Black and Blue

Investors are getting beaten, whacked about the head and hindquarters by stock prices that won’t stop falling. Economists can hardly believe it. They admit they have no words to describe this ‘baffling economy.’ But like lookouts on the Titanic, they sit and stare, dumb, mesmerized by the destruction they should have seen coming.

In the spirit of constructive criticism, once again we try to help.

You don’t get something for nothing, goes the adage.

But you’d have hardly thought so in the last decade of the 20th century. Companies with no earnings were suddenly worth billions. People were getting rich with nothing more than zeros on their income statements. Without even casting a single crust upon the water, Americans were reaping more loaves than they ever imagined possible.

What was the source of this modern-day miracle? The Fed was creating ‘credit’ out of thin air; after all, it is in the business of printing money. Money was conjured up…from nothing, credit far in excess of available savings. And the more nothing the Fed brought to the job, the more people began to like it. They felt they had something…and wanted more.

Thus did Alan Greenspan’s reputation, debt, and mass fantasy all become extraordinarily popular as the century came to a close. The economics profession had a theory: that all a central bank had to do to promote permanent prosperity was to control the price of credit – making it easy to borrow most of the time and more difficult occasionally when inflation needed to be controlled. As long as consumers didn’t see the price of beer and cigarettes rise from week to week – the more credit the better.

Throughout most of the ’90s, credit expanded at a rate 2 to 3 times the increase in GDP. But by the end of the period, credit was gushing into the U.S. economy at the rate of $2 trillion per year…or 20% of the entire gross domestic product.

As time went by it took more and more nothing to produce the illusion of something that people wanted. As reported in this space at least once before, during the first 3 decades following WWII the ratio of debt-to-GDP growth was fairly constant. For every extra dollar of GDP, debt went up by $1.40. Recently, the ratio has gone out of whack – with nearly $5 in debt for every extra dollar in GDP.

There is a hint of desperation about these figures, we think. People are borrowing not to invest in new and better industries, but to keep up appearances. As reported here yesterday, for example, Americans are refinancing their homes just to get a $40 break on their monthly payments.

Alas, the Fed’s miracle money machine was almost too wonderful. An email message found on Richard Russell’s website helps explain why:

This is different from previous downturns “PRIMARILY because underlying economic activity can no longer be stimulated by monetary or fiscal means at this point in time. Markets have become saturated, and even if you offer zero interest loans people cannot drive more than one car at a time, and they still have to pay back the capital value of the car loan. Even if you charge 0% on housing mortgage rates, people still have to have the income to pay back the capital value of the housing loan (on a house price which has risen because the buyer could afford to pay more)…

“What has been happening is that middle class people have been TRADING UP because easy money and low interest rates have facilitated the purchase of bigger and better cars and houses (not more). This is what caused the housing bubble. House “prices” have been rising, and average car “prices” have been rising as middle class people have shifted from compact cars to 4 wheel drives (as an example)…

“It is different…because all the debt that was built up to facilitate the “wild binge” in consumption of fancy cars and upgrading of houses by ordinary people, and purchase of new cars and houses by people who would not have been able to afford to buy them if “normal” credit assessment criteria had been applied – all this debt now has to be repaid. THE 30 YEAR PARTY IS OVER, AND THE HANGOVER NEEDS TO BE WORKED OFF.

“People, we need to understand that there is NO WAY that the equity markets have reached bottom. Price/Earnings ratios are still factoring in growth which…DOES NOT HAVE A SNOWBALLS HOPE IN HELL of materializing. Price/Earnings ratios WILL fall to bring the financial world back to reality (and probably will also overshoot).”

If we are right, rates will fall still further. Credit will get cheaper (and bonds more expensive) simply because people will stop asking for it.

The Fed’s legerdemain requires buying and selling treasury securities to force the cost of credit in the direction it wants. It may be the biggest customer for credit instruments, but it is not the only one. As other customers for credit exit the market, it takes less meddling from the Fed to keep rates low – simply because there is less demand for them.

Jim Grant reports that since June, “the Fed has been throttling back.”

“Our guess,” he continues, “is that the demand for funds is falling, ergo the supply of funds needed to fix the funds rate at 1ó% is also falling.”

