Animal Spirits and Other Amusing Fictions
The latest bout of bullish euphoria rests on some shaky foundations – like GDP data that are woefully short on profits. Meanwhile, on the other side of the Atlantic, the ECB is attempting to use the same remedies now proven ineffective by Japan and the U.S. What are these guys thinking?
The "bear" camp is a little lonelier these days with the stock market rallying and a few economic indicators showing some life. But we aren’t ready to pull up stakes and shuffle over to the "bull" camp. Less bad economic data are not the same thing as strong economic data. And yet, a stock market selling for 49 times the S&P’s estimated "core" earnings for the 12 months ended in June would seem to be discounting super strong economic data.
Someone, we think, needs to warn exuberant investors about the still-prevalent downside risks so they can position themselves for the likelihood of another bout of selling. An editorial in last week’s Financial Times suggested that "for all their newsworthiness," the data on existing home sales, durable goods orders and the GDP revision "are an extremely poor basis for valuing equities." We couldn’t agree more.
With the possible exception of durable goods orders, they may even be insufficient for judging the health of the economy. But you’d never guess that from reading the growing cadre of commentators who are basing their bull case on what we consider to be shaky foundations.
Take, for example, Charles Wolf Jr., economist at two different think tanks, who complains in The Wall Street Journal about the media’s "hyping of the gloomier forecasts." Wolf argues that "the ingredients of a benign trajectory for the American economy are numerous and strong," one reason being that "federal deficits, at a level of perhaps 2% to 3% of GDP principally due to increased outlays for defense and homeland security, are likely to have a mildly stimulative effect without entailing consequential risk of inflation." We have no doubt that running up deficits would augment the GDP data, since government spending is, by definition, a direct contribution. But profits are the lifeblood of sustainable stock market rallies, and the GDP data are very enlightening on this point – bearishly enlightening.
The jump in third-quarter GDP, to a 4% annualized growth rate from 1.3% in the second quarter, sounds pretty good – until you look more closely at its components and consider the evidence of weakness at quarter’s end (most notably the collapse in auto sales). For instance, what about profits? In the third quarter, profits from current production fell $14.1 billion, after a drop of $12.6 billion in the second period. Current-production cash flow, the internal funds available for investment, fell $12.2 billion.
It’s perfectly normal for profits and investment – which are both key to a sustainable expansion – to lag in a recovery. So, in itself, the profit decline is potentially not cause for panic. But what could be worrisome is that profits have fallen longer than nearly all U.S. economists were expecting. [Our own Dr. Kurt Richebundefinedcher notwithstanding.] Which means, we think, that it’s far too early to declare that a healthy expansion is under way.
Keep in mind also that, unlike most of the reported data, the profits number is in nominal, as opposed to real, or inflation-adjusted, dollars. "Real measures are not available for the specific income-side components," says the Commerce Department’s Kenneth Petrick, "because there are not direct price indices available as there are for product-side measures." Nonetheless, we know that inflation still exists (despite some exhortation to the contrary), and therefore the dollar continues to lose purchasing power. Therefore, comparisons to prior-period profits are even worse than they appear.
The breakdown of GDP is clear enough – it’s all about consumption. Out of the four percentage points of annualized growth, 2.9 came from personal consumption expenditures, while nonresidential fixed investment subtracted 0.7 points. Government spending contributed 0.58 percentage points. The next largest component came from a rise in inventories.
If consumption were self-perpetuating, as many economists (and consumers!) seem to think, this breakdown wouldn’t be so bad. Unfortunately, we live not in fantasyland, but in a world in which, at some point, you’ve got to make money to spend it. Not to mention the fact that, by nearly every measure, consumers are overstretched. That is not to say they couldn’t stretch even further, only that the risks of a break are ever-present. Until profits and investment get going, we’ll put on our hard hats and keep a wary eye out for falling share prices. Profitless "strength" is not the stuff of sustainable bull markets.
