At Least Don't Buy Bonds...
While Bob Prechter and Gary North see "deflation" in the money supply, Porter Stansberry sees inflation in commodities…for some time to come.
"All bondholders must consider that a new cycle could be arriving…after 24 years, we are closer to the end of the bond bull market than the start of it."
– Chris Weber, "Global Opportunities Report," Jan. 15 2004
Alan Greenspan was on TV, speaking to a German audience, about the grandiose accomplishments of his American monetary policy.
He was saying that the Fed’s 13 consecutive interest-rate cuts had saved the U.S. economy (and therefore the world). He proclaimed that such cuts would not cause a rise in inflation, as "there has been no systematic rise in prices."
Asset Inflation: Commodity Inflation
Simultaneously, the FOX news scroll running along the bottom of my screen told me that soybean prices had reached a new, 6-year high price.
And it’s not just soybeans, Mr. Greenspan.
On January 13, the Commodities Research Bureau, which tracks the futures prices on a broad basket of commodities, reached a new ten-year high. Other new highs posted the same week include copper and precious medals, which have literally flown off the charts.
If you go back and look at the early 1970s, you’ll see that inflation follows a pattern: precious metals move first, then soft commodities, and finally oil. Soybeans are the first of the soft commodities to jump…the others soon follow.
Asset Inflation: Plenty of Warning
But the more dangerous inflation – asset inflation – is not so easy to track or quantify. In fact, Chairman Greenspan claims that economists cannot detect asset price inflation (otherwise known as a stock market bubble) without the benefit of hindsight. I disagree. I think common sense gives plenty of warning.
Last summer there were only 12 companies trading in the United States with both a market capitalization (a total value) of over $1 billion and a price-to-sales ratio of 10 or greater. This $1 billion / 10-times sales hurdle is my favorite measure of bubble valuations: it’s simple and objective. It makes sense. When a very large company is trading at 10 times its annual sales, it’s hard to imagine how it will be able to grow fast enough to provide an economic return to new investors.
A new investor would have to expect the equivalent of 10 years’ worth of sales in retained earnings to break even on the investment. Without a very high rate of earnings growth, that cannot happen. And a high rate of earnings growth in very large companies is extremely difficult to achieve, especially in a global economy characterized by poor pricing power and overcapacity.
Today there are 98 companies trading in the United States that have at least $1 billion in market capitalization and a price-to-sales ratio equal to or greater than 10.
Let’s examine one to see if we can find any asset inflation.
Veritas (NASDAQ: VRTS) is a Mountain View, California based developer of software used in storage networks. The firm’s software works with all of the major labels – IBM, HP, Microsoft, Sun, etc. The company undoubtedly produces fine software. Sales have grown magnificently from $200 million in 1998 to over $1.5 billion by 2002. Through the first nine months of 2003, sales remained strong: $805 million.
If the test of a great business was its ability to develop high-quality products and sell them, we would rate Veritas a great company, if not a great investment at its current price. Of course, the test of a great business is its ability to develop great products and to sell them at a PROFIT. And, turning a profit seems just beyond the grasp of our friends in Mountain View.
According to the company’s balance sheet, the company has sustained accumulated losses in excess of $1.5 billion. I find it hard to fathom how a software company, which has gross margins in excess of 80%, can lose money year after year. Yet, Veritas found a way…
In fact, the losses on Veritas’ financial statements only hint at the actual losses sustained by the company’s investors. You see, software companies are only as good as their software engineers. The market for such employees is incredibly competitive. Thus, Veritas pays for these employees with stock – a form of currency that does not get charged to the company’s income statement, but is paid for out of the pockets of the company’s shareholders.
Asset Inflation: A Bleak Picture
A closer inspection of the company’s 2000-2003 results paints a bleak picture for anyone in the market for Veritas shares.
In Millions: 2002 2001 2000
Net Income (As Reported) $57 -$642 -$628
Stock-based Compensation $294 $290 $151
Adjusted Net Income -$237 -$932 -$779
As you can see, vast improvements to the company’s official bottom line have not yet overcome the rising cost of employee stock options, which of course are paid for with the investor’s balance sheet, not the company’s balance sheet. Even the strong resurgence of the United States economy has solved this compensation problem for Veritas shareholders. Through the first nine months of 2003, the company booked official profits of $168 million…but for the same period it had to pay out an additional $238 million in stock options to its key employees.
