"In death, all debts are paid."
"Credits on the left, debits on the right," said an ancient professor of commercial law, "that’s all you need to know."
The invention of double entry bookkeeping by Luca Pacioli in 1494 was one of the great milestones in business history. For the first time, a person could see both sides of the ledger and note that the sum of all our efforts, positive and negative, red or black, plus or minus, is always zero.
In the words of a 16th century accountant, Pacioli’s great essay, "Summa di Arithmetica", provided a "magic mirror in which the adept sees both himself and others."
But a real mirror – one that reveals the whole truth and reduces all human striving and pining to nothing – is not what people want. Instead, they prefer a more flattering view…and regularly let their eyes skip over the parts they would rather not examine carefully.
Until recently, investors hardly bothered to look at the debit side of the ledger. If a company was beating earnings by a penny…what else did you need to know? Besides, corporate bookkeepers and auditors were famously accommodating. If investors didn’t want to look at the debits, they certainly weren’t going to rub their noses in them.
In an amusing description of double-entry bookkeeping, Bill Fisher, "The CEO Refresher" describes Pacioli’s invention as "a tremendous breakthrough"…for the 15th century! "That was then…this is now," Fisher continues. "The Industrial Age has given way to the Information Age." In this New Era, "medieval measurement "is no longer adequate…now "We have computers…!"
We mention Japan so often in these letters that readers must cringe each time the word appears. We will take the risk of mentioning it again today…but only briefly… and only because we can’t resist.
Japan had computers, too, in the 1990s. But while America’s "new economy" boomed in the late ’90s, Japan could not seem to make a go of it. What was wrong with the Japanese? You could say whatever you liked; almost any slander was acceptable. The Japanese just didn’t "get it." Their system was "corrupt." They were "cowards"…too old, tired and gutless to reform their economy. Trillions of yen worth of liabilities were hidden…off the books…it was said.
We harbored a suspicion at the time – that Japan’s troubles were not a unique feature of the Japanese character, but a consequence of the bubble economy of the late ’80s and attempts to fix and forestall further damage. We wondered how long it would be before the biggest bubble in history – in the U.S. – blew up…and what horrors would eventually be discovered in the balance sheets of U.S. enterprises.
Now, we are beginning to find out.
Double entry bookkeeping was not good enough for New Economy companies. Accountants innovated…adding third entries. And footnotes. And forgot to mention a few things.
But when investors’ eyes finally do wander over to the debit side and study the small print, we predict, adjectives will leap to their lips that were previously only used to modify Japanese banks.
"Over the last 19 years," writes Chris Byron, "investors have poured more than $100 billion into this rural Mississippi telephone company…[Worldcom]…As a result, the company now sits, as of Sept. 30, 2001, with worthless goodwill on its balance sheet totaling more than $50 billion – so far as I am aware, the biggest such mountain of fake assets in all of corporate America.
"And here’s the really interesting thing," Byron continues, "over the course of the 1990s, this $100 billion Mont Blanc of waste has not been able to generate a single dime of net new cash…"
Generating cash scarcely seemed necessary in early 2000. But now it has become essential. Too bad there’s so little of it.
Investors "want companies that can stand on their own and generate cash at the trough of a business cycle," says Byron. Alas, "there are almost no such companies in the telecom space, and one by one the losers are being taken out and shot. Two weeks ago we had Global Crossing. Sooner or later it will be the turn of WorldCom as well…"
The mountain of fake assets on Worldcom’s books hardly stands alone. Instead, in the tectonic shifts of the New Era, a whole range of phony assets and real debt was pushed up. Not far from Worldcom’s Mont Blanc, for example, lies Enron’s Jungfrau and Cisco’s Matterhorn…
Frank Partnoy, law professor and former Wall Street derivatives specialist, recently testified before Congress:
"Enron has been compared to Long-term Capital Management…the hedge fund that lost $4.6 billion on more than $1 trillion of derivatives and was rescued in September 1998 in a private bailout engineered by the New York Federal Reserve. For the past several weeks, I have conducted my own investigation into Enron, and I believe the comparison is very inapt. Yes, there are similarities in both firms’ use and abuse of financial derivatives. But the scope of Enron’s problems and their effects on its investors and employees are far more sweeping.
"According to Enron’s most recent annual report, the firm made more money trading derivatives in the year 2000 alone than Long-Term Capital Management made in its entire history. Long-Term Capital Management generated losses of a few billion dollars; by contrast, Enron not only wiped out $70 billion of shareholder value, but also defaulted on tens of billions of dollars of debts. Long-Term Capital Management employed only 200 people worldwide, many of whom simply started a new hedge fund after the bailout, while Enron employed 20,000 people, more than 4,000 of whom lost their life savings as Enron’s stock plummeted last fall.
"In short, Enron makes Long-Term Capital Management look like a lemonade stand."
How many Enrons are out there? Maybe many.
