Unknown Unknowns

"There are things we know that we know. There are known unknowns – that is to say, there are things that we now know we don’t know but there are also unknown unknowns. There are things we do not know we don’t know."

– Donald Rumsfield

It is a wonderful day here in Paris, the most beautiful day we’ve ever seen. Too bad the world, as we have known it, is coming to an end.

Gone are the double-digit gains in the stock market. Buffett, Gross, Grantham… even CNBC. they all tell us that stock market expectations have to become more ‘reasonable’ — say, 6% or 7% per year.

Economists have stopped looking for 6% plus growth from the U.S. economy too. They believe 3.3% would be more ‘reasonable.’ The Fed’s latest Monetary Policy Report, for example, predicts GDP growth rates of 3-4% for this year and the next.

Pension fund managers, under pressure from regulators, are now adjusting their targets to more reasonable levels. Instead of 10% or 11% growth… they’re shooting for 7% or 8%.

And gone are the dollar’s glory days, too. The dollar has fallen to more ‘reasonable’ levels — say the experts — nearly equal to a euro.

All over the world, dear reader, reasonableness is back in style. But out in the far reaches of the universe, say, the day after tomorrow, anything can happen.

Even here on Earth, strange things still occur. Uruguay closed its banks on Wednesday after the currency fell for 5 days in a row. In Colombia, the peso has fallen for the last 6 days. and in Brazil, the real has fallen for 9 days in a row. It has lost 30% of its value so far this year as Brazil edges towards default on $297 billion in foreign obligations. Brazil’s bonds, for readers with a sense of adventure, now trade at 50 cents on the dollar.

But it is neither the real, the Colombian peso, nor the Uruguayan peso that disturbs Dr. Kurt Richebacher’s sleep. The world economy has survived many financial crises in second-rate economies in far-off parts of the world. But this time it’s different. This time, it’s the world’s largest economy that has gotten itself into a jam, says the Austrian economist. And, after all, even $297 billion of Brazilian debt is pocket change compared to the $9 trillion in foreign-owned dollar assets.

We know what happens when Colombia or Malaysia cannot pay its bills. Even a large economy such as Brazil can get help when it needs it. Paul O’Neill said the U.S. was ready to step in with a loan… provided the money didn’t end up in a Swiss bank account. ( He did not explain what he had against Swiss bank accounts, but we knew the answer. The purpose of the loans will be to make sure the Big Banks get their loans repaid. If U.S. taxpayers are going to pour money down the drain, better for the pipe to flow into the coffers of Citigroup than a Swiss bank whose shareholders don’t make campaign contributions.)

The unknown that haunts Dr. Richebacher’s dreams is this: what happens when the debts of the world’s largest debtor — the U.S. — go bad? The unknown unknown doesn’t bother him.

The U.S., writes Dr. Richebacher, "runs a preposterous, chronic current-account deficit from which an ever more preposterous foreign indebtedness accrues. Intrinsically, the monetary policy of such a country is hostage to the willingness of foreign investors and lenders to finance its spending excesses. They may force it to raise interest rates even when the economy is in depression."

The U.S. was lured into a tight spot by the Fed and by foreigners (mostly Europeans), both of whom provided Americans with so much easy-money rope they could scarcely avoid hanging themselves.

Foreign investors, Richebacher continues, "were the most important single group of investors fueling Wall Street’s bull run. During the 3 years 1999-2001, they pumped altogether $1.8 trillion into the U.S. securities markets, roughly half -and-half into stocks and bonds."

The poor Europeans; they got tangled in the rope. The combination of falling dollar and falling stock prices has been disastrous. But what will they do now?

"The idea that foreigners will continue to invest and lend into the U.S. economy is absurd," Richebacher concludes. "Nobody can be so stupid."

Here in Paris, we’re not so sure. No matter how long the odds, betting on stupidity usually pays off, we observe. Still, there’s a "worldwide recognition," Richebacher believes, "that the admired paradigm U.S. economy was a mirage at best and a systematic fraud at worst." European investors feel they’ve been duped, he says, by phony numbers. Little by little, .or all of a sudden… they will realize it and want to get out… or at least hedge against a further decline.

