The Bear Market According to Emerson

Jim Davidson’s attempt to counteract the widespread discredit of technology investing which, he suggests, is the result of an ill- informed mood that has swept society; the pernicious impact of "group think". Alas, opportunity still abounds.

"The dice of God are always loaded."

– Ralph Waldo Emerson

The dot-com mania may indeed have been a bust. But it would be a grave error on that account to proceed to the conclusion that the transforming power of technology is bunk. Not so. The losses of millions and tens of millions of dollars that many individual investors suffered after the Federal Reserve determined to drive down the value of NASDAQ stocks two years ago were real and painful. The memory of those losses seems to have thoroughly discredited the theme that you can gain riches by investing in technology. The question for you as an investor is where to draw the balance of judgment? The widespread discredit of technology investing is an ill-informed mood that has swept society.

Understandable, perhaps, in light of experience, but it is no more substantial than the current, fleeting fashion among women to forego flower prints for those featuring butterflies or to wear skirts of a certain length. You would not consciously choose to allow the whims of fashion houses to determine your fortune. For the same reason, you should not permit the fashionable distaste for technology to skew your investment decisions. My view is that technological innovation is almost certain to be the most important variable precipitating change around the globe for our lifetimes and those of our children. To overlook the wealth-creating potential of technology would be stupid. As the economist Paul Romer reminds us, "Wealth is another word for change."

But before that can be true for you, you must have your capital deployed in a way that captures the gains from change. By emphasizing the potential for technological change, I have hoped to counteract some of the pernicious impact of "group think" in informing a distaste for any and all technology investments in the wake of the dot-com bust. The case for technology needs a measure of bolstering to even be noticed in the economy’s bleak environment. Put simply, the world is in a bear market. This has been punctuated by the aftershocks of Islamic terrorism, a seemingly intractable blood feud in the Middle East and a dozen other dreary reminders that if technology is the herald of a new world to come, not everyone wants to go there or is prepared to enjoy the ride if he does. This retrograde impulse in modern life is underscored by a number of troubling themes in the news. Start with the news of a dramatic surge in economic growth in the US during the first quarter of 2002. Gross domestic product (GDP) grew at a 5.8% annual rate. At the surface, this underscores my optimism about the potential for growth. But there is a sobering subtext to the report of rapid growth in the first quarter. Profit growth has apparently not accelerated with the economy. Poor profits are telltale evidence of an economy constrained by some combination of surplus capacity, weak demand or high costs. The big question is whether profits will rebound quickly or if poor profits will drag down the recovery.

I am torn. The "law of accelerating returns" argues that growth may continue to surprise on the upside. To the extent that it does, profits may rebound rapidly enough to support current prices for the broad stock market and fund robust corporate investment. But if the S&P were to return to its average multiple of 16 times earnings, that would imply an almost two-thirds drop in the broad, blue chip index from current levels. (The S&P is currently priced at 46 times earnings, or 4.5 standard deviations above average.)

Growth is a primary impulse in nature. But the primacy of growth does not necessarily support unbounded optimism about prosperity in the near term. I have long been a fan of the American philosopher Ralph Waldo Emerson, whose essays harness many profound truths and much good sense. In his classic "Essay on Compensation", Emerson wrote about the inevitable action and reaction we find everywhere in life.

It would be a gross misreading to interpret Emerson as though he were writing as an economist. He was not. But his concerns are vitally relevant to "the feud of Want and Have" that predominates today’s news. Indeed, Emerson suggests that sometimes intervals of recession are part of the dynamic of growth. He says, "The changes which break up at short intervals the prosperity of men are advertisements of a nature whose law is growth." This is no flimsy paradox. Sometimes, downsides of cycles are crucial to sustaining the rhythms of growth. Emerson compassed this with his observation that "the ship that sails the truest course does not necessarily sail a straight line." But, equally, sometimes the changes that break up intervals of prosperity are degenerate. They undermine the prospects for prosperity.