Uh oh. Suddenly, people don’t want to borrow the way they used to. And here is another little item discovered in yesterday’s news: the latest figures show the savings rate going up – to 4%. Despairing of nothing, people are beginning to stock up on something.

Your editor,

Bill Bonner
October 4, 2002

The Wilshire 5000, the broadest measure of stocks in America, is down nearly 50% from its peak. $8 trillion has been wiped out.

Isn’t that enough?

Apparently not. Stocks fell again yesterday.

“We’re about halfway through the bear market in terms of time,” Robert Prechter told Newsweek, “but less than halfway through in terms of price.”

No one knows, of course, but Prechter thinks we’ll find the bottom of this downtrend somewhere below 3550 on the Dow. Bill Gross of PIMCO says it will be around 5,000. Here at the Daily Reckoning, we take the same approach as the Supreme Court to pornography: we’ll know it when we see it. Or, we won’t.

But we think it will be a long time coming. The dream of getting rich by buying stocks rocked so many people to sleep for so long…it will take more than a few years of losses and a few trillion dollars to wake them up.

Besides, nearly every broker and money manager still reassures his clients – and maybe even believes himself – that he is in it “for the long haul.” America has the most dynamic and resilient economy on the planet, he reminds them; over the long run nothing beats a portfolio of well-chosen U.S. stocks.

As time goes by, however, more and more stockholders will give up: “I don’t care about the long run,” they’ll tell him. “Just take me out; I need the money.”

Consumer debt rose $500 billion in the last 5 years. The average family has $7,000 in credit card debt alone. Federal Reserve figures show U.S. consumer debt reached 145% of GDP last quarter.

Bankruptcies are rising too – there were 1.5 million of them in the last 12 months.

“Now is the time to get your house in order,” says an article at “Somebody who has a 15% debt to income ratio has a problem,” the article explains. By our back-of-the-envelope calculations, the whole nation has a problem. More below… including a startling little number the financial press seems to have missed.

But first, Eric’s report:


Eric Fry, from the city of New York…

– Another day, another failed rally attempt. The Dow jumped more than 150 points in the early going yesterday, immediately after the Institute for Supply Management reported a higher-than-expected reading for its non-manufacturing index. But the gains quickly evaporated. A few subsequent rally attempts also failed to take hold. By the end of trading, the Dow was off 37 points to 7,717 and the Nasdaq Composite had dropped nearly 2% to 1,166.

– The brokerage stocks suffered a particularly severe beating. The XBD Brokerage Stock Index tumbled another 5%, led lower by the newest bad boy on the block, Goldman Sachs. It seems that the heretofore unsullied Wall Street firm stands accused – by Congress no less – of lavishing “hot IPOs” upon several of its investment banking clients. (Remember when initial public offerings used to be “hot?” Stocks like Etoys and Yahoo jumped more than 250% on their very first day of trading!)

– Anyway, in a classic case of I’ll-scratch-your-back- and-you-scratch-mine, Goldman liberally dispensed stock in hot IPOs to many of the very same folks who brought them investment banking business. A coincidence? Unlikely. Altruism? Even less likely. According to Bloomberg News, “Kenneth Lay, Enron’s former chairman, Dennis Kozlowski, Tyco International Ltd.’s former chief executive and Ebay CEO Margaret Whitman, a Goldman board member, were among the executives to get IPO shares.”

– We at the Daily Reckoning are shocked…shocked that Goldman Sachs would load up the personal accounts of its investment banking clients with hot IPOs. Who would do such a thing, simply to attract tens of millions of dollars of investment banking business?

– Since the early 1990s, this sort of preferential treatment was one of the biggest open secrets on Wall Street. I don’t know any hedge fund manager, for example, who DIDN’T know that this sort of thing was happening. I always felt that the overtly unfair manner in which brokerage firms allocated hot IPOs was scummy, but that’s because I never received any large IPO allocations. If I had, I might have thought this was a pretty nifty way to do business.

– We now return to the topic that has been captivating Daily Reckoning readers all week: Whither the bond market?…Will the 10-year Treasury yield continue sliding in response to an unshakeable deflationary malaise? Or, alternatively, might a renewed inflationary cycle cause rates to rise? None of us has the exact answer, of course, but we are not shy about hazarding a guess – after all, we will either be right or wrong.

