Clear Cutting Ahead

If the economy were a forest, the trees would be looking pretty thin right now. And they’re only getting thinner. "The State keeps issuing us logging permits," says Sean Corrigan, our London correspondent, "encourag[ing] us to aggravate the scarcity confronting us"…

If it were a commodity, consumer confidence would clearly be a sell. Having spent nearly a year oscillating around the mid point of the long climb from the 1991 slough of despond to the July 2000 peak of the mania, the index of current conditions has just crashed through to hit a 9 & 1/2 year low.

If you could trade it on the exchange in Chicago, the pit would be a frenzied vortex of selling, as panicked longs fought to liquidate losing positions and sharp- toothed hedge funds sought to exploit weakness by driving the market even lower.

But, unfortunately, you can only trade consumer confidence as a synthetic. Buying the beejaysus out of T-Bonds, you dump all those equities which you told yourself for the fifteenth time were actually going to build a real, sustainable rally, this time, honest.

The employment diffusion index has dipped to minus 12.5, while net business conditions have dropped to minus 12, the first measure 58, the second 51 full points off their late Summer 2000 peaks. Isn’t it amazing what a 2-year bear market can do, not just to your self-esteem, but also to your perception of your economic status?

Now, remember that according to one branch of theory, tax cuts were supposed to have revived the economy by now. Hmmm…

According to another, public sector deficit spending was supposed to have been an ‘automatic stabilizer’ and have revived the economy by now. Riiight…

And according to the most widely held myth of all, aggressive interest rate cuts and an encouragement of private sector deficit spending was supposed to have ensured ‘effective demand’ (hopefully lowering labor costs for businesses through their dumb workers’ money illusion) and revived the economy by now. Uh-huh…

So, if Greenspan and O’Neill, or McCulley and Roach, were at bat, these three strikes would presumably have sent them crashing out of the World Series and hopefully off to the Bush leagues (Ooops! Did we really say that?).

Unfortunately, the way this is going, all we will be left with is the most damaging misapprehension of all – that war was what ended the Great Depression. I bet you Saddam’s private economist, along with the rest of the Axis of Evil, was fervently hoping the ‘footfall’ would hold up in the malls of suburbia this holiday season.

But why didn’t any of this work?

Partly because solutions one and two were run together, and so just got in each others’ way.

For tax cuts to be effective, they need to be large, sustained, targeted at making saving (not consumption), attractive and fully balanced by offsetting spending reductions. It would also help if they were leavened with a widespread regulatory repeal to aid the wealth creators in their task of enriching us all.

In order to do any good, when Keynesian Corporatism (not true capitalism!) founders in its own contradictions, you have to refloat it with a large dose of free market, Manchester liberalism…not weigh it down with the ballast of voodoo economic nostrums and the anchor-chain of State titanism.

Hiking appropriations for the Crusader weapons system (however delicious its name sounds to the Strangeloves on the Defense Policy Board) is not the way to enhance entrepreneurialism. Nor is the subsidizing of sauropod steel magnates likely to foster a burgeoning of small business start-ups.

But, if the prevalent half-reasoning will grudgingly accept that the first two applications may well weaken, rather than invigorate the patient, it clings much more tenaciously to the third treatment. It is still relatively easy to persuade people that a transfer of resources and economic decision-making to the government is likely to do harm. It is far more difficult to get them to see that money is not wealth and credit is not capital, much less that a superabundance of money and wealth can only further deplete what remains of credit and capital after the depredations of the Boom.

All along, we have argued that the Fed’s best policy response back in 2000 – after it had finally slowed the violent inflation of monetary aggregates and financial asset prices – would have been to sit with rates at 6 percent and let the Boom liquidate itself.

But sadly, no government or quasi-government agency will ever just sit there doing nothing. For in that event, we might notice that government best promotes the public good through exactly such masterly inactivity. Then where would all the bureaucrats and court lackeys and power brokers be?

Simultaneously, the Fed should have been on hand to buttress any ‘systemic’ weakness – such as might have erupted when the instabilities at the heart of our deeply corrupting financial practices were revealed – though not without exercising a rigorous and disinterested practice of triage on the wounded as it did.

Of course, any such ruptures would presumably then have been all the less threatening, since they would then have involved around $5.5 trillion less in outstanding debt in the US alone. They would also have tied up some $33 trillion fewer OTC and exchange-traded derivatives, and over $1 trillion less untested credit derivatives globally.

But, as they say on the Merc, ‘we can’t broke backwards’… and they can only make us more broke going forwards. So instead, it seems we are now just one less-than-robust series of economic numbers away from another futile 50bps Fed easing.

