Ship Of Fools

Some people take abstract ideas so seriously they are dangerous. An article in Monday’s International Herald Tribune told of a cruise organized by The Nation magazine.

“Caribbean Sea, 18 miles off the southwest point of Cuba” began the article, helpfully pinpointing the cruise ship for anyone with a handy missile and GPS. More than 300 “silver haired pinkos,” as the IHT called them, readers of The Nation magazine, “sipped coffee and ate breakfast pastries in a dimly lighted auditorium, where they had gathered to hear a lecture about the environment titled, ‘Are Humans an Endangered Species’.” [many of the attendees no doubt hoping the answer would be positive].

They had each spent an average of $2,400 to join the cruise – on a Holland America ship which must contribute massively to the global warming these people fear…and operated with a non-unionized crew.

For the money, they got the dubious pleasure of listening to panellists such as Tom Hayden, Barbara Kingsolver and Molly Ivins discuss topics such as “chlorocarbons, atmospheric radiation, God and global warming” – topics that none of them actually knew anything about.

But that is the nature of Big Ideas – they allow people to divert their attention from the real problems of everyday life – with its uncertainty, complexity and baroque absurdity – to big problems that they can pretend to understand and do nothing about.

I have promised a fuller introduction to the Daily Reckoning. In today’s letter I will let you in on our little secret…the insight that gives us, I believe, a competitive advantage.

The secret, dear reader, is that the Daily Reckoning harnesses the power of modern life’s most underrated resource: ignorance. Or maybe you guessed as much?

At last night’s dinner, a group of executives from our publishing company sat at a table in a local diner, trying to solve some of the business problems that confront us. We were not small progress, but what else could we do?

Meanwhile, the group at the next table was deeply engaged in another subject – politics. There were two young men – eager to comment on Gore’s speech, which was on the TV at the time…arguing about how the Democrats might organize themselves for a comeback in 2004…and how Gore would likely take Hillary as the VP candidate…or would it be the other way around?

The older man walked with a limp and might have had severe arthritis – as if even his body as well as his soul had been corroded by too many years as a political hack. Like the silver-haired pinkos, this man seemed to have an answer for everything.

As I discussed yesterday, Darwin left the world in ignorance. He merely described the evolution of species as he saw it. Likewise, the Efficient Market Hypotheorizers described the movement of stock prices – as best they could make them out. But both ideas were taken up by the mob, vulgarized and hollowed-out…giving the “pretense of knowledge”…and ultimately producing grotesque results.

If random mutations and the `survival of the fittest’ were the guiding principles of life, reasoned the Darwinists, then God really was dead, just as Nietszche said. Henceforth, there could be no sin. Even murder could be redefined as the process of natural selection…in which the more fit survived while the less fit perished..

With his “you can’t make an omelette without breaking some eggs” rationale, Stalin did not have to ask the Kulaks if they wanted to be collectivised. He did not have to poll the Black Sea Greeks to see if they wanted to be relocated to Kazakhstan. Nor did he need to survey the bourgeoisie to find out if it wanted to be exterminated. The “pretense of knowledge” that Darwinism gave him was enough. If he were able to kill his enemies before they killed him, that must be the way nature intended it. No punishment – either in this life, or the next – was expected.

And yet, if the promise of heaven is anything more than a empty slogan, there must be a million Bolsheviks, Nazis and tort lawyers roasting at this very minute.

Believers in the random movement of stock prices, meanwhile, seem to have engineered their own destruction. If stocks move in a completely random way, the only reasonable thing to do is to “buy and hold”. Price would not matter…since the odds that an expensive stock would rise should be the same as for a cheap one.

Thus, investors were encouraged to enter the market – anytime during the last four years – when prices were absurdly expensive. “Prices always go up over the long run,” they were told.

And now we come to a paradox. I do not believe you can predict the future. Yet, I also believe that prices matter. If you buy a stock producing $1 of dividends at $10 – you get a 10% return. If the stock costs you $100 – you only get a 1% return.

Without pretending to know the future, common sense tells us that the stock is a better buy at $10 than $100 – you can get 10 times as much for your money!

Put another way, a buyer at $100 has 10 times the risk of loss per share.

But bullish investors believe risk is no problem – they, relying on the Efficient Market Hypothesis, think all price levels carry the same amount of risk, because price movements are random.

And yet, Smithers and Wright show that stock prices do not just go upwards forever. Instead, they swing from expensive to cheap – around a ratio called q, which measures stock prices in terms of book value. Historically, whenever the q ratio is extremely high, stock prices tend to “revert to the mean.” Smithers and Wright describe the pull of q as though it were a rubber band. The farther prices move away from the mean – the greater the tug on the rubber…and the more likely stocks are to move back to the mean.

Stock prices are now higher than they’ve ever been, as measured by the q ratio. That doesn’t necessarily mean they will fall right away…but it does mean that they are extraordinarily risky.

“We expect the stock market to fall,” write the authors, “to a level that is less than half what they were at the end of 1998.” This implies a Dow of about 4,000.

Your very ignorant correspondent,

Bill Bonner Baltimore, MD…Hon… December 14, 2000

*** Not much of a rally. In fact, hardly a rally at all.

*** You may recall, when we left off yesterday, investors were ready for the long-awaited post-election rally. Well, the post-election finally arrived…and GWB, as fine a post as any, won.

