Fatal Decisions

People can believe what they want to believe. In the `60s movie, Closely Watched Trains, a man tells how his father – a magician – believed he could stop the invading Nazi tanks.

“And so he stood in front of them,” he says, “and using the power of his mind alone commanded the tanks to stop. And they did stop…for a moment.”

We left off yesterday mischievously wondering whether there might be some over-riding principle – such as Emerson’s Law of Compensation – which might give us a clue as to what will happen next in U.S. markets.

Markets, being instruments of poetic justice…or torture… always seem to find the Perverse Outcome – the result that inconveniences the greatest number of people at the least convenient time. As I am fond of saying, they give people what they deserve, rather than what they expect.

There is a simple reason for this, of course. When people expect a particular outcome – they rush to take advantage of it. If a stock, for example, is expected to rise in price – they buy it. The very act of investors seeking to gain from predicted events almost guarantees that those events – in so far as they are market-based – will never happen as expected.

Thus, in the example given above, it was expected that buyers of CMGI stock would be “richly rewarded.” CMGI was not merely an Internet company…but an `incubator’ of other dot.coms and techs. Buyers of the stock could imagine their profits growing like little yellow chicks under a heat lamp…dozens…hundreds of successful projects – each one a potential AOL or Microsoft.

This expectation, alone – backed by analysts such as the infamous Henry Bloget and a chorus of financial media – was enough to destroy all hope of ever making a profit on the stock. The price of the stock soared to $163 in January – a level so unrealistic that an investor might just as likely sprinkle Miracle Gro on a pile of cash in the hopes that it would sprout additional $100 bills. Of course, you could have made money by speculating on how extravagant the hallucination would become…or when it might end…but that is a very different business…

“From a strict economic perspective,” writes Dr. Kurt Richebacher in his most recent report, “it is hard to imagine a greater economic folly than buying low-yielding equity capital with much higher yielding indebtedness.”

You could search high and low in the winter of ’99-’00 and find no lower-yield investment than CMGI. There was no yield. Zero.

And yet, if you look at the aggregate financial numbers for the entire U.S. economy, you see that buying very low- yielding assets, with much high-yielding debt, was just what was going on. Corporations sold bonds – often at junk-bond yields – in order to buy their own stock…or the over- priced stock of other corporations. People were mortgaging their homes – at 8% interest – in order to buy stocks like CMGI, that yielded nothing.

This may have had a salutary effect while CMGI and other stocks were going up in price – the capital gains offset the cost of borrowing. But when CMGI stock went down, the full effect of the folly must be felt. The asset disappeared. But the debt used to acquire it remained. It is as if you had bought a new home with a big mortgage, and then the house burned down – uninsured.

The way you become wealthy, generally, is by working hard, saving your money, investing it wisely, and waiting. People who do so deserve the wealth they get.

By contrast, when you spend more than you earn, go deeply into debt, and buy `get-rich-quick’ stocks, you deserve something else. What? We will find out soon…because that is what American businesses and consumers have been doing. Where they should have been saving – they were spending. Where they should have been investing in real businesses with real products and real profits – the money went into foolish projects – such as CMGI.

“After paying out dividends and covering their investment expenditures,” explains Dr. Richebacher, speaking of what he calls `degenerate U.S. capitalism’, “the U.S. corporate cash flow overall is in the red. So in reality the huge stock repurchases have to be financed by borrowing at interest costs that are generally several times higher than the rock- bottom equity yield. How can a corporate manager in his right mind do this?”

Why would they do such a dumb thing? Because investors as well as superstar CEO’s became obsessed with fast, easy money. Building a business…and making real money…takes time, effort, expertise, and forbearance. It was much easier to `unlock shareholder value’ by jimmying up the share price.

Dr. Richebacher provides an example: “IBM is a case study of how to delude investors,” he writes. “Over the last four years, Big Blue has managed to increase its revenues by a modest 5% and its gross profits by an even more anemic 1.3%. However, thanks to a massive $34 billion share buyback program, it managed an average annual rise of 10.5% in the one number that Wall Street treasures above all others: per share earnings.”

While per share earnings were rising, so was per share debt. But the per share debt number is not even noticed. No one cared about debt – neither consumers nor businesses – as long as they could keep the share prices rising. Balance sheets suffered – from those of powerful multinational corporations such as IBM down to those of people who live in trailer parks.

People now owe a lot more money than they did 20 years ago. So do corporations. They expect that they will not need xsavings. In the last two years, for example, personal savings collapsed from $265 billion in 1998 to less than $50 billion this year. And they think stocks will soon resume their upward move.

“The old joke about ‘Where does a 600 pound gorilla go?’ gets answered by: ‘Anywhere it wants to go!’,” wrote Ray Devoe recently, referring to the effect of momentum buying on big techs like Cisco, Sun and even GE. “…these ‘600 pound gorilla stocks’, with total market caps of just under $2.6 trillion at their highs, still represent a major supply of stock in the hands of ‘true believers’ or momentum players.” (see: The Untouchables: Taken Out And Shot http://www.dailyreckoning.com/body_headline.cfm?id=773)

The true believers, like the man who thought he could stop trains with his mind, were able to drive the price of their stocks to nosebleed heights… for awhile.

We know what these people expect. What do they deserve?

