Bad Times, Good Money

It is unwise to be too sure of one’s own wisdom. It is healthy to be reminded that the strongest might weaken and the wisest might err.

– Mahatma Gandhi

Today, we will not pick on the Fed chairman. We promise. Cross our hearts and hope to die.

We are moving on. The chairman will get whatever the Fates have prepared for him. God help him.

But the evil that men do lives after them. As the Caesar of central banking continues towards his reward, the world’s financial system lunkers on too – towards correction.

"For the first time since WWII, the world is in the grips of a synchronized global economic downturn," writes Dr. Kurt Richebacher. "We are looking for financial turmoil in the United States of a gravity without precedence in the whole postwar period."

Greenspan spent the last 16 years puffing up not only his own reputation, but also the biggest credit bubble ever.

Not that we have any special information on the subject, but we take it for granted that what inflates is also subject to deflation. Central banking in the time of Greenspan became such a popular sensation that it seemed to many that it was a permanent success. The Greenspan Fed had increased the supply of credit more than all the Fed chiefs and Treasury secretaries back to the time of Washington. Nobody complained, as the ‘inflation’ went directly into stock prices. It began to look as though the science of central banking had been mastered, and the business cycle had been brought to heel too. For, had not Greenspan proven that he could increase credit without triggering inflation? And didn’t that give him the ability to head off a recession by cutting rates quickly?

But nothing fails like success. Or, as economy Hyman Minsky pointed out, nothing can be more de-stabilizing for an economy than a long run of macro-economic stability.

American entrepreneurial capitalism, combined with enlightened Greenspan central banking, seem to have taken the risk out of stocks and paper money. The Fed seemed capable of managing both for the benefit of long- term investors. Is it any wonder they bought and borrowed when it made sense – in the ’80s – and continued to buy when it didn’t – in the ’90s?

Both the credit bubble and Mr. Greenspan’s own bubble reached their zenith about a year ago, by our reckoning. Both now seem to be losing gas.

We noted on Monday that gold hit its lowest point since the early ’70s about the very same time that Mr. Greenspan’s stock seemed to peak out, with the appearance of the Bob Woodward book, "Maestro" in November of 2000.

Mr. Greenspan had become the biggest news story in the entire world. Sure, there were probably a few primitives in fishing villages in the New Hebrides who had never heard of the man. But to the world’s intelligentsia economica, the chairman of the Federal Reserve system was ‘household,’ as well known as Ronald McDonald, Cher or Jim Beam.

On the day the book came out, you could have bought an ounce of gold for $264. But it would have cost you $11,152 to buy the whole Dow. That was a big change from the late ’70s. Then, the Dow and an ounce of gold changed hands for about the same price.

But since the book "Maestro" appeared, the Maestro himself has been in a bear market. More and more often you see him criticized in the press. Unlike Kozlowski and Blodget, he has not been blamed for stock market losses – yet. But the longer the slump continues…and the closer the U.S. economy edges towards deflation… and the more stock prices fall…the more people will wonder about the curious bubble the Fed chairman wrought.

Mr. Greenspan’s stock does not trade publicly and is not quoted on any exchange. But Daily Reckoning readers may still profit as it goes down. Gold is the nemesis of managed currencies. It is what investors turn towards when they lose faith in the managers. Since the appearance of "Maestro," the price of gold has risen 20%. The Dow has fallen nearly 30%. These are trends we expect to continue at least until Mr. Greenspan’s reputation is fully corrected.

"Gold is heading for $1,000," writes my old friend Martin Spring. Over the last 12 months gold has risen 15% against the dollar. Gold mining stocks, after taking a beating this past summer, are back up about 40% since January.

"In recent years," Martin continues, "there’s been an almost-perfect negative correlation between US shares and the gold price…which means that if Wall Street continues to fall, it’s almost certain bullion will rise."

Martin notes that global demand is currently exceeding mine and recycling production by about 400 tons a year. So little money was spent on new exploration and mine development in the last decade, production will probably fall further, until the price of gold hits $400 – $500 an ounce, high enough to encourage additional investment…

But why would gold go up in a general price deflation?

