Deflation

There is no greater genius than the man who bounces our own ideas right back at us.

That was our first thought upon reading a subscriber’s letter to Richard Russell, on his website.

The subject was the fate of the dollar…and the economy. Like Barron’s and now Forbes, the writer had come to the same conclusion we had: both are headed down.

We take it for granted that stocks are in a bear market.

What goes up, goes down. That stocks are on the downside of the cycle seems almost too obvious. Of course, it if were any more obvious, the yahoos and patsies would have seen it already and already forsaken stocks. They have not yet; so the bear market must continue.

But what of the rest of the story? Whither the dollar? What will happen as the Fed desperately tries to revive the economy and the stock market? Will inflation suddenly erupt, like a pimple on a 14-year-old…and spoil the picture?

Most economists will tell you that the economic system is controlled by mood changes at the Fed. When the Fed governors feel the need for a little more bustling about in the nation’s shops and factories, they administer a little "coup de whiskey", as Fed chief Norman Strong once put it. When they are in the mood for calm, by contrast, they take away the whiskey bottle and the party soon dies down.

Since WWII, the Fed’s mood swings do seem to correspond with the ups and downs in the economy. But sometimes things happen even if America’s central bankers are not particularly in the mood for them.

"Despite a flood of money and credit creation, and despite widespread predictions of recovery, the markets refuse to cooperate," writes Dr. Kurt Richebacher in his July letter. "Why? In short, because we are not experiencing a cyclical recession, and therefore a cyclical recovery is not on the way. Instead, the U.S. economy is sick to the bone."

The sickness doesn’t seem to yield to a shot or two of whiskey. "For the first time in the postwar period, monetary easing – even the most aggressive easing in the Fed’s history – is proving a flop in kindling a stock market rebound," Richebacher explains.

But all this extra money in the system is bound to have some effect, right? Won’t it show up as inflation – if not in equities, at least in consumer prices?

Ah…maybe not.

"China is exporting deflation at a very rapid rate," explains Mr. Russell’s correspondent. Almost no matter what Americans or Germans can make – the Chinese can make it cheaper.

Plus, "Russia is now moving towards becoming the world’s largest supplier of most industrial commodities (including oil) and they too will use their competitive advantage and sell their goods cheaper than anyone else," he continues.

But as we mentioned above, nothing ruins a good economy faster than too much easy money. Thanks to Alan Greenspan and the Fed, "the U.S. private sector debt alone is over 280% of GDP," Russell’s reader explains, "and is the largest debt pile in world economic history. The U.S. telecom sector alone has more debt than the entire Japanese property sector did or has." "In the first quarter of 2002, consumers borrowed at an annual rate of $695 billion – breaking all previous records," Dr. Richebacher elaborates. "Their incomes, on the other hand, rose at an annual rate of only $110 billion. And for the 12 months ending in April of this year, $5.9 dollars of debt was added for every $1 of growth in GDP."

Adding debt to the system is inflationary: there is the illusion of greater purchasing power, which boosts up whatever market is hot at the time. Stocks went up in the ’80s and ’90s; now real estate is having its turn.

If only it could continue forever! Alas, that is not the way of the world. For each additional dollar of debt produces less and less economic progress…and is therefore a heavier burden than the dollar that preceded it.

At some point, people realize that they cannot afford to continue borrowing – their debt-service payments have become too much of a burden. Instead, they have to cut expenses and pay down debt. Then, prices fall…sales go down…jobs are lost…and the economy sinks into a deflationary recession.

This, of course, has been the economic history of Japan for the last 10 years.

More to come…

Bill Bonner
July 10, 2002

p.s. There is another little detail to the Japan story which the letter writer noticed: "It amazes me that most people miss the appalling demographics in the Western World," he continues. "This is the thing that keeps me awake at night. By the time a 31-year-old retires at 60, almost 50% of the population of the Western world and Japan will have retired before him…" (Hmmmn…)

Another bummer day in New York. (Eric’s taking the day off, so I’m giving you the news from Lower Manhattan myself.)

The Dow fell 179 points. The S&P slipped 2.5%. And utilities dropped to levels not seen since early ’98 – wiping out 4 years of price gains.

