Not long after the 11th rate cut, we wondered why cuts 2 through 9 had failed to elicit the desired effect of stimulating aggregate demand. The following essay was first broadcast on 14 December 2001. You’ll note we have yet to experience the slowdown in the auto and housing sectors, which generally make way for renewed strength in the economy…rather, we experienced further mutations spurred on by 0% financing and delayed first payments.
“What is this madness?”
– John Gutfreund Former Chairman, Salomon Bros.
A year ago, dear reader, we wondered about the first rate cut. Today, we wonder about the 11th one. [… the 12th one, and so on…]
Readers who are tired of wondering about rate cuts – or who have made up their minds – may comfortably pass over today’s Daily Reckoning. For we have nothing to offer but more of the same. Except that, today, we explain what not one economist in 100 seems to understand: why rate cuts don’t always work.
Not that we want to take the mystery out of the market. We would no more attempt to do that than we would try to turn women into lifeless mannequins or round off Pi to a whole number. That is never our purpose at the Daily Reckoning. Instead of making things simpler…we aim to make them more complex, like…well…life itself.
You see, not all recessions are created equal. Yesterday’s commentary on The Prudent Bear.com referred to a research paper from HSBC: “The research paper also noted the difference between planned and unplanned recessions. HSBC defines a planned recession as one where vigorous steps are taken to combat inflation, like the early 1980’s recession. Conversely, an unplanned recession ‘[is] associated with collapsing private sector expectations for economic growth and profits and, from a policy perspective, are very difficult to turn around.'”
Back in 1959, notes the Prudent Bear, Alan Greenspan thought something very similar: “Once stock prices reach the point at which it is hard to value them by any logical methodology, stocks will be bought as they were in the late 1920s – not for investment, but to be unloaded at a still higher price. The ensuing break would cause a panic psychology that cannot be summarily altered or reversed by easy-money policies.”
There is no trace of “panic psychology” in today’s markets. Investors are calm and confident. They are standing their ground, to use Schumpeter’s phrase…but the ground is giving way beneath them.
Alan Greenspan, now the world’s most powerful and celebrated central banker, tries to shore up the economy with easy-money policies. The first 10 rate cuts have done little apparent good. The HSBC research paper, we believe, tells us why…and why the latest cut will do no better: because the Fed neither caused the bubble, nor did it end it. Can it revive it?
There are “planned” recessions – brought about intentionally to cool inflation in an “over-heated” economy. And there are unplanned recessions – which happen spontaneously, when individuals and businesses begin to realize that they have invested too much money in too many projects that are not too likely to pay off. They may or may not panic. But they always sell.
“From an operational viewpoint,” explains Ravi Suria, in Grant’s Interest Rate Observer, “the excess capacity created by excess capital is a highly deflationary force. This, combined with high fixed interest costs is going to keep equity returns suppressed for a long time.
“The Fed’s not going to help capital spending come back. Why? It was not the Fed rates that spurred capital spending in the first place. It was the money coming from the capital markets. The Fed was not lending you money at 4% or 6%. It was the capital markets…In the telecom industry at the low, the low on the absolute yield was 8.9%…Right now, the yield is about 17%.”
The nation’s most aggressive industries – those that led the capital spending boom of the late ’90s – never borrowed at the Fed funds rate anyway. And even though the Fed has cut the cost of money to its member banks 11 times in the past 11 months, the cost of borrowing for the telecoms has approximately doubled.
And it is not just the junk bond issuers who are paying more for capital.
“Just in the past six months,” reports Suria, “Ford Motor Co. actually paid more in absolute yield for its latest debt offering…than it paid six months ago.” Despite about 300 points of rate cuts from the Fed.
Businesses pay more for capital following an unplanned “break” because lenders see the same thing investors see: that they may never get their money back.
During a boom, it hardly seems to matter. Investors – cocky and greedy – provide too much easy money. At the beginning of a boom, investors tend to invest for the right reasons in the right projects. Then, encouraged, they invest for the wrong reasons in the right projects – paying too much for investments in sensible industries. And finally, they invest for the wrong reasons in the wrong projects – paying outlandish prices for investments that can never be profitable.
The only solution to this problem is to let nature take its course – giving investors what they deserve, as we say here at the Daily Reckoning. Bad investments need to get marked to a cynical, hard-bitten bear market. Unprofitable companies need to cut back or go out of business.
