Imagine you Daughter as a "Ke4"

The U.S. has enjoyed unchallenged economic supremacy for so long few people can imagine a world in which the U.S. isn’t the world’s largest economic power. But, explains Strategic Investment’s Dan Denning, we took a step closer last week…

The Chinese symbol for foreigner is Ke4. And Ke4’s, traditionally, are not well liked in China. For good reason.

The period from 1644 to 1911 – known as the Qing Dynasty in China – is not a happy one for Chinese nationalists. In the 15th century, the Chinese were forced to build the Great Wall to keep the Mongols out. And in the mid-19th century, they fought two wars trying to prevent Great Britain and France from forcing opium into Chinese markets. The Chinese lost, and were forced to accept humiliating terms and open their ports to Western commerce.

Today, the Chinese again are opening their country to markets, but on very different terms. Today, the Chinese have an advantage. And it would not surprise me at all that if in another 50 years, the sons and daughters of America are serving as nannies, gardeners, or English teachers in the households of the Chinese nouveau riche. Foreigners have always left their home country for better opportunities elsewhere. The United States is filled with people who’ve done so. We just never expected we’d someday have to send our own kids overseas to find a better job or more opportunity. But we very well might. And a lot sooner than you think.

You’ve probably heard all about the coming ascendancy of China as a world economic power. Eric Fry mentions it in his notes today. And consider the following from Strategic Investment’s Marc Faber: "…most people around the world still grossly underestimate [China’s] size, importance, and future potential. Already today, there are more refrigerators, radios, TV sets, mobile phones, and motorcycles in China than in the US, and I have no doubt that within the next ten to 20 years the Chinese economy will become, in physical terms, by far the largest in the world."

Chinese economic production is deflationary. It appears to be a trade-off. Americans get cheaper goods. But we give up jobs for those goods. Chinese cost advantages in labor and production make Chinese manufacturing firms difficult to compete with.

Within the next 50 years, the Chinese will begin consuming too. Their economy will mature. And when it does, a great shift will take place. They will lead the world in exports. And they will also lead it in imports, including, perhaps, America’s best and brightest.

Few people really understand the magnitude of this shift. The U.S. has enjoyed such unchallenged economic supremacy for so long that few people can imagine a world in which the U.S. isn’t the world’s largest economic power. But we took a step closer last week.

On Friday, the latest current account deficit numbers came out. The United States continues to gorge on the world’s goods and services. The deficit expanded to a record $38.5 billion in August. It now stands at just over 5% of GDP. And as Morgan Stanley’s Stephen Roach told an investment seminar in Tokyo yesterday, "That would mean the US would need to import US $2 billion worth of foreign capital per day [to achieve current account adjustment] – not an easy task with US equity indices at current levels."

In normal economies, this is a problem. Trade deficits usually demand an equal inflow of funds back into the debtor country to prevent the value of the currency from falling. After all, an economy that consumes more than it produces is not a "healthy" economy. And usually, the currency of a sick economy gets punished.

Not so in the United States. U.S. stock and bond markets are still attracting the bulk of the world’s investable capital. All those dollars we trade for cheap goods are finding their way right back into American financial markets. And just days after the trade deficit numbers were released, we had two government officials assure us to move along, "there’s nothing to see here." Instead of telling us that the trade deficit indicates a sick and chronically indebted economy with severe structural problems, they’re telling us it’s a non-issue.

In Monday’s Financial Times, Richard Clarida, the Assistant Secretary for Economic Policy at the Treasury Department, said, "It is clear from the evidence that the U.S. current account reflects a lack of growth, and growth prospects, in the rest of the world. Moreover, the present deficit in the US current account does not suggest that a change in current U.S. economic policy is warranted."

Translation from the Newspeak: "It’s not our fault the rest of the world isn’t consuming its way to prosperity. We’ll be damned if we’re going to stop buying free cars and generally living well above our means through excess credit."

And so here we have the key flaw in U.S. economic thinking. US officials maintain that the U.S. economy is a safer bet than anywhere else in the world. And in that, they might be right.

But they couldn’t be more wrong about gains in productivity powering the economy and staving off deflation. Illusory gains in productivity do not solve structural imbalances.

