Why do people vote?
Why do they get married…and then get divorced?
Why do they go marching off to war…or get caught up in a tremendous and absurd investment bubble?
In every instance, dear reader, the problem – when you strip it of its oily peel – is a lack of romantic imagination.
How much human misery could be spared…simply by the application of a little imagination! A man might imagine what life would be like with his bride after, say, 10 years of marriage. Sharing his life with her …his bathroom… his checkbook…his breakfasts and dinners…his heartbreaks and ambitions…and watching the cheek he so loved to embrace at 20 turn into quite another kind of cheek by 50…he might decide to skip the whole thing.
Or he might not! But at least he would have some idea of what he was getting into.
Likewise, if the soldiers of 1914 had been able to imagine the pointless misery of the trenches…or the soldiers of the Wehrmacht had been able to capture – in their minds’ eyes – the futile and ultimately calamitous denouement of their adventure…wouldn’t they simply have stayed home?
Or, think of all the investors who poured their life savings into the South Sea Bubble, or Tulipmania, or the Nifty Fifty? Or, think of the many people who devoted their whole lives – and their fortunes – to trying to find a way to turn base metals into gold. They could not imagine it…but their investments would leave them completely penniless!
And yet, through the fog of wishful thinking, the light of imagination shines darkly at best. The soldier imagines the glory, but not the lice and missing limbs. The lover’s internal screen shows photos like those in Playboy… airbrushed to flatter the curves, and hide the wrinkles. And the investor? Unless the experience of loss is fresh in his memory, he is no better able to understand how things work then a California lawmaker.
I say it is ‘romantic’ imagination that is lacking because while it is easy to imagine the intended consequences of an act…it is almost impossible to imagine the unintended ones…even when they are obvious. And yet, to repeat a point I make with tedious regularity – in the investment markets, it is the unanticipated consequences that are important – for those are the only ones that are not already discounted in current prices.
No doubt, you have received the latest ‘Darwin Awards’ in your email box. They seem to come around each year at this time, applauding the efforts of exceptional people to remove their own genes from the reproductive chain. The stories are often entertaining – because we see people doing very dumb things…things whose unintended consequences are obvious, as well as, fatal.
In the current instance, for example, a man is given the award for attempting to smash out his girlfriend’s windshield with the butt of a loaded shotgun. His efforts were cut short when the gun went off directly into his mid- quarters.
Surely there must be some equivalent award for investors – those whose imaginations are so underdeveloped as to be unable to foresee even the most obvious – though unintended – consequences of their actions. Alas, it is left to us to do the work. And a lot of work it is: the field of candidates is so crowded…and the resumes are so similar. It is like trying to pick the dumbest boy in the 3rd grade.
As a bubble swells in foreseeable ways…so does it deflate. Investors imagine a world much simpler than it really is. They think Alan Greenspan controls the economy and the markets – increasing interest rates when he wants to calm economic activity…and decreasing them when he want to stimulate it.
The problem, once again, is that this simple metaphor doesn’t come close to describing the romantic perversity of markets, economies, or human action.
Recalling a quotation from Marc Faber, “It isn’t rising interest rates that prick an investment bubble, but widespread losses by investors.”
Investors have lost $3 trillion since March 2000. Since the U.S. economy grows at the rate of about $500 billion per year – that loss represents about 6 years of growth!
Meanwhile, real, effective interest rates have gone from negative 15% or so per year…to positive 30% or so. That is what an investor might expect to get as a net return on borrowed money.
Lower interest rates do not automatically reverse the deflationary symptoms of the end of a bubble. In fact, they may make them worse!
“Repeated easing by central bankers,” explains Faber, “which is designed to combat the threat of a recession or deflation, actually …reinforce[s] the deflationary trend, because it allows the boom in the object of speculation to continue for far longer than would normally be the case.”
This is exactly what Intel’s announcement yesterday suggests. Buoyed by the Fed’s gallant effort at ‘reliquification,’ Intel intends to float an extra billion of capital spending.
Nor can investors imagine that the Fed’s efforts to reflate the economy may produce perverse results in other ways. I have already discussed the “adverse selection” problem. At the end of an asset bubble, new credit tends to go to desperate borrowers, rather than those with useful projects to finance. Sensible lenders get worried. After years of very loose credit policies, too many borrowers are in over their heads. Businesses and consumers go bankrupt. Lenders turn wary and demand higher rates of interest – even though money may be, theoretically, more readily available from central bankers.
This – combined with falling price levels – produces yet another paradox. “Even if interest rates are cut,” says Faber, “the borrowing costs of companies go up in real terms… Corporate margins are therefore squeezed badly, which in turn leads to further selling pressure in the stock market. Worst of all, at this stage, falling stock prices don’t bring about lower valuations, because earnings decline more rapidly than stock prices. Thus, stocks remain, even at lower levels, overpriced.”
“On the upside,” Faber concludes, “the dynamics work in a miraculous way; bubbles usually last longer than anticipated and bring valuations few could have expected at the beginning of the expansion.”
But just as investors couldn’t imagine how high prices eventually got, nor can they now imagine how low they may fall as bubble excesses fully correct themselves. “Every boom leads to a bust,” says Faber, marked by “sharply declining equity prices, a weakening currency, and a downward spiral in the economy.”
Bill Bonner Paris, France January 18, 2001
P.S. Tomorrow? The Daily Reckoning’s Financial Darwin Awards.
