A Colossal Deception

How could the colossal deception of investors in the late 1990s by corporate America – which continues to this very day – have been possible had it not been sanctioned or even encouraged by the government and its agencies?

I have discussed elsewhere the role of propaganda in the manipulation of crowds and their beliefs. But I would like to discuss here what two dictators of the 20th century, Hitler and Mussolini, wrote about how to move masses. According to them, the masses had to be relentlessly bombarded with propaganda. With their primitive minds, the masses were far more likely to fall prey to a "big lie" than a "small lie." It was quite common for people to lie on a small scale, whereas the average person would shy away from big lies.

Therefore, the crowd would never even contemplate that anyone might be reckless enough to twist the truth to such an extreme degree. Even if the truth was uncovered later, doubts would remain.

Thus I am not surprised that while investors are increasingly questioning the integrity of corporate America and its cronies (the auditors, the investment banks, etc.), they have, so far, totally failed to question the integrity of the entire financial system that has been created by our governments and central banks! It puzzles me that people can believe that the private sector is lying, cheating, and cooking the books, and yet at the same time assume that the government is behaving ethically and responsibly, and not cooking its books and statistics!

In most countries the government makes up 20-30% of the economy. Therefore, it seems to me that investors are assuming that the 70-80% of the economy that is accounted for by the private sector is, to a larger or lesser extent, dishonest, but that the 20-30% of the economy that is in the hands of the government is clean and ethical. How could the colossal deception of investors in the late 1990s by corporate America, which continues to this very day, have been possible had it not been sanctioned or even encouraged by the government and its agencies?

Don’t forget that the Nasdaq bubble of 1999/2000 was only made possible by the easy monetary policies of the U.S. Federal Reserve Board. And why has the U.S. administration now allocated additional funds in order to expand the number of SEC investigators, more than two years after the bear market began, when it did nothing to even question corporate governance in the late 1990s? It is evident that, in any country, the regulators, who seem to have failed so badly in the United States in the 1990s, are part of the administration. Clearly, we have to distrust the government, including the Fed and all other government agencies, the IMF, the World Bank, and so on, as much as the corporate sector, since large corporations have so much to do with who is elected and who gets what position within the administration.

Charles Allmon, the editor of the excellent New Issue Digest, recently commented on "The Great Accounting Charade," in which he takes corporate America and the government to task for not protecting individual investors. He writes: "Can anyone please tell me who today looks out for the individual investors? Who?? As this is written, it appears that the U.S.A. has the best government that money can buy. Money pours into Washington to keep the accounting charade flying intact."

This, incidentally, is particularly true of the Bush administration, whose vice president, Dick Cheney, was formerly in charge of Halliburton – a company that is now under a federal probe because of its aggressive accounting at the time when he was its CEO! In fact, my main concern today centers on the possibility of systematic risks that continue to be concealed by the administration. Witness people like Paul O’Neill, the Treasury secretary, trying to convince the public of the underlying strength and strong fundamentals of the U.S. economy. On June 16, 2002, he said that he didn’t know why the markets are where they are today and that, "eventually it will go back up, perhaps sooner rather than later. There is an unbelievable movement in the market without what I believe to be substantive information."

O’Neill ought to be concerned about the continuous rapid credit expansion. In 2001, U.S. national income increased by $179 billion, non-financial credit by $1.1 trillion, and debts of the financial sector by US$916 billion. In other words, debts grew ten times faster than GDP. He might also want to take a look at the deterioration in the quality of credit. Ford’s shareholder equity is down to $7.4 billion from $28 billion in 1999, while its debts are up to $165 billion. And while he’s at it, he could look at the failure to correct the imbalances in the U.S. external accounts and the gargantuan derivatives exposure of financial institutions, where some accounting time bombs are certain to be set off sooner or later. If the auditors couldn’t even identify some relatively unsophisticated accounting tricks, how can we possibly expect them to understand the complexity of proper accounting in the derivatives market?

It’s obvious that the U.S. government, with its lackey the Fed, is desperately trying to keep the system from collapsing by printing money. Whereas GDP increased in 2001 by $179 billion, broad money supply soared by $883 billion. The Fed is also keeping short-term interest rates artificially low by subsidizing the housing market and consumption through government-sponsored enterprises such as Fannie Mae.

