Nothing for Something
At the core of the Federal Reserve, in the space where there ought to be a heart, lies a myth – that modern central banks can create "money." Few people live long enough to master the details of central banking. And those whose attention spans are capable of it usually have better things to do.
What is "money," after all? How does the Fed get "money" into circulation? How can the authorities increase the supply of money without diminishing its price?
At the center of these questions stands a much simpler issue, also an interrogatory: If the central bankers really can create "money" out of thin air, why don’t they do it more often?
But there are some things that we all know can’t be true, but that most people are happy to go along with anyway…until something goes wrong. Today, in Argentina, people stand in long, unhappy lines… grumbling, because something went wrong. Surely, if Argentina’s central bankers really could create money, they would do so now. Like so many other things in life, money materializes out of thin air only when you don’t really need it.
But in today’s letter, dear reader, we give central bankers a break. Today, we look at another big myth: the idea that stock market investing will make you rich.
During the period 1982 to 2000, stocks in America rose an average of 18% per year. Since then, there’s been a crash in tech stocks and the Nasdaq; but the Dow is scarcely off its pace, down just 10% in the last two years. There has been no panic out of stocks. And even after two years of lower prices…including huge debacles in which billions of dollars worth of shareholders’ money has been lost…investors are still confident. They still believe that their stocks will bring them a 15% annual return "over the long run."
But 15% returns in the years ahead are "not even worth discussing," says the world’s greatest investor, Warren Buffett. Instead, the stock market will be a perfectly nice way to make 6% or 7%. Alas, the trouble with 6% is that it won’t make you rich.
People think they can get rich by "being in the market." But for a hundred years, the market has really only produced about a 6% rate of return. This has generally been enough to keep people from losing ground to inflation and taxes, but it is a long way from making people rich.
Investors contribute something valuable to the economy – saved resources. They deserve a decent return, just as if they had lent money to a bank or to a business start- up. Over the long term, a decent return has been about 6% per year. Investors have a right to expect 6% in the future. Do they have a right to expect more than that? In support of that proposition we have the last 20 years. In opposition, we suspect, will be the next 20.
A world of 18% annual returns is very different from one of 6% returns. In a world of 18% returns, you can put up $10,000 and have $232,144,361 20 years later. In a 6% world you would have less than $36,000.
Jim Davidson wrote recently about the "illusory hope of attaining wealth through compound interest." He’s right. The numbers don’t add up to great wealth. Even if you were to live to be as old as Methuselah, and compounded your 6% stock market gains all your life, you still would not be likely to make the Forbes list. While you get 6% richer each year…so does everyone else.
And then, even the 6% is unreliable. Suppose you had bought the Dow stocks in 1900. More than a century later, you’d be very rich, right? Nope. Only one of the year 1900 Dow stocks remains in the Dow – General Electric. All the others have faded, disappeared, been merged, bought out, or gone out of business. While the average return over the entire century may be 6%…there have been plenty of opportunities along the way to get wiped out.
That is the service provided by a period of 18% returns. When stocks rise 18% per year, people get a little giddy. That kind of return can go to a man’s head. Often, he becomes delirious – like Gilder or Necroponte – with the prospects of great wealth that lie ahead.
So great is the lure of easy wealth, that he forgets how hard real wealth is to come by. He throws his money into this new scheme and that one…believing he will make even more in the months ahead. The market is making him rich; why worry about saving money?
When stocks shoot upwards, investors become so mesmerized by the hope of getting something for nothing that they stop worrying about the risks. Rarely do their eyes glance at the debit side of the ledgers…and
rarely do they question the quality of assets or earnings. They invest their savings…their stock market gains…and money they borrowed against their houses… in order to get more of what the stock market seems to offer. In the late ’90s, billions of real resources were squandered on preposterous business models – $100 billion went into WorldCom alone, of which $50 billion in "goodwill" awaits write-off. Thus do investors give up real savings and real stock market profits for nothing…gains that can’t possibly be realized.
Later, people discover that their investments weren’t worth what they paid for them. Assets disappear. But debts remain. And then, when investors really need the money, Wall Street fails. Stocks only go up in a bull market – when people don’t think they need the money. In a bear market and recession – when money gets tight – stocks go down.
Over the long run, "money doesn’t keep much better than fish," Davidson adds
In stock markets, as in central banking, the myth works perfectly well – until things go wrong.
February 12, 2002
"Will it last?" asks Barron’s.
Gold slipped back a little yesterday, but the bull market in gold may continue. Because people have begun to look at the debit side of the ledger…and what they see are question marks.
How many more Enrons are out there? How long will foreigners be willing to finance America’s spending spree? How much are my shares really earning…and how much are those earnings really worth?
"We will likely find," says Harvard professor Michael Porter in BusinessWeek, "that even during its so-called heyday, Cisco wasn’t nearly as profitable…as many believed."
The same might be said of many U.S. corporations. Earnings and assets have been overstated. How much? We don’t know. But now, the debit side of the ledger is getting the attention usually only meted out to air travelers: Balance sheets are being strip-searched while the company’s luggage is torn apart in order to uncover hidden bombs.
Nervous investors turn to gold because it has no debit side. What you see is what you get.
"Gold has always tended to benefit when investors get into a panic over a financial or political threat to their wealth," writes my friend Martin Spring from South Africa. "It’s an asset that can’t be ‘printed’ like currencies, isn’t highly geared to prosperity like equities, isn’t someone else’s liability like bonds and bank accounts, and is universally acceptable as money."
