Failure Of Imagination

“Half the American population no longer reads newspapers: plainly, they are the clever half.”

Gore Vidal

There are “minor investment manias” and there are major ones.

“Minor manias,” Marc Faber reminds us, “took place in the US in bowling stocks and SBICs in 1961, in gaming stocks in 1978, in the first PC companies such as Commodore, Atari, and Coleco (whose original business was above-ground swimming pools) in 1983, and in such ‘dubious’ companies as Presstek, Diana and Iomega in 1995.”

These minor bubbles are like border wars or revolutions in small countries. They attract little attention and are over before most people become aware of them. For example, Laurent Kabila was shot and killed in the Congo yesterday. But who cares? I never met the man.

Major manias – like world wars – are another matter. “When these major bubbles (1873 and 1929 in the US, 1989 in Japan, 1997 in the emerging economies) are pricked,” writes Faber, “the impact on the economy is usually felt around the world and leads to vicious recessions or depressions.”

The world has had some experience with major financial manias. But Americans’ personal experience is frail. An investor would have be to at least 90 years old to recall the ’29 crash and Great Depression as an adult. There are some active nonagenarian investors – but not many.

So what do we have? Books? Histories? Theories? And our imaginations.

That is the problem with humans, dear reader. We lack the imagination to see things as they really are. How much happier a woman would be if she could see her husband as the man he really is. And how much more successful her husband would be, too, if he could only open his eyes and see the world around him as it really is…rather than as it is supposed to be.

The boom…and subsequent bubble on Wall Street, ’95 to ’99, looks for all the world like a classic, major asset price bubble. Such events are hardly unknown to financial historians…nor are their symptoms difficult to spot: They usually begin in a low-inflation environment, for example – allowing the expanding credit to feed directly into asset prices rather than consumer prices. Consumer price inflation was low in the 1920s…and very low again in the 1980s in Japan.

Likewise, a major boom is almost always accompanied by some technological or business excitement. In the ’20s, people were able to believe that the new machines and appliances were the source of the apparent boom. In ’80s Japan, they believed in the quality of Japanese management, and the whole Japanese enterprise system.

The boom actually plays an important economic role – focusing resources on an up-and-coming sector and speeding its development. Investors are not crazy to put money into the boom…the problem only arises after prices surpass reasonable expectations.

In the early stages of a capital asset boom, as explained above, the feedback loop works to amplify the boom and confirm people’s wishful thinking. Profits do rise. Asset prices do go up. People do seem to be getting richer.

Since these effects are visible, there must be a reason for it. The new technology…smarter management…or, as in the case of the South Sea Bubble, the opening of a new continent.

The media reinforces whatever delusion is popular at the time – providing investors with plenty of information with which to support their favorite fantasy. Thanks to the media and the mob, people do not have to open their eyes or flex their imaginations.

Information, as I have said many times, is cheap. But wisdom is dear. And unfortunately, there are many things that have to be learned the hard way.

You can read about sex in books. You can study ice-skating in manuals. You can find detailed studies on bear markets and depressions on the worldwide web. But to really appreciate them, dear reader, you have to experience them for yourselves. Our imaginations cannot do justice to real life.

In real life, it is not central bankers’ rate hikes that kill asset bubbles – they die from natural causes. As asset prices rise, the expectations of profit rise with them. Finally, they become so wildly optimistic that there is no chance they can ever be realized.

“Just think for a minute about the last great investment boom in the oil and gas industry in the late ’70s,” Faber suggests. “It came to an end in Houston and Dallas once the oil price failed to rise after 1980.”

Why did the price fail to rise? Because oil-producing assets had been marked up to such levels that they drew in billions of investment capital, which increased supplies to the point that prices had to fall.

“When oil prices collapsed in ’86,” Faber continues, “the drilling industry experienced a terrific slump. This would have happened even if interest rates had been at close to 0%, because when an asset declines in value, interest rates even close to zero can be high in real terms.”

“It isn’t rising interest rates that prick an investment bubble,” Faber observes, “but widespread losses by investors.”

Rising rates do not bring an end to asset bubbles, nor do falling rates protect them. This is the lesson of experience and logic. But it might as well be Aristotle’s Poetics in the original Greek – so remote and foreign is it to most investors.

At this stage, most investors still cannot imagine that they have been caught up in a massive bubble…and most cannot imagine how it will end. In their minds, Alan Greenspan raised rates last year because he thought the economy was “overheating.” Now, having seen it cool off, he’s lowering rates…which will put things back on course for double-digit stock market gains, year after year.

Yet, Bill King recently described how America’s last major asset bubble actually deflated:

The S&P 500, like today’s Nasdaq, was down 44.5% when the Fed decided it was time to cut the discount rate 50 basis points to 4.5%. Two days later, stocks rallied. The Fed cut rates in February and March, 1930.

Then, as now, investors were pretty sure that the worst was over. There were plenty of bulls back then too…and newspapers…and brokers…and Fed chairmen. None of them could imagine what lay ahead. Stocks rallied until April 10, “then,” says Bill King, “they started their death march.” The Fed continued cutting rates – in May, June, and December of 1930…and then again in May of ’31 and February of ’32. Stocks just kept going down until, finally exhausted, the S&P hit bottom on June 1, 1932 after 8 rate cuts.