Much good may it do us – other than to provide a minor mitigation of the cash flow drain of debt service to those with the best credit ratings, or with a book the most reliant on short-term funding. Much good may it do us – other than to jeopardize our Asian suppliers’ faith in our credit and risk our currency’s decline.

Let us forget any more fundamental analysis. We shall simply ask ourselves the following:

Do we believe that Japan needs to bite the bullet and to provide a realistic – if long overdue – reckoning of assets and liabilities, of genuine profit and hidden loss? Should it ruthlessly extirpate the diseased saplings it finds, such that the forest may flourish once more as the survivors exploit the sunlight and soil now freed for them?

Very few will answer ‘no’ to that, I guess. So the second question is:

Why do we have to get ourselves into a Japanese-style situation before such evident common sense becomes a matter of policy for us, too?

Do we think that because the State keeps issuing us logging permits, while exhorting us to make sure our huts and halls are fully heated all through the winter, that it can make more healthy trees appear in the copse, or persuade the rotten boughs of the damaged to burn more brightly?

No. All it can do is encourage us to aggravate the scarcity confronting us. All it can do is make worse the shortage to which our bad practices of forestry have already given rise…a dearth encouraged by the effect of too many State permits in issue at planting time, allowing the credulous (and the crooked) to take up too much suitable land and to plant too many of the wrong species.

What we should do is conserve what fuel we do have, and then sacrifice a few extra degrees of comfort in order to supply those who have what seem like reasonable hopes of helping us avoid these straits in the future…either by increasing the yield of next year’s felling, or by building us less draughty accommodation, or by making tools with which to spin us warmer clothing.

But, no, the Fed and its peers have instead encouraged us to cut down trees to make our dwellings even larger and less well insulated, or to build elaborate sleighs with which to canter down the forest paths. Worse, some of the American Emperor’s men have plans to instigate a huge bonfire on which to immolate his father’s foes.

So, here we are. Coming to the solstice with the winds turning bitter, and the woodland is already a bare stubble of stumps amid a carpet of sawdust. It makes us shiver just to look at it.

No wonder confidence is also freezing over.

Soon, however, an optimistic messenger will arrive from the palace with yet another batch of logging permits, enjoining us that all will be well as long as we use them freely.

And it is true: they may have their uses even now. They may not be a substitute for a cord or two of good, sweet wood, but they might yet bring our huddled children cheer – by giving off a momentary flame when we burn them in our hearths, thankful that there seem to be no limits to the number that can be produced…


Sean Corrigan,
for the Daily Reckoning
November 1, 2002

Sean Corrigan is the founder of Capital Insight, a London-based consultancy firm which provides key technical analysis of stock, bond and commodities markets to major US, UK and European banks. Corrigan is a graduate of Cambridge University and a veteran bond and derivatives trader from the City. He also serves with distinction as The Daily Reckoning’s ‘man on the scene’ in London’s financial district.

Autos and houses. If it weren’t for these two industries, the economy would be in serious trouble. The economy grew last quarter, 3.1%. But it took a lot of more than $100 billion of refinancings each month…and auto sales gimmicks that have knocked about $1,000 off of the average Honda.

"The strength in third-quarter consumer spending was entirely in vehicle sales," said Bruce Steinberg at Merrill Lynch. "Unfortunately, it will be a lot weaker in the fourth."

Why? Because home refinancings are plummeting – down 24% in the most recent week.

The homebuilding stocks seem to be anticipating tougher times, too…most of them look like they’ve topped out.

And autos? The dealers have been disguising deflation in the auto industry with discounts, rebates, zero- interest financing and other schemes. Anything to move the cars off the lot. But the marginal buyer is having trouble keeping up with the payments – even at zero interest. reports that auto repossessions are rising fast. And Ford’s 10-year notes, as reported in this space yesterday, are treated as if they were ready for the junkyard.

Auto sales dropped 27% in October from the same month a year ago. Is it any wonder? Buyers are probably hesitating…waiting to see what incentive Detroit comes up with next.

The stock market is said to look ahead. But recently, investors seem to have spent more time looking in the rear view mirror…at happier times.

"Consumer spending propelled the economy forward [in] the last quarter," said Donald Fine, president of Fine Financial Forecasting, to a New York Times reporter. "That is not going to continue in the fourth quarter," is his very fine forecast for the next 3 months.

We will see…



Eric Fry, our man-on-the-scene in New York…

– Neither ghosts nor goblins nor a dismal report from the Chicago Purchasing Managers caused much of a fright on Wall Street yesterday. The Dow dropped a little while the Nasdaq bounced a little.

