Still The Same, Still The Same
Why can’t things just stay the same? Why can’t this market, for example, stay at these levels indefinitely?
You may recall I posed similar questions – philosophically – in a letter not long ago. I dismissed them, actually – since nothing ever stays the same. Even the Rolling Stones are getting old. They will not be the “World’s Greatest Rock & Roll Band” forever.
Credit bubbles have life cycles too. They are begotten, born, and die just like every other natural thing.
“Margin debt,” wrote Gary North in March, “now stands at $228.5 billion – 2.41% of GDP – the first time since the Roaring Twenties margin debt has been above 2% of GDP.”
Buying stocks on margin is like buying a business with borrowed money – which has a long and honorable tradition. Anytime you can make more money from the business, than the cost of the money you need to borrow, it is, other things being equal, a reasonable buy.
Say, for example, there is a paving company in your town for sale. You can buy the business for $5 million. And you can borrow the $5 million at 5% interest (to keep it simple). If the company produces a net profit of $250,000 a year, that is – it has a P/E of 20 (about what the Dow is today) – the earnings cover the cost of capital. Of course, you will want to find one that produces more than $250,000 – so you can pay off the debt as well as service it.
That, by the way, is the way the real world of business works. A businessman has to figure out how an acquisition will pay off. So, the price of a business has to be a reasonable multiple of the earnings that he expects from it.
Buying a stock (a piece of a business) is not so different. It makes sense to borrow money to buy stocks when the yield from the stock is great enough to pay the interest on the borrowed capital. Then, if the investor gets lucky, the stock will increase in price, and he’ll be able to sell out at a profit.
But, “how will a 1.17% S&P dividend yield pay for the margin debt system that demands 7% or more,” asks Gary North . Holding S&P stocks – trading at an average P/E of 28 – is a costly business.
There are about 7 percentage points between the price of the borrowed money and the yield an investor gets from dividends. This means that the stocks have to rise by at least 7% for the investor to break even.
In a bull market, of course, a 7% increase is a cakewalk. But in a bear market, it is a nightmare. If stocks just hold even, the investor loses 7%. Well…you can do the math.
“Those buying shares on margin,” Gary continues, “must have a fast return; otherwise, they cannot feed the meter. The market’s boom phase has ended for the Nasdaq’s high-flyers. Any hope in a fast profit sufficient to enable the speculator to sell shares and pay off his debt with the profits is now utterly na?ve. We are now ominously close to the day when stock market investors will run out of coins to feed the ticking meter.”
Of course, the credit balloon has not reached its present expansion with the hot breath of margin debt alone.
“In the United States,” according to
Dr. Kurt Richebacher, “total credit expanded last year by $2,200 billion…compared to national savings of about $300 billion…[and] nominal GDP growth of $495 billion.” Credit, in other words, is growing at a rate 400% faster than the economy and 700% faster than savings. “By any measure,” Dr. Richebacher continues, “America’s credit figures for the last two to three years are horror figures.”
Credit costs money. “Americans’ investment money is 75% in stocks,” Gary North tell us. This investment is supported by margin debt, credit card debt, mortgage debt and every other form of debt known to man. Houses are mortgaged beyond 100% of their value – so the funds may be invested in stocks. Credit card lines are maxed out – again, so that shares in Amazon.com or DrKoop.com can be held for the long-awaited comeback. Credit card meters can run twice as fast as those on margin accounts.
Even if an investor does not borrow money, the meter still runs. He has to compare a stock purchase with other uses for his capital. If he can get 6% from one investment – why would he settle for 1.17% from another? It would be the equivalent of losing 4.83%. In the bull phase, he can forget about earnings and dividends. Capital gains make up for the non-existent dividends. But when the market stalls – when there are no more capital gains – the 6% interest, tax free, from municipal bonds begins to look very appealing.
Investors do not have to wake up in a cold sweat – fearful the THE END is at hand. They do not have to give up hope in the dream of something for nothing, nor in the brave new world of cyberspace. They merely have to act rationally – gradually taking their money out of expensive, non- performing stocks – and the market will fall.
Investors do not always act rationally – but sooner or later they do.
Paris, France June 13, 2000
P. S. William Butler Yeats might have been speaking of Paris, rather than Byzantium:
“That is no country for old men,” wrote the poet who was born on this day in 1865.