Judging from the last six years of Veritas’ operating history, a reasonable investor should wonder why anyone would want to own this business – at any price. It seems unable to make an accounting profit with any regularity, let alone a genuine profit that would result in an economic benefit for its owners.
Certainly the people who know the company best want no part of it: insiders have sold close to a million shares of stock in the last six months; none have bought.
Despite all of these facts – which should be well known to all Veritas investors – the shares of Veritas trade hands today for $40 per share, a price which values the entire company for an astounding $17 billion. Which is in excess of 10 years’ worth of its current sales.
There are another 97 companies I could have detailed for you, all of which present investors with the same kind of value you’ll find in Veritas – that is to say, none.
And yet, Mr. Greenspan sees no inflation in the United States economy. He will continue to say he sees no inflation, too…because in fact it is his policies that are causing the new inflation – in commodities and assets.
Asset Inflation: Focusing on the Wrong Threat
Brian Wesbury, one of the best young economists in the country, explains:
"At 1%, the federal funds rate is 3.9% below the current 2- year annualized rate of growth in GDP, the widest spread since 1978…We are now in a period that looks like the 1960s or 1970s all over again. Both the 10-year yield and the federal funds rate are significantly below the rate of growth in nominal GDP. It does not matter whether productivity is rising, or if lower tax rates are boosting the output of goods and services.
"The Fed is focused on the wrong threat. Gold, commodity prices, the value of the dollar, the steep yield curve, and the relationship of nominal GDP growth with interest rates, all point to the same conclusion. Monetary policy is excessively accommodative, and in an unsustainable position."
Sooner or later, rising commodity prices and the falling exchange rate will filter into rear-looking measures like the Consumer Price Index (CPI). When the Fed is forced to raise interest rates to preserve the purchasing power of the dollar, long-term interest rates will soar, causing bond prices to plummet.
The last time (2000) an asset bubble was pricked by raising short-term interest rates, long-term interest rates fell because the dollar was strong and commodity prices near all-time lows. This provided a substantial "wealth effect" cushion for the U.S. economy. Lower interest rates sparked a rally in homebuilding and a rise in credit-inflated real estate prices.
When the Fed raises interest rates again, CPI inflation will be a real and growing threat. Commodity prices will be high and moving higher. The dollar will be weak and growing weaker. And long-term interest rates will move higher, not lower. The wealth effect that cushioned the stock collapse of 2000 will work in reverse this time, savaging both home prices and bond prices.
If you are bold enough to look beyond the headlines into the real economy, as measured by commodity prices, exchange rates and asset prices, you cannot miss the building of another bubble – one that’s even more dangerous than the last.
Stocks and bonds may trend higher for the next several months. Given the amount of inflation we’re seeing – as measured by the Fed Funds rate versus the growth rate in our economy – it would be almost impossible for stocks and bonds not to appreciate.
Traders may have a field day.
But we are in the twilight of a 24-year bull market in financial assets and at the dawn of a long bull market in commodities.
for The Daily Reckoning
January 22, 2004
P.S. Don’t be fooled by the size of this sucker’s rally. This stock market is not safe for any buy and hold investor.
Editor’s note: Porter Stansberry is the founder of Pirate Investor LLC, a financial publishing group dedicated to providing high-quality research for high net-worth investors. The former editor of several well-known financial letters, including Latin American Index, China Business and Investment, and the U.S. edition of The Fleet Street Letter, Mr. Stansberry is regularly quoted in leading financial journals, such as Barron’s and World Money Analyst.
Porter is also the publisher of Extreme Value, an investment letter that seeks to uncover the safest, cheapest shares in the market. Read on to discover the gems the Extreme Value team have recently laid bare in the real estate market:
A version of this essay originally appeared in The Blast, a Pirate Investor e-mail missive.
"Americans are rising to the tasks of history," said President Bush in his state of the union address Tuesday.
We don’t know what that means, but when we think of the real state of the American union the word ‘delirious’ comes to mind.
The president imagines that the nation is at war – a war which necessarily demands great sacrifices from the American people. Who the nation is at war against is a matter of great confusion. Where is the enemy? How many divisions has he? What weapons does he have? What is his war strategy…what are his war aims? Why has he chosen to go to war with the U.S? How much will the war cost? What will we get out of it?