"The recent buoyancy in the gold price suggests that the markets are beginning to recognize that the long bear market in the yellow metal has ended and a new bull market has begun."
Eric Fry, our trusted man on Wall Street:
– Stocks rose. Gold fell. Is life in the financial markets returning to "normal?" Or was yesterday’s action simply a "head-fake?" No one knows, of course. But brief, sharp rallies of the type that stocks have been mounting so far this year are typical of bear markets.
– As for gold, most folks still hate it…which means the yellow metal stands a decent chance of heading higher. Yesterday, however, gold fell $3.60, closing just a whisker over $300 per ounce.
– Over in the equity markets, the Nasdaq gained 1.5% to 1,846.66, while the Dow Jones Industrial Average jumped 140.54 points to 9,884.78. IBM and Intel led the way. Bad move, says Fred Hickey, editor of The High Tech Strategist.
– "As the Internet stocks got destroyed in early 2000, people moved into the big Tech names like EMC, Sun and Lucent," recalls Fred Hickey. "Then what? All of these dropped 70%. People got killed going to ‘safety.’ So first they learned a lesson: ‘I will never buy an Internet stock again’…Then they learned: ‘I will never buy anything but the safest techs.’"
– And so they have. According to Hickey, investors have been gobbling up the "safest techs" – IBM, Microsoft and Intel. "That’s where they’re all concentrated now," he says, "It’s a wonderful lesson [investors have] learned: ‘I can still buy tech at ridiculous prices, as long as I buy the three most expensive ones.’"
– Yesterday, I crowed about the terrific group of Supper Club members I was privileged to meet last week. I probably should also have mentioned that the Supper Club gathering itself equally impressed me.
– First, a little background: the Supper Club is a group of accredited investors that meets about four times a year to examine various venture capital opportunities. At each meeting a few venture-stage companies present their business plans, hoping to attract the capital required to put their plan into action.
– Karim Rahemtulla, Vicki Beard and the other folks at Agora who organize the Supper Club meetings have done a masterful job creating a venue that actually embodies the name "Agora" – the Greek word for "meeting place."
– "For the ancient Greeks," our company’s Web site explains, "the center of social activity was the Agora, a lively marketplace where people came not only to buy and sell goods but also to meet to exchange news and ideas." This description fairly describes the Supper Club gatherings.
– The venture-stage companies featured at the Supper Club are as diverse as the U.S. economy itself – one is trying to market a safety snowboard binding, another has designed a next-generation dispenser for prescription medications, and another plans to establish a renewable timber-harvesting operation in Ecuador.
– This is primal capitalism, in which the healthy ideas that attract funding flourish and the weak ideas perish in their infancy. This is a world of entrepreneurial innovators and risk-takers – a world far-removed from the fat and happy, option-laden world of S&P 500 companies.
– And it is a refreshing fact that most entrepreneurs are attempting to make money for themselves by "creating value," as opposed to some of the powerful people in corporate America who make money for themselves by destroying value. The trick, of course, is to destroy value so slowly that minority shareholders and Wall Street analysts fail to notice. Borrowing money to buy back richly valued stock is one of the tried and true value-destruction schemes; although buy-back can do wonders for increasing the value of the management’s stock options.
– Every once in a while, the honchos in the corner offices become a little too greedy, or clumsy, and before you know it, a $70 billion energy-trading company goes bankrupt.
– But as long as a company’s share price moves higher, not too many folks care how much company cash the officers are stuffing into their pockets. When a stock is rising, everybody wins…and nobody cares about the actual value that supports the stock price.
– When this happens, says Warren Buffet’s partner Charlie Munger, "stocks sell like Rembrandts. They don’t
sell based on the value that people are going to get from looking at the picture; they sell based on the fact
that Rembrandts have gone up in value in the past. And when you get that kind of valuation in stocks, crazy things can happen."
– Says Buffett, "Once it gets going, though, people have an enormous interest in pushing Rembrandts. It creates its own constituency."
Bill, back in…New York!
*** Brokerage houses almost never issue "sell" signals. They hold stocks such as Global Crossing, Cisco, WorldCom or Enron…until the share price goes to practically zero. Then, and only then, do they change their rating from "Strong Buy" to "Accumulate." Imagine, then, the excitement when Prudential told investors to sell…Newmont! It seems to be okay to sell gold producers. They must not give Wall Street enough business.
*** Prudential’s sell signal on Newmont may confirm that a new bull market in gold is developing.
*** Meanwhile, down on the pampas, Argentines are getting a lesson on managed currencies. On January 6th, the Argentine central bank removed the link between pesos and U.S. dollars. Since then the peso has fallen 58% against the dollar…with a 17% drop on Monday alone.
*** In Buenos Aires, people stand in long lines to try to get out of the peso while there is still something to get out of…
*** Hey, I’m in the same city as Eric. We should get together; maybe we will.
*** I have not been in NYC since before September 11. The skyline has changed, but not much else. I’m staying at a dumpy little hotel called the Shoreham on West 55th. It feels like Tokyo, tiny spaces and a drab, austere, minimalist d?cor.
*** On the plane over I was sitting next to a guy who looked like he might be a terrorist-in-training. He was a thin, nervous man who kept turning a ring on his thumb. Dressed in black, he spoke English but with a heavy Middle-Eastern accent. I noticed that his shoes had very thick soles. I looked for a fuse. Finding none, I decided to put the question directly, posing it in the negative to make it easy for him to choose the right answer:
"You’re not planning on blowing up the plane, are you?"
We both went to sleep.