Reasonable Expectations

In the last 2 work days, we have looked at the stock market and the economy. In neither case did we try to guess about what will happen, but only about what ought to happen. Ought is good enough for us; it’s the best we can do.

Stocks may or may not go down in 2003, but you ought not buy them, dear reader. They are already trading at prices that are two to three times the average, based on P/E. They may go up…but it would be unreasonable to expect it.

The economy ought to go down, too. Perhaps Mr. Bush’s stimulus…or Mr. Greenspan’s stimulus…will be enough to keep it growing. Perhaps the economy will continue to expand – thanks to the furious pumping of hot air by public servants – for the next year or two. We don’t know. But it is unreasonable to expect that such a big boom would not be followed sooner or later by a bust worthy of it. Sooner or later, somehow or other…the errors of the bubble must be fully corrected.

A reasonable man expects things to happen that ought to happen. A fool ought to be separated from his money. A thief ought to go to jail. A man who abuses a child or double-crosses a friend ought to roast in Hell. Whether they do or not, is not up to us, of course…but we can hope. And what better way has a man of running his own life than of figuring out what ought to happen, and then making his decisions as if they really did? In all the systems, secrets, formulas, charts and graphs and models that help a man invest, we have found none more rewarding than this: assume that what ought to happen will happen…buy low/sell high…and don’t worry about it too much.

Managed Currencies: A Degree of Obscurity and Darkness

But what ought to happen? Alas, it is not always easy to know…

“The great judge of the world,” wrote Adam Smith in his Theory of Moral Sentiments, “has, for the wisest reasons, thought proper to interpose, between the weak eye of human reason, and the throne of his eternal justice, a degree of obscurity and darkness…[which]…renders the impression of it faint and feeble in comparison of what might be expected from the grandeur and importance of so mighty an object.”

Today, we take a feeble look at the dollar. What ought it do, we ask ourselves?

In the interests of making it easy for Daily Reckoning readers, we give our verdict before any evidence has been presented: it ought to go down.

The lumpeninvestoriat, that is, the hoi polloi of common investors, tend to believe things that are not true. In the heydays of the great boom, they believed they could get an 18% return on their money invested in stocks – even though they had no idea what the companies really did or how they operated. They believed they could trust corporate executives to make investors rich, rather than just making themselves rich. They believed that stocks always went up and that Alan Greenspan would not permit a major bear market.

They believed that the American system of participatory capitalism, open markets, and safety nets was the finest ever devised…and that it represented some sort of perfection that would remain on the top of the world for a very long time.

They believed also that the U.S. dollar was as real as money gets and that it would be destroyed in a orderly, measured way. A little inflation, they had been told, was actually good for an economy.

Managed Currencies: Limited Supplies

Of all the lies that the new investoriat took up, none was more provocative than the dollar. In order for anything to retain any value – particularly a currency – it must be in limited supply. If there were millions of paintings by Manet or Rembrandt, for example, they would be worth a lot less than they are today. Back in the 19th century, currencies were backed by gold. This had the effect of limiting the quantity of money – for there was only so much gold available.

After getting in the habit of accepting paper backed by gold, people barely noticed when the paper no longer had any backing at all. Government still printed and distributed the new, ‘managed’ currencies. Governments would make sure that they didn’t print too much, or so people assumed.

Besides, there were times when printing too much money was actually welcomed. The 1990s was one of those time. Alan Greenspan created more new money than all previous Fed chairmen combined. But who complained? The money found its way first into stock prices…and later into real estate. People looked at the house that just sold down the street and felt richer, not poorer – just as the Japanese had 10 years before.

And yet, it was not possible that the central bank could create trillions in new money – out of thin air – without affecting the value of the currency itself. “The dollar ought to fall,” economists began saying as the ’90s passed.

Finally, last year, the dollar did fall – against other currencies, particularly the euro…and against gold, against which it went down 19%.

Managed Currencies: Two Complicating Details

What ought it to do now, we ask again? Here we add two complicating details.

First, for as much as the American lumpeninvestoriat was deceived by the dollar’s apparent strength, foreigners were even bigger dupes. They couldn’t get enough of them. “You can count the empty shipping containers at America’s saltwater ports,” suggests James Grant. “Ships laden with imports arrive full; those departing with exports leave less full.”

How could a country balance its books when it was buying more from foreigners than it was selling? It had to make up the difference by bringing the money back home as investment funds. Foreigners didn’t dump their dollars for their home currencies; instead, they used the money to buy dollar assets – U.S. stocks, real estate, businesses. By the end of 2002, the total of foreign holdings of dollar assets had risen to a Himalayan high of $9 trillion – an amount almost equal to the nation’s entire annual GDP.

With the dollar now falling…and U.S. stocks also falling…foreigners ought to want to lighten up on their dollar holdings. And even tossing off a small percentage of them could have a devastating effect on the price of the dollar. The dollar fell only about 12% against foreign currencies in 2002. In the ’80s, with far less provocation, it dropped nearly 50%.