No one seems to know. Hardly anyone bothers to ask.
Poor Paul O’Neill. The former Treasury secretary seems genuinely surprised that the Bush administration would be annoyed with him simply "for telling the truth."
The truth he told was that the president had barely a clue what he was doing…and no one in the White House seemed to have any interest in the kind of open questions from which a clue might emerge.
But the truth is the last thing Americans seem to want.
"Reagan proved deficits don’t matter," Dick Cheney explained to him, hallucinating. And so the budget busters in the White House geared up spending in the homeland with the same recklessness as they have pursued their war against terror abroad.
So far, it seems to have ‘worked,’ which is to say, it lured American consumers into deeper holes of debt. One day, they will almost certainly regret it, but that day might come long after the next election. So, who cares?
Housing starts are at a 20-year high. Refinancings are running as strong as ever. Real estate prices are rising. The Dow is over 10,000. Americans owe more money to more people than any race ever did. But, for the moment, they can still make the monthly payments.
One of the biggest trends of our time is the entry of millions of people into the world labor market. As recently as a few years ago, Chinese peasants posed no threat to Milwaukee factory hands…nor did Bengali engineers seriously threaten Chicago information workers. Now, this huge surge in the proletariat is lowering labor rates everywhere. America’s middle class can’t believe it is being ruined by it. The nation’s debt is higher than at any time in history – 350% of GDP. Real incomes from work are flat or falling…while millions of Chinese and Indians stand in line to do their jobs at 1/10th the price. Each year, about 1% of the entire value of America passes to foreign owners. And yet, Americans dreamily imagine that they have some special talent…a gift from God himself perhaps…that gives them the right to progress without saving, prosperity without capital investment, and wages 1,000% above the global bid.
Maybe there is no problem. A delirium doesn’t last forever. But what does? Eventually, the patient gets over it…or dies. President Bush shows no sign yet of shaking off the fever. Nor do voters. They all seem perfectly happy to continue on the road to ruin until it comes to an end.
Americans are not rising to the tasks of history. Instead, history is rising to give them a boot in the derrière.
While we’re waiting…here’s Eric with the news:
Eric Fry in New York…
– Wall Street featured "A Tale of Two Sectors" yesterday; bank stocks rocketed while tech stocks reeled. Thus, the Dow Jones Industrial Average delighted the lumpeninvestoriat by gaining 95 points to 10,624, while the Nasdaq disappointed the lumps by slipping 5 to 2,142.45.
– J.P. Morgan Chase, the bluest of the Dow’s blue-chip components, jumped $1 to $40.10, after posting fourth- quarter earnings that "beat expectations." Citigroup shares jumped a similar amount, as the BKX Index of bank shares soared to a new all-time high.
– Pretty amazing, don’t you think?…The BKX Index manages to hit a new record high, even though the stock market is still sitting well below its all-time highs, and long-term interest rates are 1% higher than they were last June and mortgage refinance activity is 80% below where it was last May. Is Mr. Market "looking ahead" to another boom in the finance sector…or is he simply losing his head?
– We don’t trust the bank stock rally, but we wouldn’t dream of standing in its way. Although we possess an innate distrust of stocks that sit atop multi-year highs, we have learned to respect their right to establish a series of ever-higher multi-year highs…even when they don’t deserve it.
– While the bank stocks were boiling over yesterday, the semiconductor stocks were as frigid as the Hudson River. (It’s true; your New York editor saw vast sheets of ice along the banks of the Hudson yesterday…After a few more days of record-setting cold, we’ll be able to WALK to New Jersey). The Philadelphia Semiconductor Index slumped 2.6%, after Motorola reported earnings "below expectations."
– "Yet on a positive note for chips," notes CBSMarketwatch, "orders for chip equipment placed with North American-based manufacturers rose sharply in December, marking the sixth straight monthly gain, while a key ratio measuring orders vs. shipments remained above parity for the third month in a row."
– The dollar – like a kind of financial Fargo, North Dakota – is the coldest of all asset classes. Yesterday, the stone-cold greenback slumped half a percent to $1.2644 per euro. The President’s State of the Union address Tuesday night lent no support to the dollar whatsoever. Apparently, the world’s dollar buyers did not warm to the Bush doctrine of lavish tax cuts alongside equally lavish spending programs.
