Oops…I gave away our little secret, didn’t I:
Investors don’t get what they expect, they get what they deserve.
The going rate for people who provide businesses with capital has been about 6% (with various caveats and quibbles…give or take a point or two…adjust for inflation and so forth.) But the average rate of return lies in the middle of two extremes. On the one side are many years in which investment returns reach into the double digits. On the other are a few in which they go negative.
The shortcoming of the human species, we maintain, is not that homo sapiens is stupid, but that he lacks imagination. Using their powers of reason and logic, people extrapolate into the future whatever is happening to them at that very moment. Head over heels in love with a beautiful young woman, for example, a man can’t imagine that he will ever feel differently, nor that the object of his affection will wear out faster than a refrigerator. What a shock it must be when 30 years later, his Valentine of 1972 tells him he is an oaf and demands half of his money just to leave him alone!
Investors in the 1928-2000 period were smitten too. They enjoyed investment returns of 18% per year. In less time than it takes to say "I love you," they came to believe that 18% returns would last forever.
Why did they think they deserved three times the going rate? Because it was a "new era," they said.
Readers of these letters would probably sooner eat a live chicken than put up with another discussion on the dead "New Economy." We apologize for bringing it up again, but we can’t seem to help ourselves. There is just no other explanation for why investors thought they should get 18% rates of return in what had hitherto been a 6% world.
"The whole New Economy debate is much larger than the Internet itself," explains John Cassidy, author of "Dot.con: The Greatest Story Ever Told." "It took place in the Federal Reserve; it took place on Wall Street; it took place in economic departments up and down the country. The real New Economy enthusiasts argue that none of the old rules of economics work anymore. That the economy can grow 4% to 5% a year, indefinitely, without producing inflation. If that’s what the New Economy means, then I do not believe in the New Economy."
Of course, here at the Daily Reckoning, we’ve never believed in the New Economy. We’re not sure we believe in the old economy, either. But we admire the wonders of nature. And one of the wonders we most admire is the ability of Mother Nature to separate fools from their money. While the old economy did so reluctantly, the New Economy, we think, did the work spectacularly.
"The appealing idea that one can get something for nothing and create wealth out of thin air is working," wrote Thornton Parker in his book, "What if Boomers Can’t Retire," at the height of the "New Economy" boom. "But for baby boomers’ retirement plans, the idea is fundamentally flawed." The boomers could drive up stock prices. But they couldn’t make the stocks worth more money. They could only create a sort of "phantom wealth." And then, he continued, who would buy it from them?
The message of the New Economy was that investors could get more than the going rate from their investments. Thus were people persuaded to open their purses a little more widely…in order to get something for nothing. And thus did they end up getting nothing for something. The money going into companies such as Global Crossing, WorldCom, Webvan, JDS Uniphase, and Enron was real. The money coming out – on the income statements at least, these companies paid no dividends – was phony.
The financial newshounds may have been asleep in the kennel. But they woke up fast when the Enron story got tossed over the fence. The numbers were faked, they finally realized. The wealth was an apparition.
Now, they’ve got the scent in their nostrils and are in full-throated pursuit of the "next Enron." It was not just Enron that was cooking the books, they reason. In the New Economy, pots boiled in almost every accounting office; few numbers were reported that weren’t at least warmed up a bit before being served to the public.
Among the "next Enron" candidates whose cuffs are now being sniffed is the telecom Nextel. Like so many New Economy wonders, Nextel produced income statements, but no net income. Which makes it hard to pay off its $17 billion in debt. Investors, lenders, and others who should have known better are now squirming in their seats. "Nextel’s business is soft," explains Grant’s Interest Rate Observer. "ARPU – average revenue per user – in on the skids."
"Nextel’s domestic net subscription additions (‘sub adds’) have fallen steadily, from a high of 560,000 in the second quarter of 2000 to a low of 481,200 in the latest quarter."
In addition to the bad business news, Grant’s thinks it smells an aroma of books baking. Nextel is involved in a complex web of partnerships and issues financial reports that are "indecipherable," says the Grant’s team.
Who knows what might happen in the telecom business? Certainly, we don’t. We can’t even figure out our phone bill or remember which long-distance carrier handles our business. But Grant’s thinks investors might begin worrying about the quality of Nextel’s debt, already trading at 30% discount:
"We would start sweating now, at 70 cents on the dollar of quoted bond value (for yields on the order of 15%). Why procrastinate?"
Investors do Mothers Nature’s work without even being asked. Fearing that they might not get their money back, they sell Nextel debt. People who provided capital to Nextel, in the hope of getting more than the going rate, are now getting what they deserve. "Something for nothing" turned into "nothing for something."
So, even as the Fed lowers interest rates, companies such as Nextel have to pay more for credit. Even though investors expect the economy to rise out of recession… higher real borrowing costs push it in the direction it deserves to go. And even though the recession is supposedly over…people are likely to get a slump that they never imagined.
With big hugs and kisses for all Daily Reckoning readers on this St. Valentine’s Day,
February 14, 2002 — Baltimore, Maryland
What a wonderful recession!
"Spending remains robust," reports the Washington Post. (Eric elaborates, below.)
Home prices rose 6.2% in 2001. They only rose 4.7% in 2000.
And as reported here yesterday, both businesses and consumers went more deeply into debt last year.
It’s not every recession in which people borrow more, spend more, and have their main asset – their home – go up in price.
