Lighter Than Air
It’s official: The bond market is a bubble. GM’s brand-new $17.6 billion offering is positive proof.
Investors are so desperate for yield – any yield – that they will make a risky loan – any risky loan – to get it. Along comes cash-light, debt-heavy GM, offering up a great big bundle of near-junk paper that promises to pay investors 4% more per year than a Treasury bond. Enticed by the plump, “American-sized” yield, investors lined up to buy the deal, turning a blind eye to the automaker’s parlous financial health.
Unfortunately, in the case of bond yields, bigger is not always better, especially when bigger isn’t all that big. But when markets are rising, investors tend to buy first and ask questions later. In other words, bond buyers have become very indiscriminate, and an indiscriminate buyer is a stupid buyer. It follows that wherever many indiscriminate buyers congregate – like in the bond market, for example – many stupid purchases are certain to occur. And when many stupid purchases occur in rapid succession, prices rise to stupid levels.
Before you know it, you’ve got a full-blown bubble.
Bond Bubbles: Serial Financial Bubbles
The stock market bubble of the 1990s (as everyone belatedly calls it) was merely the first of the serial financial bubbles of the Greenspan era. Financial excesses spewed forth from Greenspan’s monetary policies like bubbles from a child’s bubble-wand. The bond bubble is simply Greenspan’s latest frothy creation.
When – not if – the bond bubble bursts, the resulting economic concussion could make the stock market’s three- year implosion seem like a mere tremor before the bond- market Vesuvius. A burst bond bubble, for example, would devastate stocks, particularly the stocks of homebuilders.
Some of the strongest evidence in support of the bond bubble argument is the “sniff test.” This thing just doesn’t smell right. Even an investor who knows nothing about current economic conditions in the U.S., but a little something about the history of government finance, should be repulsed by the stench of 3% yields on a 10-year government bond. Like a week-old tuna fish sandwich, it just doesn’t smell right.
The anecdotal evidence of irrational exuberance in the bond market is also plentiful. “The deflation alarms have caused savers to climb stepladders to reach for yield in the upper branches of barren trees,” observes James Grant, editor of Grant’s Interest Rate Observer. GM’s rotting balance sheet may be one of the most barren trees on the fixed-income landscape. The express purpose of the automaker’s titanic $17 billion bond offering – the largest ever by an American corporation – is to shift liabilities from one corner of its balance sheet to another corner.
Bond Bubbles: Paying off Other Debts
Like a college kid borrowing money from Mom and Dad to pay his credit card bills, GM is using the bond offering proceeds to pay off other debts. Specifically, most of the proceeds are earmarked for bolstering GM’s badly underfunded retirement plan…Of course, “issuing debt in an amount equal to about half its equity-market capitalization to finance future benefits is a stark reminder of the extent to which GM’s fate resides largely with its unions and retirees,” remarks Barron’s Michael Santoli.
“Although GM touted the debt issuance as ‘an overall effort to accelerate improvements in GM’s balance sheet and financial flexibility,’ the truth is that GM is merely substituting one debt, much of it off-balance sheet, for another debt that remains on the balance sheet,” observes a very skeptical Apogee Research. “Can anyone realistically consider this outcome a positive indicator for GM’s future prospects?…This is nothing more than a red flag signaling that escalating pension and ‘other post-retirement employee benefits’ (OPEB) obligations are placing a menacing burden on the interests of common shareholders.
“Simply put,” Apogee continues, “the $17 billion of debt- raised proceeds is not going toward R&D or product development or improved manufacturing processes, any of which might conceivably improve the fortunes of the common shareholder. Instead, the proceeds will go to support the growing needs of GM’s substantial retiree base.” All together, GM’s underfunded pension liabilities total a staggering $75 billion. Even the largest-ever $17 billion corporate bond sale, therefore, is literally a drop in the bucket. But none of this troubling math seems to vex the folks who are clamoring to lend GM billions of dollars.
Bond Bubbles: Statistically Speaking
Statistically speaking, the bond market is also looking very bubblesque. “The bond market surge in recent months looked and felt much like the spike from 3,000 to 5000 in Nasdaq in late-1999 to early 2000,” observes Donald Straszheim of Straszheim Global Advisors. “Consider the similarities – Treasuries and the Nasdaq. The Nasdaq rose 320% (April 1997 to March 2000), 1201 to 5048. In a shorter span, it rose 260% (October 1998 to March 2000), 1419 to 5048.
