And The Last Shall Be First
Lending money to the world’s biggest debtor has scarcely ever been more popular or less rewarding. This week, the yield on 10-year Treasury notes fell below 3.8%. Meanwhile, officially, consumer prices are rising at 5.6% per year. Producer prices in the United States were last clocked going up at almost 10%.
Bond investors are supposed to be the smartest of the lot. But there are times when the first become the last…when the smartest become the dumbest…and when yesterday’s roadmaps need to be turned upside down. This, we believe, is one of those times.
Between what bond investors stand to gain in yield and what they stand to lose from inflation is a built-in loss of 1.8%. Where’s the margin of safety? Where’s the upside? Why bother?
Bond investors are betting that the future stretches out before them just like the past. In that, they are broadly correct. But the trouble is, they don’t look at enough of the past. They need to turn their heads around. Looking in the mirror, they see only the straight road behind them…but not the hairpin curve a quarter mile back. It was just such a turn that flipped them over 26 years ago…and 36 years before that…and 26 years before that. The wrecks seem to come along about one per generation. Interest rates went down for more than a quarter century…then up from 1946 to 1982…then, down again.
Here, we are lured to a flagrant guess. We wouldn’t be the first to notice that it takes about as long for a major turn in the credit cycle as it takes for a man to forget the last one. And we won’t be the only ones to guess that, having forgotten the crack up of the ’80s, bond investors are ready for another one.
Major turns in the credit cycle mark Biblical urning points in investors’ fortunes. They are the points at which the smart money turns out be a half-wit. The meek stock and bond investors of ’82 inherited the world by 2000. Now it is their turn to be last.
By 2008, inflation rates have been going down…or holding steady at modest rates…for so long, the memory of man runneth not to the contrary. Or, at least, the memory of the current generation of investors runs not to the contrary. In their minds, life on Earth began on this month 26 years ago. In that hazy soup of a summer, you were considered foolish if you lent money on any terms to anyone. For a very simple reason: the money you got back would be worth less than the money you lent out. Even if you lent it to the best credit risk in the world – the U.S. government – you demanded a 14% yield to cover yourself. For those bond investors of the early Volcker years the road behind them had been bad enough; they were sure the road ahead led right to Hell. For them, inflation rates below 10% seemed as unlikely as gold below $300 or summer Olympics in Peking. Bonds were nothing more than “certificates of guaranteed confiscation,” and everybody knew it. The U.S. budget deficit – then, about $200 billion – was all the proof you needed.
And so it was that the investors of ’82 threw out their stocks and bonds, stepped on the gas, and ran right into an oak tree.
A report from February 9, 1982, courtesy of the LA TIMES:
“The stock market plunged to an early-1982 low Monday in a selloff attributed to rising interest rates and gloom over the federal budget outlook.”
Investors in ’82 had their roadmaps. They knew that Deficit Alley came out on a street marked “Inflation” and led directly to the Bear Market Highway. In the preceding 10 years, the dollar had lost nearly 2/3rds of its purchasing power; a bear market on Wall Street, combined with inflation, had taken 80% off the value of stocks; and there was hardly a bond investor still compes mentis who did not regret ever laying eyes on US Treasury paper.
By summer of that year, sweaty faces on Wall Street had become so long stockbrokers’ chins practically dragged on the hot pavement. In July, yields on the 10-year T-note reached 13.95% and in August, the Dow dropped to 776. Few investors wanted anything to do with either stocks or bonds; instead, they went to the beach with picnic baskets full of gold coins.
It was on the way home that the road took a sudden turn. Few realized it, but the bear market in stocks that began in 1966 ended that very summer. The bull market in bond yields was over too (the peak had actually been passed nearly a year before). By the dog days of August, everything investors thought they had learned in the preceding decades was not worth knowing; now, the first would come in last. Consumer price inflation was falling from a high of more than 10% per year – the index actually hit more than 14% during the month of March, 1980 – down to under 4% by 1984. Bond yields would follow, as investors gradually and reluctantly backed up and turned around.