First, as Addison Wiggin adroitly outlined in yesterday’s Daily Reckoning, Glenn Hubbard, chairman of the president’s council of economic advisors, claims that productivity gains alone would stave off deflation in the U.S. Gains in productivity, Hubbard claims, are matched by gains in income. No evidence was offered, although I offer some of a different sort below.

And now, Knight-errant Greenspan has returned the to the fray. Yesterday, the chairman told us that "At minimum…it seems reasonable to conclude that the step- up in the pace of structural productivity that occurred in the that latter part of the 1990s has not, as yet, faltered." Strategic Investment contributor Dr. Kurt Richebächer has thoroughly discredited this Greenspan thesis, so let’s move on to the really remarkable comment by the Chairman, one I suspect may haunt him.

In his prepared remarks yesterday in Washington, he made an eerily familiar claim. He said "…the transition to the higher permanent level of productivity associated with these innovations is likely not yet completed…" and that "new productivity-enhancing capital investment will pick up soon." It strikes me as either incredibly audacious or incredibly oblivious for the Chairman to use almost the exact phrasing of Irving Fisher. Just days before the Great Crash in ’29, Fisher uttered the now famous words: "Stock prices have reached what looks like a permanently high plateau."

There are few permanent things in the world, much less in dynamic economies. The new technology Greenspan lauds as productivity-enhancing is, in fact, deflationary. Prices for computer technology are declining. Major U.S. companies in the telecom and tech sector engage in regular rounds of layoffs to compensate for the huge overhang in capacity.

Lower prices are great for consumers. But why is it taking so long for the government to acknowledge that the introduction of new technologies is almost always deflationary and profitless?

What’s more, if there has been a "structural" change in the economy, as the Chairman claims, it’s been to employment. America’s headlong descent into the culture of consumption has, perhaps, permanently altered the employment landscape of America. We’re consuming our jobs away.

Over the last 25 years, employment in services has grown about 10.6% a year. It marks a permanent shift away from America’s manufacturing job base to a service base. A New York Times article from late August highlighted some disturbing numbers released by the Bureau of Labor Statistics. The BLS concluded that a large portion of the job layoffs of the last three years are "permanent layoffs." What did they mean?

Almost ten million people lost their jobs between 1999 and 2001. That was 7.8% of the workforce. We’ve touched before on how this kind of cost cutting is not good for the economy. While it gives one firm a temporary advantage over its competitors, the aggregate result across the economy is less prosperity, not more. One firm’s costs are another firm’s profits or a consumer’s wages. And lower profits for other firms and lower wages for consumers mean less total spending, and eventually lower aggregate profits for the economy.

Only investment in new goods and services creates prosperity. Trouble is, artificially low interest rates have encouraged American households to spend today at the expense of tomorrow.

This bad habit is part of a larger macro-economic employment trend – one that favors China at the expense of the Unites States. The BLS also reported that from May of last year to May of this year, over 800,000 job openings disappeared from the marketplace. That was a decline of 19%. Not only did firms fire existing workers…but they also stopped hiring new ones.

These jobs are being eliminated. And it’s having a predictable effect on the economy. For one, as some jobs disappear from the marketplace altogether, it lowers wage pressures. Worried workers are willing to take less in exchange for the security of a job. This keeps wage inflation low.

But more dramatically, the loss of jobs – especially manufacturing jobs – signals an irreversible trend in the American job market. The job vacuum is thus yet another bullet added to the deflation gun…


Dan Denning,
for The Daily Reckoning
October 24, 2002

P.S. When it comes to labor costs, the U.S. simply can’t compete with China. In the long-term, the U.S. economy is moving away from a manufacturing base and towards a service base. To the extent that this means there will no longer be job-creating investment in capital goods (machines and machines that make machines), the country is actually getting poorer, not richer.

Countries that consume more than they produce can’t do so forever. Ascendant economies don’t shed jobs, they create them. When you consume more than you produce, you impoverish your children.

Yet economies do not impoverish themselves all at once. They do it one bad debt at a time. And so it may take another 50 years for China to gain her position at the top of the world’s economic ladder. And in that time, while many industries will die in America, many new ones will born in China. There are profits to be had in each case.

