China and Deflation

Profits are falling, but stock prices are rising.

Unemployment is rising. And, the percentage of FHA home loan payments more than 30-days behind is at 11.36%, the highest since ’72, when they began keeping the figures. But lenders continue to lend more and consumers are buying more houses.

Information technology has never made a net dime of profit, but these are the very companies that are soaring in price – as if investors had learned nothing from the crash of the Nasdaq.

The supply of dollars is increasing about 8 times as fast as GDP – yet the dollar goes up in value!

All of these things are absurd. But here at the Daily Reckoning, we love absurdities. We collect them the way
some people collect coins or old cars – for fun and profit. It is amusing to gawk at them. Occasionally, it
is profitable, too…because market absurdities represent cases of extreme divergence between "should"
and "will," a form of potential investment energy. Like a jogger crossing an icy road or a fat man in a decrepit chair…we can watch for pure enjoyment…or try to figure out how to make a buck from it. Investors rarely go wrong betting that an extremely absurd situation will be less absurd in the future.

It seems preposterous that consumer prices barely budge, for example, while the supply of dollars gallops ahead. But in today’s letter we take a peek at a small part of the reason why the dollar’s purchasing power may be less absurd than it appears.

"Why aren’t prices rising as fast as the money supply is (8%)?" asks Gary North. Then, among the answers:
"…because prices of imported goods are falling. They are cutting prices because they are in recession. Also,
the dollar is rising in relation to Asian currencies."

"Last week," Gary continues, "my friend Bob Anderson was in a Costco discount store. His wife pointed to a pair of irons. One cost $79. It was imported from Germany. The other cost $23. It was imported from China."

"Millions of Chinese workers have already been laid off from loss-making SOEs (State Owned Enterprises) and millions more depend on the state companies for their
livelihood," reports Economyline. If more Chinese workers lose their jobs, it "could become a threat to
social stability."

"Idle hands are the devil’s playmates" goes the expression. The Chinese have more than 2 billion hands
that must be kept busy.

After 20 years of market reforms, state companies still make up one-third of all Chinese enterprises. The wheels and assembly lines of these factories must keep turning…or there could be big trouble in China. What can China do to keep the wheels turning? It must undercut the competition by providing goods and services more cheaply.

China sees its opportunity – to become the largest manufacturer in the world. But the rise of China’s factory capacity makes it very difficult for manufacturers everywhere to maintain prices. That is a large part of Japan’s problem. It cannot compete with the Chinese. Japan is now desperately trying to reduce the value of its currency in order to remain competitive. But it looks like a losing proposition. In order to match China’s prices, Japan would have to match China’s labor rates.

"The specter of deflation is haunting Asia, bringing the risk of further pain to a region struggling with one of the steepest economic downturns on record," says Economyline. "Economists said the unfolding shock to
global demand, coupled with a flood of goods from low- cost China, was putting heavy downward pressure on prices and could pose serious policy challenges, if the trend persisted."

Prices in Hong Kong have been falling for 35 months. Prices have been falling in Taiwan and Japan too.

What’s causing prices to go down? "…The inexorable rise of China as the world’s lowest-cost producer in
most sectors, robbing its competitors of pricing power," says Economyline.

Says Vincent Chan of UBS Warburg in Hong Kong: "China’s exports have been holding down world inflationary pressure, and I think that’s going to last for a long
period of time."

While American manufacturers have been in decline for more than a year, China’s factories have been booming. All over the world, economies are in recession – except for China’s, which is growing about at fast as America’s money supply!

Ah ha! We know it is a meaningless factoid, but we find it irresistible nevertheless: To the question – Why are consumer prices stable? – comes the immediate and simple answer: because China’s output of goods is growing at about the same rate as America’s output of dollars.

The big exceptions to stable prices in America are services and real estate – which are still rising in
price and to which China offers no competition. The Chinese cannot build houses in the U.S…nor can they
manufacture U.S. land. If they could, those prices would be stable or falling too!

Yours sincerely,

Bill Bonner
January 04, 2002

Should stocks be going up? Nope.

Are they going up? Yep.

Will they continue going up? Who knows!

There you have it: Wall Street on the first week of the first palindromic year since 1991.

We, investors, cannot know what the market will do. We have to content ourselves with what the market
should do.

Yesterday brought news that unemployment was still rising. "The number of U.S. workers filing new claims
for jobless benefits unexpectedly surged last week," according to Bloomberg.

Meanwhile, manufacturing continued to decline too – its 17th consecutive monthly decrease. Not since the
Great Depression have we seen anything like it. But, the rate of decline is – according to news reports –
slowing.

