Game Over

Manufacturing is for losers…Even Alan Greenspan says so. "Is it important for an economy to have manufacturing?" Alan Greenspan wondered aloud recently. "There is a big dispute on this issue. What is important is that economies create value."

In the Age of Greenspan, nobody builds anything unless they have to.

"Financial services" is where the modern-day rubber meets the road…And investors have celebrated the low-residue realities of this Brave New Economy by bestowing a massive market capitalization upon the financial services sector. Financials are now the most heavily weighted group by far in the Standard & Poor’s 500, representing about 21% of the index.

That’s why the stock market is much more vulnerable to soaring interest rates than most folks realize. Now that the bond market bubble is bursting, we should expect to see the "echo-bubble" in the stock market’s financial sector lose some air as well. And that could be bad news for the entire stock market.

Since the stock market lows of last October, the BKX Index of bank shares has soared more than 40%, or nearly double the gains of the S&P 500 over the same time frame. And certain über-financials like Countrywide Financial, have rocketed nearly 60% since last October. It would be no exaggeration, therefore, to say that the shares of banks and mortgage lenders have been "carrying" the market for the last several months. But those days are over. Interest rates aren’t falling anymore; they’re rising rapidly. Which means that the nation’s financial services industry is about to come screeching to a halt, in the process laying down skid marks across the stock market’s back.

Playing the Yield Curve: Closet Financials

Unfortunately for the stock market, the so-called financials are not the only companies at risk from rising interest rates. So are the myriad "closet financials" that populate the major stock indices. Many, if not most, large American companies produce most, if not all, of their profits by conducting finance activities. Whatever their putative businesses may be, these companies, in fact, generate most of their income by conducting various finance activities.

Can you blame them? Who’d want to mess around with bolts and rivets, when you can simply "play the yield curve" from the comfort of an air-conditioned office? Consequently, most of the few remaining American companies that still build things that rust are also in the financial services game. In the process, corporate America has become a vast financial services operation.

"Arguably, the definition of ‘financials’ needs to be updated to acknowledge the broadening out of lending beyond the traditional bank sector," says Stephanie Pomboy of Macro Mavens. "These days, industrial companies like GE, Ford, GM and Sears are all getting into the mix. Throwing the finance arms of these companies into the equation brings the financial sector’s market cap comfortably over the 25% mark."

For the last several years, Greenspan’s Fed has created a ‘predictably’ low-interest-rate environment, which enabled financial services operations to flourish. For perspective, since the stock market peaked three years ago, employment in the financial sector has increased 3.3%. Meanwhile, the U.S. manufacturing sector has watch helplessly as more than 2,000,000 manufacturing jobs have disappeared.

Playing the Yield Curve: Boosting Income from Financial Services

Thanks to Greenspan, therefore, banks of all stripes have fearlessly leveraged their balance sheets and cavalierly assumed higher risk loans in order to boost their income from financial services. The finance arms of many non- finance companies have been plumping up their profits in a similar fashion. General Motors and Deere, to name two well-known American manufacturers, operate large and growing financial services divisions which contribute an astonishingly large percentage of each company’s net income. The obvious – and disturbing – corollary is that finance division profits will now come under pressure as interest rates rise.

The improvement in GM’s profits in the second quarter came almost entirely outside its core auto business. The automaker posted a second-quarter profit that topped expectations, but only because its booming finance unit produced a record result. For the quarter, GM reported overall earnings of $901 million, as the profits from its worldwide automotive operations collapsed by nearly $1 billion to a mere $140 million. By contrast, profit from the finance division almost doubled to $834 million.

Astonishingly, therefore, GM’s finance arm generated nearly all of the company’s net profit for the quarter. "How much money did GM’s mortgage operations kick down to the bottom line?" your New York editor asked Apogee Research’s Robert Tracy.

"You’re not gonna believe it," Tracy replied. "GM’s mortgage operations produced a breathtaking $415 million in net profits, or about three times more than the profit from the company’s vast, worldwide auto operations. Another way of looking at it," Tracy explained, "is that mortgage financing produced nearly half of GM’s entire net profit."

"So what happens to this so-called car company," your New York editor inquired, "when interest rates rise and the mortgage refinance market dries up?"

Playing the Yield Curve: Can’t Make Money Selling Cars

"The so-called car company makes a lot less money," Tracy replied, "unless it can start making money selling cars again."

Unfortunately, however, General Motors can’t seem to make a buck selling cars anymore.

So if old-economy companies like GM have converted themselves into closet financials in order to make a dollar, how do they make a dollar when rates are rising? And what hope is there for a stock market that is selling for more than 30 times earnings, when at least 25% of those earnings rely on a favorable interest rate environment?

"Is it important for an economy to have manufacturing?" wonders the Fed chairman. "What is important is that economies create value, and whether value is created by taking raw materials and fabricating them into something consumers want, or value is created by various different services which consumers want, it presumably should not make any significant difference, so far as standards of living are concerned, because the income, the capability to purchase goods is there."