Editor’s note: Daniel Denning is the editor of Strategic Investment. You may remember Dan from his earlier investment advisory service. His focus on little-known stocks led investors to profits as high as 5,182%…as well as over 570% on Isle of Capri Casinos, 457% on Big Entertainment, 411% on Gentner Communications and 130% on Total Research Corporation. Today, Denning is the architect of Strategic’s winning portfolio up across the board, while Wall Street’s finest take it on the chin.

See: Strategic Investiment

"How would you like to have a crystal ball to be able to see which trends, sectors and individual stocks are going to be hot in the months ahead?" asks

"While that is obviously impossible," the Street concedes, "…you can have the next best thing!"

What’s the next best thing to a crystal ball? Jim Cramer!

We’re not making this up. That’s what the message says. And here’s another message just received, this one from Louis Navellier:

"This is one of the best times to invest in stocks that I’ve ever seen in my long career."

Louis Navellier and Jim Cramer are smart guys. But neither has been around long enough to have any idea of what this bear market might have waiting for them.

The trouble with the ‘long run’ is that it is so long you have to live as long as Methusela to have any experience with it. Neither Cramer nor Navellier could have been investing for much more than 20 years. But two decades represents only a small part of a complete cycle. Since 1982, stocks have generally gone up.

Yes, there have been ‘bear markets’ and ‘recessions,’ but they have been merely brief counter-trends – like the temporary calm a neighborhood enjoys before the local delinquent, in a worse mood than ever, is released from reform school.

Fifteen years ago this October, the Dow dropped 508 points on a single day – its biggest fall ever. But the Maestro quickly struck up the band…and came up with enough easy money to keep the party going. The fun continued until the end of the millennium. And those who lived through it believe they have an insight into how markets work: they go up most of the time, and down sometimes.

Not so.

"These people will be surprised," writes James T. Kahn in Barron’s. "A 20-year horizon has led them to believe in platitudes that have only begun to go wrong: ‘You can’t time the market,’ ‘buy and hold,’ and ‘bear markets tend to be brief.’

Cramer and Navellier are probably too young to remember. But the bear market that ended in ’82 had run for more than 16 years. During that period, Mr. Kahn reminds us, investors lost an average of 1.5% per year – in nominal terms. Adjust the numbers for inflation, which reduced the value of a ’66 dollar to just 12.5 cents in ’82, and the average investor suffered a loss of 12% per year over the 16-year period.

"American history since 1792," writes Kahn, taking the long view, "consists of nine bullish eras averaging 10 years and eight bearish eras averaging 14 years."

One of the platitudes that found favor in the last 20 years was the notion that ‘stocks almost never fall 3 years in a row.’ Along with the other illusions of the Great Bull Market, this has helped to keep Navellier’s and Cramer’s spirits up as prices fell. And now that stocks have been up for two weeks in a row, they are hoping that this year will be a winner.

But when Kahn deconstructs the numbers, adjusting for inflation, he discovers that "in fact, markets typically fall five years in a row." Going back 400 years, Kahn finds the charts of markets in both the U.S. and Britain "peppered with 5-year declines."

Even a very old American investor might not notice, however. Born during the last years of the Wilson Administration, he might have become keenly aware of stocks, say, at the end of WWII. He would have enjoyed a powerful bull market from ’42 to ’66. Then, inflation disguised the real effect of the ’66 to ’82 decline. And then, the ’82-2000 bull market was the biggest ever. Even a very old investor might still believe in the promise of ‘stocks for the long haul,’ says Kahn.

Today, inflation is low. It is not likely to hide the effects of this bull market. Au contraire, if the nation slips into outright deflation – as has happened in China and Japan – it will likely amplify the losses. Perhaps then, the old coot will see things differently.

But for now…Eric’s latest news:


Eric Fry in New York…

– Investors witnessed another sensational off-Broadway performance yesterday – two blocks off Broadway, to be exact, on Wall Street. The Dow created some early-morning drama by falling more than 150 points. But this tragic opening scene did not foreshadow a tragic ending. Rather, the plot took a surprisingly favorable turn, bringing tears of joy to a sympathetic audience. By the time the final curtain fell, the Dow had gained 44 points to 8,494 and the Nasdaq had tacked on more than 2% to 1,320. There wasn’t a dry eye in the house.

