"More than any other time in history, mankind faces a
crossroads. One path leads to despair and utter
hopelessness. The other, to total extinction. Let us
pray we have the wisdom to choose correctly."
Why has this recession been such a dud?
The figures from the manufacturing sector are impressive – the biggest drop since the Great Depression. But manufacturing was already being "hollowed out" in the U.S. as more and more industries moved production to foreign countries.
And the high tech sector has gotten smashed. But the absurdities in technology – the New Era, the productivity miracle, eyeballs, eliminating ignorance from the planet, preposterous valuations – were piled so high they had to fall over.
Yes, people have been laid off – but the unemployment rate, at 5.6%, is still very low.
But consumers and investors still act as though it were 1998. "In the past 12 months," say the managers of Hoisington Management Company of Austin, Texas, quoted in Grant’s, "new home sales were 2.8% higher than a year ago. In the late stages of earlier recessions, they were down by an average of 23%. In the past calendar year, vehicle sales fell 2%, but late in prior consumer-led recessions they had dropped 15%."
We’ve never even visited Vienna, but along with the Austrian economists, we think recessions have a function. Like rainy days, they remind us to fix the roof. But, what is wrong with this one? The drizzle has been so light – in most areas of the country – that homeowners have scarcely had to get out a pot to catch the drips.
Typically, consumers lose jobs, or worry about losing them. Even in the mild downturn of 1992, unemployment reached 7.6%. But, so far, the worst this recession has been able to do is 5.6% – barely worse than what economists regard as full employment.
Consumers must be losing income…but you wouldn’t know it. Thanks to the avarice of the home mortgage industry, they’ve been able to trade additional parts of their homes – bedrooms, dining rooms – for ready cash.
Business profits are down sharply. Balance sheets and earnings reports are ugly…but investors, as though they were talking to a man who had been in a bad car wreck, have tried not to notice. Stocks still sell for absurd prices. At 40 times earnings, the S&P is twice as expensive as most European markets.
How can you explain it, dear reader?
Consumers and investors are "brain damaged," says Marc Faber. Fair enough, as explanations go. But we are curious here at the Daily Reckoning headquarters. From whence cometh the brain damage, we asked ourselves.
No sooner was the question asked, then answered: "One theme [in recent U.S. economic history] is preponderant," writes our favorite Austrian economist, Dr. Kurt Richebacher, "consumer confidence and consumer spending."
Whereas European or "old school" economists saw economic growth as a consequence of capital investment and profits, American economists thought they saw an easier way to get rich. "For policy makers and economists in America, consumer spending is the most important GDP component…" he writes.
It became most important in the 1920s when William T. Foster and Waddill Catchings put forth the idea, in a series of books, that "the one thing that is needed above all others to sustain a forward movement of business is enough money in the hands of consumers."
"Contrary to prevailing opinion," Dr. Richebacher elaborates, "the boom of the 1920s was far more a consumption boom than an investment boom, the first of this kind in history. It centered on the rise of the automobile. The tripling of automobile productions was the single biggest force for economic growth in the boom, and it propelled similar growth in related industries, such as steel, rubber and highway construction.
"But by no means was it only new technology and the bull run of the stock market that stoked the auto boom. It was made possible through another watershed innovation that enabled millions of lower-and middle-class people to buy the car without having the money. This innovation happened in the financial sphere and was the invention of consumer installment credit. For the first time in history, consumers could spend large sums in excess of their current income…"
We cannot recall 1930 "just like it was yesterday." We cannot recall it at all. Still, the credit boom of the 1920’s and the aftermath in 1930 are so similar to recent – and perhaps upcoming – events that it wouldn’t hurt us to remember them.
Auto production peaked in April of ’29. By the 4th quarter of that year, passenger car output declined by 70%. But big drops had happened before. Few people worried about it. Then, the market crashed in October. But that, too, had happened before. Why shouldn’t prices rebound as they always did? Surely, this was a buying opportunity, thought many investors.
"The great shock to the prevailing complacency," Richebacher continues, "occurred more than a year after the stock market crash, in late 1930, when production continued to fall and serious troubles in the banking and the credit markets surfaced."