Charles Wolf Jr., in the aforementioned Journal article, lauds "the important if ill-defined ‘animal spirits’ of American entrepreneurs" as another reason for optimism. If anything is worthy of the title "voodoo economics," it is the lingering use of Keynes’s concept of "animal spirits." Journal editor Robert Bartley, in his "Thinking Things Over" column, picks up the same theme when he says that "the recovery has been lackluster so far because businessmen have lacked animal spirits," but he adds that "perhaps risk aversion started to break last week." Keynes’s famous phrase is often used by those who misinterpret the causes of a downturn, and hence the stimulus necessary for recovery, as being mainly psychological. On the contrary, until the unprofitable investments of the boom are liquidated or adapted to actual consumer preferences (as opposed to the dreams of investors), the recovery will be based on wobbly footings.
Meanwhile, following the same line of, um…thinking, the European Central Bank finally pulled the trigger and cut interest rates by 50 basis points. They must have been admiring how effective 12 rate cuts have been here in the New World at raising the spirits of American animalia. Or perhaps they have missed the point. Europe, like the U.S., is trying to grapple with the lingering ill effects of the post-bubble economy.
Should the ECB be taken to task for lounging on the couch while Greenspan was doing the heavy lifting? Well, we don’t know. Certainly its stated purpose is to keep inflation from rising above 2% year-over-year. Presumably, it also aims to keep inflation from hitting zero, and theoretically, at least as far as anyone can tell, European central bankers have done their job: the inflation rate has even picked up speed, rising from 1.8% in June to the latest reading of 2.2% in October.
European politicians – like their wild American counterparts – would like it if the ECB could solve their problems with the touch of a button; hence the widespread criticism of the bank’s inactivity. But the fact that one interest rate would seem to be appropriate for, say, Germany and another for Ireland testifies to the folly of excessive centralization. There is little that ECB President Wim Duisenberg can do about it now, without risking some major imbalances. We might add that Europe’s woes include a tendency towards fiscal ineptitude – and we’re not even talking about the Growth and Stability Pact, which sets a "limit" on government deficits. In Germany, for example, Chancellor Gerhard Schroeder has decided that what his struggling economy needs is higher taxes.
Morgan Stanley’s Joachim Fels and Elga Bartsch suggest their may in fact be a "Dark side of an ECB Rate Cut." [You think!?] Their concerns include the potential loss of credibility should inflation remain stubbornly high, the emergence of asset bubbles due to excessive monetary growth and the moral hazard of sanctioning imprudent behavior by governments, unions and corporations, thus forestalling necessary reforms.
Is it possible that a rate cut is not the panacea it’s made out to be? We don’t know for sure, but with Europe following Japan and the U.S. down a well-trodden, but hardly illuminated path, we’re certainly going to find out.
for The Daily Reckoning
December 13, 2002
P.S "Greed is good," Gordon Gekko proclaimed in the 1987 movie "Wall Street." Now comes The Economist to proclaim that war is better. The British magazine joins the chorus of those trumpeting the most dangerous myth of all. "[M]ost wars in America’s history have – thanks to massive government spending on defense – tended to stimulate the economy," it says. All we can do is implore you not to believe everything you read in the GDP – and ask yourself, perhaps, why we haven’t heard economists propose what would seem to be the obvious all-season remedy: perpetual war for perpetual growth.
Editor’s note: Andrew Kashdan is a top analyst for Apogee Research (formerly Grant’s Investor). For "brutally honest" investment insights consistent with those you read in The Daily Reckoning, click here:
The big news yesterday was that the price of gold jumped $6.60…and the dollar fell to a new low.
What would make gold go up so much? Ah, this is what is so interesting. Fed Governor Bernanke announced to the whole world that the Fed had both the means and the will to destroy the dollar. It was as if he had walked into a waterfront bar and said he could beat anybody in the place. Is it so surprising that Mr. Market would want to take a swing at him?
