Rotten Apples

One way or another, America’s excesses will have to be worked off. The bigger the bubble, the bigger the hangover; just ask Japan.

Stephen Roach

If you laid all the world’s economists end to end…it would be a good thing.

Bill Bonner

“The most comparable post-war situation is the bubble economy of Japan in the 1980s,” writes Marshall Auerback, “during which a capital expenditure boom (also fuelled primarily by debt) reached an unprecedented 25 per cent of GDP at its peak (whereas during most of the post-war period, capital expenditure as a percentage of GDP in Japan was about half this level)…. the unwinding generally persists for a long time and proves surprisingly impervious to repeated interest rate cuts. Is this what lies in store for the US economy?”

In the space of less than a decade, the Japanese went from being considered the world’s smartest and most dynamic race….to being a tribe of hopeless losers.

“The Japan scenario must surely be the nightmare scenario that secretly exorcises the Fed…. ” continues Auerback. “Unlike the events of the 1930s, this is not lost in the sands of time, but very much a comparatively recent event well within the experience and recollection of a number of investment professionals. Yet curiously, no Wall Street strategist has yet drawn the ominous linkage. … Despite repeated cuts in interest rates, Japan’s economy has proved curiously unresponsive even 10 years after the puncturing of its bubble. Whenever Japan is discussed it is always in the context of ineffective policy response … we get constant carping about the nation’s ‘clueless’, incompetent bureaucrats, those same bureaucrats who were once venerated for their long-term insights and planning throughout the post war period. We suspect a similar downgrade in the respective historic reputations of Messrs. Greenspan, Rubin and Summers lurks at some point in the future.”

Rate cuts, in which Americans have so much faith that they can already see the recovery, didn’t work in Japan.

Nearly all the vital signs in Japan even now….11 years after the Japanese bubble peaked…are near major lows. Bankruptcies, unemployment, stock prices….all are reasons for despair.

The Japanese themselves, once so sure of themselves, are afraid of the future. “Can Japan Compete” asks a popular book title? Japanese exports peaked in 1986, as a percentage of the world total. And GDP growth has been only about 1% throughout the 90s – about a third of the U.S. rate and less than half the European rate.

If that weren’t bad enough, not only is the Japanese economy shrinking…so are the Japanese themselves. The reason: the reproductivity of the average Japanese woman has fallen well below the 2.08 level needed to sustain current population levels. Instead, Japanese women have an average of only 1.34 children. As a result, Japan has one of the oldest population’s in the world, with one out of five people over the age of 65.

Why didn’t the rate cuts work? Why didn’t they revive at least some animal spirits, some exuberance, some lust for profits …and children?

Should we ask Robert McTeer to visit? He could give them a little pep talk…urge them to buy those SUVs, get credit cards, and refinance their homes.

The trouble with the Japanese, as everyone knows, is that they’re too prudent. They save their money, rather than spend it the way we Americans do. With little consumer spending, there seems to be no kindling with which to ignite a good fire. The whole economy remains damp and cold.

And the recurring nightmare of Fed governors is Americans will suddenly start to act a bit like the Japanese. Instead of spending more than they can afford, they may begin to spend less than they can afford – which will douse the U.S. economic blaze in a matter of weeks. America’s economy and stock market, it turns out, depend upon the willingness of consumers to spend recklessly. Any movement towards prudence, no matter how slight, is likely to cause a collapse of sales, earnings, stock prices, employment, and so on. In short, if Americans started to act like the Japanese, the American economy would begin to look like the Japanese model.

What kind of a whacky world do we live in? Maybe you can explain to me, gentle reader, how is it possible to spend your way to wealth? It would make Elizabeth feel so much better – knowing that each trip to Franck et Fils was no longer impoverishing the family – but making us rich!

Is it possible?

The slender reed upon which this hopeful reasoning rests is this: spending stimulates production which results in more wealth.