The serious troubles were the result of an unsustainable burst in credit and consumption. Installment had given consumers new purchasing power. But, it gave them no new wealth. Bills still had to be paid. As consumers loaded up automobiles and other items, industry expanded to meet the need. Investors saw the expansion, thought it would never end, and bid up prices accordingly.
Inevitably, consumers eventually ran out of credit and the money to pay their bills. They had to cut back. Businesses – which had borrowed heavily to increase production – were suddenly bad credit risks. And the banks, which had lent the money, were also in trouble – because they didn’t have the money to cover all the loans that were going bad.
As loans went sour, Richebacher explains, "lenders, both banks and investors, virtually stopped lending, apparently fearful of the rapidly deteriorating credit quality."
Finally, the entire economy seized up. A quarter of the workforce was soon unemployed. And both consumers and investors had learned their lessons. The generation that lived through the ’30s despised credit ever after and regarded stocks with distrust and contempt.
That generation has largely disappeared from American economic life. Another waits to take its place, brain-damaged.
January 24, 2002
"The U.S. is facing an unsustainable current account deficit," writes economist Stephen Roach. "Its resolution could well turn a U.S.-dependent world inside out." Is it possible that the U.S. economy, which rides so high now, could one day lie very low?
The U.S. is the world’s only superpower…armed with a super-dollar. What could go wrong?
"The world has paid the U.S. the highest financial compliment imaginable," writes Jim Grant. With no gun to its head, the rest of the world accepts American paper money and other dollar-denominated financial assets as if they were worth something. These bits of paper… often little more than electronic ghosts of money…fill the widening canyon between what the U.S. sells to the world and what it buys from it.
That gap – the current account deficit – is headed towards 6.2% of GDP in 2003, says Stephen Roach. The previous record was 3.4% of GDP in 1987. In that year, the U.S. needed $1 billion of new money from foreigners every two days, to finance its deficit. Now, the breach has grown to the point where it will take $2 billion every day to fill it."
Today, foreigners flatter the U.S. economy by financing the current account deficit with their excess dollars. But, as La Fontaine reminds us, the flatterer encourages the ruin of the person who listens to him. Foreign flatterers are in a position to ruin the U.S. economy. Sooner or later, they will find the temptation irresistible.
"America has indeed been living beyond its means," says Roach. "That’s what the excesses of debt and the paucity of income-based saving are all about. In my view, only by lowering the domestic consumption of households and businesses alike can the U.S. hope to bring its aggregate demand in closer alignment with its domestic income generation. The outcome could be a long- overdue shift in the sources of global growth – away from the United States and back toward the rest of the world…It’s a world turned inside out relative to perceptions formed in the latter half of the 1990s. For financial markets still clinging to the time-worn perceptions of this glorious past, the outcome could be exceedingly treacherous."
So, let’s turn to Eric and see how treacherous Wall Street was yesterday:
Eric Fry in New York…
– The quarterly earnings parade on Wall Street continues. Unfortunately, it’s starting to look more and more like an earnings charade, and investors are growing tired of the game.
– Thanks to the ankle-high expectations many companies set for themselves in the wake of September 11th, "beating the estimate" has lost a little bit of its "oomph." Yesterday, several high-profile Dow stocks matched or exceeded their reduced earnings forecasts, and investors collectively yawned.
– The Dow rose a mere 17 points to 9,730.96. The Nasdaq, however, produced a sparkling 2.1 percent gain to 1,922.38. No matter how many companies beat estimates by one penny per share, there’s no hiding the fact that earnings are falling hard. So far, more than a third of the companies in S&P 500 have announced fourth-quarter results, and profits have dropped an average of 20.4%, according to First Call.
– Maybe that’s why Abby Joseph Cohen took a chainsaw yesterday to her 2002 earnings forecast for the S&P 500. She sliced $10 – or about 20% – off of her estimate for the benchmark index.
– That’s pretty big news: "Abby the Bull" becomes "Chainsaw Abby."