But stocks, it is said, are looking beyond the grim present to the glorious future. There, earnings are supposed to double in the next 12 months…and stock prices as supposed to go up at double-digit rates
forever.

Is this the future? Or Never-Never Land?

Of course, Mr. Market can do whatever he wants. Far be it for us to tell him otherwise. But, we feel confident that eventually…he will do the right thing!

Eric, what did he do yesterday?

*****

Eric Fry in New York…

– My oldest son and I went to Madison Square Garden last night to watch the Knicks play against the Mavericks. The Knicks couldn’t seem to make a basket, but somehow they still managed to win the game in overtime… "Winning ugly," it’s called.

– And winning ugly is exactly what the stock market has been doing. Every company, it seems, is laying off workers and reporting earnings that are well below what they were last year. No matter, the stock market keeps going up and investors keep paying 50 to 100 times earnings for the stock of any company whose CEO says, "Visibility is improving."

– Yesterday, the NASDAQ surged more than 3% to 2,044 and the Dow gained 99 points to 10,172.

– Whoops! What’s this?…Rising unemployment? Didn’t Larry Kudlow and Abby Cohen assure us that Greenspan had fixed that problem already?

– Sometimes the cold hard facts intrude upon Wall Street’s pat little stories. The story Wall Street has
been peddling for a few weeks now is that the world’s most resilient economy – ours – is on the mend. "And there is no one who doesn’t know it," Jim Grant quipped yesterday.

– But then…Wham!…along comes an ill-fitting subplot to the story line. Imagine Lady MacBeth hosting a quilting bee. It doesn’t quite fit, does it? And neither does the fact that initial jobless claims increased by
36,000 to 447,000 in the week that ended Dec. 29. Furthermore, the Labor Department sharply raised the
level of claims for the prior week to a revised 411,000 from 392,000.

– And the bizarre subplot thickens…as the total number of individuals collecting unemployment benefits
continues to soar – up 42,000 to 3,715,000 during the week that ended Dec. 22.

– None of this troubling news seems to bother investors however…not while Wall Street is tackling their ears
with many other happy stories about better times ahead in the technology sector.

– A virtual "Tech-stock-palooza" thundered through Wall Street yesterday. The feel-good spectacle featured a pyrotechnic display of skyrocketing tech stocks. EMC, the data-storage company, kicked things off by
soaring more than 10% two days in a row, sparked by kind words from a Salomon Smith Barney analyst.

– Many other tech stocks put on a show worthy of "ooohs" and "aaaahs." Cisco, Oracle, and Applied materials all soared more than 8% each. Might the imagined future technology company revival be far more spectacular than the real thing?

– Meanwhile, GM figured out a completely new way to lose money selling cars – it’s much better than the old way. Give $2002 cash rebates on the purchase or lease of any new 2001 or 2002 GM vehicle. The Big-Three automaker launched its "GM Overdrive" cash rebate plan to replace the "Keep America Rolling" 0% financing package. Stay tuned for the "GM Earnings Downshift" package.

– When toasting in the New Year earlier this week, a few JP Morgan executives might have switched from vintage champagne to Andre’s Cold Duck. That’s because the big bank slashed its investment bankers’ year-end bonuses by an average of 40%. Several times in the Daily Reckoning we’ve mentioned the prospect of reduced year-end bonuses and wondered aloud whether this phenomenon might put a crimp in consumer spending in early 2002. We’re still wondering, especially now that the rumored bonus cuts
are becoming a reality.

– Sadly for the consumer, smaller bonuses aren’t the only item that might start to take a bite out of his spending money. Rising unemployment and rising interest rates have been known to take a large bite or two as well.

– Therefore, the list of things consumers aren’t buying – like theme park vacations – seems to be growing. The Walt Disney Company’s parks were among the hardest hit. "Epcot at Walt Disney World in Orlando recorded the largest drop in attendance, 15%," the Wall Street Journal reports, "followed by Disneyland in Anaheim, California, down 11%."

– But according to a couple of prominent insiders, business is rebounding in some pockets of the tourism and leisure industry. "Marriott International CEO Bill Marriott Jr. said the negative effects of Sept. 11th have largely faded," Investor’s Business Daily reports, "Hilton Hotel’s CEO Stephen Bollenbach also said
business has returned to pre-attack levels."

– Don’t believe it. Manhattan’s luxury hotels are engaged in some pretty severe price wars right now. Even
5-Star hoteliers like the Carlyle – which normally keep well above the fray – are getting into the act.

– The only thing in the country that’s selling for "full retail" these days is the S&P 500.

*****

Back in Ouzilly…

*** The euro is rising. But I prefer the franc. It was easier to pronounce.