But people can only spend what they earn, a fact which seems to rest like a permanent wet blanket on the tinder of progress.

Here, I am going to quote an article from Australian economist, Frank Shostak. I do so, because I believe it will help us understand how things really work…why the Japanese found it so hard to get their economy rolling again…and why the American financial model is destined to self destruct.

Shostak refers to savings as “a pool of funding” (In his view…to give you a little head-start… only real savings can create wealth.)

“Essentially, the pool of funding is the quantity of goods available in an economy to support future production. In the simplest of terms: a lone man on an island is able to pick 25 apples an hour. With the aid of a picking tool, he is able to raise his output to 50 apples per hour. Making the tool, however, takes time. During the time he is busy making the tool, the man won’t be able to pick any apples. In order to have the tool, therefore, he must first have enough apples to sustain himself while he is busy making it. His pool of funding is his means of sustenance for this period – the quantity of apples he has saved for this purpose.

“The size of the pool of funding determines whether or not a more sophisticated means of production can be introduced. If it requires one year of work for a man to build a tool, but he has only enough apples saved to sustain himself for one month, then the tool won’t be built and the man won’t be able to increase his productivity.”

Ah…but there is credit.

“If only there were more hours in the day,” Addison lamented yesterday. “We could get a lot more done.” A longer work day would allow us to produce more…thus increasing our wealth.

No one believes the Federal Reserve can expand time. Time is a natural, immutable part of life. And yet, it is widely believed that by increasing the stock of cash…or by lowering the Fed Funds rate…will have the same effect as adding a few minutes to the earth’s rotation. A much better effect, in fact, because we will work neither longer nor harder.

The proximate source of this new wealth is not a gift of time…but something manmade – new and better tools, systems, software, allowing us to get more productivity out of every hour on the job. Somehow, the Fed , it is believed, can help produce this extra capital. It does so by expanding the pool of funding. But where does it get the extra apples?

More to come….

Bill Bonner Paris, France February 7, 2001

*** The Cisco Kids’ announcement had the anticipated effect. Investors took the stock down 13%. Cisco, once $81, now trades at $31.

*** People are just not buying routers the way they used to, explained John Chambers. Business investment in equipment and software had been rising at 15% annually… but it fell by 5% in the last quarter of 2000.

*** “Capital expenditure,” explains Prudent Bear Marshall Auerback, “…now appears to be in sharp decline. It is falling from an unprecedented lofty peak. It is being slowed down by the sheer burden of debt and the consequent inability to service that debt as saturation dynamics take hold. We have not seen anything like this in the US economy since the 1930s.”

*** Venture capital investments dropped too – down 18% in the 4th quarter from the quarter before. That makes 3 consecutive quarters of decline, which we have not seen in more than 5 years.

*** What’s the matter with people? Why don’t they get out and buy some routers…and, yes, an SUV or two, as Dallas Fed chief McTeer suggests? Why can’t you just spend your way to wealth? More dreadfully boring economics below…

*** Even after getting knocked down more than 60% – Cisco stock is still selling at more than 40 times earnings. Even with stock prices falling, remember, P/Es can still rise…because earnings are dropping faster than stock prices.

*** Cisco is not the worst one: According to the LA TIMES Ciena has a P/E of 122, Juniper 98, Yahoo 96, PeopleSoft 70, and Microsoft 35.

*** Why are people willing to pay so much? The implication is that these companies are growing so fast – their P/E’s might not fit today, but like Edward and his new roller blades, they’ll grow into them.

*** Cisco says, for example, that it will grow profits at a rate of 30% to 50% annually, which seems to make sense of a P/E in the 40s.

*** But there’s not much margin for error. And error is usually a fairly dependable feature of the investment landscape…especially of the topography around Silicon Valley. The trouble with new technology is that there is always newer technology. And people who sound like they know what they are talking about say that Cisco’s routers are…like…yesterday’s news, not tomorrow’s.

