Blind Faith

“Faith is the assurance of things hoped for, the conviction of things not seen,” the writer of Hebrews reminds us. Today, investors pay more than 30 times estimated earnings for the S&P 500 – an act of faith of Biblical proportions.

Today’s stock buyers “hope for” a second-half recovery that will drive a robust earnings recovery, and they rely on the conviction that paying 30 times earnings for stocks will prove to be a rewarding proposition. We do not share the hopes or convictions of the bulls.

The recent rally on Wall Street has been a classic triumph of faith over fact…of hope over substance. No stock better exemplifies misguided faith at work than Dow component General Motors. GM’s frightening investment profile should inspire far more fear than greed. And yet, the automaker’s shares have rallied a sparkling 18% since early March, contributing handsomely to the Dow’s 1,000-point rally over the same time frame.

GM’s Economic Prospects: A Peek under GM’s Hood

Apogee Research took a peek under the hood of this struggling automaker early last month and recommended that subscribers sell the stock short. Mr. Market had other ideas. The stock rallied sharply over the ensuing weeks, eventually hitting Apogee’s stop-loss limit and forcing the research firm to advise exiting the trade…for now.

For the time being, the bulls are “right” about GM; their faith is serving them well. By contrast, Apogee’s well- reasoned, skeptical analysis of the automaker has produced little more than weeping and gnashing of teeth, thus far.

What do the bulls know – or what do they think they know? Are the automaker’s operations firing on all eight? Hardly. GM’s “earnings growth” relies upon one lone cylinder: its credit operations…and that cylinder, too, is beginning to sputter. Meanwhile, GM’s mounting pension and benefit obligation is an ominous drag on shareholder equity.

Most folks think of GM as a car company. But it’s really a finance company in disguise. Of GM’s three primary businesses, only GMAC – also known as the Financial and Insurance Operations unit (FIO) – has been the consistent leader in providing net income. As we noted in the Daily Reckoning last week, “Of the $1 billion that the company earned during the [first] quarter, $700 million came from its finance unit. Meanwhile, profits at the automotive division tumbled 16%. Hmmm…some banks give away toasters to attract new customers. General Motors, apparently, gives away cars.”

GM’s Economic Prospects: Losing Its Lustre

GMAC’s contribution to overall net income has nearly doubled since 1996 – from about 16% of net in 1996 to about 31% in 2002. But recent trends suggest that GM’s shining star may be losing its lustre. Credit quality has deteriorated markedly over the past year, while less-reliable mortgage banking income has become increasingly important to the operations of GMAC. The percentage of GMAC’s net income that comes from mortgage operations rocketed 64% higher in 2002, which means that mortgage lending contributed a whopping 29% of the entire company’s net income. Not bad for a car company! What’s more, this surprising trend accelerated in the first quarter of this year, when mortgage lending kicked in a breathtaking 38% of GM’s overall net income.

Clearly, GM’s booming mortgage banking business is masking the difficulties plaguing its auto operations. The buyer of GM shares must believe that the mortgage boom will hang on long enough for GM’s struggling auto operations to produce a “hoped for” turnaround. Unfortunately, there are already some troubling clouds gathering on GMAC’s credit-quality horizon. The provision for credit losses as a percentage of finance revenues has doubled over the past three years.

Meanwhile, charge-offs are accelerating. The $1.395 billion in credit charge-offs for 2002 is 160% higher than the $532 million in 1999, even though the $27 billion of FIO revenues in 2002 were only 32% higher than the $20.45 billion booked in 1999. In other words, change-offs are growing five times faster than revenues!

Another challenge for GMAC arises from its lowered credit rating, which S&P downgraded last October to triple-B from triple-B-plus. Although the rating is still in the investment-grade category, the downgrade has increased the cost of financing GMAC’s credit operations, thereby squeezing its interest margin. The impact of the credit downgrade on GMAC’s operations is described in GMAC’s 2002 10-K as having “increased the Company’s unsecured borrowing spreads to unprecedented levels”.