But uh oh…boo hoo…economists tell us it will end next month. We don’t know about you, but here at the Daily Reckoning, we’re going to miss this recession. And we have a hunch others are going to miss it too…
Eric? Tell us about Wall Street…what do people do there? What is life like on Wall Street? Do people walk around with their eyes downcast and the heads bent…now that the recession is ending?
Eric Fry, our man on the Street:
– It was "Downgrade Wednesday" in the financial markets
– First Japan and then JP Morgan Chase. Neither entity actually suffered the shame of a downgrade, merely the rumor of one. But investors did not seem too troubled by the stories going around. Why worry about the deteriorating creditworthiness of the world’s second- largest economy and of America’s second-largest bank when there are stocks to buy?
– The Nasdaq Composite jumped 1.4% to 1,859, while the Dow Jones Industrial Average climbed another 125 points to 9,989.
– The "strong" retail sales report for January was the most popular explanation for yesterday’s rally. How strong were the sales? They fell 0.2%. Even so, retail sales "ex-autos" jumped 1.2%, and that’s the number all the bulls say we should focus on.
– So there you have it, retail sales almost grew in January, which means that the recession we almost had is already almost over…and that’s gotta be bullish.
– To the uninitiated, the 0.2% drop in retail sales during January might seem like a bad thing. But the cognoscenti know better: Delete whatever component of an economic statistic you find troubling, and voila, you arrive at a number that suits your prejudice. Is this numbers game any different than saying, "my stated age is 50, but excluding the 1960s and the 1980s, I’m actually 30." We could all be many things…if we weren’t already something else.
– If we just look at the overall number for retail sales, we find a consumer who is spending less, not more. That’s good for the consumer’s balance sheet, but not so great for stimulating economic growth.
– Speaking of stimulating growth, Japan could use a little bit of that these days. Unfortunately, the economy is heading in the wrong direction. "The yen fell against the dollar after Moody’s Investors Service said it may cut Japan’s credit rating as much as two notches," Bloomberg News reports. Moody’s, which lowered Japan’s rating as recently as Dec. 4, 2001, is threatening to do it again.
– Sounding very much like a faithful Daily Reckoning reader, Moody’s declared, "Deflation is the foremost challenge facing Japanese authorities." The credit- rating agency is therefore considering knocking Japan’s "Aa3" down two rungs to a sixth-ranked "A2."
– Just how risky is an A2 rating, you may be wondering? "A one-notch cut would make the world’s second-biggest economy the riskiest borrower among the Group of Seven industrial nations," says Bloomberg, "relegating it to the ranks of the Bahamas, Botswana and Chile. A two- notch cut would put it on the same level as Cyprus, Greece and Mauritius."
– From the looks of Japan’s recent credit trends, Moody’s might be insulting Mauritius. Japan’s debt totals 140% of GDP, according to the Ministry of Finance. "That’s the biggest debt load among the 30- member Organization for Economic Cooperation and Development," says Bloomberg.
– American economists, as always, stand at the ready with easy answers to Japan’s intractable economic problems. Glenn Hubbard, the White House’s chairman of the Council of Economic Advisers, urged Japan "to ease credit further and promote disposal of bad loans."
– I’ve got some additional advice to offer: Japan should make fewer bad loans, produce stronger economic growth and create more jobs for more people…I hope that helps.
– The blinding spotlight of rating-agency scrutiny also shines on J.P. Morgan.
– "[I]nvestors should favor the likelihood of a downgrade of J.P Morgan Chase’s debt in the foreseeable future," predicts bank analyst Charlie Peabody of Ventana Capital.
– The potential ramifications are enormous, says Peabody, both for J.P. Morgan itself and for the U.S. financial system broadly. A downgrade would increase JPM’s borrowing costs, which means its interest expenses could soar on its whopping $44 billion debt load.
– "More importantly," Peabody continues, "a credit downgrade of JPM would also affect its ability to act as a counter party [in derivatives contracts]. Given its outsized exposure in the derivatives market and two other financial engineering products, a credit downgrade could have a major impact on the company’s revenue producing capability and possibly the [financial] system."
– It’s probably nothing to worry about, right?
Back in Baltimore…
*** Yeah…it’s probably nothing to worry about. Now that that nasty recession is over…
*** But if you wanted to worry that the U.S. would follow Japan into a long, slow, deceptive decline: Stocks might rally for a year or two…then go nowhere…then go down. The economy itself might grow a little…then not grow a little…then not grow a lot.
*** But, hey, that’s only if you wanted to worry.
*** Christian Noyer, VP of the European Central Bank, said yesterday that he wouldn’t mind seeing the euro rise a bit. Our guess is that the Bush Administration – under pressure from desperate U.S. manufacturers – wouldn’t mind either. Our guess is that the dollar will go down against the euro. Of course, that has been our guess for a long time. And we never said when. But if you wanted something to worry about – you could worry about the day the dollar goes down and foreigners stop financing U.S. deficits. A little give in the dollar could result in a lot of take from foreign investors – who would dump U.S. assets to protect themselves.
*** And you could worry about the effect of credit downgrades. Yesterday’s news told us that Viacom is writing down $15 billion of goodwill. Last year, JDS Uniphase booked the biggest loss in corporate history – thanks to its write-offs of various "goodwill" from silly acquisitions. This is real money we’re talking about; it has to come from somewhere. And what do lenders and investors do when they see their money disappearing? They tend to get a little stingy…more about that below.
*** Here at the Daily Reckoning, we’d rather not worry. We’d rather be happy, especially on this St. Valentine’s Day. So, we will be happy…and confident, as always, that sooner or later, somehow or other, investors – like lovers – get what they’ve got coming…