Capital Spending Bust
“Three successive announcements that the Fed was lowering its targeted short-term rate – from 6.5 percent Jan. 3 to 5 percent as of March 20 – have so far brought about no significant response form the economy itself,” Chris Byron notes. “Factory orders are declining, gross domestic product continues to inch downward, durable goods orders are slipping and leading indicators are weakening.”
It is possible, of course, that Mr. Greenspan & Co. have not yet found the magic interest rate that sparks new growth in the economy and sets investors’ hearts on fire. He still has 500 points that he can try – on the downside – and an infinite number on the upside.
But it is also possible that there is no magic rate – and as the Japanese have demonstrated, sometimes even free money is not cheap enough to entice borrowers.
“As economists now increasingly realize,” Byron continues, “the boom of the 1990s was rooted to a significant extent, in the soaring value of financial assets on Wall Street, which are now disappearing.”
“The growth of those assets had dramatic and far- reaching consequences for the economy,” he explains. “Among other things, they encouraged individuals to stop saving for retirement since rising asset values on Wall Street were, in effect, doing the saving for them. The freed-up capital poured into the economy has sustained a surge in consumer spending, creating a level of demand for consumer goods that had not before existed.”
In today’s letter, to quickly give you (there, I split an infinitive for you) a warning of what is coming, I attempt to explain how a boom in capital spending misled businessmen, economists and investors.
“An entire generation of companies like WorldCom and Cisco Systems…grew to spectacular multi-billion- dollar valuations,” Byron elaborates, “[and] helped fuel a huge boom in capital spending – an investment explosion that in turn generated an enormous outpouring of goods and services for which there was, and is, no demand…” Byron adds.
It looked for all the world like a bubble. Sober men and women were buying stocks at levels that seemed absurd. With straight faces, CEOs announced multi- billion dollar acquisitions of start-up companies with no revenues. Popular books promised a Dow of 36000. Financial magazines – not satire rags – told all the world how to GET RICH…STAY RICH…AND LIVE RICH FOREVER.
But economists – including the most famous and powerful practitioner of the dismal science who ever lived, Alan Greenspan – saw two things in the developing boom that made them think it was solid and enduring.
First, corporate earnings rose. And second, so did productivity.
“In the past 50 years,” writes Marc Faber in Forbes, “after tax profits have increased at an average rate of 7.6% a year, compared with 7.4% growth in nominal GDP. However, in the past 9 years, corporate profit growth accelerated, particularly for the S&P 500 companies, whose operating earnings have grown by 13.5% a year on average, compared with 5.8% growth in GDP. This was the highest annual earnings growth rate over a 9-year period since World War II.”
Meanwhile, productivity doubled to 2.4% in the 10 years beginning in 1990.
The increases in productivity and corporate earnings seemed to confirm that the billions spent on new Information Technology were paying off…and that the Information Age was for real.
That was then. This is now:
“Today, CEOs are scrutinizing the payback from all the IT spending,” reports an article in Fortune Magazine. Despite the productivity gains, Fortune says, “now even Greenspan seems to fear that all these gains were induced not by IT itself but by spending on IT. In other words, if a firm buys a new computer, the very act of spending will add output to the economy, and assuming employment remains steady, increase productivity…”
What did corporate America really get for all the billions spent on routers, computers and software? What did it gain from all the preaching, hectoring and lecturing it endured from the oh-so-superior technophiles? Probably not much. But for a while, the spending had a very flattering effect on corporate income statements as well as on productivity levels.
Capital investments, unlike consumer spending, are treated as current income by the seller, while the cost is expensed, over time, by the buyer. The net effect is to leave businesses with higher profits in the short-run, but expenses spread out for years to come. These expenses should be offset by higher levels of productivity and future profits – but, in this respect, IT spending could be a big disappointment.
Typically, businesses borrow to make capital improvements. Thus the future expenses are not just bookkeeping entries on next year’s operating statement. They are real debts that have to be paid.
“The U.S. corporate sector now has the highest-ever burden of debt as a percentage of revenues. In a sluggish and possibly deflationary environment,” Marc Faber warns, “this will wreak havoc with profits.”
If stock prices continue to fall – as they should – consumers will cut back on spending. Businesses have already cut back on IT spending – as evidenced by the rising inventories at Cisco and other Big Tech suppliers. In Silicon Valley, they are calling it a “buyers’ strike.” But that is probably the most optimistic way to look at it. Strikes can be suddenly called off. What would induce businesses to invest big money in IT once again? A rate cut, perhaps?
“Even an interest rate of zero cannot revive the capital spending boom,” Christopher Byron concludes. “So get used to it, Greenspan, you’re now going to be blamed for being unable to fix a problem you never should have created in the first place…and nothing you can say or do about it now seems to matter much either way.”
Your humble scribe, reporting the news…sticking to the essentials,
April 10, 2001
*** Another relatively slow day on Wall Street. Light volume. Little news.
*** So starved for excitement were investors that when Amazon.com founder Jeff Bezos said that yes, Amazon.com would lose money, but no, not as much as expected, the stock rose more than a third. Of course, a third of AMZN is not nearly as much money today as it was a year ago. That only left the stock at $11 and change.
