Anatomy Of A Bust

The Daily Reckoning Presents: A Guest Essay in which the author takes a look at the “vicious cycle” currently consuming the markets…


by Eric J. Fry

The vicious cycle of falling corporate profits that prompts cuts in capital spending and layoffs, that fosters less consumer spending, that leads to even lower corporate profits – it’s just getting warmed up.

During the boom, $50 million, give or take, would buy a standard suburban garage stocked with two PCs, two recent college grads and a B2C business plan scrawled on a napkin. We called this “investing” – or more specifically, venture capital investing – and, from coast to coast, folks lined up to give it a whirl.

Since then, we have learned that $50 million is a lot of money, especially when it is gone. We have also learned that much of what passed for investing was nothing more than rank speculation. Like a bottle-blonde, it only looked like the real thing. Enter the bust, phase one: Billions of dollars of VC money went “poof,” along with another $5 trillion or so of stock market wealth. And sooner or later, we’re going to miss this money.

The astonishing thing is that hardly anybody acts like it’s gone…so far. The line of people at Starbucks waiting for $5 cappuccinos is just as long as it’s ever been. (I know. I stand in it.) What kind of pathetic excuse for a bust is this? Five trillion dollars disappears and still people buy lots of expensive cars, houses and espresso drinks.

“A few quarters of weak GDP growth? A collapse in capital spending offset, in part, by the indomitable leveraged consumer? Is that all there is?” colleague James Grant muses. “No, it seems to us. The millennial adjustment is far from over. Telecom and tech were not the whole bubble, only the most visible portion.”

Make no mistake, the bust isn’t over – in fact, it’s just getting warmed up. All Greenspan’s horses and all Greenspan’s men, not to mention all Greenspan’s interest rate cuts, won’t be able to put this economy back together again…at least not any time soon.

About the only way to get things back on track is to clear away the debris of the boom years. “Busts are indispensable,” says Grant. “At least – behold Japan – no proper boom can be built on the uncleared debris of a preceding boom. What is this debris? Business and financial error as reflected in misbegotten investment projects, bad debts, impaired balance sheets, wild expectations. The job of the bust is to redress these mistakes – in effect, to mark them to market…”

“Bust” is just a four-letter word for vicious cycle. It takes a little time to crank these babies up, but once they start humming, there’s no shutting ’em down. The cycle goes something like this: Corporate profits fall; businesses curtail capital spending; businesses lay off workers; the newly unemployed and the now-paranoid remaining workers, in their part-time role as consumers, spend less money. And once everyone starts spending less money, corporate profits fall even further. You get the idea.

Come, let’s take a closer look at the bust currently underway. First off, corporate profits are falling. The surge in productivity that Greenspan and all the ivory- tower dwellers crow about did not prevent business sales from dropping 1.1% in the second quarter – the first such decline since the last recession in 1990.

Expressed another way, the quarter-to-quarter annualized decline in business sales registered at a minus-2% rate in the first quarter and worsened to minus-2.8% in the second quarter. “Meanwhile, [corporate] profits stumbled from a year-to-year growth rate of 19.8% in Q3 2000 to a 21% decline by Q1 of this year,” reports Moody’s. “Without a real upturn in revenues and profits…it is hard to imagine hiring activity gathering speed…”

Indeed, quite the opposite is occurring. Cutting expenses is the hot topic in boardrooms across the land. Businesses are slashing both discretionary capital expenditures and non-discretionary costs, otherwise known as employees. After rising by a cumulative 287,000 in the first quarter, non-farm payrolls reversed course in the second quarter, shedding 217,000 jobs. “The annualized growth in state unemployment benefit recipients soared from 37.5% to 90.1% over the same span,” Moody’s relates. “July’s 3.06 million state unemployment benefit recipients was the highest [number] since October 1992.” Clearly, hiring activity is not gathering speed.