*** Gore was more wooden, but Bush had more friends in high places, notably the U.S. Supreme Court. And so we have a new Commander in Chief.

*** Stocks didn’t seem to care. The Dow barely moved – up just 26 points. And the Nasdaq resumed its losing ways – giving up 109 points.

*** The nation’s favorite big techs were mostly down – with Intel off a buck. Microsoft fell more than $1. Oracle dropped $2.25. IBM lost $2.50. Cisco went down $3.25. And Juniper plummeted more than $6.

*** Since election day, the S&P 500 has fallen 5%. The Dow is only off 1.5%. But the Nasdaq has slumped 17%, with the Internet sector sinking 37%.

*** So what’s new? Well, bonds rose. The dollar moved little…and the price of oil fell 94 cents.

*** The Producer Price Index comes out today. It is not expected to reveal much of an inflation risk.

*** That’s because the risk is on the other side. People are hoping that Mr. Greenspan will lower rates next year – and that the economy will come to rest at a more moderate rate of growth. This is the “soft landing” that – like the Big Bottom – the financial press thinks it sees all the time.

*** But the problem in the U.S. economy is not that credit is too tight – it is that it has been far too loose. As a result, too many people owe far too much money – and have too little to show for it. Consumers frittered away money they had never earned…and businesses invested trillions in projects with a much lower rate of return than the cost of capital.

*** You don’t solve these problems with lower interest rates. You solve them with bankruptcy, defaults, work-outs, cutbacks and real savings.

*** “Of the 300 CLECs operating in the United States, only two are profitable,” said John Windhausen, President of the Association of Local Telecommunications Services. An estimated $150 billion has been lost in dot.coms. An article at by Marshall Auerback explains that “in today’s turbo-charged world of new economy finance, this sum is but a pinprick of the scale of the credit problems likely to result from faltering telecoms and Internet infrastructure companies. Here, the quantities of debt held by several leading household names (AT&T, British Telecom, KPN, Cisco, Lucent, Germany’s MobilCom, and France Telecom to name but a few prominent examples), and the concomitant deteriorating backdrop for their respective businesses, imply future debt write-offs and possible bankruptcies that will dwarf those of the dot.coms.”

*** Alan Greenspan recently discussed the problem as follows: “In many respects, the situation may be analogous to a phenomenon of which I am sure many of you are all too painfully familiar – the tendency to overbuild in commercial real estate when low vacancy rates prompt commercial building starts well beyond the point that, on completion, could be supported by the ongoing growth in demand. Problems have even arisen among a number of well- established companies whose forays into uncertain newer technologies have come up short.”

*** “But ultimately,” Auerback continues, “the biggest losers are the millions of investors who have bought into this nonsensical rhetoric about the new economy, whose euphoric expectations were stoked by people who ought to have known better than anyone how to recognise and prevent a financial mania.”

*** The telecoms have hundreds of billions in debt already. But even that will not be enough. They have bought expensive licenses and made commitments for hundreds of billions more in capital investment.

*** Where will they get the money? People who expect Fed rate cuts to automatically make cash available to these high-risk borrowers are going to be disappointed. Lenders need to be compensated for the risks that they have, suddenly, noticed. The result will be higher effective rates for the people who actually need the money.

*** This is not a set of conditions likely to end up in a soft landing. The Financial Times reports that the chief economist for HSBC, Stephen King, “believes that even aggressive rate cuts may not be sufficient to prevent a hard landing. This is because of the irrational exuberance that prevailed in the late 1990s – companies have over- invested, consumers have over-borrowed, and banks have over-lent. All three will decide to cut back whatever the level of interest rates.”

*** “The US is now showing severe symptoms of distress,” writes King. “Banks are showing a degree of credit constraint last seen during the early 1990s’ hard landing. The collapse in the Nasdaq carries enormous implications for the cost of capital. The deterioration in household net wealth this year is an event that, in the past, has been a precursor to recessions.”

*** Meanwhile, unionised bank workers in Seoul decided that they would not take a credit crunch sitting down. They took the chairman of Kookmin Bank hostage until he agreed to discuss future merger plans with the union.

*** And energy is in the news on this cold, rainy morning in Baltimore. Natural gas was about $2 per thousand cubic feet last year. Now it trades for between $9 and $20. U.S. Senator Frank Murkowski wanted to know why “the demand for natural gas in the future has been grossly underestimated.”

*** He’s got a point. It’s not exactly rocket science. Still, even in this Information Age, it is ignorance that moves markets – not information or knowledge. Apparently, nobody bothered to check the fuel gauge until the snow started to fly. Meanwhile, inventories of computers and manufactured goods rose – beyond what the market could take up.

*** People don’t like the uncertainty that markets – and life – produce. They much prefer the false security of politics. Thus, a headline on today’s newswire: “Energy crunch adds to deregulation doubts.”

*** A modest prediction: millions of people will go broke in the coming downturn. More than a million bankruptcies are expected in the coming year alone – without forecasting a major bear market or recession. These people will not blame themselves for making bad investments. They will blame anyone and everyone they can. There will be lawsuits…criminal charges…and the demand for greater regulation.

The Daily Reckoning