We humans flatter ourselves. We believe we are reasonable people. So successful are we at applying reason to the things close at hand that we cannot resist applying the same process to things far afield about which we haven’t a clue.
We try to make sense of the events around us by describing the "reasons" they happen…and then we extrapolate…looking logically forward to what those reasons will produce next.
From an investor’s point of view, the events we see coming are uninteresting. For there is little profit in them. The company that earns 20 cents per share every year, year in and year out, for an entire century, offers few surprises. Investors rarely get carried away with enthusiasm or despair.
And yet, there are times to buy the shares and times to sell them. For the world does not stand still. Beneath the obvious and predictable trends are less obvious ones…some that seem wholly unpredictable, and yet have patterns of their own. It is these trends that produce the tragic surprises, the comic moments and the pathetic scenes that inspire artists and historians.
Here at the Daily Reckoning it is these latter patterns that interest us. Not merely because they are more entertaining, but also because they are most profitable. It is the unexpected events, after all, which are most mis-priced. It is the unseen menace which causes the most damage. But seeing the unseen and expecting the unexpected isn’t easy. Even here at the Daily Reckoning, we have our hits and misses.
Still, we go about our work with the patience of the proto-economists – the two Adams, Adam Smith and Adam Ferguson, the Scottish moral philosophers of the 18th century. We do not try to predict the future, but only to understand the nature of man. We study him as if he were a bug or a maybe a honey bear – adorable, dangerous, and moronic all at once – and try to guess about what he will do next.
What is unique – more or less – about man is his ability to reason. Unlike the tse-tse fly or the wallabee, man can put 2 and 2 together. Up close, working with things that make sense to him, he comes up with 4 more often than not. But, when he applies these same reasoning talents…collectively…using compound abstractions… to other people’s business – such as how to achieve peace in the Mideast or a boom on Wall Street – 2 somehow becomes 5.245 or a swamp in Indonesia…and the whole equation soon degrades into complete nonsense.
Reason, as it turns out, is man’s greatest strength. It is, alas, his greatest weakness.
Nietzsche identified two different kinds of knowledge. There are the things you know from personal experience and observation, which he called "erfahrung." There are also the abstractions you think you know – the kind of thing that is reported in the paper and discussed on the editorial pages – which he called "wissen."
Today, continuing in the Nietzschean tradition of erudition and the Daily Reckoning tradition of pseudo- intellectualism, we expand Nietzsche’s insight. Not only are there two forms of knowledge, there are also two entirely different ways of reasoning.
The first is the type of reasoning you do with things you know about. If you see someone climb too far out on the limb of a tree, for example, and see the limb break…you might reasonably conclude that the same thing could happen to you in similar circumstances. We’ll call this kind of thinking "schwer uberlegen."
But if you turn your thoughts to the WAT (War Against Terror) or the next election, you are using a different thinking process altogether. Instead of thinking about things you know…you are thinking about things you cannot know and cannot even explain. We call this type of thinking "leicht denken." For example, yesterday’s International Herald Tribune offered an editorial comment from Zbigniew Brzezinski, entitled "Time for America to intervene." Immediately, we are in a different world.
America cannot intervene, because the nation exists only as an abstraction. An American soldier can shoot someone…an American plane can drop a bomb…but America itself is much too big. Whatever "America" does will only be done by a tiny percentage of the whole thing…most Americans will play no role, some will be opposed…and more than a few will be completely unaware of what is going on.
"The U.S. response…has to be guided by a strategic awareness of all the interests involved…"
Who is he kidding? Take America’s interests, for example. What are they? Who can say? Americans have various interests – relatives, vacations, business connections – but they are not necessarily the same.
You could say, broadly, that "America has an interest in peace" in the Mideast. But so what? At what price? Under what conditions? Even if it were true…there is no way of knowing what actions might bring it about.
But people take this kind of thinking seriously. They think they can understand big issues as well as small ones and manipulate world events as though they were rubbing two sticks together.
"Germany must pay…" voiced an editorial from 1919 in Le Temps. "The enemy must pay for everything…that’s the fundamental principle." Philippe Simonnot continues his long slog through the errors of economists during the 20th century. At the end of WWI arose the third big one – the illusion that Germany would, or could, pay for the huge losses incurred by the allies during the course of the world’s most costly war. All the combatants had borrowed heavily to finance the war. Now, they wanted Germany to pay off the debts.