Furthermore, a decline in hours worked reflects the weakening demand for labor. “After rising by a meager 0.2% year-to-year in the first quarter, hours worked in the productivity series declined 0.5% annually in the second quarter,” observes Moody’s. “Hours worked last year entered into a year-to-year decline in 1990’s third quarter, or what was the first quarter of the last recession. Since 1950, annual drops in hours worked were recorded in nine instances,” Moody’s goes on. Eight of the nine coincided with recessions.

Enter Greenspan, armed to the teeth with rate cuts and money-supply growth. His six rate reductions in six months were – like Evil Knievel trying to jump the Snake River Canyon – an audacious feat never before attempted. Throughout its 88-year history, the Federal Reserve had never before cut the discount rate six times in less than six months (thank you, James Stack).

Greenspan has “succeeded” in cutting rates, to be sure, but the cuts seem to have done little more than reduce the number of Denny’s “Grand Slam” breakfasts that retirees can afford to buy each week. Neither consumers nor businesses are borrowing as much as hoped, or, for that matter, as much as needed.

Throughout the Greenspan regime, the Fed has always attempted a kind of recessionus interruptus whenever trouble loomed, by fostering an environment in which it is easy to borrow money and, therefore, to spend it. In other words, the Fed lowers interest rates and expands the money supply, thereby enabling banks to lend more money at cheaper rates.

Businesses and consumers then avail themselves of the “inexpensive” debt and start spending money they don’t have. Soon, the economy recovers, and paying back those old debts becomes no worse than a manageable nuisance. At least, that’s the theory.

This go-round is no different, as far as the Fed is concerned. Greenspan’s game plan for reversing the current slowdown relies on the hope that businesses and consumers, even if they stop spending the money they actually earn, will start spending whatever money they can borrow. But it’s not happening and that’s why this economy is in trouble.

Initially, when the Nasdaq bounced last April and a handful of economic indicators followed suit, the Fed seemed to be succeeding in its mission to revive the economy. But that brief respite now looks like a fluke, more the result of surging home-equity borrowing than any Greenspan magic. But for the largesse of home loan lenders and their relaxed lending practices, our economy would be in the tank. Mortgage refinancings through July surged 469% year-over-year.

“Aha!” you say, “the result of lower interest rates.” Not quite. Many homeowners refinanced not to lower their payments, but to take equity out of their homes. Fully half of this year’s record $660 billion of refi transactions put money in the borrower’s pocket, according to Mortgage Servicing News. In most of these cases, the monthly mortgage payment actually increased. Susan Sterne, of Economic Analysis Associates, Greenwich, Conn., reports that home-equity mining has become, for some, a kind of career. “There are people [in hot areas] who live on refis of appreciated housing,” Sterne says. But not even a record $660 billion of refi cash can compensate for $5 trillion of stock market losses and rising joblessness.

All the more so because home-equity mining looks to be a one-off phenomenon. Putting aside the unthinkable possibility that home values might decline, thereby slamming shut the door to more home-equity borrowing, the willingness and capacity to borrow, both practically and psychically, may be pushing up against the limits.

“Private sector credit as a percentage of GDP has fallen to 137% (from a peak of 143% in 3Q00),” Walker and Fishwick observe. “Bank lending to commercial and industrial categories is now running negative year-over- year. Commercial paper outstanding to non-financial companies has fallen to $234 billion from its peak of $350 billion a year ago.”

Which brings us back to the beginning of our vicious cycle. If businesses and consumers don’t spend, corporate profits don’t rise. In fact, they fall. If six rate cuts have not managed to break the downward cycle, why should the seventh?

Eric Fry

Eric J. Fry, the Daily Reckoning’s “man-on-the-scene” in New York, is the former editor-in-chief of Mr. Fry has been a specialist in international equities since the early 1980s and was a portfolio manager for more than 10 years.