The world abounds with such symptoms of degeneration. Look at Argentina. Look at the preposterous farm subsidies just approved by the U.S. Congress. Look at Japan, which has been as stagnant since 1990 as Argentina was 50 years ago. Japan is the perfect refutation of the Pat Buchanan/Jean-Marie Le Pen fallacy that curtailing immigration strengthens a country. Japan is the only major country without immigration. It is dying for that reason. Thirty percent of the population is over the age of 60. Who will bus the tables and pay the ruinous taxes required to pay off the trillions in bad debt? The Japanese will come to rue the fact that they don’t have lots of Mexicans and Koreans helping with the heavy lifting.

Lots of major news stories are "advertisements of a nature whose law is growth" only in the sense that they remind us how much more prosperous we could be, if not for the seemingly inevitable perversity of politics.

When younger, I wasted years of effort trying to counter what I took to be feckless, ill-informed or ill-intended attempts by losers to live at their neighbors’ expense. When I was at Oxford, I studied the deficiencies of electoral politics, the hidden biases in democracy that induce electorates to muddle the free market by exploiting whatever engine of compulsion they can engage to subsidize themselves. Without a doubt, a decision by politicians to screw up the efficiency of the free market with impositions, imposts, regulations, and taxes is not a surprise, but merely a manifestation of the outcome that was always latent in the system itself.

It does no good to lament the deficiencies of democracy. To do so is to diagnose an untreatable disease. Until history unfolds a more apposite system of governance, which can better segregate the costs of degenerate policies and make them fall more squarely on those who choose them, democratic politics will manifest the dualism that, as Emerson reminds us, "underlies the nature and condition of man." As he says, "If there is good, so is there evil; if the affinity, so the repulsion; if the force, so the limitation."

"If riches increase, they are increased that use them. If the gatherer gathers too much, Nature takes out of the man what she puts into his chest; swells the estate, but kills the owner. Nature hates monopolies and exceptions."

This is nowhere as clearly evident as it is in Argentina, a naturally rich country full of enterprising people. Half a century ago, Argentina was richer than Germany, France or Italy and many times richer than Japan. Then it fell under the sway of protectionist, populist politicians intent upon "sharing the wealth." They imposed high tariffs to coddle local industry and bullied private business to employ more people than were necessary. When the companies sporadically threatened to go broke under the burden of make-work jobs, the politicians offered concessional loans financed by printing press money.

As a result, Argentina stagnated while Germany, France and Japan advanced.

Politicians everywhere are trying to spell "prosperity" with the wrong blocks. They respond to the insecurities and demands of losers, who favor protectionism, regulation and income redistribution. They say, give us money and we will love you. Or at least vote for you.


With the rush to cater to losers setting the agenda, you can expect higher prices and reduced efficiency. Which means lower profits. And lower stock prices than we would have seen in the alternative.

Retrograde politicians around the globe are "taking a stand against globalization" and "supporting good jobs for our people." This is the meaning of the surprising second place showing by the buffoonish Jean-Marie Le Pen in the recent French presidential elections.

It is a factor in the breakdown of trade liberalization, and retrograde U.S. moves, like slapping tariffs on steel and Canadian lumber. When protectionism is on the march, innovation tends to be curtailed. Which is generally bad for technology.

That said, not all technology will be equally diminished by the degenerate changes in policy regimes. The technology that will be least adversely affected is that which undercuts costs. And those which promote rapid change in society.

Despite retrograde reactions and a world torn by politics, I remain optimistic that we can navigate the dangerous winds of investment to make Paul Romer’s adage true in the most meaningful sense: "Change is another word for wealth."


Jim Davidson, for The Daily Reckoning
May 15, 2002

P.S. As Emerson reminds us, retrograde reactions have been shown to be part and parcel of life. Whenever "human fancy attempted to make bold holiday and to shake itself free of the old law, this backstroke, this kick of the gun, certifying that the law is fatal," brings us back to the conclusion that "in nature nothing can be given, all things are sold."

Understanding the subtle movements in a market produced by the winds of change can have a profound impact on your money. Especially when you get behind companies that are going to have a huge effect on the world. Despite the ill-repute into which "technology investing" has fallen, buying early… and staying with them… still puts you in the enviable position of turning as little as $5,000 into enough to retire on.