– However, neither bonds nor gold had much to say about the show. Bonds gained a little and gold dropped a little. – We can’t shake our suspicion that the current stock rally will fail to blossom into a new bull market. Rather, we suspect that the latest round of stock-buying will end nearly as badly as all the prior rounds of stock-buying since march of 2000…But the latest rally probably won’t end just yet. The market seems very "bulled-up," as the traders say.

– Furthermore, the firing of Tom Galvin ought to be worth a couple hundred Dow points at the very least. Yesterday, Credit Suisse First Boston dismissed Mr. Galvin as the firm’s chief market strategist. During his brief stint at CSFB, Galvin amassed a reputation as one of the most bullish of the ever-bullish Wall Street strategists.

– Galvin recently projected that the Standard & Poor’s 500 Index would end the year at 1,140, or 27% above current levels. His forecast was the highest of the 15 analysts surveyed by Bloomberg News on October 18.

– From a contrarian perspective, could there be a more compelling "buy" signal? Now that Wall Street has sacrificed it most-bullish strategist to the stock market gods, could the market do anything other than go up? Then again, maybe the gods will require still more sacrifices…Will Abby Cohen be next?

– The stock market has gained ground on all but two of the last ten trading days, which means that the bulls are excited and the bears are annoyed. The seasoned, old-time bears at Comstock Partners seem only slightly annoyed.

– They dismiss the current rally as a typical bear-market affair. "Bear markets," says Comstock, "always have sharp rallies that act to test the conviction level of the bears…You have to keep these bear market rallies in perspective…You will not get the start of the next bull market coming from the condition of the masses being worried that they are missing the next up move. It won’t come until they are totally and completely fed up with stocks…We believe this rally should be used to short stocks…to benefit from the next decline."

Remember, that’s just one bear’s opinion.

– Folks are so busy buying stocks that they’ve almost forgotten about sucking the equity out of their homes. The number of applications to refinance mortgages tumbled 17.7% last week. Soaring mortgage rates are the primary culprit. As The Daily Reckoning has been noting lately, long-term interest rates have been climbing dramatically over the last two weeks. Is this the credit-noose tightening, as Addison suggested on Tuesday? We don’t know for sure, but if rates continue climbing, the mortgage re-finance boom will stop dead in its tracks.

– Then, where would the indebted consumer turn to borrow his next dollar with which to purchase his next unessential item?

– Amidst a parched, desert-like global economy, Morgan Stanley’s Stephen Roach points out, "China is the closest thing to an oasis…The Chinese economy is on track to grow nearly 8% this year, making it, by far, the fastest- growing economy in the world…And foreign direct investment hit nearly US$35 billion in the first eight months of this year, putting China on track to break the $47 billion record of 2001."

– Evidence of China’s economic vitality arrived Monday in the form of a $1 billion order for telecom equipment from Lucent and Motorola. Further evidence of China’s global economic prowess is the fact that its trade surplus with the United States surged to $10.6 billion in August from $9.3 billion the month before.

– Enterprising global investors probably ought to be sniffing around for opportunities to invest in this vast economic powerhouse.


Back in Paris…

*** It was a treat to visit Germany. We took a new, high speed train from Koln to Bonn. A friend from Baltimore was amazed: "We have buildings that vibrate more than this," he observed.

*** "American technological superiority is largely a myth." We recalled Dr. Richebacher’s remark from our summer get-together. "The only way you make real progress is by saving money and investing it in new and better equipment," he said, or words to that effect. "America does not save. And it does not invest either. It just pretends to invest with phony accounting, hedonic measures, mergers and acquisitions…and so forth. It is all make-believe…just look at the trains. And the cars…"

We looked at the trains and cars in Germany. Dr. Richebacher may have a point…

*** Life is full of regrets, both big and small, we seem to have written recently. A German friend of ours, recently returned from a visit to Auschwitz, regrets something he had nothing to do with. More than 50 years after-the-fact, young Germans cannot imagine what got into their fathers and grandfathers…and led them to do such horrible things. At dinner…disturbed…our friend seemed to turn to us for an explanation.

"I guess it is a little like America and slavery. It haunts the nation…even now, and it’s been nearly a century and a half… Many, maybe most, white Americans had nothing to do with it. Our families didn’t even arrive in North America until after the Civil War. Still, it bothers us…it is a sore point…"

"Yah…maybe it is a little like that…but it seems so much worse…"

The Daily Reckoning