The other complication is that in addition to the $9 trillion worth of existing foreign holdings, the current account deficit adds another $1.5 billion every day. However successful the U.S. has been as a military super power, it pales against its success as a monetary super, super power.

Managed Currencies: Little Pieces of Paper with Green Ink

For every day, Americans strike a bargain with foreigners in which the latter trade valuable goods and services for little pieces of paper with green ink on them, of no intrinsic value, whose own custodians have pledged to create an almost infinite supply of them, if need be, to make sure they do not gain value against consumer goods!

“There is a crack in everything God made,” Emerson reminds us. The crack in this bargain is that it undermines the profitability of U.S. companies. Spurred by the Fed, consumers spend their money at full gallop. They even spend money they do not have. But profits at American companies continue to fall. In fact, as a percentage of GDP, profits have been falling ever since the early ’60s, not coincidentally as the percentage of the economy devoted to consumer spending…and the current account deficit…have increased.

What is happening is obvious. Americans are spending money, but the funds end up in the pockets of foreign businessmen. U.S. businesses have the expense of employing U.S. workers…but the money does not come back to them. Instead, it ends up overseas.

Profit margins at U.S. businesses fall. They are currently at a post-WWII low. This is not a trend that can go on forever. And as Herbert Stein pointed out, if it can’t, it won’t.

The dollar ought to fall further this year…maybe a lot further.

Bill Bonner
Paris, France
January 7, 2003


The Bush family must hate recessions the way others hate the Devil or the IRS. A recession in the early ’90s cost the elder Bush an election. The younger Bush is determined not to let it happen to him.

Thus, did word come yesterday that the president is proposing a huge new fiscal stimulus package. Already, “fiscal policy changes have produced a stimulus exceeding 4% of GDP – the largest since those of the early Reagan years and WWII,” writes economist David Hale. This new round of stimulus is expected to titillate the economy even further.

Alert Daily Reckoning readers may already be asking themselves: ‘where’s the money come from?’

We don’t like to be a wet blanket…nor can we help it if we drip a little on the floor. But we feel obligated to point out that in attempting to avoid the footsteps of his father, George W. Bush has found the prints of Tomiichi Murayama.

The Japanese tried fiscal stimulus, too. Lots of it. In fact, they did so much of it, the entire nation tingled all over…and then shook, roughly to the rhythm of cement mixers. Between 1993 and ’94, Japanese government expenditures stunned the world by rising a breathtaking 59.6%.

The apparent effect was to create jobs and spending and keep the ruling politicians in power. The real effect was to steal away valuable resources that might have helped the economy stage a real recovery. Unlike their American counterparts, the Japanese were always good savers. Even at the peak of their mania in the late ’80s, savings rates never fell below 10%. This money represented real resources that might have been used to create new products…hire new people…and make new profits. Instead, much of it was sucked up by public works projects and squandered.

As reported here yesterday, the Japanese economy declined in the midst of the biggest fiscal stimulus program in history. By the year 2000, GDP per person was no greater than it had been 7 years before.

Now the Bush administration proposes to squander money Americans have never saved, an amount equal to 6% of GDP. Where will the money come from? How long can the nation depend on the kindness of strangers to fund it spendthrift habits? Will the day come foreigners decide to spend their money themselves? And then what?

Perhaps then George W. can pick up the trail of another figure who got himself in a similarly tight spot – Carlos Menem. The Argentinean president tried a program of fiscal stimulation, too…but without domestic savings or foreign lenders. The result? The Argentine currency crashed and continues to disappear into the ground. The CPI in Argentina is rising at 41% per year…the economy is collapsing by 10% this year…and people are starving to death.

Eric Fry, our man on Wall Street, gives us the market’s reaction to Bush’s proposal:


Eric Fry from New York…

– 2003 has been a great year for the stock market…and there’s only 12 months left to go!

– The S&P 500 is already ahead 5.5% so far this young year, which would qualify 2003 as the best year for stocks since 1999. But there are no “byes” in this league; investors have to play all 12 months before the game is over…or do they?

– An investor who cashed in this early 5.5% gain and rolled the proceeds into a very short-term bond fund could wake up on December 31, 2003 with a portfolio gain for the year of more than 8%. But what fun would that be? Anyone who sells his stocks now will miss out on all the excitement that Mr. Market may have in store for us! It’s been a pretty darn exciting year already.

– Yesterday, the Dow charged ahead 172 points to 8773, while the Nasdaq advanced 34 points to 1,421. The market soared higher on the news that President Bush hopes to spend $600 billion over the next 10 years trying to stimulate things. We think he can do it…spend the $600 billion that is. As for stimulating the economy…well…that’s a whole other matter.