"Enron was run by smart men," comments Gary North. "They indebted the company by using what are now standard techniques: derivatives. These techniques are so complex, so highly leveraged, that the ‘gatekeepers’ spotted nothing wrong."
Certainly, investors – casually eyeing the debit side of the ledger – saw nothing wrong. But now everyone is looking harder.
"This debt complexity is worldwide and is growing," Gary adds. "Derivatives are everywhere; over $100 trillion worth, at least. No one knows how much money is at risk."
But, eventually, all the assets and all the liabilities will sum to zero…For all of life’s books must balance, sooner or later. Dust must come to dust…Then, we will feel more sympathy for the sushi eaters.
"It is almost as corrupt here as it is in Japan," Gary concludes.
Feburary 02, 2002 — Paris, France
Things are very busy in Paris today. Thus, I’m going to dispense with my usual opening and let Eric bring you the latest from Wall Street…
Eric Fry, reporting from Manhattan…
– The stock market fell for the fourth session in a row yesterday, bedeviled by the corporate bookkeeping bogeyman. The Dow lost 32 points to 9,653, while the Nasdaq dropped 25 to 1,812.
– After the close of trading, Cisco Systems reported a profit of nine cents per share – handily beating the consensus estimate of five cents. But like a washed-up lounge singer, the networking giant’s tired rendition of "Earnings Better than Expected" would receive no standing ovation, nor even polite applause. Instead, investors "closed out their tabs" and headed for the exits. The stock tumbled more than 7% in after-hours trading to $17.22.
– Why the harsh treatment? Perhaps because the better- than-expected earnings were still worse than last year’s. What’s more, CEO John Chambers offered nary an encouraging word about the company’s near-term earnings prospects.
– "Visibility is still very limited," said Chambers, "because our own customers’ visibility for their own revenue remains limited."
– As Cisco’s struggles illustrate, the stock market just isn’t as sexy as it used to be back when public companies would array themselves in the alluring finery of deceptive accounting.
– Sadly, those days are over. Investors have discovered to their chagrin that many of the stocks that seemed beautiful from afar were far from beautiful. Having been burned by some of these Wall Street beauties, investors will find nothing appealing about dressed-up earnings.
– Income statement beautification is out. Balance sheet strip searches are in…and that is not a bullish development.
– If the American investor’s infatuation with stocks gives way to dispassionate analysis, the stock market could really take a tumble. Under the harsh light of critical examination, nothing looks more attractive, least of all richly valued stocks.
– That’s because honest-to-goodness GAAP earnings aren’t even close to the "pro-forma" earnings that corporate CFOs and Wall Street analysts always toss around.
– When stylishly attired in the haute couture of proforma accounting, the S&P 500 "earnings" might be about $50 in 2002.
– But buck-naked GAAP earnings might be no higher than $30 this year. For perspective, GAAP earnings for the 12 months ending last September were $28.31.
– Here’s a thought: if our nation’s accounting practices swing from excess to restraint at the same time that stock market valuation fashions swing from an excessive 40 times earnings to a more restrained 15 times, the S&P 500 would tumble more than 50%. That would not be very sexy.
– So if you’re seeking something sexy and exciting, you’ll have to make your way over to the stodgy gold market. That’s where the real action is these days.
– The monetary relic soared as much as $10 yesterday to $309 per ounce, before settling 80 cents lower at $298.30.
– The reason for the recent gold rally is really quite obvious – too many Olympic events this year in Salt Lake City. If there were fewer events, that would mean fewer gold medals, which would mean less demand for gold and hence, no gold rally.
– A fallback explanation for the rally might be that millions of worried investors worldwide have decided to hedge their bets by buying gold. Falling currencies and falling share prices from Tokyo to Buenos Aires to New York have frightened just enough folks to spark a small migration into the gold market.
– These misguided investors obviously haven’t read the latest Wall Street research. Gold – as all the experts agree – has no business trading higher. Furthermore, as all the experts agree, if gold does manage to rally a little, the advance will quickly fade. Lastly, as all the experts agree, gold is a joke. The smart money buys tech stocks and, for a little diversification, General Electric.
– Notwithstanding expert opinion, a lot of worried amateurs seem to be buying gold. The metal has already jumped more than $20 since last week, when Outstanding Investments editor John Myers wrote a very prescient guest essay for the Daily Reckoning entitled "Why Gold is Set to Soar."
– John’s subscribers are profiting nicely from his timely call. Back in mid-December, he urged the subscribers of his Resource Trader Alert to buy the June $280 call options on gold. "These calls are now going for $30 per contract," John wrote yesterday, "nearly twice the $16.50 level of my original recommendation."
– So many years have gone by the wayside since the yellow metal opened up some distance between itself and $300 that even many gold bulls consider a run toward $400 unlikely.
– A Patriot victory in the Super Bowl also seemed unlikely…but it happened.
Monsieur Bonner, back in Paris…
*** I’ve got to run…so, we’ll pass directly to today’s letter. More from me tomorrow…