Greenspan’s tortured logic may be true, as far as it goes. In other words, as long as corporate America can make money by playing the yield curve, they needn’t worry about building anything at all.

But when interest rates are rising, the rules change. Finance profits evaporate and manufacturing comes back into fashion. Neither the struggling U.S. economy, nor the richly valued U.S. stock market is ready to play by the new rules.

Are you?


Eric Fry,
The Daily Reckoning

August 06, 2003

Eric J. Fry, the Daily Reckoning’s "man-on-the-scene" in New York, has been a specialist in international equities since the early 1980s. He is also a renowned portfolio manager, author, and financial commentator. Mr. Fry is the editor of Apogee Research.

Today, we raise our heads to have a look around.

Where are we, we wonder?

Investors have no GPS system; they have to guess. Here, we look up at the stars and do our own dead reckoning…

We know where most people THINK we are: they think we are in a recovery following a series of shocks – the tech blowout, 9-11, the war against Iraq, corporate fraud, and so on.

Who can doubt it? Greenspan says it is so. Snow nods his head in agreement. ‘Amen,’ says the choir of Dobbs, Rukeyser and Cohen.

And there’s the proof: the Dow is up 20% from its March low. Markets in Britain, France and Japan are up more than 25%. And Germany’s stocks have risen 54%!

Everyone wants to believe it. An entire generation of Americans has grown up believing that things always get better…and that stocks always go up over the long run… They believe things revert to the mean, but the mean to them is 12%-18% annual gains – in their stocks and in their houses.

But as we look around the U.S., we do not see the telltale signs of a robust, prosperous nation. We see a nation living in a style to which it has become accustomed, but one it cannot really afford. We see unemployment lines that stretch around the block for jobs that don’t really pay any more than they did 30 years ago. We see couples working long hours trying to keep alive the illusion of financial progress; they refinance their houses to make ends meet, and leave their children to watch television. We see a trade deficit of 5% of GDP…headed to 8%. We see China taking U.S. jobs and American profits. We see the federal government turning a projected surplus of $5.6 trillion into a projected deficit of at least $4 trillion in a space of only 24 months…with a total projected shortfall in federal revenues of up to $44 trillion!

We see the Nasdaq bubble followed by a bubble in bonds…and another bubble in home refinancing. We see an economy that has been sustained by mortgage lending now facing a 50% cut in new mortgage creation.

We see consumers and businesses, more deeply in debt than ever before, and still complacent. They are so fearless, they buy tech stocks again – at absurd prices…and buy bond funds at absurdly low yields. The whole of America’s lumpeninvestoriat seems ready to be wiped out, not ready to get rich. And we wonder: how is it possible to build a genuine recovery on such a shaky foundation?

Most likely, the ‘recovery’ will prove to be as big a disappointment in 2003 as it did in 2002 and 2001. We are in a great bear market, we think, which will correct 2 decades of rising prices – just as it did in Japan. Stocks will fall until the Dow is down near 3,000…or until you can buy the entire Dow for one ounce of gold – eventually.

The 20-year bull market in bonds is over too, according to our reckoning. Long bond yields have risen 100 basis points in the last two months. There may be some hemming and hawing, some backing and filling for several years – but the bull market is over.

But there is still an even bigger correction ahead: the Dollar Standard system.

"What will happen if the dollar goes down to 1.5 to the euro?" asked an inquisitive reporter yesterday.

"Standards of living in the U.S. will fall," we explained. "The price of gold will go up. Beyond that, we don’t know. Depression, war, revolution, famine, drought, hyper- inflation, plague, locusts, Hillary Clinton…anything is possible."

"It does not sound like a very happy time for Americans," continued the reporter, leading us on.

"Maybe not," we concluded, wanting to end the conversation on an up-beat note, "but it won’t be dull. The U.S. is probably heading in Argentina’s direction…complete with Evita Clinton in the White House. At least, we’ll be able to tango."

Right Eric?


Eric Fry in Lower Manhattan…

– The Dow Jones Industrial Average tumbled 149 points yesterday to 9,036, while the Nasdaq crumbled 2.4%, to 1,673. Financial stocks led the way lower, as the BKX Index of banking shares fell to their lowest closing level since the day the Greenspan Fed last cut interest rates on June 13th. Indeed, every asset-class related to interest rates has dropped in value since that fateful day.

– The bond market, of course, has been imploding since June 13th…and it continued imploding yesterday. The 10-year Treasury note stumbled more than 1 point to drive its yield back up to 4.45% from 4.29% on Monday.

– The explanation du jour for the bond buyers’ absenteeism was the ‘surprisingly’ strong July non-manufacturing report from the Institute for Supply Management. According to the ISM, the nation’s non-manufacturing business index jumped to 65.1 in July from 60.6 in June. This is the highest level of the index since Oct 1997. Interestingly, the ‘Bank and Finance’ component led the advance. We doubt this sector will perform as splendidly in the ISM’s August report.

