Flight to Imbecility

Investors are up and running…but whither do they go? Bill Bonner weighs in with his judgment, below.

"Just because every fiber of society and government wants bond and housing price inflation to continue without consequence does not mean that this will happen."

– Michael J. Burry

In a crisis, investors fly to safety; all of a sudden, their attention shifts from return ON investment to return OF investment. Bond buyers, typically headed down the yield curve, will give up the gray skies of high-yielding debt in favor of the more reliable weather offered by Treasuries. ‘We’ll at least get our money back,’ they tell themselves. Whatever else may happen, the U.S. government will pay…

…even if it has to print the money.

Stock buyers, meanwhile, fly to quality by moving from growth and momentum stocks towards those that offer value and yield. Thus out of harm’s way, they prepare to wait out the crisis…cashing dividend checks.

But what about today’s investor? He looks around him and sees no menace, neither from the highest debt levels in history, nor from the trillions in derivatives, nor from rising unemployment, nor from falling profits, nor from high stock prices, nor from the largest deficits in history – both in government and trade. What should he do?

Get another pair of eyes, is our answer.

Instead, he has boarded a cheap flight to mediocrity…and taken the entire market with him.

Smart and Dumb Money: Favoring Junk

In the bond market, investors have favored junk over quality. "C-rated paper in aggregate has outperformed B- rated paper by more than 3000 basis points since the market low on October 10, 2002," writes Dr. Michael J. Burry of Scion Capital (courtesy of Marc Faber).

And in the stock market, the most speculative tech stocks have been the best performers – by far – so far this year.

"Just as the lowest-rated of junk bonds led the bond rally during the first half of the year," Burry continues, "the best stocks in terms of performance were the worst in terms of quality."

There is the smart money and the dumb money. In normal times, they are like Republicans and Democrats, not so different from one another that you can tell them apart. A stock trading at 10 times earnings, for example, may be too expensive. Or it may be too cheap. Only time will tell.

Worse, for long periods of time, the dumb money actually looks smart. Nothing raises the I.Q. of an investor faster than seeing his shares go up; until a crisis changes attitudes, even the dumbest investors think they are geniuses.

Smart and Dumb Money: Parting Company

As investors reach for higher-yielding bonds, for example, they drive the junk up in price. Stock market investors, meanwhile, rushing to buy shares of bad companies, push up prices…making both the companies and themselves look like winners.

But at extremes, the smart money and the dumb money part company. We read in yesterday’s news that insiders, usually the smart money, sold $44 of stock for every $1 they bought. Insiders are generally net sellers. But this ratio is the highest ever. The smart money is taking advantage of this opportunity to get out.

Looking back on the bubble years – 1997-2000 – we see who was who. The smart money sold stocks. The dumb money bought them. Smarter money sold stocks it didn’t own. But the real geniuses created the stocks investors wanted to buy.

Not all the money lost in the initial phase of the bear market, 2000-2003, disappeared. Many companies – notably Amazon.com – took advantage of investors’ fearlessness to create and sell stocks. Investors offered money with no strings attached. The companies needed neither collateral assets, profits, dividends, nor even a reasonable business plan. Effectively, the money was free. Amazon and other companies raised billions of dollars this way…which gave them a cushion of cash, on which many fat derrières rest even now.

On the other side, the dumb money bought Amazon at the peak. Dumber money borrowed to buy the shares. And the dumbest money of all was in the hands of corporate managers, who borrowed money to buy back their own inflated shares! The object of the game was to run up your share price, issue millions of shares, and sell them to yokels without a clue. But these corporate finance wizards completely misunderstood what they were doing. Instead of taking advantage of the dumb money, they bought the dumb money’s shares back – at higher prices. In this case, the money was not merely dumb, but so severely retarded that you would be doing it a favor by holding a pillow over its head.

Smart and Dumb Money: Where Is the Dumb Money?

