Gray Matters

"In extraordinarily sharp terms, U.S. Treasury Secretary Paul H. O’Neill declared himself baffled by a recent series of moves and countermoves by policymakers in Tokyo aimed at reversing a plunge in the Japanese stock market and reviving the nation’s economy. O’Neill said with evident asperity that, when he meets with his Japanese counterpart, "one of my questions will be… exactly what it is you’re doing."

The Washington Post
Friday, Sept. 27, 2002

It was just 75 years ago today, according to the International Herald Tribune, that a scientist in Ithaca, N.Y. discovered that a woman’s brain was not necessarily inferior to that of a man. Dr. James W. Papez, in a breakthrough worthy of Fleming or Bohr, reported on his investigation into the brain of Mrs. Helen S. Gardener.

We are suspicious from the get-go. For however much is known about the inside of Ms. Gardener’s brain cavity, we know nothing about the rest of her. We do not know the color of her eyes, or the sharpness of her wit. We do not know if she was a good mother to her children or a good wife to her husband…nor to what heights in the business world she may have risen. We know nothing that would allow us to form our own judgment about the quality of her brain. All we know is what was revealed by Dr. Papez and recorded in the International Herald Tribune:

"Her brain reveals a wealth of cortical substance or gray matter only equaled, but not exceeded, by the best brains in the Cornell collection.."

Here at the Daily Reckoning, we find ourselves disappointed by this report. It is a reminder of how shabby the scientific process often is, and how major theories often rest on pathetically little evidence. What does it take to rank as one of the ‘best brains’ in the Cornell collection? We don’t know, of course, but we imagine that Dr. Papez might have found a "wealth of cortical substance" in almost any noggin he chose to carve open. Even the leading film stars and central bankers of the day might have yielded a respectable portion of the gray glop, thereby casting the whole hypothesis (gray matter = superior brain) into question.

But today’s cogitation, we rush to reassure you, has as little connection to brain power as a stock analyst. Instead, our subject is theory.

The problem with theory, outside of mathematics and the ‘hard’ sciences, is that nature is very much alive. She won’t stand still. Trying to force a theory upon her is like trying to argue with a smart woman…she squirms, feints, and distracts you from your point so thoroughly that, after a few minutes, you have forgotten what you were talking about. A man will take your point, stand his ground, and try to fight back, which at least gives you the opportunity to return the blow. Not so a woman. She will dodge…appear to change the subject…and sneak in a rabbit punch when you’re least expecting it.

We say this with no scientific backing and no prejudice. One approach is as good as an another, for all we can tell.

Maybe women would make better economists. Men are just too blunt and dull-witted to appreciate the gray matters of nature. They need things simplified, put into black- or-white…idealized, like a cartoon drawing, reduced to a caricature of its real self…or lifeless all together. Contemporary American economists, for example, seem to believe that they have only to adjust the price of short-term loans – manipulating the Fed Funds rate – in order to control the economy’s moods. Cheap loans are expected to produce roughly the same warm, accommodating response in a souring economy as a bouquet of roses and a box of Belgian chocolates provokes in a cross mistress. Of course, they both work…for a while. But a time inevitably comes when excesses, insults and irritations have built up to the point where high dudgeon cannot be overcome with low rates and Godiva. Au contraire, the offering merely seems to make the problem worse, by seeming to trivialize its causes.

Japan brought rates down to near-zero, and has kept them there for half a decade. Despite the sweet cadeau, Japan’s investors, consumers and businessmen remain at least in a state of low dudgeon – reluctant to spend, invest, or borrow. Stocks – after nearly 13 years since the bear market began – are still down 75% and seem inclined to sink even further. Desperate, the Japanese central bank has said it would resort to ‘unconventional’ solutions. Recently, it proposed the adoption of unwanted and unloved securities. Then, it suddenly seemed to reverse itself, saying it would leave them out on the streets…in the hopes of teaching investors a lesson.

O’Neill has promised not to criticize the Japanese, at least not in public. But he could not help himself at the IMF meeting. "Huh?" he seemed to say, right out loud.

When he finally gets his answer, we suggest he pay attention, not just for entertainment, but for instruction. For, as we keep saying, the theories of central banking science that guided the Bank of Japan for the last 12 years are little different than those that now provide a beacon for the Federal Reserve system and its benighted chief. Mightn’t the results be nearly the same? And mightn’t Paul O’Neill and Alan Greenspan be looking, someday, for unconventional means to rouse the national economy from a sulk?