"Gold can also prove to be a good defensive investment in deflationary times, as it was in the ’30s," Martin explains. "Over the past three years the bullion price has risen 23% despite a fall in inflation both actual and anticipated by the markets (as shown by the declining differential between the yields of fixed and inflation-protected government bonds.)"

Gold is real money, after all. It is decent money when Fed chiefs prosper. It is even better when they don’t.

Your correspondent,

Bill Bonner
September 18, 2002

"Stocks sink Americans’ net worth," says a USA TODAY headline.

Figures from the 2nd quarter show household net worth down by 3.4%.

The other headline that caught our eye was this one from Chicago:

"Fed says debt climbing at fastest rate in a decade."

From the article we learn that non-financial debt has been increasing at a 7.8% annual rate.

"Behind the scenes, the Fed is working feverishly to keep the music from stopping," writes Randall Forsyth in Barron’s. "Greenspan & Co. have their monetary pedal to the metal again."

It used to be axiomatic that borrowing boosted the economy. It increased sales and business investment. For each additional $1.40 borrowed, according to Dr. Richebacher, you got about $1 of GDP growth. But lately something has gone wrong. In the period 1997-2001, it took $2.60 of extra debt to produce another dollar of GDP. And more recently, the figure has been more like $4.80.

Why so little growth for so much debt?

There has been "a major change in the use of credit in the United States," writes Richebacher. Can you guess what that change is, dear reader? Instead of borrowing for investment and growth, people are now borrowing just to keep up appearances. Take out a bigger mortgage and buy a big screen TV that came all the way from China… or one of those SUVs that they make in Detroit. People have been encouraged to consume…but not to produce.

See: Perception Versus Reality

Without the increase in auto sales the economy would be in recession. But is Detroit booming? What automaker is going to hire people or build another assembly line when he can only sell his cars by offering zero percent financing and cutting his price margins?

And what about refinancing your mortgage? Why not? Mortgage rates – after tax – are lower than the annual growth in house prices. You get cash to spend…but how is anyone richer as a result? You owe more money, but do you have any better way to pay it back?

According to an undersecretary of the Treasury, the increase in debt is no problem, because debt levels as a percentage of net worth are not as high as they used to be. But if your house doubles in price, are the mortgage payments easier to make? It is earnings, salaries, and dividend yields that really count. You can’t live off paper profits.

Fannie Mae and Freddie Mac may have finally cracked yesterday; their stocks fell 4.73% and 3.26% respectively after it was revealed that Fannie’s ‘duration gap’ slipped to negative 14 months. From the press reports, we could not quite figure out what a ‘duration gap’ is, but it must be a bad thing.

The Mortgage Bankers Association reports that delinquencies are at a 20-year high. Greg Weldon says the number of foreclosures is the highest in 30 years. Fannie Mae can buy all the mortgages it wants; if people can’t make their payments, Fannie gets knocked on her derriere.

The big decline in Americans’ net worth is still ahead, we think. It will happen at about the same time Fannie Mae and Freddie Mac hit major new lows – when the real estate bubble finally finds its pin. Then, the music stops…Americans will stop borrowing…and stop spending too.

And now a report from our Wall Street reporter who, today, is far from the canyons of Manhattan…


Eric Fry at the Supper Club meeting in Colorado…

– Even from way out here in Colorado Springs, the action on Wall Street yesterday looked pretty horrible. The Dow tumbled another 172 points to 8,207, while the Nasdaq fell 16 to 1,260. Even worse, the misery did not end with the ringing of the closing bell. After the close of trading two major bellwether stocks – J.P. Morgan Chase and Oracle – both warned of disappointing earnings. Both stocks dropped more than 7% in after-hours trading.

– Morgan’s warning was nothing short of disastrous. The banking giant said third-quarter earnings would be well below analyst expectations due to weak trading profits and to write-offs of commercial loans to troubled telecom and cable firms. Adding insult to injury, Standard & Poor’s and Fitch both slashed the bank’s credit rating yesterday afternoon.

– Bad news for the stock market was great news for the bond market. Treasury bonds soared, driving the yield on the 10-year Treasury note down to 3.85% from 3.90% late Monday. Apparently, investors are fleeing stocks in favor of any investment that promises a plus sign.