In one another’s arms, birds in the trees…
In one another’s arms, birds in the trees…
Consume my heart away; sick with desire
And fastened to a dying animal
It knows not what it is;
But Yeats’ best known poem is ‘The Second Coming.’ Written before WWI, it seems to have foreseen the century ahead:
TURNING and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the centre cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all conviction, while the worst
Are full of passionate intensity.
Surely some revelation is at hand;
Surely the Second Coming is at hand.
The Second Coming! Hardly are those words out
When a vast image out of Spiritus Mundi
Troubles my sight: somewhere in sands of the desert
A shape with lion body and the head of a man,
A gaze blank and pitiless as the sun,
Is moving its slow thighs, while all about it
Reel shadows of the indignant desert birds.
The darkness drops again; but now I know
That twenty centuries of stony sleep
Were vexed to nightmare by a rocking cradle,
And what rough beast, its hour come round at last,
Slouches towards Bethlehem to be born?
Now, the blood-dimmed tide has ebbed, and passionate intensity has given way to the profit motive. It is a different world – at least in some respects.
But that old ‘rag and bone shop’ of the human heart is still the same.
*** “Dollar’s Dominance Shaken” proclaims today’s Reuters headline. Picking up the theme we’ve been discussing in the Daily Reckoning, Reuters notes that the euro is inching up against the dollar.
*** Meanwhile, things are looking up for Japan, too. GDP grew 2.4% (annual rate) in the first quarter…after three years of almost no growth. The second quarter is expected to show even faster growth.
*** By contrast, international investors – the big players in world markets – are worried about a slowdown in the US. Long bonds now yield less than short-dated notes. This is the “inverted yield curve” you hear discussed from time to time. It is unnatural – because, other things being equal, investors require higher rates of interest for longer term lending. No one knows what the future will produce, so the farther out you go, the greater the uncertainty…and the more interest you want to collect to offset it.
*** Unnatural acts rarely herald good things – and the inverted yield curve is no exception. It signals economic slowdown. The long bonds seem to be anticipating a recession – and/or a bear market.
*** “48% Say Gas Prices Crimp Driving” says a USA TODAY headline. This is the story the BLS forgot to mention. While inflation is supposedly low…the price of gasoline reached a record level yesterday. It was up 6.8% from June 1, to an average price of $1.63 a gallon.
*** That doesn’t seem like much to Europeans – who are used to paying 3 to 4 times that amount for their gas. But, then again, the French and Germans don’t drive around in land barges – those gas-guzzling SUVs and motor homes.
*** Oil rose $1.54 yesterday. And the National Association of Realtors reports that the average house price increased in April at an annual rate of 10%.
*** Still, the rate of consumer inflation won’t look nearly so bad as long as it only counts the cost of computing power. Too bad Americans can’t live in a computer or drive one to work.
*** The Dow fell 49 points yesterday. The Nasdaq dropped 106 points, or 2.76%. This is how a bear market works. There are sharp rallies…followed by a long period of degradation. The gains get chiseled away.
*** “The cycle of the market goes from caution to optimism to enthusiasm to mania on the upside,” wrote Doug Caseyrecently, “Then, after the mania breaks, comes uncertainty,disbelief, fear then panic on the downside. I think we’re now at the uncertainty stage.”
*** But traders are still bullish – as illustrated by the put/call ratio. Money is still flowing into mutual funds (though at a reduced rate). And the average guy still believes that things get better in every way, every day. In this long, slow fin de bubble era – people still believe in, and go through the motions of, a bull market. But the market doesn’t cooperate.
*** Amazon.com fell below $50. GE is also below $50.
*** “It’s a perfect dawdler’s market,” Lynn Carpenter of the Fleet Street Letter tells me. Lynn has made her way from zoology, through French, anthropology, urban studies, journalism, English and linguistics… to become an investment analyst. She’s “roamed from computers to candy bars to banks and beer to hi-tech instruments, and made 183% on Mellon Bank, 91% (in one day) on American Express, 48% on Tandy, 127% on Agilent, 131% on Hersheys, 36% on W.R. Grace.” She’s referring to her trading record: A Perfect Dawdler’s Market
**** “On May 1st 1975 the Dow Jones Industrials closed at 830.96 up 9.62 points or 1.2% on the day.” Says Ray Devoe “That would be about 7.6% of where the DJIA closed yesterday, or you could say that the DJIA is up 1,210% since then.” At the close of the worst bear market in post war history… it was not a happy time on Wall Street. But, says Devoe, May 1st was also the date of “the biggest non-event in Wall Street history”…
*** This is the anniversary of William Butler Yeats’ birth. See below.