Where then is the dumb money now…and how can we take advantage of it?

We don’t know; we’re just asking. But in the stock market, it seems obvious; buyers of Krispy Kreme, financial stocks, or builders are probably cruisin’ for a bruisin’. The stocks are expensive. As a general principle, the smart money buys cheap and sells dear; the dumb money does the opposite.

But how about people who are lending money at the lowest yields in 40 years? Are they not providing capital at astonishingly low rates? Shouldn’t we borrow it…before lenders look around and notice a possible crisis or two? Foreign lenders, for example, won’t they soon realize that they have little to gain from a bond paying 5%…if the dollar goes down 10%?

And there is the spectacle of people mortgaging their houses for more than they are worth; what do we make of that? Who is the greater fool…the borrower, or the lender? It is hard to say; both seem to be headed towards a disaster.

Theoretically, the lender is the expert; the borrower is the rube. But, in their flight to mediocrity, mortgage lenders have reached further and further for yield – going after more and more marginal credit risks. Haven’t they created a situation in which both sides could be losers?

The lender stands to lose from a boost in inflation rates. Inflation would collapse the value of a fixed-rate mortgage.

But inflation is no sure thing. The homeowner stands to lose, too. Jobs are disappearing. Pay levels are stagnating. Deflation would make it harder for him to make his mortgage payments. And if his house fell in value, maybe he wouldn’t want to.

Smart and Dumb Money: Who’s the Chump?

An adjustable rate mechanism would protect the lender from inflation…but then again, not if the borrower can’t pay.

In a real crisis, over-stretched homeowners couldn’t continue servicing their mortgages. Already going bankrupt at the highest rates in recent history, millions more could go down if a genuine recession were to begin. Most likely, Fannie Mae, Freddie Mac and other mortgage lenders would soon be insolvent, too.

What about gold? Who is the chump? The buyer or the seller? We don’t know, of course, but trading the Dow stocks for 26 ounces of it seems almost like a giveaway; you get 26 times more for your money than you would have 23 years ago. Back then, the dumbest thing you could do was to trade the Dow for a single ounce of gold. Over the next 20 years, the Dow went up 1,100%, while the gold price got cut in half. Of course, that was a period of crisis – when investors took flight for quality. The Dow may have been cheap, they reasoned, but gold was sure.

They were wrong. And now they probably are wrong again – but in the opposite direction. Now there are crises waiting for them everywhere, but they don’t see them. Instead of flying to quality…they scoot off towards mediocrity, and imbecility. They take up the worst deals on Wall Street, and leave gold untouched.

Bill Bonner

September 12, 2003 — Paris, France

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of "Financial Reckoning Day: Surviving The Soft Depression of The 21st Century" (John Wiley & Sons) due out later this month.

Today’s news is scarcely worth reporting. The Dow went down slightly. Gold dipped slightly, too. The dollar stayed about where it was.

None of it means much.

So we cast our new eyes around the world and wonder what is going on. And nowhere is more going on than in China, where GDP has been growing 4 times as fast as in the U.S.. And it is real GDP – not phony numbers puffed up by debt and military spending. By all measures, the Chinese are actually producing more goods and services at a remarkable rate.

Still, the Chinese economy is nearly as dependent on U.S. debt as the American economy; don’t forget, the former is just the latest bubble created by the Dollar Standard system. American households now borrow 11 cents of every dollar they spend. Much of that money finds its way to Wal- Mart…and then to China, where factories work overtime trying to keep up with U.S. demand.

"Fears grow that China is overheating," say the worrywarts at the Financial Times.

"China on High Alert on Influx of Speculative Capital," a headline from the People’s Daily tells us.

And all over the world, political leaders are beginning to gang up on China. "Unfair," say they of China’s policy of fixing its money to the world’s reserve currency, the dollar. The Chinese have faithfully maintained the yuan at 8.3 to the dollar for nearly 10 years. Now that their own economies are having trouble competing, the Finance ministers of other countries – notably the U.S. and France – think they spot an injustice…or an opportunity.