"There is a disconnect between the economy and the stock market," said an economist, voicing a common view. "The economy is recovering. Investors seem to be over- reacting to bad news…"

The Fed cut 475 basis points from short term rates last year. Hardly a month went by without another delivery from FTD and the Chocolate Express. Consumers continued to spend. Homeowners continued to borrow. But stocks sank anyway…and continue to go down.

Possibly, investors are acting irrationally. But possibly they know something – that the economists’ theory is as shallow as Dr. Papez’s view of Ms. Gardener’s brain; whatever she was, when she was still among the quick, Ms. Gardener must have been a lot more complex and interesting that the slimy goo in her cold skull.

If the economy would drop dead, economists might get a chance to open it up and poke around. Maybe they would find out something. As it is, they seem almost uninterested. After 475 basis points, and more than 18 months since the rate cuts began, a docile economy should be headed in the direction the economists want – towards faster rates of growth, higher profits and higher asset prices.

It is not. Nothing has worked at it should have. Last year’s recession did not do what it was supposed to do. Consumers did not stop borrowing; their debt levels went up instead. Nor did they stop spending so they could build up demand for the breakout later. Stocks did not go down to low levels…so they could be bid up in the following boom. Instead of selling stocks, people bought them.

Then, the recovery proved as big a failure as the recession. Factories did not rush to hire back workers. Demand did not pick up. Profits and stock prices did not rise; they fell.

Theories are useful because they allow you to predict what will happen in a given set of circumstances, even without ever having experienced it yourself. If you forget your telephone number, for example, a good economist can estimate it for you. But none of the predictions made by America’s leading economists and analysts have come true.

What gives? Remarkably, almost no one asks. But the inquiring minds who read the Daily Reckoning want an answer…

We will try to come up with one – for Wednesday.

Bill Bonner
September 30, 2002


Reuters reports that more Americans continue to buy stocks. The number of households that own them has risen 7% since the bear market began.

And polls show that they still believe in them. A large majority say they are ‘long-term, buy-and-hold’ investors who believe their stocks will come back to at least what they paid for them…

People can believe anything they want, of course, but we merely note that these are not the kind of beliefs that people confess at the bottom of a bear market. Instead, they come to believe that the stock market is merely a tool for redistributing wealth from savers to the financial industry and from outsiders to insiders.

But on Friday, oh la la, we smelled the air and we thought we detected a faint aroma of fear, panic…and desperation. Investors – even those who say they are in stocks for the long haul – are beginning to sweat.

Consumer confidence is ebbing, say the pollsters at the U. of Michigan. Investor confidence is giving way too, say the stock market and the Confidence Index. The latter index measures investors’ preference for super- safe Treasury bonds over the sort put out by people who can’t print money. As of Friday, it was down to 70.4 – indicating that bond buyers are increasingly worried about getting their money back.

Everybody wants treasuries. A 10-year T-note yields on 3.75%, but that’s better than losing money. Eric says even Mom & Pop are moving from equity funds to bond funds. So high have bonds been run up that people are beginning to speak of a ‘bubble’ in the bond market and beginning to worry that higher levels of inflation will force up yields and destroy bond prices.

Could be. But if there is a bubble in bonds, we wouldn’t be surprised to see it get even bigger than it is now. Eric…


Eric Fry, reporting from the Big Apple:

– Uno, dos, Adios. A two-day rally on Wall Street last Wednesday and Thursday ended abruptly on Friday when the Dow disgorged almost 300 points to 7,701. And just like that, investors bid "adios" to yet one more short-lived bear market rally.

– The Friday sell-off capped a fifth straight losing week for the Dow. The blue chips fell 3.6% over the five-day span, while the S&P gave up 2.1%, to 827, and the Nasdaq dropped 1.8% to 1,199.

– "Barring some sort of miracle in September’s final trading session," Barron’s points out, "the Dow by today’s close will have fallen for six straight months, a mournful pattern that has occurred only five other times in the history of the average. Friday’s rout caps a miserable quarter that will make forthcoming mutual- fund statements unpleasant to open. The Industrials so far have lost 11.1% in September and 16.7% for the quarter, while the Nasdaq Composite has fallen 8.8% in September and 18.1% in the third quarter. The Standard & Poor’s 500 index has given up 9.7% this month, and 16.4% for the three months."

– The stock market’s excruciating slide has been chasing investors out of stocks and into bonds. The result has been a bond market rally every bit as spectacular as the stock market’s collapse. Has the bond market become simply the latest of the serial bubbles floating through our economy?…We don’t rule out the possibility – not least because Mom and Pop seem to be calling the shots. Mom and Pop are decent folks, of course, but they’re not known for being terrific market-timers.