Meanwhile, GM’s operating margin has been contracting, due in large part to the company’s aggressive sales incentive programs – 0% financing seems to be “standard equipment” on most new car models rolling out of Detroit these days. GM expects to continue its aggressive sales incentive program, according to CEO Richard Wagoner. “We’d obviously like to scale back on the incentives somewhat, because, frankly, it would help our bottom line,” Wagoner candidly admitted earlier this year, “but when we’ve tried to do that over the past 12-18 months, we’ve found that the market shrinks and we lose share. And so we’ve actually decided we’re going to stay aggressive in the marketplace.”

GM’s Economic Prospects: Pension and Benefits

Last, but certainly not least, GM’s pension and benefits obligation is an ominous drag on shareholder equity. All told, GM’s underfunded pension and other post-retirement and employee (OPEB) benefit obligation increased a whopping 27.6% last year, to $76.8 billion from $60.2 billion at year-end 2001.

For perspective, the shortfall is nearly 20 times GM’s average annual net income of $3.9 billion for the past seven years. The rapidly worsening pension and OPEB underfunding led GM to take a $13.6 billion charge to shareholders’ equity last year, which amounts to a staggering 70% bite out of the $19.7 billion in such equity listed as of Dec. 31, 2001. Last year’s charge came on top of a $9.5 billion charge to shareholder equity that GM took in 2001. Because of the torturous complexity of the Financial Accounting Standards Board (FASB) rules that govern a company’s accounting for pension and OPEB obligations, both charges bypassed the income statement and were charged directly to shareholder equity. As a result, many shareholders probably didn’t realize the sheer enormity of the combined $23.1 billion charge, which decimated book value from more than $30 billion in 2000 to only about $7 billion at year-end 2002.

In effect, GM is selling the family silver to satisfy retiree benefits.

The growth in the OPEB obligation is being driven by escalating health care costs, which is more than a little ominous given the seeming intractability of these continually rising costs. The ever-increasing cost of providing health care, especially for the vast family of company retirees, is an obvious worry for GM’s management, and it related as much in the September 2002 edition of GM Encore, a publication directed specifically at the retired employees. “GM spends $1.3 billion a year on prescriptions,” the magazine said, “while annual costs are increasing 15% to 20%.”

We can’t help but note the incongruity of a company telling its retiree base that prescription drug costs are increasing at a 15% to 20% clip, while continuing to estimate far lower growth in its own OPEB obligation. In calculating its OPEB obligation, GM assumes only a 7.2% increase in health care costs for 2003, less than half the rate of increase in prescription drug costs that it laid out to retirees. Of course, while GM is cautious in not overestimating the rate of increase in health care costs, it throws caution to the wind when it comes to estimating future returns on pension assets.

Like other members of the S&P 500, GM has used a more than generous 10% expected rate of return on its assets. (GM will moderate its expected rate of return for 2003 to…9%.) Such exceedingly optimistic assumptions served to increase GM’s operating income line by $8.7 billion in 2001 and $8.1 billion in 2002, even though the pension assets actually showed losses of $5.3 billion in 2001 and $5.4 billion in 2002.

How does GM get away with this sleight of hand? you may wonder.


GM’S Economic Prospects: Expected Rather Than Actual

It’s all perfectly legit under generally accepted accounting principles. GAAP rules allow a company to book its expected return on pension assets, instead of its actual return, as part of its operating earnings.

Even more worrisome than GM’s questionably favorable assumptions about future health care costs and asset returns, we think, is that most of the benefits are payable to people who no longer work for GM. The projected obligation is calculated on the costs for current employees as well as on the increasing costs for current retirees, who account for about two-thirds of the people covered by the OPEB obligation. According to GM’s 2000-2001 “Corporate Responsibility and Sustainability Report,” the company is “the largest private purchaser of health care in the United States and in 2001 provided health care coverage to 1.2 million employees, retirees and their dependents at a cost of $4.2 billion”.

Given that GM’s current employee head count is 349,000 (down from 362,000 in 2001), it doesn’t take a mathematical genius to figure out that health-care coverage for 1.2 million means that a substantial portion of the costs are attributable to GM’s aging retiree base. As of September 2001, GM’s hourly employee pension plan had more than 520,000 participants, and its salaried employee pension plan supported 199,392, for a total of nearly 720,000 beneficiaries, both working and retired, or more than double the 349,000 people working at GM as of last December 31.