Let’s get a couple more drinks, dear reader, and see what happens next:
All the world’s central bankers are crowding ’round. They’re putting their money on Bernanke and the Fed. They all believe they’ll knock out deflation. Mieno wasn’t able to do it in Tokyo, true enough they say…but the Japanese just can’t punch; everybody knows that.
"It’s really simple," Milton Friedman says from the end of the bar, "just print money."
Well…yes. Just like the way to avoid a winter cold is to blow your brains out in October. Everybody knows it’s true, but who’s going to pull the trigger?
Given a choice between mild deflation and the risk of hyperinflation…maybe a little deflation isn’t such a bad thing. "Maybe the Japs aren’t so dumb after all," says a quiet voice in the corner.
"Nah, they’re a bunch of wussies in Japan," shouts back Paul Krugman, célèbre Keynesian economist for the New York Times. "What the Japanese need to do is promise borrowers that there will be inflation in the future!"
Bernanke, with perhaps more guts than brains, has made it clear to Americans that if the nation’s prices are stable in the future – it won’t be his fault. He can lick deflation any day, he says. And inflation? Heck, a little of that is a good thing…and he can control it.
In a more genteel world, we would say he had ‘thrown down the gauntlet’. Mr. Market, we think, has picked it up. The room goes silent…
Over to you…Addison…
Addison Wiggin, keeping score from Paris…
– As if to accept the Bernanke challenge outright, the Department of beLabored Statistics released Producer Price Index numbers today revealing…what’s this?…after a miniscule 1.1% rise in October, prices for finished goods dropped 0.4% in the month of November. (Yeehoo! Chalk one up for the deflationists…)
– Nor was the current account balance the hoary number economists and analysts the world over seemed to expect it would be yesterday morning. In fact, it came in just shy of the record-setting pace of $127.6 billion pace set in the 2nd quarter.
– Yet, it still takes $1.4 billion a day to feed America’s bad habit of consuming the world’s capital…the dollar still fell to a 34-month low against the euro…and gold did jumped to a 3-year high…so in all, I’d have to begrudgingly concede a point to the inflationists, too…awwww…
– Alas, even with a slipping dollar, it still only costs a about $2.00 for a good red table wine in Paris. So we Daily Reckoneers are happy with both reports. Neither provide any clear indication of a trend setting in…and we expect there will be plenty of opportunity for entertainment through the holiday season.
– On the day, Mr. Market barely noticed any economic activity…the Dow hiccupped 50 points lower to 8,538 by the close, while the S&P 500 index shrank a whopping 3 points to 901. The formerly-proud-home-to-the-TNT-sector Nasdaq index showed a little sign of life – very little – it closed up 3 points to 1,399.
– And here’s news…the erstwhile American consumer appeared to have averted his eyes from the television long enough to form an opinion last week, too. An ABC News/Money Magazine survey appropriately titled The Consumer Comfort Index reportedly fell 5 points to negative 22 on a scale from +100 to -100. We have no idea what these numbers represent, nor do we necessarily suggest you accept them as an accurate sentiment indicator, but serious people with real opinions say, "this is not good." Only 19 times in 900 continuous weeks of polling has this indicator dropped 5 whole points or more. Doesn’t bode well for the Walmarts of the world if there’s any correlation between that number and consumer buying habits this season.
– Likewise, the World Bank has gotten all gloomy on us. The officious institution headquartered in Washington, but responsible for mucking around in economies as far away as Bangladesh, issued a report yesterday suggesting the global economy faces a "significant risk" of recession in 2003. After just 1.1% growth was logged in the books for 2001, the WB projects a slovenly 1.7% for earthly expansion in 2002. Soon to be revised no doubt, up or down. Despite it’s ‘warning’ however, it left the 2003 growth projection at a respectable 2.5% – lest anybody get concerned.