*** AMZN led the Internets to an 8% increase for the day.
*** What else happened? Well, IBM fell 2% following a negative article in Barron’s. And GE rose 2%, for no apparent reason.
*** The Dow ended up 54 points. The Nasdaq rose too – up 25.
*** Broad money supply (M3) rose by $66 billion last week. Consumer borrowing is still expanding at a 10% rate. Revolving debt, too, is increasing at about a 10% annual rate.
*** “Money supply as measured by M2 and M3 growth has skyrocketed since the beginning of the year…” says Daily Reckoning contributor Michael Belkin. “In fact, the surge is equivalent to those that accompanied the Fed’s Y2K credit expansion over a year ago, or the late-1998 LTCM bailout. Those were bullish events for the U.S. equity market…that is,
until the monetary binge ended.” (href=”http://www.dailyreckoning.com/body_headline.cfm?id=1060″>Has The Fed Abdicated Its Authority?)
*** How long can money and credit continue to expand nearly 10 times as fast as the economy (that is, the value of all the goods and services the money and credit buy)? Good question. Answer: not forever.
*** But while money comes into the system, it also goes out. The LA Times reports that the city of Los Angeles alone stands to lose $193 million from the bankruptcy of Pacific Gas & Electric. In Japan, banks are writing off 4 trillion in bad loans. And the Toronto Globe & Mail puts total U.S. stock market losses at $6 trillion.
*** One of the miracles of the modern world is the way the dollar has, so far, held steady…or actually risen. Yesterday, the dollar rose again, slightly…pushing the euro back below 90 cents and knocking the price of gold down $1.70.
*** This miracle is viewed as an enduring one by investors – as evidenced by the widening gap between the CPI and the “break-even” rate on inflation- indexed bonds. On February 28 of this year, the Consumer Price Index was clocked at 3.5% – that is, the cost of living was said to be rising at that rate annually.
*** On March 26th, the 10-year inflation-indexed Treasury yielded just 3.36% – for a negative real yield and only 1.65% less than a regular non-indexed Treasury obligation. This latter figure is Mr. Market’s implied expected increase in the CPI each year for the next 10 years. If the inflation rate is higher than 1.65%, investors who bought the indexed Treasuries will come out ahead. If the inflation is less than that amount, investors who bought the regular Treasuries will be the winners.
*** Are you still with me? I hope so. Because I haven’t come to my point yet: 1.65% is a low number. In fact, it is lower than any of the numbers the CPI has registered for the last 30 years. According to Grant’s Interest Rate Observer, “the CPI has risen by an average annual rate of 2.67% over the past 10 years, by an average of 3.57% a year over the past 20 years and by an average of 5.04% a year over the past 30 years.”
*** After destroying their currencies – little by little – the world’s central bankers are undoubtedly getting good at it. Of course, there is no law that says they have to continue doing what they do best. But nor is there any law that prevents them.
*** If you consider Treasury inflation-protected securities (TIPS) as insurance against inflation, the cost of protecting yourself is cheap. It is cheap because most investors do not believe there is much risk. “TIPS constitute one of the world’s few investment bargains not measured in troy ounces,” says Jim Grant.
*** Dallas Fed chief, Robert McTeer, said he expected the economy to grow at a 1% annual rate in the first quarter and then to slip into negative territory.
*** Lynn Carpenter: “The cover article in the March 19 Forbes gives the ten best tech trends to invest in…’even in a down market these will pay off,’ Forbes swears. Maybe so. I checked. To be fair, Forbes gave four pans: Motorola, Sirius, Amazon and The Street…and they did drop an average 32%.
*** “But the winner list? Even worse.” says Lynn. “The average loss was 35%. Only one of the 16 recommended stocks is up, Network Associates. The other 15 are down. Some really down, like Palm -67%, Level Three -63%, ECM -78%, Brocade -57%, Foundry – 45%. This is in seven weeks…even after Nasdaq had already dropped 40%. Fools do rush in, don’t they?
*** “Forbes picked Global Crossing to buy,” Lynn adds, “It fell 39%. I picked it too, as a short play for Contrarian Speculator. We bought a put option last Thursday and made 80% in three days on half our contracts. We’re now up 113% on the remainder – and looking for more.”
*** “Splitting infinitives sounds bad,” said Elizabeth.
“But it only sounds bad because you believe it is a mistake,” I replied, fresh from reading “Tense Present” in Harpers. “The rule comes from Latin, where you can’t split infinitives, and was misapplied by 19th century grammar snoots. It made them feel superior to the hoi polloi.”
“Yes,” said Elizabeth, “but that’s true of everything. Once you know how things should be – that’s the way you think they are best. You judge things by applying the standards…the rules of refinement…”
“But once you know that the rule against split infinitives is a mistake, like pronouncing the ‘t’ in often,” I continued, “you can split all the infinitives you want – and feel even snootier than the snoots.”