“In Nasdaq, the 3000 to 4000 move took just 70 trading days. If there ever was a mania, this qualified. In the 5- year Treasury, the yield declined 70% (May 2000 to June 2003), from 6.83% to 2.08%. In a shorter span, it declined by 57% (April 2002 to June 2003). This decline in yield (price rally) is unprecedented in the postwar era….The deflation story has been overdone,” Straszheim winds up. “Fashionable for a time, the Fed has plenty of capability to flood the system with liquidity in the effort to avert deflation….We don’t expect an inflationary surge in rates, but recent lows were far below sustainable.”
What has been helping to sustain these “unsustainable” yields, of course, is the massive flood of dollars into bond mutual funds. In the 12 months ended April, $160 billion of new cash flowed into bond funds. “The bond market is over-bought, over-valued [and] over-leveraged,” says Jim Bianco, president of Bianco Research in Chicago.
We wouldn’t argue with him. So letting this bubble float on by seems like the best way to stay out of harm’s way.
The Daily Reckoning
June 3, 2003
Another great day on Wall Street…
That is, if you were an insider selling your shares at prices they did not deserve; the little guys came into the market to buy them from you.
Yet another calculation, this one by Vickers Weekly Insider, shows the 8-week moving average of sales compared to purchases running at 4.11 to 1. The last time the ratio was over 4 was in May of last year – just before the Dow fell from 10,353 to 7,286.
The lumps are coming into the market like tourists at the Port Authority bus terminal, ready to have their pockets picked. The American Association of Individual Investors reports that it members are 7l.4% bullish while only 8.6% are bearish. The bullish percentage is almost as high as the all-time peak, which was reached on January 6 of 2000 – – just before the worst bear market since the 1930s.
But what do we care about these yahoos? Isn’t this the way it is supposed to work? The sun rises in the East and sets in the West. Jelly sandwiches fall face down. Lots of poor investors make a few rich ones. And when you’re worried about the world going to hell in a handcart, you buy gold to protect yourself.
Sometimes inflation threatens the world’s paper money system. Sometimes deflation menaces it. It is theoretically impossible for both of them to pose a threat at the same time. But here at the Daily Reckoning, we’re too naundefinedve and simpleminded to worry about the contradiction; we see a danger from both inflation and deflation. “In a textbook deflation,” my old friend Rick Ackerman helps to explain this dizzy situation, “cash supposedly is king. This implies that, to survive deflation, you must stay mainly in cash or near-cash until a bottom is reached. But this is not a textbook deflation; rather, it is like no other deflation that has occurred before in human history, since it will be the first to emerge atop a global currency system that has been hollowed to the core.”
All over the world, central banks are lowering interest rates, printing money, and buying bonds. It is “inflate or die,” as Richard Russell puts it. We suspect it will be both. Creating money out of thin air won’t stop the deflation in financial assets or reverse a worldwide economic slump. But it will eventually destroy the paper currencies in which this magic money is calibrated. Real money, by contrast, will be more appreciated than ever before. “Gold is the no-brainer investment of our lifetime,” Rick continues. “Moreover, it offers an opportunity to leverage the destructive force of a millennial deflation that is certain to devastate the net worth of millions of investors, as well as to ravage valuations across a broad swath of asset classes. Let me go on record as having begged you to move immediately into gold, perhaps with 10- 20% of your investment capital. “As far as I can recall, it is unprecedented that the escape route from a severe economic downturn should be so cheap, so obvious, and so essentially risk-less.”
Eric? Your thoughts please…
Eric Fry writing from Wall Street…
– Hmmnn…brand new quarter, same old result. In fact, the result seemed so old as to be utterly ‘retro.’ The stock market’s months-long rally powered ahead yesterday. Tech stocks rallied like it was 1999. Names like Cisco Systems and Juniper Networks led the Nasdaq to a 2.4 percent gain to 1,679 – a new 13-month high for the technology-charged index. The Dow surged 102 points to 9,143.
– Outside the tech sector, Nasdaq icon Starbucks jumped 6 percent to reach a 52-week high after reporting that it sold about 10% more lattes, frappuccinos, espressos and “double-grande-half-caf-soy-vanilla cappuccinos” than they did last year.
– The rising stock market, like a potent narcotic, dulls investors’ sensitivity to adverse economic trends. But rising share prices can’t make the painful economic data go away. No matter how high Starbuck’s stock soars, for example, consumers continue to choke on debt and businesses continue to resist hiring workers.
– “Wait and see” has become the prevailing philosophy of the land, or at least the prevailing philosophy of the private sector. Over in the public sector, the all-weather “tax and spend” philosophy still pertains. However, the state and local governments have been doing more taxing than spending these days. Thirty states have raised cigarette taxes since the beginning of last year. Meanwhile, spending cuts are all the rage.
