Useful Activity Will Survive the Meltdown

The bell of American finance has cracked. It was a long time coming, as I’ll show you. The biggest change in the American economy in the last generation or so has been the rise of finance at the expense of making things. This seemed to work for a while, but like a boxer who has a habit of dropping his hands, America finally caught one on the chin.

Every crisis, though, brings opportunity. In this one, investors will go back to investing in simpler, more durable things (at least until forgetfulness kicks in). For instance, investing in a company that supplies grains to hungry people looks like a better bet than investing in one that sells mortgages to people who can’t afford them. The focus will shift to things we need, rather than things we want.

I have two ideas for investing in the post-financial world in this letter, including a new idea — a family-owned conglomerate that combines operations in pork, grains, shipping and more. It’s a stock you can sock away for a long time. And if the post-financial world develops as I think it will, you’ll be glad you parked some money in this sector…

I was spending a few days in Paris when the U.S. markets put on a show that had the feel of a movie climax. Uncle Sam bailed out AIG. Merrill Lynch sold out to Bank of America. The U.S. government hastily arranged a $700 billion bailout. Markets rose and fell hundreds of points per day. Gold and oil enjoyed their biggest one-day rises ever. It was a wild stretch.

The French have a chance to gloat a bit. Even though the crisis in America, the world’s biggest economy, helps no one, the French may have a better shot than most at coming through it with only flesh wounds. The housing market stinks in France, too. Housing sales in France are off 20% in the last 12 months. But the French market is not nearly as leveraged as the U.S. market was.

Financial innovation seems to occur slowly here. Mortgages in France are typically for terms of only 15 years. The French have also not embraced creativity in this field, as most mortgages bear fixed rates of interest. There is no subprime market. And French consumers did not borrow much against the rising prices of their homes. (The savings rate here is 13% of income, versus zero in America.)

The U.S. economy followed a very different path. Sometime over the past few decades, we abandoned the old-world notion of making things. We turned to making shuffling paper our stock in trade. Precisely when and why this happened will be something for historians to debate. But sometime in the 1990s, the percentage of corporate profits from finance passed that from manufacturing.

It was the first time that had happened, and the gap has only grown wider since. Before the great credit crisis hit, profits from financial firms made up nearly half of corporate profits. Only 10% came from the manufacturing sector. As recently as the mid-1960s, it was the other way around.

The French go on and on about their cheeses, wines and breads. For us, mortgages became our national product. Mortgages, before the crisis hit, made up 60% of total bank loans and the financial sector grew to become our biggest sector — bigger than health care, retail or manufacturing.

Replay the 1970s — Only Bigger…

To a smaller degree, we had a similar crisis in the 1970s, Kevin Phillips tells us in his new book, Bad Money. Mortgage debt doubled from 1960-70. The Dow crashed, losing 36% of its value from 1969-70. Hedge funds blew up. The top 28 funds lost 70% of their assets, and about 100 brokerage and financial firms disappeared — by either acquisition or outright failure. Seems a lot like the outlines of the present day, does it not? The 1970s also had two major oil price spikes. The first in 1973-74 and the second in 1979-80. We’ve already had one oil spike now, and a second one is in the cards.

The neglect of making things is perhaps most evident in the oil business. Phillips says the U.S. has a “dated, ghost-of-glories past petroleum infrastructure.” He writes that the major oil companies “are wealthy, but aging behemoths, hard-pressed to maintain production levels, despite large exploration outlays, and no longer enjoying access to overseas oil fields they once commanded.”

Exxon Mobil, once the largest oil company in the world, now ranks 25th by booked oil reserves. The top 10 are all state-owned national oil companies (NOCs). The top 13 NOCs own four-fifths of the world’s known oil reserves. They don’t share them cheaply.

A look at where we get our oil is not encouraging, as the chart below shows. Most of these sources of supply are not particularly reliable. As Phillips opines (the table below comes from his book): “Of the eight principal 2007 suppliers of petroleum to the United States as of August, only one, Canada, could be called secure and reliable.” Mexico seems secure, but exports have been falling since 2004, as Mexican production has fallen. It could become an insignificant source of oil by 2012.

And we are not alone in competing for these oil reserves. China became a net oil exporter in 1993, and its appetite grows every year. It is now the world’s second largest consumer of oil, behind only the U.S. China actually imports more oil from Saudi Arabia than the U.S. This partnership is not surprising, given the dynamics of the New Silk Road.


The “New Silk Road” is a term I use for the boom in trade between countries from the Middle East to China. In matters of energy, you see a lot deals inked on the New Silk Road. Saudi Arabia and China get together regularly like newfound pals. Sinopec, a Chinese oil company, recently got the OK to explore the Saudis’ Empty Quarter for oil and gas. Saudi Aramco, the big oil company, put $750 million toward a huge plant in China.

Just as interesting to me is what I like to call the “New Burma Road” — after the road of World War II fame that linked China and India via Burma. The New Burma Road identifies the booming trade between India and China. As Phillips writes, “China has already made a six-lane highway out of its portion of the road from Chinese Kunming to India’s state of Assam… The demographics of a Sino-Indian entente would make it especially momentous.” Yeah, I’d say so, given the strengthened ties between more than two billion people.

As you know, there is an awful lot going on in the world today, and it’s all far more complex than I can get into here. But this is where we are, in brief: The U.S. economy faces a crisis in its biggest sector — finance. The neglect of making things is finally taking its toll, a fact most apparent in the oil and gas world, but also apparent in infrastructure across the spectrum. And the world is less U.S.-centric than it has been in a long time. We see this, too, in the oil and gas sector and in the flurry of deal making along the New Silk Road (and its “momentous” segment, the New Burma Road.)

The implication of this post-finance U.S. economy is a theme we’ll explore more in this letter. As an early conclusion, though, I believe the spread between finance and manufacturing has reached millennial extremes, like a rubber band at its limits. Now begins the snap back.

Chris Mayer
October 21, 2008