– Another plausible explanation for yesterday’s bond sell- off is that investors are becoming increasingly terrified about holding the low-yielding obligations of a government that seems to care little about how much money it must borrow from the rest of the world…or about how many dollars it must print to repay its creditors.

– Or maybe bondholders are growing a little anxious about the stubborn strength of many vital commodities, like crude oil, for example. Yesterday, crude for September delivery jumped another 61 cents to $32.45 per barrel.

– Whatever the reason, bond yields continue to soar, and the once-glowing prospects of the nation’s mortgage lenders and finance companies continue to fade. Over the last seven weeks, 30-year mortgage rates rate have jumped nearly one percentage point to 6.14 percent, up from 5.21 percent in mid-June.

– So what happens when rapidly rising interest rates overflow their banks? Well, for starters, the lush, idyllic "Lake Refi Market" dries up immediately. And it wouldn’t surprise us if the nearby Mt. Housing Market crumbles into the parched lakebed.

– The Mortgage Bankers Association of America forecasts that mortgage production volume will reach a record $3.39 trillion this year, then plunge to $1.9 trillion next year. "Obviously, going from 20 million loans a year to 13 million loans a year will be a hit on everybody," one mortgage industry insider remarked.

– "The dramatic and sudden collapse of the mortgage refinance boom is sending shockwaves throughout the home loan and real estate closing sectors of the nation’s economy," reports Real Estate Web site Inman News. "Loan officers are staring at pink slips. Title and escrow companies are capping payrolls, and real estate agents are recapturing power they once held in their relationship with mortgage and settlement services providers."

– The mortgage boom has so suddenly become a bust that Contrary Investor predicts massive looming layoffs in the mortgage industry. "Since late 2000, we’ve added about 125,000 mortgage broker positions in this country," Contrary Investor relates. "Remember, that’s just brokers and not the very large supporting cast that comes along with significant mortgage underwriting activity each cycle. Appraisers, title company employees, underwriting administrative staff, you know the rest. During each of the last cycles over the 1990’s, the mortgage broker ranks were thinned by at least 70,000 bodies…We could eclipse that in a big way as the current cycle comes to a conclusion at some point…

– "Without sounding melodramatic," Contrary Investor continues, "we could be facing the conclusion of the greatest mortgage underwriting cycle in U.S. history directly ahead…We could easily see a few hundred thousand folks potentially jumping aboard the jobless claims ranks if what happened in prior cycle conclusions is repeated ahead. And with 30-year conventional mortgage rates backing up over 100+ basis points over the last four to five weeks, it may be here quicker than most believe possible.

– "Will the mortgage industry be shedding bodies while the broader economy is starting to add to staff in some fashion? Will this be a zero-sum game for labor in the aggregate? Or worse?…With each basis point increase in the ten year Treasury yield, mortgage related employment becomes a bit more tenuous."

– Way to go, Alan!


Bill Bonner, back at the Château d’Ouzilly…

*** We continue to be fascinated by parallels between our situation and that of Japan. With a 10-year lag, everything that happened in sushi-land seems to happen to us.

Ten years ago, for example, Japanese shares rose 30% in 4 months, following rate cuts and fiscal stimulus efforts. But…uh oh…the rally petered out, and those same shares are cheaper today than they were in 1993.

*** We still can’t get over it; the dollar has fallen against the Argentine peso over the last 12 months. And Japanese stocks are up more, so far this year, than American ones. What’s more, the Japanese economy has been growing at a 2.6% rate, while the U.S. lags at only 1.5%. Has the world been turned upside down?

*** "Another mort," said Damien yesterday afternoon. But this time he was smiling and pointing to the old tractor, which seemed to have given up the ghost in the middle of the driveway.

"It couldn’t take the heat," he explained.

*** We are learning to live with the heat. The idea, in these old stone houses, is to shut out the heat of day, but let in the cool night air. So, we close all the windows and shutters in the morning and then open them in the evening. It gets very hot outside in the middle of the day, but remains surprisingly cool in the house. It is so hot that even the boys don’t want to go outside. Instead, they sit around in the darkened house and play chess. Henry got a chess set for his birthday last week and is emerging as the family champion.

*** "One of the dumbest things I have ever seen," commented a French architect, "is the way you Americans build your houses. Even in the south and west of the U.S. houses have no shutters. So there is no way to keep the hot sun out of the house. Instead, people just close the curtains and turn up the air-conditioning. It’s not only very inefficient, of course; it’s just not very charming.

"I remember seeing the Old Quarter of New Orleans…there, the houses have shutters that they still use, and the place has real charm. Inside, you can control the light by setting the shutters at the angle you want.

"But outside the Quarter, they don’t use shutters. Instead, they just take on plastic imitations onto the walls. They look ridiculous and do nothing useful.

"Bill, if you really want to do some good, stop writing the Daily Reckoning and start a campaign to bring back the use of shutters in America. If you succeed, they should erect a monument to you somewhere."

The Daily Reckoning