And there is a high probability that the "Plunge Protection Team" is intervening from time to time to support the stock market and depress the gold market. While the government is trumpeting that companies become more transparent, its own transparency and that of its agencies is rapidly heading for the twilight zone.

The problem with this present set of conditions is that it makes forecasting even more difficult. One is no longer dealing only with economics, the capitalist system, and the market mechanism, which – while not entirely predictable – are at least understandable. The current situation is one of continuous statistical revisions, hedonic adjustments, and repeated interventions in and whitewashing of the true problems of the international capital market and the global economy by governments around the world. But as Friedrich Hayek remarked, "The more the state plans, the more difficult planning becomes for the individual."

It is in this spirit that I want to warn our readers once again not to consider our forecasts as being engraved in stone. The markets are likely to become rather unpredictable in the short term and even more volatile than they have been in the past few years. Undoubtedly, the huge monetary injections by central banks around the world – not only in the United States but more recently in Japan – over the last 18 months, and which can be expected to continue ad infinitum given the central bankers’ monetarist economic ideologies, will produce from time to time very sharp short-term stock market rallies, but in the long term we can expect more economic maladjustments. Therefore, economic hardship on an unprecedented scale will eventually follow in the Western industrialized countries.

My concerns for the long-term center on several issues that are likely to put additional pressure on U.S. equities or, at the very least, contain a sustainable secular advance. I am concerned about another deeper recession in the United States due to sluggish or declining consumption and housing activity, the health of the U.S. and international credit markets (Japan, Turkey, Brazil, Argentina, etc.), and the still high valuation of U.S. equities.

The first concern we must address is the continued rapid appreciation of house prices and the consumer’s ability to continue to consume in the wake of the stock market having eroded at least some of his wealth. As Gary Shilling notes, the "conviction that money has no place else to go is a sure sign of a bubble in any investment." The only question is: what will trigger the downturn in housing? In my opinion, there are several factors that could act as a catalyst for the housing bubble to burst.

Affordability will inevitably become a problem at some point. Especially if housing prices continue to appreciate by around 10% per annum amidst weak nominal income gains. Rising interest rates could also be a factor. But the weakest links in the bull market for houses are the financial intermediaries, including banks, insurance companies, sub-prime lenders, the asset-backed securities market, and, especially, the government-sponsored enterprises such as Fannie Mae and Freddie Mac. If any of these markets or institutions should encounter any financial difficulties, housing credit could dry up and lead to a collapse in the property market. The U.S. housing market now depends more than ever before on a further expansion of the present credit bubble. The average down payment for a new homebuyer in 1999 was only 3%, compared to 10% a decade earlier.

Signs of the possibility of impending weaker housing activity are already evident from the recent poor performance of home improvement retailers such as Home Depot and Lowe’s, as well as home builders such as Toll Brothers (TOL), Ryland Group (RYL), KB Home (KBH), and Lennar (LEN). Over the last two years, the S&P Homebuilding Index has outperformed the S&P 500 by such a wide margin that investors should become increasingly concerned about home builders. The present housing boom, which is financed by very "easy money," will certainly not last forever. Homebuilding has and will always remain a highly cyclical industry. Also, closely related to the health of the U.S. housing industry is the health of U.S. financial institutions. Again, the recent pronounced weakness in consumer finance companies, banks, and other financial stocks, which have also so far outperformed the S&P 500, is another warning flag.

I have been accused in the past of being too bearish. But compared to a Global Equity Strategy report, which I received from Dresdner Kleinwort Wasserstein, written by James Montier, I almost seem to be a moderate heretic. According to Montier, investors should "not be fooled by those pointing to bond equity earnings yield (BEER) charts, and shouting BUY! Such cheerleading strategists are committing financial idolatry. Absolute valuation is the only way to deal with these markets. If you want 7% total return then you shouldn’t be buying the S&P 500 until 476 – 574 – 40 – 50% downside."

According to Montier, the expectation of a 7% total return from equities implies a P/E of 14 based on the assumption that the earnings yield is an approximation to total returns. The next problem, writes Montier, relates to earnings, which, according to Graham and Dodd’s, should be looked at over five or 10 years.