This will not be the first time the dollar has dropped against other currencies. In the 1980s, the dollar lost 50% of its value over a 2 year period. But did anyone care — other than bankers and international currency speculators? At the time, says Dr. Richebacher, "there was virtually no measurable involvement of foreign investors in the U.S. securities market." This time, they practically own it. When they sell, it may not only depress stock prices… but the entire world and nearly everyone in it.

No economy has ever been as big as the U.S. None has ever been so willing to buy the whole world’s excess production nor has ever become so heavily indebted. None has ever depended so much on the kindness of stupid strangers in strange places. No nation has ever needed to import $1 trillion per year from foreigners just to keep its currency from falling…

What happens when those strangers become less kind or less stupid?

We will find out.

Your correspondent,

Bill Bonner
August 2, 2002

On my desk there’s a graph of the S&P 500 charting it’s progress from January 1982 to July 2002. We’ve assembled it for a project we’re working on… it’s a remarkable portrayal of stock market mania.

The chart begins below 200. And meanders gradually up to 400+ over the next 13 years. Then, round about the year of our Lord 1995 it spikes skyward like the space shuttle Challenger… tripling in 5 short years… and peaking out at 1,527 on March 23, 2000.

But then… well, you know what happens next.

While we’re not much for technical analysis, we do have a thing for symmetry… gravity… momentum, even. If any of these forces of nature still hold sway in the world you can expect the S&P to continue it’s earthward spiral… down to 600 or so… even less.

And it might be getting a little help soon.

A recent 100+ page report from Bear Stearns suggests that if you adjust for the fair value of employee stock options, the aggregate operating income for the S&P 500 drops by 12% for 2001.

Intrigued by the number, our friend John Mauldin wondered what the affect the expensing of options would have on the NASDAQ. "The S&P 500 is mainly populated by firms which are far more conservative," says Mauldin. "In fact, the bulk of the options expenses in the Bear study come from a small percentage of the companies in the S&P 500, so the effect on those firms will be far more pronounced. The NASDAQ is heavily weighted with companies that liberally use stock options."

After analyzing the 15 largest NASDAQ companies – about 37% of the $2 trillion NASDAQ index – 2001 pro forma profits earnings added up to $25 billion. Real earnings were about half, or $13 billion. But total option expenses for the 15 firms were $12.5 billion.

"That means pro forma income was cut in half," says Mauldin "and real, Honest-to-Pete profits were a mere $423 million, give or take a few million."

Mauldin notes if you take away Microsoft, the combined earnings of the remaining 14 is a negative $3.5 billion. "That means 14 of the largest NASDAQ firms could not combine to make a profit," Mauldin continues. "if you deduct the expense of their options. Seven of these firms had negative earnings once options were deducted."

If history… symmetry or gravity… have any pull, this group of the 15 largest stocks on the Nasdaq are subject to "[another] a 50% drop from today’s levels."

Eric, how do numbers like these play in New York?


Eric Fry in on Wall Street…

– The stock market was fresh out of miraculous comebacks yesterday. Stocks dropped shortly after the opening bell, just like they’ve done on many mornings recently. But this time, the market didn’t bounce back. The Dow fell 230 points to 8,507, while the Nasdaq tumbled nearly 4% to 1,280.

– All of a sudden, the market’s spectacular bear-market rally since July 23 is starting to look somewhat less spectacular. Sure, the blue chips have jumped more than 10% since the rally began last week, but the Nasdaq has gained only 4% since then. And the hapless index still languishes 34% below where it started the year.

– While stocks struggled yesterday, gold finally poked its head out of the avalanche of sell orders that buried it last week. Although the yellow metal dipped briefly below $300 early in the morning, it climbed steadily higher throughout the day to end the trading session up 80 cents at $306 an ounce.