Easy money policies merely make the situation worse – postponing the eventual reckoning and making it more painful. That is why zero rates for the last five years in Japan have done no good; they’ve only helped to slow down the correction and spread the (greater) pain over a longer period of time.
“…the former ‘maestro’s’ increasingly desperate effort to keep American consumers borrowing and spending is a strategy doomed to fail,” writes Chris Wood in his Greed & Fear Report. “For, like the carmakers, all he is doing is borrowing from the future…In other words, stronger consumption today means weaker consumption tomorrow.”
In a “planned recession”, the Fed increases rates, which strikes immediately at interest-rate sensitive industries such as housing and autos. Sales in these sectors fall. Then, when the economy is “cooled off” a bit, rates are cut and autos and housing lead the recovery.
“This cannot happen on this occasion,” notes Wood, “because housing and autos have not really gone down yet.”
“…the Greenspan approach,” Wood concludes, “should be viewed, therefore, as an effort to cheat nature and the business cycle, since there is nothing more natural than for American consumers to slow down after their decade- long shopping spree. Like any effort to cheat, it is, ultimately, not going to work…”
Your devoted correspondent…
December 16, 2002
No real blows yet…but things are getting tense…
You’ll recall, dear reader, that we’re watching what looks as though it will be one of the best bar fights in history.
Fed governor Ben Bernanke, along with the rest of the Fed gang – Greenspan, McTeer, Parry…backed up by a mob of Keynesian and monetarist economists…notably Paul Krugman and Milton Friedman…walked in like they were looking for trouble.
“I can lick anyone in the place,” Bernanke seemed to say. Deflation is no problem, he went on; we’ve got a printing press! And we’ve got inflation under control, too.
And who wouldn’t like to believe it? At last, the science of central banking has progressed to the point where Bernanke et al. can manage paper money almost perfectly! Inflation, deflation, the business cycle, panic, fear, greed – the brutish ‘low-lives’ are finally cowering behind the bar, right?
Who could stand up to Bernanke and his gang, we wondered? With their computer print-outs…their econometric hoop-de- doo…credentials (including Nobel prizes) spilling out of their back pockets like dirty handkerchiefs…they look almost unbeatable.
But then, Mr. Market turned around from his drink…and the place went silent.
Late last week, the Producer Price Index came out (unexpectedly) negative. In November, prices took their biggest drop in 6 months.
The dollar dropped, too. Hardly surprising, since its custodians have announced that they would rather destroy it than allow prices to fall. Oh là là…the dollar fell to $102.5 against the euro…a 3-year low.
Bernanke may think he can control the dollar – but what about the people who own it? Are they just going to sit still while the Fed ruins the greenback? Already, dollar holders are getting out of the way. They don’t know which way the fight is going to go, but they don’t want to get smashed by a barstool finding out.
Gold moved up to $333.80 (Feb. contracts) – a 5.5 year high. If Bernanke wins the scrap with deflation, he might still lose to inflation. Either way, gold looks like a good place to sit while you watch the action.
Here at the Daily Reckoning, we don’t know how it will turn out. But we have a feeling that one way or another, Ben Bernanke is going to get his butt kicked.
Over to you, Addison…
Addison Wiggin in Paris…
– Round about this time of year we start craning our necks toward the Northern night skies to see if dear ol’ St. Nick will whisk down with his sleigh and sprightly reindeer and spread good cheer among all the girls and boys busily crunching numbers in brokerage firms around the world.
– In bad years, as well as the worse ones, Santa – in a little ceremony that has come to be known as the ‘Santa Claus Rally’ – sometimes pays an early visit to the corner of Wall and Broad in lower Manhattan…and allows even the naughty and not so nice a chance to get in on the holiday cheer.
– Alas, “there’s little good news out of the US and we’re certainly not going to get a slew of retail money coming this way, so Santa may disappoint,” the New York Times quotes Hans Kunnen, an analyst in charge of research at Colonial First State Fund Managers in Australia…proving that a snub by Santa this year may be felt as far away as the South Pole (where, curiously, they celebrate Christmas in the middle of summer).
– In fact, following a 212 point drubbing last week, the Dow, at 8,433, stands poised and ready to close out the year at its lowest point since 1997. “People are already closing the books on the year,” says Prudential Financial’s Bryan Piskorowski in the same NYTimes piece. “The volume has really died down.”