Unfortunately, there is probably little that GM could do to trim benefits for the current population of retirees. As Robert S. Miller, Bethlehem Steel’s chairman and chief executive officer, told Bloomberg News: “I hope other companies are ready for this, because many of them, including some automakers, aren’t going to be able to outrun their pension liabilities. At some point, the great sucking sound of pension and health-care liabilities just overwhelms your ability to raise capital or invest in new plants and equipment.”

Over time – a very long time – GM may be able to overcome its myriad difficulties. But success is far from assured. We suspect that investors will require the faith of Moses and the patience of Job to reap a long-term profit from GM shares.


Eric Fry
for The Daily Reckoning
April 30, 2003


Now that the war jitters are over…we have only the economic jitters to bug us, the very same ones we had before the war began.

But the lumpeninvestoriat have neither a clue nor a prayer. The happy schmucks don’t read the Daily Reckoning and don’t seem to be aware of the vulnerability of the dollar, the national savings rate…debt…

…bankruptcies…jobs disappearing to China…falling profit margins…the fall of Rome…the deplorable state of French railroads…the decline in manners and architecture following WWI…the humbug of Democracy and contemporary opera…or any of the other end-of-the-world-type problems we worry about.

Yesterday, for example, we reported the remarkable news that, according to Stephen Roach, the U.S. current account deficit seems to be headed for 6.5% to 7% of GDP…which would require $3 billion of imported capital every day in order to balance the books.

Where on earth will the money come from?

By our rough calculations, it would take the entire savings of all of Christendom and most of the rest of the world, too. Or else, the whole shebang falls apart.

But the lumpen seem to have not a care in the world. The Dow has been up two days in a row…and the latest consumer confidence numbers show the biggest increase in wishful thinking since Bush père was president. Jobs are still scarce…and may be getting scarcer, but homeowners are still mortgaging their homes as if they never had to pay them back. They seem to think the IMF is lending the money…or that Alan Greenspan has personally guaranteed that housing prices will continue to rise so that they can live forever by ‘taking equity out’ of their miserable barracks.

House prices may or may not be in a bubble, but mortgaging them definitely is. Countrywide Credit, a leading mortgage monger, reports that it made 682,000 loans in the last quarter, up 101% from the same quarter last year.

What a happy race we Americans are!

So blessed by circumstance…so favored by nature! Our soldiers can go around the world and kick any foreigners’ butts they want…and these same foreigners then lend us money on the inflated value of our houses (because the house itself is little different from the one we had 10 years ago, which was worth only half as much money).

We wish to take a moment to doff our cap and thank the Chinaman…the Indiaman…the Germanman. The worker in China, for example, schleps in an unheated factory 12 hours a day, 6 days a week…and then is thoughtful enough to save 25% of his take home pay – so that we Americans can continue to live in a style that is beyond his imagination and beyond our means.

If only it could last forever!

And who knows? Maybe it will…we will see…



Eric Fry from the belly of the beast…

– Perky consumers helped perk up the major stock market averages for the second straight day. The Conference Board’s consumer confidence index soared to 81.0 in April from 61.4 in March – the largest one-month gain since March 1991, when the first Gulf War concluded.

– The feel-good vibe spilled over into the stock market yesterday, as investors stepped in to buy one or two of their favorite overvalued stocks. By the closing bell, the Nasdaq had gained 9 points to 1,471 – its highest level of the year. The Dow added 31 points to 8,502.

– Prior to the robust April reading, consumer confidence had declined for four consecutive months. The expectations component of the index jumped to 84.8 from 61.4…Hope springs eternal.

– Back here in the present, however, conditions haven’t changed all that much. State governments are still strapped for cash, unemployment is still heading higher and Secretary of Defense Donald Rumsfeld is still threatening military action against any country that refuses to adopt English as its official language.

– Despite all of that, it’s nice to see stocks moving higher for a change. And it’s nice to see the little guy make a buck in the stock market again, just like old times. Unfortunately, it looks like taxes may be on the verge of heading higher…just like old times…like, say, during the Carter Administration.

– The National Conference of State Legislatures estimates that the states collectively face deficits in the $80 billion range for fiscal year 2004 (California takes the cake with a budget gap that is likely to exceed $35 billion). Lawmakers have covered nearly $30 billion of the $80 billion shortfall through a combination of tax and fee increases, borrowing, and program cuts. But that means they have more than $50 billion to go.

