanos pitched the group on a stock you may have heard of: a high-flying energy firm called Enron."

– I was sitting in that room last year and I will be meeting up with Chanos and his buddies again next week. All those of us who attend are sworn to secrecy about the specific investment ideas that are presented. Even so, many of the skeptical insights gleaned from this year’s Miami meeting will certainly make their way into upcoming editions of the Daily Reckoning…for better or worse. Read them at your own risk!

******

Back in Baltimore…

*** I took the train back to Charm City last night. In America, trains are full of busy people.

*** "They get out their laptop computers and cell phones and go to work almost immediately…making deals," Eric had warned me. "But the first car is an electronic free zone. No computers or cell phones allowed."

*** On European trains, it is not hard work that makes people feel superior, but diplomas, politics and the cut of their clothes…Taking the train from Paris to Bonn, for example, the snob quickly gathers up a collection of newspapers in as many languages as possible. Reading the Financial Times, Le Monde, Der Handelsblatt and the Herald Tribune – all at the same time – gives a man a certain distinction. Better yet, he picks up a copy of the paper from Brussels – in a language no one has ever heard of and probably no one actually reads. Just be careful not to hold the paper upside down.

*** And do not get out a laptop computer. It marks you as a hopeless bourgeois striver.

*** A Financial Times article puts numbers to the observation. In Europe, GDP output per head of population is only 67% of American levels. Why the difference? Productivity per hour is not much different, but in America more people work and they work longer hours. Unemployment levels in Europe are higher than in America…and fewer women work outside of the home. And those who do schlep and cipher do less of it. Our office in Paris, for example, is required to shoo employees out the door in the evening – or risk getting fined by the government. The 35-hour workweek is the law of the land. Employers have to be careful to make sure workers don’t "feel" as though they should work more than that. Only one employee regularly stays past 6 in the evening…and he is allowed to do so only because he convinced his supervisor that he is not really working…but just amusing himself on the computer.

*** But in America, the rabid Wall Street dealmaker sits on top of the social pile – proud of working 80 to 100 hours per week. Seldom does a quarter hour go by that his cell phone does not ring or rattle. Rare is the day that some deal is not teased along or a sale consummated.

*** But in Europe, as in America, the art of trying to feel superior has its irony; no matter which train you ride, the people you are trying to feel superior to always take you for a fool.

Back tomorrow,

Bill Bonner