If one examines the P/E of the S&P 500 based on the five and ten-year moving average of earnings, commonly called normalized earnings (which in my opinion are far more relevant than recently reported earnings, which are still doctored by the corporate sector and were artificially boosted by several unusual factors in the late 1990s), valuations remain very high by historical standards. Concerning the health of the financial system, I came across a comment by Len Williams about the hedging techniques of Barrick Gold. Len is the head of fixed-income and commodity research at Durlacher. His work highlights the risk inherent in the derivatives market.

According to Williams, trouble may arise in the gold market if gold prices rise to $400 and above. Such a rise could prove very bad for any big-name banks caught on the wrong side of this price move. He writes that the phenomenon revolves around a highly unusual form of gold derivatives, a market in which Citibank, Goldman Sachs, and JP Morgan are the major players. The particular form of derivative is a type of hedging pioneered by Barrick, one of the world’s largest gold producers and a leader in innovative hedges.

Ordinarily, a hedge protects a producer or investor from the downside. Other things being equal, it does so by limiting their upside. Barrick, whose hedge book had assets of $5.5 billion at the end of 2001, however, has managed to construct a hedge that allows it considerable upside if gold rises. And one big bank could be caught very short. Apparently, Barrick has hedged part of its production through a spot deferred forward sale contract. Barrick makes a forward contract with a bank to deliver (unmined) gold at a certain price at a certain date. But what makes these contracts different, and also dangerous, for counter-parties is that Barrick has the right to defer the delivery of the gold for periods ranging from five to 10 years.

More recently, Barrick seems to have entered into contracts that allow it to defer delivery for 15 years. We don’t know this for sure, but we do know that the total U.S. notional derivatives position of U.S. banks and trusts exceeds a staggering $44 trillion (GDP is $10.2 trillion) and that JP Morgan Chase controls over $26 trillion, or close to 60%, of that market with assets that only amount to 13% of total U.S. banking assets!

Somewhere, sometime, an accident in the financial system is bound to happen. It is unlikely that such huge positions can be constantly rebalanced without anyone taking a huge hit. Financial stocks have continued to outperform the S&P 500 this year. But given the rising risk of bad loans, losses on trading positions, and the exposure to derivatives, we reiterate our recommendation to sell the shares of banking and consumer finance companies.

Avoid financial stocks and housing companies. Both have continued to outperform the market so far in 2002. Any rally may prove to be sharp but short lived, as economic and financial fundamentals remain murky at best.

Sentiment towards stocks from a longer-term perspective remains too optimistic; cash positions today are nowhere near where they were at major market lows such as in 1974, 1982, and 1990; and insider selling remains at an uncomfortably high level.

The de-leveraging of the U.S. corporate sector has just begun. In the late 1990s, companies repurchased shares and issued bonds to finance these share repurchases. I envision an environment where, on each market rally, companies will issue shares in order to improve their leveraged balance sheets. Thus, the supply of equities will remain high at a time when the demand will likely be more moderate, as households still hold 57.1% of their assets in equities, which is just 0.6% below the all-time high of 57.8% in November 2000.

A sharp market rally aside in the near future, the very best we might expect from U.S. equities is a trading range for the S&P 500 from about 950 to 1,200. Moreover, if the dollar and bonds should experience a more pronounced bear market in the next 12 months – as we expect – then stocks will be pressured by reduced foreign buying and rising interest rates.


Marc Faber,
for The Daily Reckoning
August 20, 2002

Editor’s Note : Dr. Marc Faber is the editor of The Gloom, Boom and Doom Report and a major contributor to Strategic Investment. Dr. Faber has been headquartered in Hong Kong for nearly 20 years, during which time he has specialized in Asian markets and advised major clients seeking down and out bargains with deep hidden value – unknown to the average investing public – bargains with immense upside potential.

"There are some good companies selling at good prices and some bad ones," my brother-in-law concluded. The investment banker is taking a holiday from Wall Street, spending time with us in France. Your editor is taking advantage of the opportunity to ask questions.

"Who can say what the market will do?" he continued, giving the Peter Lynch view, "so the rational thing to do is to not even think about it."

Here at the Daily Reckoning, we agree with the first part of the sentence, but not the second part. We can’t help but wonder what will happen next. And we’re coming to believe that there are larger patterns and a deeper logic to the stock market that would be worth knowing – if we could.

"Economics do not underlie social mood," wrote Robert Prechter in his Elliott Wave Theorist recently, "social mood underlies economics."