– The Dow has lost 5.3% since a rather boisterous bear rally came to an end two weeks ago. What do you suppose has kept Santa away this year? A regime change at the Treasury and a sliding dollar have forced layoffs at the North Pole, and now Santa and the missus are having to chip in on the toy production line? Maybe the old graybeard is fearful of cruise missiles misfiring on their way to targets in Iraq? Perhaps Santa’s waiting a bit for an earnings announcement due out this week, harboring some vague hope that corporate profits are actually on the mend…naahhh, everybody knows they don’t matter anymore.
– My guess is, he of the pudgy red belly has been secretly hoarding gold bullion and buying shares of penny mining stocks…and yesterday’s intra-day spike beyond $336 has given the old bugger heart trouble, and right now he’s too spent to make the trip. There are, of course, nine days left before Santa’s time will be fully occupied distributing toys to another set of needy boys and girls, so perhaps there’s time yet for him to recover and make an appearance.
– If not…well, there’s always the fabled “January Effect” – that period of time when after returning all the presents they didn’t want…and checking credit card balances and payment plans left unexploited…consumers spread out in droves seeking, spending and getting everything from X-BOX game consoles to overpriced stocks.
– The Nikkei closed nine days down yesterday for the first time since its woes began to seriously pile up over a decade ago. Of course, back then the Nikkei was trading at atmospheric heights of which even Santa would be proud. Fast forward to the holiday season 2002…and yesterday’s fall to 8,450 puts the Nikkei less than two percent above a 19-year low…and only 17 points away from overtaking the Dow in the race to the bottom.
– “If you want a little holiday cheer,” writes our London correspondent Sean Corrigan this morning, “look at what’s happening in Japan and count your blessings. There, the disposal of the gargantuan amount of bad debts in the system under the present financial revitalization program could cost 650,000 jobs within a year.” That figure, reports the Asahi Shimbum, depicts a scenario in which the 13 leading banks erase all loans categorized as non- performing. The Cabinet Office reckons that 220,000 of those axed…will become long-term unemployed.
– Ouch…we may be able to count our blessings this year, but, we wonder…will we still be able to do so next? Today’s DR classique (below) makes it seem increasingly less likely…
Back in Baltimore…
*** One of the redeeming charms of macro-economics is that you never have to think about it. Inflation, deflation…balance of payments…interest rate policy — what difference does it really make?
From an investment standpoint, what really matters is what you can see for yourself…without worrying about the macro-economic context.
For example, if you can buy a good company at 8 times earnings…what do you care if the discount rate gets raised? Or, if you buy an apartment building, in good shape, with good tenants and good cashflow – does it really matter to you if real estate is in a bear market?
Or, what difference does it make if the ‘battle of the sexes’ is raging across America…as long as you have an armistice at home?
*** Stocks are headed for their 3rd losing year in a row. Investors’ Business Daily’s Mutual Fund Index is down nearly 30% for the year. The Wilshire index, the broadest measure of what is really happening to investors, is down more than 20%. Many of the leading stocks have taken a much worse beating. AOL is down nearly 60%. AT&T has lost more than 50%. Cisco is down 22%. GE is almost down 50%. And even Microsoft has lost 18% of its value this year.
But even after all that, stocks are stubbornly expensive. Earnings are falling. Even with dropping stock prices, resulting P/Es are very high. Barron’s puts the S&P P/E ratio on trailing earnings at 29. S&P itself gives a P/E of 48, based on “core” earnings – that is, earnings after major pension and stock option expenses.
Looking at these stocks up close and personal, without worrying about macro-economics, is a little like seeing an aging hooker in broad daylight – not a pretty sight. And probably not something you’d want to pay good money for.
*** “Now is the time to buy land in Argentina,” said a cheerful friend last week. “The country is a mess…”
The weekend brought news that Argentina continues to default on its foreign debt. “We’re not going to pay,” said an official, confirming what everyone already seemed to know.
Argentina is in its 4th year of recession. So far, 10 people have died of starvation.
Argentina, recently known as the ‘bread basket of South America’, has some of the richest farmland in the world. A century ago, the country was nearly as rich as America and widely considered a major competitor. Now, it is no longer a bread basket, but a basket case.
And yet, during the entire 20th century, the nation – like Japan – never once lacked for central bankers, central planners or government policymakers. Could it be that these people err from time to time? Could it be that central planners err in the Northern Hemisphere as well as the Southern one…and in the Western as well as the Eastern?