– For now, state lawmakers are holding off on implementing any major new taxes. Instead, they are making the “tough choices” like raising sin taxes and slashing benefits to the poor. After all, the poor are not well organized, and they don’t scream quite as loudly as the rich.

– “Twenty-one states have targeted K-12 education spending for cuts,” reports. “Twenty-six states plan to cut higher education spending. Twenty-seven states have targeted Medicaid, a joint state-federal program that provides healthcare to more than 40 million low-income Americans. In Massachusetts, 50,000 long-term unemployed lost Medicaid coverage April 1 due to budget cuts…Other areas getting hit include prisons, state employee benefits and wages, and environmental programs.”

– Tax hikes are all but inevitable. Not to worry, the citizenry can always pay their taxes by tapping their ever- rising home equity.

– Last week, we aired the views of David Rosenberg, a Merrill Lynch economist who worries that a housing bubble spans the 50 United States…or at least the Lower 48. Today, a bit more grist for the housing-bubble mill.

– Mortgage applications have tumbled for five straight weeks. What’s more, Market tracker DataQuick reports that March sales in the San Francisco Bay Area were down 15% from a year ago. Numerous other markets are also reporting double-digit sales declines. Is the weakness in SF a harbinger of national trends? Will the epicenter of the boom become ground zero of the bust? Certainly, the VC market – an emblematic feature of the California economy – is looking very bust-like.

– Venture capitalists, on average, saw a drop in their returns for the eighth straight quarter, with back-to-back losses of 20 percent or more the past two years. Oh well, the VC funds are likely to bounce back over time…There will always be another once-in-a-lifetime stock market mania.

– [Editor’s note: Ironically, the drop in interest in VC funds makes now a great time to fund companies at the private placement level…that is, if you have the capital. If you’re interested in reviewing a list of private placement deals being presented to members of Agora’s Supper Club, please send an e-mail to club director Vickie Beard: VBeard@agora- ]


Bill Bonner back in Paris…

*** We came upon this on Richard Russell’s excellent Dow Theory Letters website ( It reminded us how long, hard and frustrating the path to a bear market bottom can be. The numbers show the progress of the Japanese stock market from its high in 1989 to its low of last week.

12/25/1989 38,916
9/25/1990 20,984 -46.08%
4/19/1991 26,542 +26.49%
8/10/1992 14,820 -44.16%
8/30/1993 21,116 +42.48%
8/29/1994 20,658 -2.17%
6/12/1995 14,703 -28.83%
6/17/1996 22,531 +53.24%
12/22/1997 14,803 -34.30%
10/5/1998 12,879 -13.00%
7/12/1999 18,248 +41.69%
4/10/2000 20,434 +11.98%
3/12/2001 12,232 -40.14%
9/17/2001 9,554 -21.89%
5/20/2002 11,976 + 25.35%
4/21/2003 7,699 -35.71%

Readers will note that the Nikkei Dow rallied more than 25% on 5 separate occasions…while still continuing its death march. Despite the rallies, over a 14-year period Japanese stocks lost 80% of their value.

Why did it take so long?

Japan’s government and central bank fought the correction at every step of the way. The Bank of Japan lowered interest rates – down to zero, where they’ve been for the last 5 years. And the Japanese government did just what the Bush Administration is doing: increase public spending.

In fact, the Japanese increased government spending so much that Japan now has the highest public debt in the developed world.

If Japan is the trendsetter we think it is, American investors can look forward to a long, hard slog. And in the year 2013, they can expect the Dow to be trading around 2500.

By then, people will have stopped paying attention to the Dow. Instead, they will probably keep an eye on the Chinese stock market or the price of gold, for they will have concluded years ago that U.S. stocks are not a suitable place to put money because, they will say to one another, “In the long run, stocks always go down.”

In Japan, at the peak of the bubble, the average fellow had 50% of his assets in stocks; now, he has less than 10%.

Americans had more than 50% of their money in stocks in the late ’90s. Now, the figure is less than 40%…and probably headed much lower.

But there is one major difference between the U.S. and Japan. The Japanese never saved less than 10% of their incomes (in the U.S., savings rates fell near zero) and never had to rely on foreigners to finance their economy.

*** House prices in the UK are beginning to fall, says the Financial Times.

*** At last, we are enjoying a gray, rainy day in Paris.

The Daily Reckoning