“If I am right,” Marc Faber observed recently, “and the next recession is a deflationary bust, then corporate America will have made a fatal decision…[to go so deeply in debt].” Non-corporate America, having made the same decision, will suffer too.

Your correspondent…

Bill Bonner

Paris, France November 22, 2000

P.S. Tomorrow is Thanksgiving. But it is not a holiday in France. So I will write, anyway. My apologies in advance.

*** Yesterday’s big news: the trade deficit hit a new record. Americans are exporting less and importing more.

*** In September, the US imported a record $126 billion of goods and services, producing a gap between imports and exports of more than $34 billion – $3 billion more than economists expected.

*** Caterpillar, the world’s largest manufacturer of heavy equipment for the construction industry, said its profits fell 1.4% in the 3rd quarter.

*** US manufacturing companies have only been able to increase profits 3.4% per year for the last three years – the peak years of the New Paradigm economy. Why the low profits? The strong US dollar makes imports relatively more attractive. US companies – faced with cheaper competition from abroad – have been unable to raise prices…which also explains why domestic inflation has been so low.

*** The total deficit through September came to $270 billion, compared to $188 billion in the same period last year.

*** There were big increases in imported energy – oil imports, for example, rose 16% in September. Natural gas, imported in volume from Canada, is at a record high price. Heating oil is near its highest level since 1979 – over $1 per gallon.

*** Meanwhile, a snowstorm in the Buffalo area reminds us that there are cold winters as well as warm ones…and that nature, and her markets, are perverse. When better to have a cold winter than when heating oil supplies are low? People don’t necessarily get what they expect or what they hope for, but what they need and deserve. More below…

*** You might think that the dollar would fall on the news of a greater-than-expected trade deficit. But no! The dollar rose. The euro fell about 1% – under 85 cents.

*** “The bottomline,” according to Nick Sanger of JP Morgan Private Bank, “is: why are foreigners putting money in [the U.S.]? International and U.S. investors perceive that the returns on investment in the U.S. are higher than the rest of the world.”

*** International investors, like their domestic counterparts, suffer from the momentum of sentiment factor. Ed Hyman, for example, reports that even though both the Dow and the Nasdaq are down for the year – with the Nasdaq close to losing half its value – equity fund managers are “record bullish”.

*** Perceptions will eventually catch up to reality. But it takes time. Rarely do you see the media discussing the end of the bull market. Why? Because they never recognized that there was a bull market. In the minds of these pilgrims stocks always go up in the long run and the stock market always acts pretty much as it has for the last 18 years. There is volatility…but no downward trends.

*** Lucent warned investors that its 4th quarter profits may not be exactly what it had hoped for. The stock fell 16% on the news – dragging down a number of issues in the tech and net sectors. Lucent was $60 a share in July. Now, it’s $17.

*** “The whole market on the tech side,” said one analyst, “just has no support.” “Still a massive weakness in technology,” added another.

*** One of the stocks noticeably weak was CMGI, the Internet incubus… I mean incubator. This was one of Henry Blodget’s favorites back in the glory days of dot.coms. Blodget was undisturbed by the high price – $163 last January. Many of these stocks, he said, “perpetually look overvalued.” But don’t worry, buy them, he advised, and you will be “richly rewarded.” Well…investors got the reward that they deserved, if not the one that they expected. In the last month, two of CMGI’s sucklings have announced layoffs. Four said they were going out of business. The stock closed at $10 and change yesterday – down 94%.

*** The Dow rose 31 points yesterday. But the Nasdaq fell 4 points.

*** Yahoo hit a 2-year low, losing 14% during the day. AOL, which was $95 a year ago, can be bought for $43 today. Amazon.com closed down – at $24.25. A news report says that Amazon’s 400 customer service people are trying to unionize. [Collective bargaining suggestion: forget pay hikes, ask for generous layoff and termination terms]

*** Gold fell 70 cents. Gold mining shares are among the ugliest securities you can buy. This may be a good time to buy a few shares.

*** “The strikingly popular earnings augmentation,” writes Grant’s Investor’s Eric Fry, “is a delicate operation that typically requires the replacement of a company’s GAAP earnings with a kind of financial prosthetic. Thanks to a nip here and an injection there, Flextronics Corp. has increased its gross profit size in the first quarter to a much sexier $169.2 million form only $85.5 million before the operation. Is it any wonder investors admire the company’s well-endowed income statement?” (see: Financial Makeover http://www.dailyreckoning.com/body_headline.cfm?id=776)

*** “Imagine a company… that strip mines national forest land to get asbestos that it then puts in cigarettes – using sweatshop, child labor in India to roll the smokes by hand.” I reprise this remark from yesterday’s letter because Steve Sjuggerud found a company that might fit the bill.

Steve writes: “Gudang-Garam is the largest clove cigarette manufacturer in Indonesia…[it fills) nearly all your required ingredients, even the sweatshop Asian child labor rolling clove cigarettes by hand (with 40,000 employees, many of them have to be underage by western standards) Maybe the paper mills are loaded with asbestos too! Gudang is at a P/E of 9, with little overall debt and zero long-term debt.”

*** I cannot express the sadness that overcomes me as I read that the two sanctimonious sugar mongers, Ben and Jerry, may be leaving their trade. They sold out – but made an agreement with the buyers to devote a portion of the sales to “socially beneficial activities.” What, wasn’t making ice cream socially beneficial?