– Mysteriously, the very real threat of large, looming budget deficits caused nary a ripple in the Treasury market. The benchmark 10-year Treasury note gained 6/32 at 101 23/32, dropping its yield to 4.02 percent from 4.05 percent on Tuesday.
– The stock market’s robust rally over the last couple of months has stolen the spotlight from the rallying bond market. But make no mistake, bonds are enjoying a spiffy rally of their own, despite – and here’s the curious thing – a plummeting dollar, a gaping current account deficit and a widening Federal deficit.
– Should bond investors sell the rally?…"Yes," says the "Bond Man," Bill Gross of PIMCO.
– "Bill Gross is paid more than $40 million a year to manage the world’s biggest bond mutual fund," explains colleague Steve Sjuggerud, editor of True Wealth. "Gross is ultimately responsible for $350 billion in bonds. (That’s billion with a ‘b’.) They call him ‘The Bond Man’ and ‘The Warren Buffett of Bonds.’ For good reason…Gross has beaten 95 percent of his peers since his PIMCO Total Return Fund started in 1987. Funny then, that Bill has sold a chunk of his own retirement money out of his famous bond fund."
– Gross’ recent commentary on the PIMCO Web site argues eloquently against owning long-dated bonds. He predicts: "Bonds (and stocks too) will be low-return asset classes for the foreseeable future."
– We would not argue with Mr. Gross. Au contraire, the Daily Reckoning’s New York bureau considers the U.S. bond market to be the best short sale west of the Atlantic. Treasury bonds, in particular, are vulnerable to America’s acute reliance upon foreign creditors. Consider the following observation from William Poole, President of the Federal Reserve Bank of St. Louis: "Foreign-owned U.S. assets increased by an average of $155 billion per year during the 1980s. Since 2000, foreign ownership of U.S. assets increased at an average rate of $833 billion per year – more than a fivefold increase in the rate of foreign buying. In 2000, over $1 trillion of U.S. assets were purchased by foreign entities. And, by the end of 2002, foreigners owned more than $9 trillion of U.S. assets; including more than $300 billion in cash, far more cash than is held by all U.S. citizens combined. –
"To give you an idea of how important foreign-ownership of U.S. assets is to our economy, consider the recent sales of U.S. government debt. In the last six quarters, the U.S. government issued $345 billion in debt. Net foreign holdings of U.S. debt increased by $304 billion during the same period. Foreigners must buy all of our new debt because our economy produces almost no net saving. –
"The willingness of foreigners to continue to invest in U.S. assets depends, mainly, on currency management…The dollar is the world’s reserve currency because of its perceived soundness. Rising rates of inflation in the U.S. economy will jeopardize the dollar standard, make foreigners increasing reluctant to hold U.S. dollar assets and make it increasingly difficult to sell U.S. bonds at affordable rates of interest." –
Responding to Poole’s comments, Porter Stansberry writes, "I’m reminded of what Alan Greenspan himself said this month in Germany when asked about the growing U.S. foreign debts: ‘In the end, the restraint on the size of tolerable U.S. imbalances in the global arena will likely be the reluctance of foreign country residents to accumulate additional debt and equity claims against U.S. residents.’
– "Commenting on the rise of prices across the board in commodities," Stansberry continues, "Fed Governor Ben Bernanke maintains that commodity price rises are not a harbinger of future inflation, but instead a proof of ‘strengthening economic activity.’ He also mentioned that, while shopping for cheap dry land in Florida, he had a wonderful lunch with Santa Claus." (More from Mr. Stansberry, below…).
– To conclude: Bonds might rally more, but they don’t deserve to.
Bill Bonner, back in Paris…
*** "A pessimist is a optimist with experience," say our Swiss friends.
"Do you know the difference between an optimist and a pessimist?" asks a Daily Reckoning reader. "The optimist thinks we live in the best of all possible worlds. "The pessimist is afraid that the optimist is right."
*** "I was interested to read your quote from George Orwell about women and money," writes an English reader. [Orwell had described, cynically, how much women seemed to care, not about making money, but about spending it ostentatiously]. "Coincidentally, I read this in today’s London Times (section 2).
The relevant line:
"…economists believe that women are more receptive to displays of wealth."