*** Poor James Glassman. If only he had half a brain!

*** He should have panicked when the fear first came creeping up his back.

*** Instead, he let his left brain talk his right brain out of doing what it wanted to do – sell out. He’s holding “for the long run” – when, he’s darned certain, stock prices will be higher. They’re always higher in the long run, aren’t they? Life always gets better, doesn’t it?

*** Well, yes…except when it gets worse.

*** Yesterday, things got worse for investors worldwide. With no virgin and no volcano anywhere in sight, Alan Greenspan cut the fed fund rate by another quarter of a point. It was hoped that this 7th cut would do that which the previous six had been unable to do – touch off the “rocket fuel” of cash that is said to be lying around. But instead of shooting up…the stock market blew up.

*** Eric, can you give us the details?


Eric Fry in New York:

– The Dow Jones Industrial Average dropped 146 points yesterday to 10,174, while the Nasdaq Composite Index tumbled 50 points, or 2.7%, to 1,831.

– Greenspan seems like a nice enough guy and it’s clear he means well, but can somebody please tell him that his interest rate cuts don’t really do anything?

– Stocks, in particular, are putting the lie to the myth of Greenspan’s magic interest rate. They’ve been declining all year. No doubt about it, the stock market is a rough place these days. How rough? Even James Cramer, founder/columnist and self- anointed investment guru, is losing money.

– Cramer’s personal portfolio, updated daily in the “RealMoney” section of, has lost 8% since April Fool’s Day, 2001. The starting date is, I’m sure, pure coincidence…

– The genetically bullish Abby Joseph Cohen reduced her earnings estimates for the S&P 500 and trimmed her year- end price target – again – for the index from 1,550 to 1,500. Considering that the S&P 500 currently trades at 1,157, she has left herself plenty of room for future price target reductions.

– Neither Cramer nor Cohen’s brand of investment genius operates “24/7,” but only in bull markets. In bear markets, it’s a pretty safe bet that Mr. Market doesn’t care what either one of them predicts.

– Down in the dark, dank caves far removed from proper society, where gold bugs, class-action securities lawyers and other social outcasts congregate, the question on every investor’s lips has been, “Is this the big one?”

– Is it? Could it be? Is this the beginning of the epic new millennial gold rally?

– The bullion price has advanced about 4 « % over the last three weeks. What’s more, the XAU Gold Stock Index has gained almost 14% since Greenspan kicked off his rate-cutting adventure on January 3rd. By contrast, the Dow has dropped more than 4% since then and the Nasdaq a perfect bear market 20%.

– It’s enough to make a guy bullish on gold.


Back to Bill in France…

*** Oh la la…as we say here in La Belle France…God does not share His plans with us here at the Daily Reckoning. But He occasionally drops a hint.

*** The Wall Street Journal reports that P/E ratios are typically understated, because companies tend to inflate the divisor, that is…earnings. If earnings were brought down to GAAP standards, the P/E ratio of today’s S&P 500 would be 36.7 – the highest it has ever been.

*** So, let me pose a rhetorical question; Does it make sense to own stocks at the highest prices in history when:

-rate cuts have just been cut for the 7th time – after which, investors dump stocks!

-consumers are tapped out – savings are at their lowest level ever, consumer debt at its highest

-durable goods orders are falling – they fell 2% in June, after a rise of 2.7% in May…car sales dropped 5% in June

-unemployment is rising – AOL announced another 1700 layoffs yesterday. Ford says it is cutting 5,000 jobs. And Futjitsu is eliminating nearly 15,000 employees…

-world trade growth is off 60% since last year… while world GDP growth is falling below the IMF’s 2.5% recession threshold

-business profits are falling…down 17% in the 2nd quarter with no sign of improvement…

-And the dollar is, finally, going down?

*** People believe in stocks “for the long run” because equities tend to go up more often than they go down. But nature does not give something away without taking something back. In order for stocks to go up most of the time, they have to go down A LOT some of the time…

This may be one of those times.