Your reporter…flexing his imagination…

Bill Bonner Paris, France January 17, 2001

*** The big boy – GE – was supposed to come forward yesterday and make its announcement. Did it ‘beat the numbers’ yet again? Or was this last quarter of the 2nd millennium a killer, even for the house that Jack Welch built?

*** Here at the Daily Reckoning, we were all sitting on the edge of our chaises…for we, apparently alone in the universe, are on record saying that GE is overpriced. Sooner or later the news will get out, we think.

*** But not yesterday, GE delayed its announcement until Thursday. And investors used the occasion to boost the stock 4% – a move, I predict, they will some day regret.

*** The Dow rose 127 yesterday. The Nasdaq fell 8. The dollar was up a bit – the euro at 94 cents.

*** Gold rose 20 cents, to $272. “A common feature of manias,” according to Marc Faber, “is that the asset class that was the epicenter of the whirlwind of speculation goes out of fashion for a very long time – in fact, usually forever.”

*** Gold was the epicenter of a bubble in the late ’70s. Has it gone out of fashion forever?

*** Earnings are falling. Earnings almost have to fall. The economy is slowing down, as everyone knows. But beyond that, earnings always fall at the end of an asset boom. That’s how they work. People pour money into capital investments – because capital assets are rising in price. “In the recent U.S. capital spending boom,” wrote Marc Faber a few weeks ago, “capital spending as a percentage of the economy reached a 40-year high.” This created a glut of capacity – which could only end in falling prices and falling profits.

*** But there’s something else at work: accounting. Faber explains that profits surged in the first stage of the boom because “the sales of business equipment were immediately recognized as revenues by the vendors, whereas the expenses of the purchased equipment will only gradually be recognized by the buying company.” Capital assets are expensed over time.

*** “When the boom stops accelerating,” continues Faber, “profits slow dramatically as the back-end expenses rise faster than the front-end revenues.” We are plainly at this stage now.

*** As of the 11th of this month, a record 624 companies had issued earnings shortfall announcements – almost twice as many as the year before. The previous high was 554 whose earnings fell short in the 4th quarter of ’98. Nokia, Yahoo, Gateway, Int’l Paper, Ameritrade, Martin Marietta have all disappointed investors. And, as one analyst put it, “it’s still early in the game.”

*** The Fed is fighting the credit cycle. It hopes to pull off the same ‘reliquification’ that it managed in 1998 – when it was faced with LTCM, Russian debt, and Asian currency crises. One of the effects of that reliquification was that good money was poured into glutted industries, following the bad money that had already been lost.

*** “Over the past 11 quarters (first quarter 1998 to third-quarter 2000), in what has been a key aspect of an almost continuous reliquefication, home mortgage lending expanded by more than $1.1 trillion, or 30%,” writes Prudent Bear, Doug Noland. “Predictably, the results of this reckless credit expansion have been spectacular home price inflation, and resulting overspending (and massive trade deficits) by the household sector. … The question now becomes, when does the marketplace discount this scenario, and what are the ramifications for interest rates and the dollar.”

*** The International Harry Schultz, a man who has been logged in Guinness Book of World Records as the “highest paid investment consultant” on Earth for over 20 years, sees only weakness in the dollar. Schultz: “Why is the US$ ‘weak’ when it’s not far down from its multi-yr high? For some of the same reasons the Nasdaq was weak when it was making one new high after another. It was pricing itself out of existence. The US$ has priced many US products out of world mkts, & US current account/trade deficits are the biggest in world history, for any nation or any 5 nations combined.”

*** “The US$ is also vulnerable because of bad US bank loans,” continues Schultz “derivatives, certain commodity shortages, looming recession, the tech stock catastrophe, the productivity myth, oil denomination, overvaluation of most US stocks, corporate over-merging, endless spin on a strong $ which can lead to overnight disenchantment…”

*** In fact, the news is full of evidence of financial distress. Both Globalstar – a giant telecom – and California Edison said they could no longer pay their bills. The Financial Times reports that the Bank of America would write off between $1.1 and $1.2 billion in bad debts this week.

*** The average 401 k fell 4% last year. Owners cut back their exposure to stock from 80% two years ago to 70% at the end of last year.

*** “There is no evidence,” concludes the Financial Times, after reviewing a report from Ernst & Young, “that the large increases in information technology investment over the past 5 years has raised the rate of UK productivity growth.”

*** While GE rose 4% yesterday, GM rose even more – 5.4% to $55.75.

*** And here’s a little item on the indomitable human spirit from the Independent Institute. Despite billions spent to wage war on drugs…and a prison population that is the envy of incarcerators the world over…federal judge John L. Kane noted that “about 1.3% of the population is addicted to cocaine – the same percentage as in 1979, a few years before the Drug War, and the same percentage as in 1914, when cocaine was sold legally in grocery stores.”

The Daily Reckoning