– “There will be a little less ‘rockets’ red glare’ across the United States this Fourth of July,” Reuters reports, “as some fireworks displays have been cancelled or scaled back due to local government budget troubles. With the national economic slowdown eating into state and local tax revenues, governments have less money to spend on the traditional displays, which can typically cost $1,000 to $2,500 a minute.”
– As the states’ budget surpluses go up in smoke, one-by- one, $25,000 fireworks shows begin to seem more ostentatious than patriotic. So maybe the government bean- counters are right to cut back on fireworks. But it just doesn’t seem right. And besides, we suspect that most taxpayers would rather pay for a bad fireworks display than a good congressman.
– Struggling state finances are simply one of the hallmarks of the post-bubble environment. Bear-market rallies are another. “Even bear markets bounce,” David Tice reminds us. David is both a friend of your New York editor and the manager of the Prudent Bear mutual fund.
– “Here we are in the season of summer reruns,” says Tice, “and sure enough, we’ve seen this stock market before. The S&P 500 and Nasdaq are deep into the black year-to-date, and up 22 percent and 26 percent from their March lows…This doesn’t remind me so much of the U.S. in 1999 as it does Japan in 1993. Although down some 60 percent from its bubble peak, the Nikkei rallied 25 percent from early March to early June of ’93…The April ’93 issue of Business Week described the bullish mood this way: ‘Analysts now think the Nikkei will head toward 21,000 before long. That would bring the market’s average price- earnings ratio back to a lofty 70, compared with 35 at its bottom last year. Yet stock-pickers seem unworried by that prospect.’
– “Sound familiar?” Tice continues. “Today’s investors in U.S. stocks aren’t sweating much over valuation either. By virtually any measure, stock valuations have more in common with bull market tops than bottoms…Such bullish enthusiasm has Yahoo! selling for three times the 2002 revenues of the entire online advertising industry – a valuation truly worthy of an exclamation point.”
– Tice says the bear market rally is almost over…but the bear market itself is far from over. The bear market will not end, says Tice, “until either (1) prices come down substantially, or (2) stocks meander long enough for earnings growth to make valuations compelling…It looks to me like this U.S. bear has a long way to run.”
Meanwhile, Bill Bonner back in Paris…
*** California is broke. In Connecticut, the governor called out troops to force lawmakers to come up with a budget.
*** This week, thanks to the Bush tax cuts, a single guy making $50,000 per year will take home another $8. We never met a tax cut we didn’t like. But we can’t help but wonder where the $8 comes from. Did the Feds make the troops in Afghanistan or Iraq skip lunch? Did George W. Bush take a taxi over to the Pentagon? Did the universities decide they really didn’t need another copy of “Hidden Lesbianism in the Writings of St. Thomas Aquinas” for the campus Gender Studies library?
“No,” we are told. “They borrowed the money from the Japanese.”
“How will we pay it back?” we ask.
“Silly fools,” comes the reply, “we will never pay it back. Because the Japanese admire our dynamic economy so much they will continue to lend, more and more, forever. Besides, if they don’t lend us money, we won’t buy their Toyotas or their sushi.”
*** The Australian dollar is at a 5-year high against the U.S. brand. The NZ and Canadian dollars are also at multi- year highs. Is there any currency that isn’t rising against the dollar? Even the Argentine Peso is going up; it’s gained nearly 30% in the last 12 months.
*** “Asia or Bust” begins a Barron’s headline. “U.S. Tech firms increasingly move jobs overseas.” Small wonder. An engineer in Shanghai earns only about one one-seventh as much as one in Silicon Valley. So, Asia booms…while the developed world slugs along.
*** How to take advantage of it? Buy a company in Shanghai, suggests Shu Yin Lee in Barron’s. Despite the growth, property prices in Shanghai are about 30% of those in New York, and the companies are cheap, too. China Overseas Land sells for 8.9 times earnings. Hopson Development Holdings has a P/E of only 8. And Shanghai Real Estate’s P/E is only 7.6.
Warren Buffet likes Petrochina – a large oil company with a P/E of about 9 and a dividend yield of 5%.
*** Tomorrow is the 4th of July, when America celebrates its independence. The Revolutionary War was won – and here we remind readers of one of those natty little details of history they might prefer to forget – by the courage of the French, whose fleet blocked the entrance to the Chesapeake Bay, stranding British troops at Yorktown, Virginia.
More on the Land of the Free and the Home of the Brave… tomorrow.