Meanwhile, the dollar fell and gold rose. DDGU…

And this all happened after President Bush got out the handcuffs, went on TV and continued his campaign for re- election: WAT abroad, SWAT at home. "We must find them [the evildoers in corporate America] and expose them now," said the nation’s CEO. Bombing raids on Lower Manhattan are now being discussed in the Pentagon.

The Wall Street Journal did a fair job of exposing one of them recently – in its article on George W. Bush’s career as a stock manipulator at Harken Energy. But now that Bush has moved from the boardroom to the Oval Office, the man may pretend that he never held an honest job in his entire life. And maybe he didn’t.

But no one seemed very impressed with the Bush plan. "Being lectured by the Bush White House on ethics," suggests our own Sean Corrigan, writing from London, "is likely to raise more sneers than cheers."

Immediately following the speech, Judicial Watch – a public interest law firm (if that’s not an oxymoron) – said the president’s "rush to crackdown on corporate fraud seemed intended to deflect attention away from his and Cheney’s own business practices" and filed a suit against the Vice President himself, relating to his time as CEO of Halliburton. Justice Watch’s chairman, Larry Klayman, said: "To look the other way for the vice president would be to set a precedent that the Washington elite are above the law." (We’d never have suspected THAT might be the case.) In the meantime, "Asian Stocks Favored as U.S. Investors Flee," says a headline in the Jakarta Post.

"If you thought Thailand had corporate governance problems, you haven’t been following the soap opera that the American securities business has become," opined an editorial in the Bangkok Post.

When the Asian Crisis of ’97-’98 was in the news, fingers wagged at the East. They should follow the American example, said the IMF…the World Bank…the fund managers and western tycoons. Now, the Asians are watching what they believe may be an even bigger crisis developing in the U.S. Can we blame them for gloating just a little?

And in Europe, Chancellor Gerhard Schroeder of Germany said the scandals uncovered in the U.S. so far were just the "tip of the iceberg."

Corrigan observes, "Relishing the humiliation – after all, schadenfreude is about the only form of merriment for which the Germans are noted – the Chancellor seized his moment to rail against the American Way."

At an election rally, Schroeder told an audience of BASF workers, "Now it has been revealed that egotism practiced at the top under the catchphrase ‘shareholder value’ is worth less…than a system based on a fair balance between the interests of workers and employers. [In the US] the individual employee is not valued and shareholder value is everything."

What’s this? First Barron’s. Now Forbes…the major financial media is muscling into our territory.

You and I, dear reader, have known for a long time that the promise of long-term stock market riches was largely a myth. Stocks go up; then, they go down. Companies come and go…you win some, you lose some. Your portfolio grows at about 7% per year over your entire career. Then, along comes a bear market, which knocks off half your gains…just as you were getting ready to retire… Then, you get audited by the IRS and you die.

But hey, we didn’t design this strange ball we live on. We just keep our eyes open and try to enjoy the show. Besides, we’re just talking about money – and who cares about that?

"The Great Stock Illusion" is the title of the Forbes’ piece. Citing the work of Robert Arnott and Peter Bernstein, the article explains that investors have made about 7% per annum on their stock market investments going all the way back to 1871. But, as was also pointed out to us by John Mauldin, who covered the Arnott study with some precision, of those 7 points, 5 came from dividends. The S&P 500 now yields 1.5%, so investors hoping to make a lot of money in the future will almost certainly be disappointed.

But wait, instead of paying our dividends, aren’t companies such as Microsoft putting earnings to work so as to earn even more money and increase the capital value of the stocks? Alas, Arnott and Bernstein discovered that lower payouts almost always mean lower future earnings, not higher ones.

Nothing ruins a good man, a good nation, or a good business faster than too much easy money. It turns out that retained earnings are treated no better by corporate managers than the money they take in from banks and yahoo investors – it is often squandered on foolish empire-building projects, extravagant executive compensation, and absurd mergers.

"There’s an incredible arrogance in management, thinking that its 10th-best idea is better than shareholders’ first best idea," said Arnott.

Forbes explains the result: "When the dividend payout ratio – the percentage of earnings paid out as dividends – climbed above 50% in the late 1950s, subsequent ten- year earnings growth was between 2% and 4% a year. When the payout ratio fell below 50% in the mid-1970s, subsequent earnings growth plunged into negative figures."

"We’re coming off peak earnings in 2000 with the lowest [dividend] payout ratios ever," Arnott added.