– Oracle’s profit-shortfall announcement is but the latest indication that life in Silicon Valley isn’t as rosy as it used to be. The bubble years are dead and gone, and many a valley resident will miss them.

– Tim Lucier is a former comptroller for tech companies in Silicon Valley who now drives a taxi for a living, and he has some very interesting things to say about the bubble years in Silicon Valley. (Thanks to my mother-in- law [a faithful DR reader and better off for it!] for bringing this story to my attention.)

– "Lucier’s switch from Silicon Valley powerhouse to San Francisco cab driver is merely an extreme example of a trend that has been playing itself out in the Bay Area for the past few years," the San Francisco Chronicle reports, "an industry wide shakeout that followed the popping of the Internet bubble.

"But Lucier’s situation is a bit more interesting than most, because this is a guy who looked after the accounting for a series of valley companies at a time when tech firms were accountable to virtually no one. The picture he paints of those days is not pretty."

– "It was a new age," Lucier tells the Chronicle. "There were no rules. You made them up as you went along… Making things look good for just two years. That’s what the valley was all about."

– Financial chicanery was especially prevalent amongst the valley’s corporate management. "The CEOs had a lot of money coming in from VC companies," Lucier said. "They didn’t know what to do with it so they moved a lot of it offshore. The VCs never knew…It was a given that this kind of thing was going on."

– Lucier claims that senior execs at one particular software company asked him routinely to siphon off $10 million a week and transfer the money to offshore corporate accounts. "After the money was in those accounts, anything could have happened to it," Lucier said.

– If Lucier is to be believed – and we have no reason to doubt him – there may be a silver lining for our economy. Up to this point we had assumed that all the money investors had lavished upon and had been frittered away on things like sock-puppet commercials. If, however, it turns out that some of this money has been squirreled away in offshore bank accounts, maybe our national savings rate is higher than reported. And maybe our economy is just a wee bit stronger than we thought…(Hey, a man can dream can’t he?)

– Still, for every former executive who embezzled millions, thousands of folks lost everything as the bubble collapsed. Thousands lost their jobs as well as their savings.

– The tell-tale signs of a boom gone bust are visible up and down the Silicon Valley, according to "Eric B.," a recent contributor to the Daily Reckoning discussion board. In his post entitled, "My Silicon Valley Commute," Eric B. writes, "Every morning I drive about 16 miles to get to work. I have to go across a toll bridge and this used to be an extreme bottle neck. My commute was in excess of one hour’s time in the AM and 45 minutes in the PM. I now sleep in much later and enjoy a commute of around 20 minutes to work. My brother-in-law was a top sales executive during the hey- day of the "Dot Com" era, he has been living off his severance package and investments for 1 1/2 years now waiting for the return of this market segment (a classic case of denial!) 50 to 60% of the parking lots of Silicon Valley corporate campuses are empty…"

– Oh well, easy come, easy go.


Back in Paris…

*** USA Today gives us the "contenders for the most overpriced real estate market in the U.S.A." – Tacoma, Wash., Naples, FL, Boston, Denver and San Diego. If you have property in those markets and are thinking about selling, too soon might be better than too late.

*** Markets tend to peak on Sept. 22 more than any other day, says Paul Macrae Montgomery, who studies "non- rational" relationships between markets and other phenomena. After the September highs come the familiar October drops…such as those in 1978, 1979, 1987, and 1989. October was also the month of the Asian crisis (1997) and the month the geniuses failed at Long Term Capital Management (1998). It was also the month that the market crashed in ’29.

*** Mutual funds have less cash in their portfolios than they had a few months ago, said Michael O’Higgins to Barron’s. And mutual fund investors are very near to losing real money – their savings. Their stock market gains are already gone, he points out. The celebrated fund manager believes fund investors could panic soon – if the market drops further. If so, the funds will be forced to liquidate their positions. Who knows, maybe this October will be the month that the panic we’ve been waiting for finally comes?

*** A big story in the Paris newspapers: "Baghdad Embarrasses the U.S." Saddam called Bush’s bluff, the story tells us. "Come on down," the Iraqi dictator seemed to say. "Have a look around. I’ve got nothing to hide."

What will the American president do now, they want to know.

The Daily Reckoning