– Here’s what’s happening: Mom and Pop – a.k.a. mutual fund investors – are fleeing equity funds in droves and putting what’s left of their money into bond funds. "After raking in a record $28 billion in July, Lipper estimates bond funds attracted a hefty $19 billion in August," Dow Jones News reports. "Fund managers say the trend continues this month. Equity funds, meanwhile, bled nearly $60 billion during the first two months of this quarter.

– This abrupt reallocation from stocks to bonds is forcing equity mutual fund managers – already low on cash – to continuously sell stocks in order to meet the redemptions. Meanwhile, the increasingly flush bond fund managers feel compelled to do something with all the cash flowing into their funds. So they keep buying bonds, no matter how low the yields fall. Obviously, there’s a self-fulfilling aspect to all of this that has nothing to do, necessarily, with underlying economic fundamentals.

– "Welcome to the bubble economy," says John Myers, whose Resource Trader Alert recently recommended buying put options on the 10-year Treasury note. "Capital pouring out of the bursting bubble in stocks has created another bubble in bonds, as bloodied investors scramble for safety.

– "The view on the Street is that inflation is a dead issue, so the money keeps flowing into ‘safe’ Treasuries." But John questions whether Treasuries, especially long-term bonds and notes with low interest rate coupons, are necessarily "safe" at all.

– "Yes," he concedes, "investors will get a coupon, plus a return of their principle – if they don’t sell before maturity. But they are also locking up money at these historically low rates for a long, long time. Ten-year T-notes are currently yielding 3.75 percent…3.75 percent!

"Meanwhile, the Federal deficit gets bigger by the hour; war with Iraq (and who knows who else before it is over) grows more certain by the day and the Bush tax cut, along with the plunging stock market, have decimated Uncle Sam’s balance sheet. Oh…and did I mention that commodity prices are UP 18%? Does this sound like deflation to you?

"Quite to the contrary we think."

– John also points out that Fannie Mae’s hedging activities are artificially boosting the price of 10- year notes. "Fannie Mae purchases the majority of mortgages in the US," John explains. "With interest rates dropping, millions of homeowners are paying off their existing mortgages and refinancing. In order to cover this risk, Fannie Mae buys huge amounts of long- term Treasuries to hedge itself."

– "What happens," John wonders, "when mortgage rates finally stop dropping and begin to rise? The risk of prepayment drops and Fannie Mae…will need to begin lifting hedges by selling bonds – exacerbating any move to the downside."

– John concludes: "[Combine] the threat of inflation with the potentially devastating effects of a reversal in Fannie Mae’s hedging policy and I believe the time is right for a bearish play in T-notes."

– If you’re interested in the details of this trade see:

Resource Trader Alert


Back in Paris…

*** So you see, dear reader, even in our own little group we have different views on the bond market. Will bond prices go up or down? Who knows? Our guess here in the Paris office is that they will go up for a while longer – as the U.S. economy continues to deflate. We wouldn’t be surprised to see yields drop to 3% on 10- year notes before the current trend runs its course.

Does that mean we are buying treasuries? Well, not exactly. While we are impressed by the security of the treasury note, we are unimpressed by the currency in which it is quoted. Maybe the T-note will rise in value, but among the things that could happen, a decrease in the value of the dollar seems at least as likely. So, until we are proven wrong…or go broke…we’ll stick with our position: euro bonds for our coupon needs, gold for savings…

*** "Goldman to lose 100 Investment Bankers," says an odd FT headline. Here in our office, we lose pens and staplers; we would be alarmed if we lost a single employee, let alone 5 score of them.

*** Not many tourists visit Milan. The competition is too stiff – Venice, Florence, Rome. But Milan has her attractions. In the church of Santa Maria della Grazie, for example, is Da Vinci’s "Last Supper." Da Vinci spent many years in town, so you can see much of his work.

Not having a large tourist industry is a great blessing. Restaurants cater to demanding local customers, rather than transient foreigners. And here we offer some gratuitous recommendations. You will be impressed, dear reader, by the Ristorante della Santa Marta and the Bagutta – each on streets of the same names.

We were impressed by the Italian wines. Here at the Daily Reckoning we drink a lot of wine – to loosen up the sluices of our circulatory systems, of course. But we tend to stick to local favorites – gamays from the Loire Valley and Bordeaux of all sorts. The ’96 Chianti Castelgreve measured up to the best of them.