*** Yes, hmmmm…Intel’s sales and earnings weren’t great, but they weren’t terrible. Revenues are falling. Costs are rising. And a third of Intel’s earnings came from investments and interest.
*** That is one of the features of an asset bubble. Companies pad profits by investing in the inflated assets. They buy each others’ stock – or real estate, as companies did in Tokyo in the 1980s. “During every investment boom,” as Marc Faber puts it, “companies make extraordinary profits by participating in the boom through the purchase of the object of speculation.”
*** Intel said that it would increase capital spending next year, from $6.5 billion to $7.5 billion. Intel seems not to have noticed, or cannot imagine, that the industry may be at the tail end of a capital spending boom, burdened with too much capacity already. Investors’ trimmed Intel stock by 3%.
*** Jack Welch was on TV too – with a similar message. Things were not great at GE, because the economy was slow, but the economy would surely pick up later in the year. GE had no plans to cut IT spending next year.
*** GE did not beat analysts’ estimates. But it did not fail to meet them either. Instead, it came in right on the money, not a penny more. Investors took 1% off the stock’s value.
*** Juniper reported strong earnings…3M reported weak ones. Investors heard what they wanted to hear, and did the inappropriate thing.
*** The Dow sank 68 points. But the most speculative sectors – the Big Techs and the Internets – rose. TheStreet.com’s Internet index rose as much as 6% intra- day, and ended up 2%. It has gained an impressive 25% so far this year. The Nasdaq 100 is up 9% for the year.
*** The Nasdaq itself rose 64 points yesterday – as the nation’s most naive investors bought up Wall Street’s most overpriced stocks.
*** “The bear is starting to retreat,” said one optimistic trader at Kaufman Brothers. Maybe. Maybe not. In the 13th century, Subadai took a small army of Mongol horsemen all the way across Asia and into the heart of Europe. Often outnumbered, his favorite tactic was to pretend to retreat. His pursuers left their bases…stretched themselves out…wore out their mounts…and exposed their flanks – as Subadai wheeled around for the kill. Could Mr. Bear be that clever?
*** A chart of mortgage refinancing has a line going nearly straight up beginning the last 2 weeks of December. In the last two weeks, the index has doubled. Could all these people really be attracted by a half-percent cut in the Fed Funds rate – especially when more cuts are as certain as a gambler’s second bet? Or, are they desperate?
*** Merrill Lynch is now forecasting flat earnings – zero growth – for the S&P 500 this year.
*** Power blackouts in California? Emblematic of the failure of the New Paradigm, California will begin rationing power rather than allow prices rise and clear the market. All the billions of IT spending…and all the genius of Silicon Valley…were not enough to overcome the titanic imbecility of California lawmakers.
*** The Boston Globe, meanwhile, reports that nuclear power is making a comeback. The plant on Maryland’s Calvert Cliffs had its license extended for another 20 years – thus, doubling its expected life cycle. Suddenly, there’s a bidding war for nuclear power.
*** The Financial Times reports that losses are growing for U.S. banks. Wells Fargo’s loan losses are up 20% over ’99. Citicorp’s problem loans rose 5.8% in the 4th quarter of last year. And Bank of American says it will lose $3 billion to bad loans next year – that is, if there is a soft landing.
*** Expectations of a ‘soft landing’ are wide and deep. Investors, CEOs and bank analysts all agree: things are getting better. And upon this happy forecast, they build their plans for the future – investment, business and personal. Polls show consumer confidence falling – but still very positive. Investors, too, expect much less than they did a year ago…but much, much more than they did 20 years ago. According to CNBC $15 billion went into equity funds since the Jan. 3 rate drop.
*** The dollar rose after Paul O’Neill, the man the incoming Bush administration has fingered for the Secretary of the Treasury, said he favored a strong dollar policy. But Reuters reported that “O’Neill may tolerate weak dollar.” Reporters, as well as investors, hear what they want to hear.
*** I was intrigued when Steve Sjuggerud recommended the Argentina Fund a few weeks ago. It was trading at a 32% discount while Argentina struggled to stay solvent. Yesterday, I asked Steve how it was doing:
“The Argentina Fund is already up about 20% this year,” Steve replied, “and it’s going much higher. But again, don’t worry, you haven’t missed a thing – the Argentina Fund is actually trading at the same price it was back in 1992, when it was first established. There’s plenty of upside left.” According to my back-of-the-envelope calculations, the current discount – about 22% – gives you Argentine companies at the equivalent of about 8 times earnings.
*** “France’s tax regime is among the most diabolical in the world,” writes International Living’s Kathy Peddicord. “As the French tax minister Jean-Baptiste Colbert (1619- 1683) explained to his King Louis XIV, ‘The art of taxation is to pluck from the goose the most feathers with the least hissing.’ Jean-Baptiste’s present-day counterparts don’t even seem to mind the hissing.” Despite that fact, it seems Addison and I reside in one of two countries deemed to have the highest standard of living in the world… an honor France shares with the United States.
*** And this amusing report from the frontiers of the New Paradigm… George Gilder: “Dynamic Silicon, the missing- link technology I have been predicting for 15 years is emerging now and will unite the Microcosm and the Telecosm, and consummate the transformation of the economy of matter into an economy of mind. This emerging revolution in the microchip industry will be as profound and transformative as the invention of the microprocessor itself.”
I don’t have any idea what that means, but I thought you should know.