"Social mood determines the character of social events," he explained. "As previous studies demonstrate, rising stock trends do not improve the public mood; an improving social mood makes stock prices rise…Politics do not affect social mood; social mood affects politics…"

When people get in the mood for a bull market, a bull market is what they have. But moods do not last forever. What are people in the mood for now? Saving… retribution…revenge…war…deflation?

We will see…more below…

But first, Eric’s report:


Eric Fry, our eyes and ears in the Big Apple:

– Mr. Market, like an aging baseball slugger, can still "go yard" every once in a while. Yesterday, he did just that by knocking the Dow into the cheap seats. The blue chip index flew 213 points to land at 8,991. The Nasdaq, likewise, sailed 34 points to land at 1,395.

– The Nasdaq has jumped more than 15% since August 5th…Only 160% more and it will have regained its record high!

– "Before the recent peak," write Andrew Smithers and Stephen Wright, a couple of insightful British economists, "there have been four clear peaks in U.S. share prices…1906, 1929, 1937 and 1968. In every case these peaks were followed by severe falls in the stock market, which took share prices down to very cheap levels, and these falls coincided with major recessions."

– "A rise in stock prices that is not justified by any corresponding rise in fundamental value must ultimately be followed by a subsequent decline, in real terms," Smithers and Wright continue. "When the relationship between asset prices and income gets out of line, either asset prices must fall in nominal terms or incomes must rise. Neither of these alternatives is painless."

– In other words – for readers who are not fluent in econ-speak – when stocks soar to ridiculous levels like they did in 2000, they must fall a lot to get back into line with their real-world values.

– "Major falls in nominal asset prices, such as occurred in the U.S.A. in the Great Depression and more recently in Japan, tend to result in debt deflation and be followed by major recessions."

– The "major recession" part of this grim scenario has yet to occur, but a major fall in asset prices appears to be well underway, both in the stock market and in the bond market.

– "Never in the post-World War II period has the stock market been this weak during this stage of the business cycle," marvels William Dudley, Goldman Sachs’s chief economist. Normally, stocks rally nicely when coming out of a recession. But plainly, that’s not happening this time.

– What’s more, there appears to be a whiff of debt deflation in the air…"From April through June, 56 companies defaulted on $52.1 billion of rated debt, a new quarterly peak (the runner-up was the $36.9 billion of debt gone bad in the first quarter of 2001)," Jim Grant observes. "In the bubble, prospective borrowers were approved after submitting a valid government-issued ID card."

– American households are in no better financial shape than American corporations. "Household debt as a percentage of GDP is way up," Ned Davis observes. "Debt has continued to skyrocket during this bear market…The debt is still here but the collateral’s gone."

– Jim Grant explains: "[The bubble] has distorted values and the perceptions of value. It has induced conservative people to take risks they wouldn’t have dreamt of taking a decade ago and less conservative people to play with fire. On a macroeconomic level, it helped to foster record-high borrowing, in relation to GDP, by households and businesses."

– In the wake of this reckless borrowing, the New Era of rising productivity and prosperity that Greenspan tirelessly promoted has turned out to be nothing but a chimera – an expensive self-delusion.

– We’re in a new era, alright, says Paul Kasriel, economist at Northern Trust. "But not the one George Gilder and his merry followers had in mind. No, the new era we are in is the one of declining household net worth." And that is a new, new thing indeed.

– "From 1953 through 1999," Kasriel explains, "there never was an instance when household net worth declined year-end to year-end. [But] now, we have two consecutive years of declining net worth, and we’re on track for a third year." Is there any reason to doubt that this reverse wealth effect – coupled with a rediscovered urge to save – will take a big bite of consumption, which in turn will take a big bite out of economic growth?

– "Now that the ratio of net worth to income is falling from the stratosphere," Kasriel continues, "the personal saving rate is starting to rise. After averaging 2.3% in 2001, the saving rate rose to 4.2% in June of this year…We think that over the next several years, the saving rate is going to levitate toward this long-run average of 8.7%."

– Clearly, any significant increase in the savings rate – however laudable – will have dire near-term implications for economic growth.

– We anticipate a long slog out of the post-bubble era," writes Grant. "A grim business, it will sooner or later be enlivened by the confessions of Alan Greenspan. If only because the truth will become too glaringly obvious to ignore, he will have to try to explain what happened to the New Economy and to ‘structural’ productivity growth…Confronted with his costly misapprehensions from the bubble era, he will have to admit that it might be better for all concerned if he left his post and devoted his time to touring the British Empire, wherever it is.