*** The other problem with high P/Es is that the very same people who were willing to pay almost any price for a stock one year may be unwilling to buy it at any price the next. I offer no explanation for this phenomenon, it is merely an observable part of human nature…like the tendency of cab drivers to be unable to speak English.

*** This is another way of saying that psychology matters. Investors get caught up in an inflationary psychology, in which they think they need to buy stocks, for the simple reason that they will be more expensive in the future, even though the actual company may be unchanged.

*** That is what nearly everyone seems to be expecting – even now. “People are able to look beyond the Valley, [the one of Recession, not Silicon]” said a trader of no particular pedigree, “They’re now anticipating the recovery later in the year.”

*** The coming recovery has been spotted as often as the Russian troops, reportedly marching through France on their way to aid the allies in WWI. Despite numerous eyewitnesses and newspaper stories, the troops never existed. Still they gave hope and encouragement when it was needed.

*** Also providing aid and comfort is the Fed itself. The latest report from the St. Louis Fed is that MZM – cash – increased at an annual rate of more than 19% during the last 3 months. GDP during that period may have increased less than 2%. This inflation has to have an impact. Can you get rich by destroying the value of your own money? More on that, too, below….

*** What’s with Ravi Suria anyway? The Lehmann Bros. analyst seems to be a traitor to his cheerleading class. He recently took a sharp pencil to AMZN’s balance sheet and says the company’s working capital will turn negative in the 3rd quarter of this year. Amazon, says Suria, ended 2000 with $386 million in working capital. It will spend $440 million this year.

*** Amazon’s stock fell 5% yesterday, following a further announcement that the company will charge publishers as much as $10,000 to recommend their books.

*** Many other big techs fell along with AMZN and Cisco. Juniper lost 7%. Extreme Networks lost 12%. Broadcom ended down 10%.

*** There were 140,000 people laid off in January, according to MSNBC, further confusing the employment situation.

*** Australia followed the U.S. and cut its central bank rates by 50 basis points. The American Syndrome is spreading… What does it mean? Where does it lead?

*** “If you track the movement in the Dow minus London’s FTSE 100,” writes Brian Durrant from London, “you’ll find that from 1989 to late 1994, this relationship was comparatively stable, with the differential ranging from 250 to 1000 index points. However from early 1995 there has been a consistent trend of the Dow outperforming the FTSE. The differential exceeded 4,500 in the first half of 2000. This illustrates how much more virulent the stock market boom was in the US since 1995 …and just how much more vulnerable the US stock market is – should the pre-1995 relationship be re-established.”

*** A Barron’s interview with fund manager Warren Isabelle, revealed a stock that could qualify for our “Darned Cheap” list. Trucking company, Consolidated Freightways does $2 billion of business but is valued at only $124 million, and has about half that amount in cash. It earned more than $1 a share in ’97 and ’98…and shares sell for only about $6 today.

*** Jerry Taylor, director of natural resource studies at the Cato Institute: “Imposing price controls [on electricity] would reduce incentives to add new generation. Moreover, it would falsely signal to consumers that electricity is more plentiful than it actually is. In essence, it would repeat the economic calamity caused by oil price controls in the 1970s. Politicians cannot simply ‘regulate away’ a supply shock, and attempts to do so always have and always will result in further shortages.”

*** Edward, by the way, rushed to the hospital by his anxious mother, made a miraculous recovery as soon as he arrived.

*** Here at the Daily Reckoning, we have our own share of trouble with routers and switches and the like. Last week, Addison sent you an announcement regarding a program developed by friend and colleague Justin Ford, called Seeds Of Wealth. Unfortunately, the “server” used by the credit card company for placing orders was down for nearly two days, I’m told. If you are interested in the program – and weren’t able to complete your order you can either try again by going to Seeds Of Wealth or you can call this toll free number: 888-396-8881. If you have no idea what I’m talking about… we’ve included last week’s announcement below, following today’s essay.