Pressure, both political and economic, is growing for a revaluation of the yuan. It may happen. But would it be the end of China’s incipient bubble?

Not necessarily. As we pointed out yesterday, even a big increase in the yuan would not eliminate China’s advantage in cheap labor. In fact, a more expensive yuan may actually help stretch out the bubble.

In the mid-’80s, Japan was the world’s fastest-growing economy. Like China today, Japan attracted the rest of the world’s envy…and disapproval. In 1985, at the Plaza Hotel in N.Y., Japan was the center of attention of the world’s finance ministers, who demanded that Japan let its currency rise against the dollar.

The effects were as unexpected as they were dramatic. At first, Japan’s economy was knocked off its feet; suddenly, its products were nearly 50% more expensive on world markets. Fighting back, the Japanese did what Greenspan does – they cut rates and eased banking rules. In a few months, the whole country was booming again…and attracting billions in speculative money from abroad. The result was a bubble as absurd as America’s tech bubble of the late ’90s. Japan’s bubble finally blew up in January of 1990; America’s bubble popped almost exactly 10 years later.

Now it is China’s turn.

Chinese stocks, and Asian stocks generally, are still relatively cheap…and still under-represented in international investment portfolios. Typically, portfolio managers assign about half their global assets to U.S. markets. Only 11% is given to investments in Asia, which, as Marc Faber points out, is "already the world’s largest economic bloc with 3.6 billion people and the world’s most favorable growth prospects.

"I believe that investors should allocate at least 50% of the money they invest in equities to Asia," Faber concludes, "where…valuations are far lower and growth prospects more favorable than in the U.S."

So, go ahead. Buy China. Just don’t forget to sell too soon…while the exits are still clear.

Eric, what say ye?


Eric Fry, checking in from the Big Apple…

– As if anyone needed reminding, yesterday was September 11th. We New Yorkers tried to behave as though it were an ordinary day. But a vague sense of paranoia was difficult to suppress.

– "Are you worried about riding the subway today, Eric?" an acquaintance asked your New York editor yesterday morning.

– "Nah, I don’t think so," came the reply, immediately before your New York editor walked out of Grand Central Station to Lexington Avenue and hailed a cab to Lower Manhattan. He would ride a subway later in the day, but not without a bit of unease.

– Happily, September 11, 2003 came and went without incident, which allowed New Yorkers to serenely remember the wretched tragedy of September 11, 2001, and to pay homage to the victims. The NYSE’s opening bell was rung by family members of stock exchange employees who perished on Sept. 11th. The bell-ringers were escorted to the podium by the NYSE’s multi-million dollar bell-ringer himself, Dick Grasso.

– Additionally, the U.S. financial markets observed four separate moments of silence yesterday: 8:46 a.m., when the first hijacked plane struck the North Tower; 9:03 a.m., the time the second plane hit the South Tower; 9:59 a.m., when the South Tower fell; and 10:29 a.m., the time of the North Tower’s fall.

– Except for these four brief moments of silence, the NYSE was the same old raucous casino that it always is. Indeed, investment activity on the stock exchange was rather festive. The Dow Jones Industrial Average climbed 39 points to 9,460, while the Nasdaq Composite rallied 1.2%, to 1,846. America’s patriotic investors buoyed share prices with a flood of buy orders, just like they did in the weeks following 9/11.

– Remember when short-selling was an act of treason and all red-blooded Americans were expected to buy overpriced stocks, even if they didn’t really want them? Well, we are pleased to report that the patriotic buyers of stocks in September of 2001 are finally back to break-even, assuming that the gut-wrenching declines that occurred between then and now did not spook them out of their holdings with steep losses. The Dow is down 1.5% from its closing level on Sept. 10, 2001, while the Nasdaq is up almost 9% from its pre-attack reading.