James Davidson has enjoyed astounding personal success founding new companies in a variety of industries. He’s a graduate of Oxford University, and a renowned author and venture capitalist. Mr. Davidson’s articles have appeared in The Wall Street Journal, Investor’s Business Daily, The Washington Post and USA Today. He has been a guest on MacNeil Lehrer, Good Morning America, Larry King Live, and John MacGlaughin

How long will it be before we here at the Daily Reckoning are forced to admit that we were wrong?

First, the productivity number came in for the first quarter – and it was great. Then came the GDP number – and it looked terrific. Next up, Cisco proved that there was still life in the New Economy, with its breathtaking first quarter profits up 2 cents above expectation… helping to drive stocks back up above 10,000. And now this…consumers are not only "hanging in there," the darned fools are spending like they had just stolen someone else’s wallet!

But we’re not admitting anything yet. Even Alan Greenspan acknowledged that the recovery depends not so much on consumer spending (where will they get the money?) but on business investment. Without it, no future productivity gains, no new technologies, no new profits, and no new jobs…which would make it hard for consumers to keep on spending.

From where…and why…will business investment come? "Airlines won’t see profits until 2005," declares a headline. Why would the airlines invest in more planes? In the tech sector, 2 out of 5 factories are idle. Why would people want to build more of them? "Even High Income Young Save Less," says an LA TIMES story. Without savings, where will businesses get the capital to invest?

Business investment is both the sine qua non of a decent recovery and the one thing this recovery hasn’t got. Instead, what it has is what Dr. Kurt Richebacher calls "Ponzi financing," in which "debtors have largely stopped financing their interest service out of current income, meeting it instead by further borrowing."

"To get an idea of the possible amount of Ponzi financing," Dr. Richebacher continues, "we did a simple calculation: At the end of 2001, outstanding credit in the U.S. totaled $29 trillion. How much interest may this monstrous indebtedness presently require? It can’t be far from $2 trillion annually. Strikingly, this amount roughly corresponds with the recent annual credit growth. Rapidly rising unpaid compound interest appears to keep the American credit machine running at full speed…"

What will happen next, we don’t know. But we’ll wait to find out before turning bullish.

What do you think, Eric?


Eric Fry in New York…

– Like Saturday Night Live’s "Hans and Franz," Mr. Consumer is no "girly-man." He can clean & jerk heavy debt-loads with the best of them.

– These great big debts power great big spending. And as CNBC tirelessly instructs its viewers, anything that sustains consumer spending is good for the economy. We have our doubts about the CNBC theory of economic growth, but there is no doubt at all that the news of resilient consumer spending sparked yesterday’s rally on Wall Street.

– Upon learning that Mr. Consumer had not abandoned them after all, investors piled into their favorite stocks yesterday. The Dow rallied 188 points to 10,298, while the Nasdaq surged 4% to 1,719. Old favorites like Dell and Intel powered the Nasdaq’s advance by gaining about 6% each.

– Retail sales surged 1.2 percent in April – nearly double the gain predicted by those nameless, faceless "economists." Wal-Mart punctuated the pleasing retail sales report with some surprisingly strong sales news of its own. The world’s biggest retailer announced that its first-quarter revenues surged 14%, leading to an impressive 20% jump in earnings. Wal-Mart shares popped 4%, boosting the company’s market cap to a titanic $245 billion.

– Should it concern us at all that the Commerce Department’s retail sales report is "adjusted for seasonal, holiday, and trading-day differences?" Maybe not, but it is interesting to note that without these "seasonal adjustments" retail sales increased a puny 0.2%. NOT the 1.2% that so thrilled investors. Maybe Mr. Consumer is a girly-man after all.

– What’s more, it won’t be easy for Mr. Consumer to stay "pumped up." As Bridgewater Associates observes, "Weak labor markets remain a headwind that must be overcome, rather than something that is actively contributing to strong recovery." As a case in point, the latest Challenger "announced layoffs" survey shows that 113,000 layoffs were announced in April, up more than 10% from the 102,000 announced in March.