"It may be that Alan Greenspan’s professional inflection point will have something to do with the gold price… The bet of the gold bulls is that faith in Alan Greenspan, and in the currency he manages, is on the wane. Who comes after him? A central banker not imputed to possess the magical powers of divining the optimum funds rate and imposing that rate on the world. Greenspan does not now possess that capacity and never did. No one does or did."

– Mr. Gold Market, are you listening?


Back in Paris…

*** It is Day 6 of your editor’s annual summer vacation. But he came back to Paris anyway…partly become he has work to do, and partly because he needs some rest.

*** "We’re taking the mansion," says Tom DeLay, coming up with another crowd-pleaser. "We’re draining the account. We’re going after the yacht."

*** As the public’s mood darkens, politicians light their torches and rush to the front of the mob – promising to get even with the corporate villains du jour.

*** And what’s this? "We’ve got to wage a war against terrorism in the boardroom," says Richard Grasso, president of the New York Stock Exchange, giddily turning on his old friends.

*** War against drugs, war against illiteracy, war against terror, war against crime, war against poverty…and now a war against terrorism in the boardroom! What will they think of next?

*** Not since 1914 has any nation been so eager to get itself blown up in a war it can’t win.

*** "Can you believe it? They sat me between my own brother and some English guy with bad teeth," Maria complained, outraged.

*** "It was worse for me," Jules replied. "I had to sit between you and Dad."

*** We were coming home from a dinner party. Everything – even the weather – is an outrage to our 16-year-old daughter. Everything – even the end of the world – is a bore to her 14-year-old brother. Everything – even a dinner party in remote rural France – is entertaining to their father.

*** But Elizabeth accepts every invitation that comes her way; anything is better, she reasons, than dining with outrage, boredom and amusement.

*** So it was that the innocents abroad found themselves at the table of Mr. du Plessis last night. "The man is a pompous windbag," your editor had protested to his wife. At our last encounter, he had aggressively criticized the U.S. for "destroying the planet" by failing to sign the Kyoto Accord, which would have reduced worldwide carbon dioxide emissions.

*** "It is just a hypothesis," we had replied. But the windbag just kept blathering as if he could foretell the future, indignant that the Americans were ruining his home planet.

*** At least at last night’s dinner, your correspondent was seated on the opposite side of the table from the windbag, next to his pretty young wife, and separated from him by a large table ornament of wicker and flowers that threatened to burst into flames at any moment. The dining room was magnificent; the walls had been marbleized early in the 19th century and on them were the heads of stags hunted down and killed by various ancestors. Curiously, there was also the small head of a hare; a trophy that seemed unworthy of the room, like a woman showing off a ring she got out of a box of cereal.

*** But neither distance, camouflage nor the threat of conflagration could stop the windbag.

*** "You Americans have become hysterical," he began, recounting his latest trip through the high security/low comedy airports of the U.S.

*** "Hey," my brother-in-law added his own tale, "You won’t believe what happened to us. I was travelling with a friend to Utah. We both took our 8-year-old boys. The security people stopped us and then ran the boys’ hands under a scanner to check for explosives. Did they really think that a couple of 8-year-olds were planning on blowing up the plane?"

*** "They do it to everybody, whether it makes any sense or not," Congressman Ron Paul told me a couple weeks ago in Aspen. "I was going through the St. Louis airport… the security guard was checking everything, asking questions, so I showed him my card proving that I was a member of Congress. It didn’t make any difference…he just kept poking around in my underwear (though not the pair I had on, thank God.)"

*** What is the nation coming to, dear reader?

*** "I mean, it is as if they think they are the only nation to ever take any casualties," the windbag continued. "That’s the trouble. That’s why you are so ready to go to war now. America has never taken any real casualties in its wars…I mean, not on the scale of Europe where we’ve lost millions. Whole generations wiped out. And it’s not as if this were the first time innocent civilians were killed either. In WWII millions of civilians were killed. London was bombed. Dresden. Hiroshima. Tokyo.

*** "The big difference this time is that it was the Americans were on the receiving end…They’re used to dropping bombs…but not to being bombed themselves."

*** "Would you please pass the cheese?" your editor asked.

The Daily Reckoning