What would it pay with? Germany was falling apart. Her economy was ruined. She had borrowed colossal sums to pay for the war – an amount equal to 3 times her GDP! German political and social structures were tottering. It looked, in fact, as though the country might be on the verge of revolution.
Besides, as Keynes pointed out, the cease fire was achieved by explicitly promising (he called them "sacred engagements") Germany that she wouldn’t have to pay more than her fair share of the war’s costs. But the argument fell on deaf ears…except those of the young Nazis, who used it to show that Germany had been stabbed in the back.
Asked his opinion of the war debts, Calvin Coolidge reduced the matter to a simple and ineluctable logic: "They borrowed the money, yes or no?"
Of course, Germany would never pay the war debts. Of the 152 billion marks demanded, only 23 billion were ever paid. And even this modest amount came with a very high price tag – "the crisis of ’29 was engendered, in part, by the financial illusions of 1919," Simonnot says.
And so, Norman Angell was almost right, after all. War does not pay.
But from the beginning of the war until its end, liecht denken helped people believe what they wanted to believe – that there would be no war, that it would be short, that the costs would be borne by someone else. World War I took a course that hardly a single person in the whole world expected. And that no one – save perhaps some lunatic fringe revolutionaries – would have wished.
How is it possible, dear reader? The world’s finest minds – millions of them – focused on an issue of life and death importance…and still, barely a solitary person was able to understand or even predict it.
What to make of it…when the result of their aggregated efforts is the biggest catastrophe to ever befall humanity? For WWI was no natural catastrophe. No Vesuvius buried people in ash. Instead they were buried by millions in the mud of Europe by cannon and machine gun fire. No freak storm…no asteroid hit the planet… no drought or pestilence. Still, by the war’s end millions lay dead.
A third of France’s capital was used up. A third of Britain’s. A fifth of Germany’s. And then, mankind went back to its business… on its way to its next big mistake.
Your editor, on his way to his next big mistake…
April 09, 2002 — Paris, France
Analysts lie. Politicians lie. Lovers lie.
Figures don’t lie. But liars can figure, as they say. And there are plenty of liars in public companies and plenty of figures to work with. So, we end up with vastly different numbers for "operating income" or "earnings" than is reported to the IRS as profits.
When it came to crunching the numbers few companies were as adept as IBM. Big Blue crunched the numbers so much we felt for the poor things, all crumpled and swished into unrecognizable new forms.
Amid the sturm and drang of the world’s biggest information technology boom, IBM was as placid as a cesspool. While revenue at other IT companies soared 50% per year, Big Blue added to sales at only a 2.5% annual rate from 1996-2001. But this didn’t stop the account abusers from beating up the numbers to produce a little swelling. Per share earnings managed an 11.7% growth during the wonder years.
We wondered, along with everyone else, how it was possible.
Those were the days when people still believed that "operating earnings" were as good as the old-fashioned kind and before Ken Lay and Jeff Skilling were celebrities. In those days, hardly a soul – and especially not an analyst – bothered to look at the debit side of the ledger.
But on Monday, Big Blue issued its first post-Enron 10-K and investors didn’t like what they saw. Eric has more details, below…
Eric Fry in New York…
– Like a World Wrestling Federation tag-team, "Big Blue" and "Black Gold" took turns smacking the market around yesterday.
– Black Gold delivered the first body slam, as crude oil futures jumped more than a dollar a barrel in European trading on news that Iraq would halt oil exports for 30 days, or until the Israeli army withdraws from Palestinian territories.
– The oil price eased off a bit in U.S. trading, but gained 33 cents to $26.54 a barrel.
– In response to Israel’s intensifying military offensive in the West Bank, Saddam Hussein announced Monday that Iraq would "stop exporting oil totally as of this afternoon through the pipelines flowing to the Turkish ports and the south for 30 days."
– Next, Big Blue stepped into the ring to put the hurt on the stock market. IBM’s shares plummeted 10% to a new one-year low after the black-and-blue chip computer company announced that its first-quarter revenues would fall about $1 billion shy of expectations. IBM also shocked the Street by predicting net income of 66 cents to 70 cents a share, well below the consensus forecast of 85 cents a share. And that’s a big no-no.