The pile up of the early ’80s widowed commodities and orphaned gold. But in the next straightaway, stocks and bonds were soon as readily adoptable as a blond-haired boy. By the late ’90s, everyone wanted them. The Dow rose 11 times. Bond prices rose too, as yields fell. And gradually, the roadmaps of ’82 were redrawn. What everyone knew for sure then, they know now was not so. And what everyone knows for sure now is the very thing they knew was false 26 years ago. George W. Bush will leave office with a deficit that would have staggered the generation of ’82 – around $500 billion. But investors know now that ‘deficits don’t matter.’ They expect the dollar to rise and bond yields to fall anyway. Likewise, the stock market was thought to be expensive in ’82; even with shares selling at only 8 times earnings, they considered them too risky. Now, with p/e’s twice as high, stocks are thought to be bargains.
But every generation of automobiles has to find its own way to the scrap heap. And every generation of investors – even those with GPS on the dashboard – has to find its own Deadman’s Curve.
Enjoy your weekend,
The Daily Reckoning
August 29, 2008
“Market buoyed by strong GDP report,” says a headline.
Yesterday, the Dow managed a strong rise – up 212 points. Oil fell back to $115. Even with a hurricane whipping up the waters of the Gulf of Mexico investors figured oil was a sell.
The dollar rose to $1.46 per euro. And gold rose too – plus $4.80, to $838.
Gold seems to have bottomed out at $784. That might have been the best buying opportunity we will have for many years. Time will tell.
We’re not bothering to guess. To us, gold is a good thing to have when things go bad. And after such a long period when so many things went so well, we suspect it’s time for them to go bad – and in a big way.
Badness in economic terms means either inflation or deflation – or both. And both is what we’re seeing.
“This is the first business cycle ever in which the middle class had less income at the end than the beginning,” says a report at CNN. The report refers to figures put out by the Census Bureau, showing that median real incomes for U.S. families dropped in the period 2000-2007 – from around $58,500 to $56,000.
“Real” is the important word. Most families have more dollars. The trouble is, consumer price inflation has made those dollars worth less.
An interesting nuance came to light as well – one much discussed by Democratic politicians. While the median family got poorer over the period, the people at the top got richer. The wealthiest 1% of the population now has the highest percent of national income in 80 years.
But what are we to make of these latest GDP numbers? The numbers have been lying to us for years; what story are they telling now?
Readers will recall that except for a 6-month period in 2001-2002 the U.S. economy grew during the entire 7 years – usually at very impressive rates. In fact, it was common for American economists to boast about it. They thought they had discovered some magic formula and actually taunted the Europeans for not following their model.
What they had actually discovered was not the miracle of eternal growth, but the mirage of episodic credit expansion. And it was a special kind of super-powered credit, courtesy of the dollar-based monetary system. In effect, Americans could borrow without ever having to pay the money back. They sent IOUs – dollars – all over the world. Since ’71, they couldn’t exchange their dollars for gold. And, besides, the grateful foreigners were so happy with the strong dollar, they were glad to keep them. They used them to stuff their mattresses, build up central bank reserves, and capitalize Sovereign Wealth Funds.
Of course, you can’t really get rich by spending money you don’t have on things you don’t need. So, we – often alone…often mocked and always unappreciated – pointed out that the GDP figures were a fraud. In a consumer economy in the late stages of a credit bubble, GDP growth measured the rate at which people impoverished themselves – not the rate at which they built wealth.
Hardly anyone believed us. (Usually a good instinct…) But now we have the figures to show we were right. GDP grew substantially during the last 8 years. But people actually got poorer.
And now we have more GDP numbers; and again, they’re claiming that the economy is growing. In the second quarter, U.S. GDP grew at a surprising 3.3% annual rate. Economists applauded. Investors celebrated. Politicians and central bankers slapped each other’s back. And many analysts take these GDP numbers to mean that the crisis is over; the economy is growing again – and healthily.