– More than likely, the economy will do what it wants to do, no matter what the President does. But most Presidents, like most investors, feel that they should always be doing something, even when doing nothing would be the wiser course of action.

– Of course, there’s no “dundefinedjeuner gratuit,” as they like to say in the Paris office. All this spending and tax-cutting will end up costing somebody some money. For now, we’ll keep borrowing it from foreigners like we always do, which means our federal budget deficit will likely top $250 billion this year, up from $158 billion last year. And as surely as boredom follows passion, a rising federal deficit will lead to rising interest rates. Yesterday, U.S. government bonds lost ground again, as the yield on the 10- year Treasury note rose to 4.06% from 4.02% late Friday.

– One of the most interesting features of the Bush “growth and jobs” package is the proposal to eliminate the taxes individuals pay on stock dividends. Ironically, very few corporations still pay a dividend that’s large enough to bother taxing. But the select minority of companies that do pay a hefty dividend attracted some hefty interest from investors yesterday.

– The shares of JP Morgan, for example, which pays about a 5% dividend (at least for now), jumped $2 yesterday to $27.98. The shares of numerous other companies that pay plump dividends jumped a similar amount. And just like that, dividends are the hottest new, old thing on Wall Street.

– In a recent issue of Grant’s Interest Rate Observer, James Grant makes a compelling case for dividend-paying stocks, no matter what the tax treatment. “Dividends were everything that a regulation New Economy bull didn’t need and couldn’t use,” says Grant. “With the market averages ascendant (and with capital gains taxed at more favorable rates than income), a significant dividend yield was taken as the sign of obliviousness on the part of the management paying it out.”

– But times have changed – at least a little – and most investors are at least willing to consider the idea that receiving dividends might be not be a bad idea.

– Grant continues citing a new study from International Strategy & Investment: “…dividends have contributed an essential portion of the stock market’s total return through the years – more than 70% in the decades of the 1940s and 1970s and almost 39% in the 1980s. In the 1990s, as you will not have forgotten, capital gains carried the performance ball; dividends contributed just 23.2% of the spoil…Never does the adage about a bird in the hand seem so apt as during a bear market. In such times, cash is the highest good. Investors prefer it to forecasts, estimates, promises, predictions and CEO interviews. And, in most circumstances, a stockholder in receipt of a dividend check is ahead of the game.”

– If Bush gets his way, and dividends escape taxation altogether, the stodgy old dividend may become the hottest thing on Wall Street since IPOs.

– Who’s grinding amphetamines into Mr. Gold Market’s orange juice? Despite the big rally in the stock market – an event that usually pressures the gold price – the yellow metal tacked on 50 cents yesterday to $352.10 an ounce. Earlier in the day, gold had climbed more than $4.00 higher, before fading into the end of the New York trading session. The gold market “acts well,” but many of the short-term sentiment indicators in the gold market are registering extremely bullish readings.

– In other words, gold has gained a lot of fans in a hurry. That’s usually a sign that the market is on the verge of a short-term drop. We still love the stuff, whether as one- ounce ingots or as pierced naval ornamentation, but we wouldn’t be surprised to see a sharp sell-off in the yellow metal very soon.


Back in Paris…

*** While we think the fiscal stimulus idea will actually retard America’s economic recovery, we have no quarrel with the Bush administration’s proposal to eliminate taxes on dividends. We never met a tax cut we didn’t like.

*** Gold is at a 6-year high. We’ve been urging readers to buy the metal for the last three years. So, if you don’t own gold, dear reader, it is your own fault.

*** The BBC reports that economist Roger Bootle expects a 20% drop in UK house prices, which would trigger a major recession, he believes.

*** The U.S. home market has the look of a bubble, too. Not that prices are so high – increases in most parts of the country have been modest. But the methods used to lure marginal homebuyers into mortgage debt reveal the problem of increasing consumer demand without increasing consumer means; they are bound to blow up.

If we have read the Wall Street Journal article correctly, as many as 20% of new buyers get “Down Payment Assistance” money indirectly from the builders. These feeble credit risks end up as proud homeowners without having put up any of their own money. Default and foreclosure records are already hitting records – even as the economy grew by a healthy 3% last year. What will happen when the going gets tough? We think we know.

*** You can increase a consumer’s demand by giving him an extra hundred dollars. It seems so simple; why not boost all consumers’ demands….by sending them all checks for $1 million dollars? “Just print more money,” says Milton Friedman. But what would be the effect? Would a single consumer actually be better off? They would all be millionaires, but prices should rise immediately too. Central bankers can create pieces of paper and call them ‘money’ – but they can’t create wealth.

*** New York will lose 300,000 service jobs over the next 12 years…says a report in the NY Post. The jobs – mostly in sales, call centers and customer service – will be exported overseas, thanks to lower labor rates in foreign countries and lower telecommunications costs worldwide.

The Daily Reckoning