– Bill is partial to the notion of a deflation that slowly billows through every nook and cranny of our economy log fog through downtown San Francisco. I, on the other hand, consider inflation the betting man’s wager. As money manager Edwin Levy said recently in an interview with James Grant, “[T]he idea of America falling into deflation is a bad bet. I am not saying I am short [Treasury] bonds…I am saying that this is a lousy bet.”

– But the nice thing about the great deflation vs. inflation debate is that both sides are bound to be correct at some point in the future. Anticipating this possibility, PIMCO’s legendary bond-fund manager Bill Gross predicts BOTH deflation AND inflation. “Deflationary fears are all the rage these days,” he observes, adding that in his own five-year forecast, “deflation might rule the early years while reflation might command years four and five plus.”

– What if Mr. Bonner is right? What if rates are more likely to fall than to rise? Wouldn’t that be a good thing? Well, maybe not, as Jim Grant explains:

– “What is implied by [today’s] yields and prices is that Treasury securities are just as safe today as equities were in March 2000. They are safe because they are going up…The risks to the downside are familiar to anyone who keeps up with Japan. Ultra-low yields damage the sponsors of underfunded pension plans. They hurt life insurance companies with obligations to deliver streams of relatively high-yielding annuity income. They tempt investors into the old conjuring trick of trying to coax a 6% return from a yield curve unable to give that much.”

– Not to worry, a couple of hot IPOs from Goldman Sachs could make up the difference.


Back in Paris…

*** A message from my friend, Dan Ferris: “Hey, Bill… I’m in Hawaii researching that company, Alexander & Baldwin. I’m going over to Maui and maybe Kauai (I’m on Oahu, yuck!) to check out their sugar and coffee plantations, watershed land, residential developments, as well as to visit the Maui County Real Property Assessment Division office.

“Not many beautiful women here. I’m a little stumped about that.

“I told my dad that ALEX owned 90,000 acres of Hawaiian land, about half of it carried on the books for $150 an acre. I think he bought some. The carrying value of all the company’s land is a measly $104 million. Its entire real estate business lists assets of $476 million.

“The fair value of its 1246 acres of urban land and buildings is about $1.5 million per acre…not including the buildings. That’s like $1.5 billion, about 50% more than you can buy the whole company for today. Another 1710 acres is at least one step along the way toward that process. Another 11,000 or so will go into that pipeline in the next decade or so.

“Who cares about its relatively flat cash flow (10 years: -2%)? Who cares about modest earnings growth (5%)? I just wanna own a piece of all that land…(and make 4% in dividends, too).”

*** “The situation is pretty simple,” said Jean Charles, a bureau chief for the French daily, Le Monde, over drinks last night. Your editor’s wife had invited her horse friends over; one was married to the newsman. Neither of us had much interest in the central topic – four-legged animals with disagreeable temperaments – so we turned to the subject of world affairs.

“I remember back to the ’70s. Then, the U.S. had Jimmy Carter and double-digit inflation and French shopkeepers were reluctant to take dollars. Europe was on its high horse back then…and it seemed like Europe would lead the world into a new era of peace and prosperity.

“Instead, Europe contracted some form of sclerosis… costs rose…unemployment went up and nothing seemed to work as it was supposed to. Instead, the Japanese economy took the leadership role.

“But by the ’90s, the U.S. had sorted itself out. It dominated the key industry – software – and nobody could compete with it. Plus, unlike the Japanese or the Europeans, the U.S. is also a military superpower.

“That is the big difference. The U.S. has severe economic problems – with all the debt that consumers carry – but it also has a lot of military muscle to throw around. We wait now to find out how long it will be before it destroys itself…it could be 5 months… or, like Rome, it could take 5 centuries.”

*** “We get along fine with the English,” a French businessman said to me last week. “We detest each other equally. What we don’t understand is the Americans. We detest them, of course…but they seem to like us anyway.”

“Don’t worry,” your editor reassured him, “there are plenty of Americans who detest the French.”

The Daily Reckoning