– We here at the Daily Reckoning have been remarking about the perils of September. James Stack of Investech Research provides a few more historical details…

– "Let’s face it, September is a BAD month for the stock market," writes Stack. "Last year saw an 11% decline in the S&P 500 Index – the largest decline for any month of the entire 3-year bear market. The previous September in 2001 experienced an 8.2% loss – making it only the third largest monthly decline of the bear. Neither the S&P 500 Index…nor the DJIA…nor the Nasdaq has seen a positive September gain since 1998."

– But September 2003 is gamely bucking the trend…so far. This particular September has been kind to stock investors, but it has been brutal to the nation’s laborers. The economy is shedding jobs faster than the Dow is adding points.

– Weekly jobless claims jumped again last week to 422,000 – the second consecutive claims figure above 400,000 and the highest reading in two months. September’s dismal jobless claims reports are merely a continuation of a months-long trend. The economy unexpectedly lost 93,000 jobs in August, the most since March, according to the Labor Department.

– Not surprisingly, the mounting job losses are contributing to rising credit delinquencies. "More homeowners were behind on their mortgage payments in the last quarter as job losses put a strain on some households’ budgets," the Associated Press reports. "The seasonally adjusted percentage of mortgage payments 30 or more days past due for all home loans rose to 4.62 percent in the April to June quarter, up sharply from 4.52 percent in the first three months of this year, the Mortgage Bankers Association of America reported."

– Apparently, consumers without jobs don’t pay their mortgages on time. But not to worry, they will always find a way to buy a couple hundred shares of Fannie Mae, or Cisco Systems.


Bill Bonner, back in Paris…

*** "Foreign holdings of U.S. Treasuries Hit Record 46%," says a headline in the Financial Times. Who are the major buyers? Asian banks. Foreigners are expected to buy $775.4 billion of U.S. bonds this year.

"Should the day come when Asians have more confidence in their own economic bloc (which I think will happen in the next few years)," writes Marc Faber, "we could see a massive shift of assets from the U.S. to Asia, with Asian financial assets and Asian currencies raising very strongly against the dollar."

*** Elsewhere in the news, Europeans are wringing their hands over the death of the Swedish foreign affairs minister, an attractive woman who seemed likely to become Prime Minister.

Anna Lindh was stabbed as she did her grocery shopping, unprotected by security guards. You see, in Europe – especially in the Scandinavian countries – politicians do not have praetorian guards protecting them. They often live like ordinary people and take their chances. A friend reported, for example, that he saw France’s Prime Minister, Jean-Pierre Raffarin, on the same train we normally take, headed out to the country for the weekend, like everyone else.

"It’s unfortunate, but this ‘open society’ can’t continue," say various European pundits, recalling the killing of a popular politician in Holland earlier this year, and the murder of Olaf Palme, Sweden’s Prime Minister, 17 years ago.

And yet, what is charming about Europe is that it is so relaxed and normal. Ministers, congressmen, and presidents say outrageous things, but often go grocery shopping along with everyone else. Losing a few politicians to homicidal voters every once in a while seems like a small price to pay for such a civilized society.

*** What the Pentagon sought, it seems to have wrought. The Flypaper Strategy may be brilliant or it may be moronic, but it seems to be attracting (or creating) terrorists. Terrorists are said to grouping in Iraq, forming new organizations, developing new tactics, devising new ways to attack the Great Satan.

"Bin Laden’s network is rallying new recruits to battle U.S. forces in Iraq," says an account from yesterday’s news.

*** And this from our correspondent in South Africa, entitled ‘Another good man down’:

"Just a short note to say I’m taking the plunge on Saturday, finally getting married to Sabine, the German girl I met at our offices last year.

"We’re really looking forward to it, only problem is I’m in a cast (torn ankle ligaments) after my bachelor’s party and my best man went to hospital for 9 stitches…As you can guess, the party was a resounding success…"