– The downbeat employment picture is unlikely to improve until business sales recover. And no such recovery is yet in sight. "For the 12 months ended March 2002, the 2% year-over-year decline in business sales was the steepest since 1982," says Moody’s John Lonski. Business sales look even worse in relation to GDP. By this measure, says Dr. Kurt Richebacher, before tax profits of non-financial corporations have slumped to their lowest level since World War II.

– "The profits carnage continues in full force," Richebacher warns, "implying much worse to come for the economy and the markets. There will be a rude awakening."

– Meanwhile, in the shadow of the stock market’s brilliant recent performance, an interesting sub-plot is unfolding. The "inflation trade" is heating up. Gold’s rally through $300 is but the most visible part of this trend. But crude oil prices and interest rates have both been tracking steadily higher as well. Yesterday, crude oil jumped nearly $1 to $29.36 a barrel. Less than six months ago, crude was going for about $18 a barrel. Meanwhile, bonds suffered their biggest two-day loss since March, pushing the 10-year Treasury yield up to 5.32%.

– Neither of these trends will aid consumer spending or business sales. Rising interest rates alone could halt a recovery in its tracks. Add rising oil prices to the mix, and things could slow down rapidly. Last year’s "cheap oil" boon to consumer spending has become this year’s "oil tax."

– As Chairman Greenspan himself observed last month, "With the rise in world crude oil prices since the middle of January, higher energy costs are again sapping the purchasing power of households…Coincidence or not, all economic downturns in the United States since 1973, when oil became a prominent cost factor in business, have been preceded by sharp increases in the price of oil."

– But it’s probably not a coincidence. Nor is it a coincidence that Moody’s industrial metals price index has jumped 8.1% so far this year, nor that the prices- paid component of the ISM’s manufacturing index jumped to 60.3 in April from a low of 32.0 last November.

– In earlier financial epochs, a rising gold price and rising oil price – coupled with rising interest rates – signaled a coming inflation. Should this epoch be any different?

– "Believing that the bear stock market is unfinished and that a bear dollar market is only beginning," writes Jim Grant, "we guess that the index ultimately to be inflated is not the NASDAQ but the CPI. Underscore ‘guess’ and ‘ultimately.’"


Back in Paris…

*** A Daily Reckoning reader joined me for a drink at the Paradis yesterday.

*** "Are you enjoying your visit?," I asked.

*** "Well, I’d be enjoying it more if my wallet had not just been stolen. I should have paid more attention to your warning…I was pickpocketed on the metro!"

*** "Were they gypsies?," I couldn’t help but ask.

*** "I don’t know…a guy pushed against me in the turnstiles. I thought he was trying to get through without paying…but instead he was doing something else."

*** If you come to Europe this summer, dear reader, be on guard. The pickpockets are pros.

*** "Jules, I’m going to let you in on the secret to success," I began. And why not? A father has not only the right, but the duty, to pretend that he knows what he’s talking about. "Normally, I would wait until you were older…but you may need this now. So here goes…

"There are two principles that almost no one understands…but they are critical to success. First, everything happens at the margin. Take some kid who’s just as smart as you are…and one of you will do very well, while the other one might do not-so-well. What’s the difference? One makes just a little bit more effort. Of course, just a little bit more effort doesn’t make any big difference the first day…but that’s where my second principle comes into play – ‘compounded effort over time.’ You know how compound interest works. You put money in the bank. Depending on the interest rate, it builds up. At first, you barely notice the increase. But after a while, it grows at an incredible pace. Well, effort is the same. At first, the results are barely perceptible. But over time, the guy who puts in just a little more effort…who listens just a little more carefully…who tries to work just a little harder…and just a little longer…and who cares just a little bit more about the way things turn out…after a few years, this guy’s extra efforts compound until he is far ahead of the other guy."

*** "Uhh…thanks, Dad…" said Jules.

*** And here is the story we’ve been waiting for. "Did you know they elected a monkey as mayor of Hartlepool?," asked one of our English editors at last week’s luncheon. "The guy was a mascot at soccer games. H’Angus, they called him. The townspeople caught a monkey during the Napoleonic Wars. They thought he was a French spy…so they hung him. Hence, H’Angus the monkey.

"Well, the guy in the monkey suit ran for mayor…and he won! Best mayor they ever had."

The Daily Reckoning