– In the old days, IBM might have tried to gloss over its soft earnings outlook by "finding" some earnings somewhere in its balance sheet. But in this era of new and improved corporate transparency, the company’s results are naked to the world – and they aren’t pretty. If IBM’s announcement is a preview of things to come, the market might be in for a rough ride. Somewhat amazingly, despite IBM’s shocking shortfall announcement, stocks held up pretty well.
– The Dow lost just 22 points to 10,249, while the Nasdaq, which had fallen more than 2% at one point during the trading session, managed to gain nearly 1% to 1785. To lapse into trader-speak, "The market acts like it wants to go higher." It seems to have decided that it has suffered enough abuse at the hands of investors. A mini-rally would not be too surprising. But the market cannot escape its "genetics." Stocks are expensive – no ifs, ands or buts.
– To justify current stock prices, "you really need very high earnings growth in an environment that is unlikely to deliver it," David Testa, T. Rowe’s chief investment officer tells the Wall Street Journal.
– "Typically, price-to-earnings ratios return to historical norms," the Journal observes. "So today’s high multiples have two possible explanations in Mr. Testa’s view: Either stocks are overvalued or earnings are poised to grow dramatically. Alas, explosive or earnings growth is unlikely, he figures…
– "Companies on average can expect natural revenue growth of 6% or perhaps 7% at best. For corporate earnings to outpace that 7% revenue growth, companies would have to sharply improve operating efficiency, which Mr. Testa thinks is unlikely. ‘To get earnings up to double-digit growth rates for any stretch of time just isn’t going to happen,’ he says…
– "His bottom line: Investors should expect ‘either a correction, or a long period of not going anywhere… while the fundamental underpinnings catch up – and that could take awhile…"
– Pimco economist and fund manager Paul McCulley agrees: "Our overall theme is: Get real, and get used to 5% to 7% in terms of overall returns from financial assets." Mr. McCulley would get no argument from us, except whether one ought to put a plus or a minus sign in front of those numbers. Even a plus 5% return might prove optimistic.
– To wit: The average diversified stock fund gained 0.36% in the first quarter, according to Lipper Inc. When stocks as a whole are expensive, selective stock- picking becomes all the more important.
Back in Paris…
*** Dividends don’t lie. A company can report any number it wants. But in order to pay out a dividend it has to have cash.
*** March was a bad month for dividend payouts…On the S&P, dividends fell 12.2% year to year, wiping out the gains of the previous two months. "The 3.3% falloff in dividends for all of last year on the S&P," says the Barron’s report, "along with the 2.5% dip in 2000, represented the first back-to-back dividend declines in payments since 1970-71, when the Nixon Administration called for a voluntary payout freeze to help control inflation."
*** But "dividends are back in style in the post-Enron era," says another Barron’s article. Why? Not only are they honest, they are also rewarding. We can’t put our finger on it at this very moment, but we recall reporting that most of the gains received by equity investors over the last 118 years have come not from capital gains, but from compounded dividends. Stocks have gone nowhere for the last 3 years. If we’re right, they’ll probably continue going nowhere for the next 5 to 10 years. Without dividends, investors will get nothing for their trouble – except the risk of a severe bear market.
*** With a decent dividend at your back, you don’t have to worry about what the market does. You can sail along, happily…even if stocks lose half their value…until the dividends stop.
*** So how do you get a good dividend? Barron’s helpfully included a list of high dividend payers. At the top of the list, for example, is American Capital Strategies with a dividend yield of 7.81%. Second in line is Allied Capital, yielding 7.79%. R.J. Reynolds will give you a 5.39% yield. And our old favorite, Philip Morris, yields 4.49%.
*** Not far behind is Consol Energy, a favorite of John Myers at Outstanding Investments. It would give you a dividend yield of 4.28%.
*** "Yesterday I had my fourth pickpocket experience in two weeks," reports a friend of mine recently returned to Paris. "Thankfully, I wasn’t the mark this time. A group of pickpockets, young girls around 20 years old [apparently, not gypsies], got on the subway. The woman standing next to me recognized them: they had hit her the day before. The woman started screaming, in French. "Pickpockets! You come to Paris just to rip people off! Get out of here. Get off the train.
*** "She kept screaming until, at the next stop, the pickpockets got off, presumably to find better pickings elsewhere. As they were leaving one of the girls yelled back at the woman. ‘I’ll take care of you.’ And the woman said, ‘Just get out of here. Just go and f*** yourself. (‘Vas te faire f***re.’) Which I thought was pretty strong language. Then again, she told me later she’d been hit for two hundred euros."