Not so. Most of the GDP growth in the 2nd quarter came from exports. But most of the exports were higher priced agricultural products. Grains went up in price. And U.S. farmers sold a lot of them on the world market.
Nothing wrong with that. But not many people are going to get much out of it. Consumers are still squeezed…and spending less money. Officially, consumer spending went up at a 1.7% rate in the second quarter. If you take into account the rising population, this is barely any increase at all, per capita. And retail sales actually fell in July.
Bankruptcy filings are rising at nearly 30% per year. And even Tiffany’s says it’s hard to make a sale.
So, before coming to a verdict on the economy, we’d like an opportunity to cross examine those GDP numbers…in order to get out the truth. And water-board them too…just for fun.
*** “Uh…well…there wasn’t any heat. Not even any hot water…”
Friends had just come back from our ranch in Argentina. They brought hundreds of photos and many happy memories. But they brought us some disappointment too. We spent – how much was it, we’ve forgotten already – some $75,000 on a state-of-the-art solar heating plant, we find that it doesn’t work. It is winter in Argentina now. Up in the mountains, temperatures drop down into the teens (in Fahrenheit) every night. Without heat, it can be rough.
Our friends had a professional as well as a leisure interest in the ranch. Patrick is a cattle breeder in France. His animals regularly win top prizes at farm fests. We had asked him to take a look at the herd down in Argentina.
“It’s a different world down there. We were very impressed. Everyone was so nice. They treated us like family wherever we went.
“And the scenery is spectacular. We drove over the mountains to get to your place. It was unbelievable. There’s nothing like it in France. So wild. So empty. And the sky is so blue. It was always blue. Without a cloud. They told me that the sun shines every day. Even when it rains, the sun comes out soon after, so there is never a day without sun. Very different from here in France. In the winter here, you can go for weeks without seeing the sun.”
There, you can’t go a single day.
“We were impressed too by the way the mountains change color as the sun makes it way from dawn to dusk. It was so beautiful, we just wanted to stop, sit down and look at it…
“Even at night, it was spectacular. We had a full moon. And sometimes we would be out on the trail late, after the sun went down. But the moonlight was so bright, we didn’t need the sun. I have never seen anything like it.
“I have to tell you though, that your ranch is so rugged…we were surprised you had any cows at all. The first thing I asked when I got there was: ‘What do they eat?’ There’s no grass. It’s so dry. I know you have plans to build more water storage areas…but, you might need more than that.
“Naturally, the cows are very thin. They’re not the kind of cattle you’d find in Europe. You have a local brand – practically your own breed of creole cattle mixed with various trains of Brahmin, Bradford, even some Limousines. But the operation is so different…and the terrain is so different…I realized that everything I knew about cattle was nearly worthless out there.
“I heard from Jorge that your place is so remote even the cattle buyers don’t want to come out. Besides, the beef is too tough – which I guess is not surprising.
“You know, here we move cattle from one field to another. It takes about 10 minutes. But I asked Jorge how long it took to move them from that huge valley in back of the house to the pasture just in front, where you treat them for diseases and sell them. He told me it took 12 hours…if the cattle are in good shape.
“And they have to move them over a stone path barely a meter wide with a drop-off down the canyon of about 100 meters. It looked like a death trap to me. We wanted to see them, but we were afraid to ride over on horses…it just looked too dangerous and uncomfortable, so we decided to go on foot. Jorge told us it was just a ‘couple hours.’ So we set off. But after two hours, I could barely breathe…it’s just so high. And we looked over at a snow-capped mountain…and Jorge said, ‘it’s just over there…’ But I knew it was at least another couple hours hike. And it was getting dark. So we had to go back.
“It’s an amazing place…and we had a great time…with memories that we will keep for our entire lives. But, seriously, you need to get the heating system fixed.”