– At first, investors seemed a bit spooked by the news that the Purchasing Managers Index fell to 45.9 from 48.1 the prior month. But they quickly regained their courage and stocks regained some lost ground. The Dow finished the day with a loss of 30 points to 8,397. The Nasdaq rose 3 to 1,330.

– Elsewhere in the financial markets, the dollar continued its recent slide, while gold and bonds both continued their recent rallies. The dollar fell about half a percent to 99 cents per euro and gold gained $1.50 to $318.40 an ounce.

– The gloomy purchasing manager’s report sparked a rally in the bond market as well, as the yield on the 10-year Treasury note fell to 3.89% from Wednesday’s 3.95%.

– But even if the day belonged to bonds and gold, the month of October clearly belonged to the stock market. During the month, the Dow gained almost 11% – the best monthly performance for the blue chips in nearly 15 years. The profits-deficient Nasdaq gained more than 13%.

– Now that the sprightly stock market has been rallying for the last few weeks, many investors are confident that a new bull market is underway. But Adam Lashinsky of Fortune Magazine counters with three simple words: "bear market rally." Lashinsky says the current rally may be nothing more than "a short-term spike that fools optimists into believing the downturn is over."

– So who’s crazier? The bulls, for jumping into a grossly overvalued market with no earnings growth, or the bears, for scorning a market that just racked up its biggest one-month rally in 15 years? The bulls are crazier, no doubt about it. Bears are never crazy, merely bewildered, perplexed and fearful.

– Most of the time, a mildly crazy bullishness is the most profitable frame of mind on Wall Street. But then, there are rare instances when bewilderment, tinged with fear, is the most profitable attitude. If the bear market still has a bit of unfinished business – and that’s our guess – then it’s probably a little early for crazy bulls to make money…and keep it.

– Bear-market rally or not, pension funds from coast to coast will take whatever stock market gains they can get. Most pension funds are licking their wounds from the 3-year bear market’s vicious attack on their asset values. Some, like the NJ public pension, must conduct a full-scale triage operation.

– "New Jersey’s pension funds lost about $6.07 billion, or 9.4%, from July through September, the worst quarter in the state’s modern history," Bloomberg News reports. "The losses cap three years in which declining stocks have shrunk New Jersey’s retirement funds by $20 billion, or 24 percent…The state lost $826 million on AOL Time Warner Inc., and let an investment in Sun Microsystems Inc. shrink by $970 million."

– You see, pension fund managers are not so different from most investors. They buy expensive stocks when they are going up, mostly because they are going up. And they sell cheap stocks when they are going down, mostly because they are going down. The inevitable result is miserable performance.

– In 2001, for example, all but two of the S&P 500 companies with traditional pension plans had investment losses in their pension funds. And most plans have fared even worse this year. This sorry state of affairs creates a number of consequences, none of them good. One little-remarked, but very painful consequence for our economy is that most of America’s largest corporations will divert much the of the cash-flow that would normally be earmarked for capital spending and investment into their pension plans. That’s great for the pensioners, but it is a net drag on the economy. Increasing pension plan piggy banks does nothing to boost economic activity over the short term.

– "Now that it’s time to square pension accounts for annual reports due in the spring," writes Michael Brush of MSN, "many [companies] will have to lower earnings guidance as they divert profits to shore up pension plans. Others will rob cash from important capital investments and debt-reduction or share-buyback programs."

– So if any of you bears are running out of reasons to be fearful, here’s a new one: pension plan liabilities may take a bit our of economic growth.


Back in Paris…

*** A few months ago, only we took the threat of ‘turning Japanese’ very seriously. Now, the newspapers are competing to see who can name the ‘next Japan.’

"Some fear Germany has begun to mimic Japan," says a headline in the International Herald Tribune.

"Symptoms look depressingly similar," says the paper. Germany is expecting growth of only 0.5% this year. Next year it is hoping for 1.5%. Its big banks are reeling from bad loans. And no one seems to have a good plan for improving things.

*** Will Germany turn Japanese before America? Will America turn Japanese at all? Some think the U.S. is more likely to turn Argentine – another people with big economic trouble. Argentina, like the U.S., but unlike Germany and Japan, has big debts to worry about. Unable to sell its exports and earn enough to pay its debts, its economy and its currency collapsed.

*** A prudential analyst finally decided to downgrade Dynegy to a sell. His clients had been holding it all the way from its high of $59 down to its current level of 68 cents. His current target price for Dynegy? Zero.

*** Jules got back from his class trip to Baltimore this morning.

"Dad, I want to go back to the U.S. and go to school," he announced as we were coming home in the cab.

"It’s easier and it’s more fun," he said. "And nobody yells at you…"

The Daily Reckoning