– Also, more as a side note than anything, we suspect that Japanese Finance Minister Masajuro Shiokawa may be a Daily Reckoning reader. You recall that in yesterday’s edition we discussed Bloomberg’s William Pesek Jr. suggestion that now might be the right time to revalue the Yuan? Well, this morning, the BBC news reports Shiokawa as saying, "China might also benefit if it makes the yuan’s value higher." What do you think? Coincidence? Hmmmnnn…
– In any case, it appears as though China may unseat the U.S. as Japan’s most favored nation of import. Since the end of WWII, the U.S. has exported more to Japan than any other nation. But new figures show that 6.31 trillion yen in Chinese goods sold in Japan – up 9% since last year – has outpaced the 6.04 trillion yen worth of product the U.S. sends to Japan.
– As we noted yesterday, China is the object of increasing scorn for exporting deflation around the globe, largely because it has pegged the yuan at 8.3 to the dollar…an exchange rate that some analysts say doesn’t accurately reflect it’s share of the global economy. [For more on China and its supposed "exported deflation", see the Prudent Bear’s Marshall Auerback’s article, " The Rotten Fruits Of America’s Strong Dollar Policy"]
Back in Baltimore…
*** Small investors are pulling out of stocks. This will be the 3rd year in a row (unless something dramatic happens between now and the year’s end) of falling stock prices. People are getting tired of it. 350 mutual funds have closed this year.
*** Wall Street strategists, of course, missed it. Almost all of them expected a higher Dow by the end of the year. ‘Wrong way Ed’ Yardeni, for example, thought the S&P 500 would be at 1260 by the close of December. He’s reduced his estimate 4 times…and now guesses the S&P 500 will end the year at 900, about where it is now.
*** But what’s this? The Templeton Dragon fund, run by Mark Mobius, is up 17.5% this year. How did it do so well? It invests mostly in Chinese companies.
*** We do not get to read tomorrow’s newspapers. So we don’t know what the stock market will do. However modest our own view of our forecasting ability, it is probably not modest enough, you may be thinking, dear reader.
But here at the Daily Reckoning, we’ve learned to live with ignorance the way men learn to live with fat wives – happily and comfortably.
All we know is that things are usually as they usually are. If they are not as they usually are, chances are good that they will be – sooner or later. We look for regression to the mean in all things – and are rarely disappointed. By definition, things that are extraordinary are uncommon, and like snowstorms in late spring and managed paper currencies – they can’t last.
Regression to the mean, alas, is neither simple nor compulsory. We look to the long run to figure out where things are meant to be…but how long? In the long run, we are all dead, as Keynes pointed out. Obviously, it the extraordinary part – those precious hours when we defy the odds by being alive – that is most interesting to us.
But what about stocks? If stocks were to regress to the mean, where would they end up?
My friend, Steve Sjuggerud, examined the question as if he were an oilman eyeing a belly dancer. Here is his conclusion:
"THE MARKET WILL BE 41% LOWER FIVE YEARS FROM TODAY.
"Since we have no concrete knowledge of the future, the safest guess for five years from now may be that the market will be in line with its historical values. Of course, the market may be substantially higher than history would suggest…or substantially lower.
"I came up with that number by looking at the three most time-tested measures of valuation…the price-to-earnings (P/E) ratio, the price-to-book value (P/BV) ratio), and the price-to-sales ratio (P/S) ratio. Over history, the average value of these has been 16, 2, and 1, respectively. (I’m actually being a little generous, here, so I can’t be accused of being a bear or fudging any numbers.)
"All I could assume was that these numbers will be roughly in line with history in five years time. In that same spirit of history, I assumed that sales, earnings, and book values will all increase by 6% a year for the next five years, again, (very) roughly in line with historical averages. Based on that, the S&P 500 would be at 530 in five years – or 41% below it’s current value of 900."
*** Well, your editor visited his London tailor for the 7th time.
"What’s that bulge..?" Elizabeth wanted to know.
"Oh my…something not quite right there…" the tailor replied, "it seems to want to go out where it should want to go in… Well, we’ll have it ready for you the next time you come to town."
"I hope so," said Elizabeth, "I’d like to see it on him once or twice before he begins shrinking from old age."