– The casualties of the equity bear market continue to pile up, including some very unlikely casualties, like the air conditioning on New York subways. The city’s Metropolitan Transit Authority has shut down the air conditioning on several subway lines. Rumor has it; the city is trying to save money. It’s bad enough having to endure Mr. Market’s abuse all day long, without having to head home from the office in a 100-degree subway car. Curiously, the Lexington Line, which is the subway line favored by Mayor Bloomberg, remains air-conditioned.

– The selling on Wall Street seemed perfectly rationale yesterday in light of the latest grim report from the Institute of Supply Management (ISM). The Institute’s index of business activity took a tumble to 50.5 in July from 56.2 the month before. The new orders reading also fell off a cliff – from 60.8 in June to 50.4 in July. Not surprisingly, the employment reading dipped as well.

– About the only items showing an increase in the ISM report are prices. The ISM’s prices paid index jumped to 68.3 in July from 65.5 the month before. All in all, not a great report.

– With business activity foundering and prices rising, buying stocks seems like a somewhat less urgent priority. But as the saying goes, "It’s not a stock market, it’s a market of stocks." In other words, there are always good stocks to buy, even in "bad" markets. And of course, there are always bad stocks to sell (or to sell short), even in a "good" market.

– For example, even though most stocks have been rising – more or less — over the last few days, there have been some notable exceptions — one of the most notable exceptions being Sealed Air Corp. The stock sprung a leak earlier this week, much to the delight of C.A. Green, Investment Director of the Oxford Short Alert. C.A. issued an extraordinarily timely short-sale recommendation on Sealed Air last week. "One company battling a host of potential problems is Sealed Air," warned C.A. in a July 22nd email to subscribers.

– Specifically, he pointed out that "Sealed Air bought a unit from bankrupt W.R. Grace that is vulnerable to asbestos-related lawsuits."

– Six days later, disaster struck. Or, as C.A. put it, "Asbestos hit the fan. On Tuesday, Sealed Air was broad-sided by a legal ruling that indicates that it faces potentially crippling asbestos-related liabilities. Investors voted with their feet. Tuesday the stock plunged 41% on the news. [Wednesday], Sealed Air followed up with an encore performance for short sellers, plunging yet again. As I write, we’re up 51% on our short position in less than two weeks." Who knows if Sealed Air will come up for air again…


Back in Paris…

*** Investors are thought to have yanked over $47 billion out of their mutual funds in July. That’s the largest net monthly outflow in history. "These forecasts have raised concerns that investors are losing faith in equities…" offered a helpful commentator in the FT.

*** US GDP figures were revised significantly (again) by a handful of wonks in Washington. Reading the tea leaves, Morgan Stanley’s Stephen Roach suggests the revisions are not just to be expected, but signal a double-dip recession is on the verge of commencing and portend dark days for foreign investment… and the recently hearty US dollar.

Roach: "While the past is not always prologue for what lies ahead, the lessons of history should not be forgotten. Double dips have been the rule, not the exception, in business cycles of the past. Five of the past six recessions over the past 45 years have, in fact, contained a double dip — the rare single dip occurred in the early 1990s. Moreover, in two instances — the mid-1970s and the early 1980s — there were actually triple dips.

"Double dips happen because demand relapses invariably occur at just the time when businesses are lifting production in order to rebuild inventories. With the current production upswing well advanced — industrial production has risen for six consecutive months — a demand relapse would come at a most inopportune time. Yet with the US economy now back to its stall speed, that’s precisely the risk.

"Like it or not, the post-bubble excesses of the US economy remain largely intact. That’s the unfortunate outcome of a still mild recession — it doesn’t result in a major purging of long-standing imbalances. That’s especially true of America’s gaping current-account deficit. The current-account gap widened to 4.3% of GDP in 1Q02, and based on the import surge just reported for 2Q02 (+23.5% in real terms) undoubtedly expanded further in the period just ended.

"The net result is that the current-account deficit as a share of GDP could easily be one percentage point larger than we had previously thought — surpassing the 5% threshold that typically triggers a current-account adjustment. Needless to say, that has important implications for capital inflows into the US and for the dollar — requiring more of the former and implying more downward pressure on the latter."


Addison Wiggin