– Ms. Cohen is certainly entitled to change her mind, but this is a biggie. This change of mind is not like Michael Bloomberg, the erstwhile moderate Democrat, becoming a moderate Republican. This would be more like Michael Bloomberg becoming "Michelle" Bloomberg, New York City’s very first transsexual mayor!
– What happened to the great big V-recovery she was telling us about just a few weeks ago? What happened to the great buying opportunity in tech stocks and financials that she confidently proclaimed in the New York Times earlier this month?
– No need to worry. According to Cohen, even though earnings might be 20% less than forecast, we can still enjoy a bull market in 2002. (Shouldn’t bulls get to have some entitlements, too?) Cohen maintains her prediction that the S&P 500 will rise at least 13% and perhaps as much as 21% from its current level by year’s end.
– Apparently, in Cohen’s world, earnings come and go, but bull markets are forever.
– Ms. Cohen does deserve some credit, however, for recognizing that, post-Enron, companies will tend to report more honest earnings…and that would mean lower earnings.
– Lower, honest earnings cannot possibly be as much fun as higher, dishonest ones. On the other hand, honest earnings don’t cause a lifetime of savings to disappear overnight. Honest earnings don’t enrich a handful of corporate officers while putting thousands out of work. In short, honest earnings are healthier for the markets in the long run.
– But honest earnings, along with the budding bull market in investor skepticism, may not be so healthy for the Wall Street crowd over the short run. A skeptical investor is a hesitant buyer, and that might make Wall Street’s job more difficult.
– Both equity and bond underwriting could suffer immediately, as investors decline to buy the dubious products that Wall Street is peddling. Retail brokerage operations might also suffer, as individual investors decide that they’re better off without compromised advice.
– Perhaps it is no coincidence, therefore, that brokerage stocks have been sliding lower recently. Greg Weldon observes that the AMEX Broker Dealer Index topped out on January 4th and has dropped about 10% since then.
– Throughout the 1990s, many investors embraced deception as readily as they shunned the truth. After all, bull market stories are so much more pleasant than bear market stories. Not to mention that bullishness paid extremely well for several years.
– When the stock market party was still rockin’, few investors cared to heed "Cassandras" like James Grant. Maybe they should have…
– "The July 13  issue of Business Week contains a bombshell on the quality of blue-chip corporate earnings in general," wrote Jim Grant way back in the pre-bubble days of 1998. "Tucked away in an advertising supplement are the results of a poll of 160 delegates to the magazine’s seventh annual forum for chief financial officers last April. Employing ‘audience response electronic keypads,’ the attendees…were asked to respond to the following proposition: ‘As CFO, I have fought off other executives’ requests that I misrepresent corporate results.’ The responses were: 55%: Yes, I fought them off. 12%: I yielded to the requests. 33%: Have never received such a request. In other words, observes James S. Chanos, paid-up subscriber and gimlet-eyed reader (it was he who picked up on the BW revelations), two-thirds of the magazine’s sample set have been asked to lie about the numbers."
– Enron is only one company. Where are the rest of the 67%?
Back in Paris…
*** What happened to the U.S. budget surplus? As predicted in this space…"U.S. Budget Surplus Gone", the BBC reported yesterday. The Congressional Budget Office estimates that the U.S. will run a $21 billion deficit in the fiscal year begun in October.
*** Barron’s predicts a "new surge of high tech buying." This surge in investment spending in new technology, says Barron’s Eric Savitz, will lift the entire economy.
*** But the Financial Times fails to see it. "Steep fall in investment gives little sign of bouncing back," says yesterday’s headline. Why?
"In a recent paper published by the IMF," continues the article, "Stefan Oppers, an IMF economist, suggested that the current downturn might be explained by the ‘Austrian’ theories of the economic cycle developed in the first half of the 20th century.
"In that model, cheap money leads to over investment and bad investment, which then has to be purged in a recession. Investment will not pick up again until companies have adjusted their capital stock to match consumer demand."
*** We agree with the FT. There is little hope for genuine improvement until the recession has done its work. But as long as consumer demand remains high – sales do not sink low enough to drench excess capacity or wash out bad investments.
*** There is nothing wrong with this recession, we maintain, except that it hasn’t really happened yet.