The Grand Illusion

“The single hardest concept to get over to investors is that there are tidal movements in the market. The bull tide takes stocks from undervalue to overvalue. The bear tide corrects the bull movement as it takes stocks back to undervalue again.

Why can’t people accept this? Probably because it too simple, too basic, and too theoretical.”

Richard Russell Warren Buffett’s success in the investment markets are testament to the power of humility. Instead of trying to predict the future, outsmart the market, or figure out which new technology is going to be a hit in the years to come…Buffett sticks to simple principles and ‘immutable’ rules. He favors a bird in the hand over two in the bush, for example.

Even so, Buffet errs: “Obviously, we can never precisely predict the timing of cash flows in and out of a business or their exact amount. We try, therefore, to keep our estimates conservative and to focus on industries where business surprises are unlikely to wreak havoc on owners. Even so, we make many mistakes: I’m the fellow, remember, who thought he understood the future economics of trading stamps, textiles, shoes and second-tier department stores”

But Buffett’s mistakes are small mistakes, correcting relatively small exaggerations of his pride and prejudices.

Larger excesses require larger mistakes and grander illusions that can puff up a bubble until its ready for its pin.

Today’s letter focuses on a huge blunder – an illusion grand enough to correct not only the exaggerations of the Nasdaq…but those of the Dow too…as well as the other historic excesses in the U.S. economy.

Savings have almost disappeared in America. Since WWII, the world has come to rely on America as the spender of last resort. America does not sell enough goods and services abroad to pay for the many things it imports. Instead, the entire system rests on three things which have become exaggerated to the point of becoming grotesque: the dollar, debt and deficits.

As a result, “despite the illusion of prosperity over this past decade, most American workers haven’t shared in the new wealth…” writes Stephen Gottdeiner in the Letters page of Barron’s. “But they have engaged in conspicuous consumption of life’s luxuries at the higher cost of credit,” he continues.

“Since 1990, average credit-card debt has risen from $3,000 to $8,000. Filings of bankruptcy have more than doubled. Home refinancing may have only prolonged consumption and inevitable termination of the debt cycle.”

How could people have allowed themselves to sink into a bog of debt – at the very time the economy was supposed to be making everyone rich?

But that is the pernicious joke that Mr. Market plays: “Speculation is most dangerous,” says Warren Buffett, “when it appears easiest.” And it is the very moment that you think you are getting rich quick that you are most likely to go broke in a hurry.

“Speculation buys up, in a very practical way,” wrote John Kenneth Galbraith, “the intelligence of those involved.”

Thus, as prices rise, people convince themselves that they are geniuses for getting in on it. They turn their brains to thinking of reasons why prices might rise even more. The smarter they are, the more easily they can convince themselves that there is a marvelous opportunity to get rich just waiting for those investors smart enough to seize it. They embrace an illusion… and thereby make the mistake needed to bring things back in balance.

America’s bubble market of the 1990s was made possible by a single over-riding conceit: that America’s new Information Economy is different from every economy that ever came before and doesn’t need to follow the same old rules.

The illusion is so far-reaching that it has led Americans to believe that they actually got richer over the last decade.

But while Americans celebrated their “information economy” and thought it was making them rich, they were actually getting poorer – a fact which cannot be ignored forever.

“What is pushing the United State into a recession is an unbalanced economy. There’s simply too much debt accumulated by working-class families, and insufficient income growth to pay for it,” Mr. Gottdeiner concluded.

Meanwhile, “corporate America has created the crisis of overproduction. Thus, as the rate of profit falls, layoffs will accelerate as well. Our economy will experience a deflationary spiral that interest rate cuts can’t cure. Time has run out, not only for the debtor, but the creditor as well.”

More tomorrow…

Bill Bonner Paris, France March 14, 2001

*** Mr. Bear must have had the same idea I had yesterday …you don’t want to spook the campers too much or they’ll pack up and go home.

*** So, he backed off. The Dow recovered 82 points. The Nasdaq rallied 91.

*** The big winners yesterday were the Internets. The big losers, wouldn’t you know it, were gold mining companies.

*** Dell and Cisco were both up about 12% each. GE CEO Jack Welch assured Wall Street that the company would meet its earnings estimates and will continue to grow “in any foreseeable economic scenario.” You can recognize nonsense when you see it, so I will not call attention to it. But most investors, apparently, cannot. GE rose 7%. Sell the rally.

*** And once again, investors think they can see the ‘big bottom’ they’ve been looking for. But stocks are no bargains.

*** “We can say with reasonable conviction that this could well be ‘a’ bottom,” writes Kevin Klombies, “but it isn’t likely ‘the’ bottom. As Barrons pointed out, Intel was trading at 45 times earnings at $75 per share and was still trading at 45 times earnings at $29 per share. That hardly suggests that valuation levels are being wrung out of this market.”

*** “Usually, falling prices mean stocks are bargains,” says a WSJ article. “But earnings are falling at an even faster clip than prices lately – so price-earnings have actually been going up. A week ago, the price-earnings multiple of the Nasdaq was 121, according to Birinyi Associates, below the current 154 figure, meaning that investors are paying more for a dollar of earnings than just a week ago. [Whoever wrote this sentence needs an editor even more than I do.] Even if the money-losing stocks are taken out of the Nasdaq calculation, the P/E ratio is 35 – an historically high level.”

*** But not all stocks have rising P/Es… I noticed a note this morning in the Richmond press about a local company, Ethyl, laying off 40 employees after profits fell 77% in the last quarter. Keep an eye on Ethyl simply because it is one of the ‘ugliest’ companies in America. Its main product is a lead additive for gasoline that is being banned all over the world. The stock has been hammered since 1998, when it was selling for more than $8. You can buy it today for less than $2 – a price only 2.2 times earnings.

*** Markets do not go straight down. After hitting a high in 1966, for example, prices went up and down for years… while inflation lowered their real values. Finally, the market fell apart in 1973 and did not recover in real terms until the early 1990s. Investors waited a quarter of a century to get even.

*** Daily Reckoning readers will remember just 2 weeks ago Lynn Carpenter forecast the Nasdaq would reach 1800 by summer. Will she be right? We’ll see… we’ll see…

*** “The break below the important psychological benchmark 2000,” says John Myers, “will prove troubling – very troubling – for the journeyman investor and his 401(k). By contrast the Canadian gold and precious metal index is at the cusp of breaking long-term resistance and is threatening to break through its 52-week high. The index, which touched below 3500 last November, is now standing at 4700.”

*** “The Japanese may do it…But America doesn’t rig its markets,” writes John Crudele, rhetorically, in the NY Post. Or does it? Crudele points to Peter Fisher, an important member of the Federal government’s Working Group on Financial Markets (a.k.a. the Plunge Protection Team) as the man who can save the day for Wall Street. How? “He and the Bush administration need to inject money directly into the market,” advises Crudele. “They need to buy the heck out of stock index futures contracts, which will give a lift to the entire equities market.” More below…

*** MSNBC surveyed the nation’s reaction to the slump, finding that “business leaders…say they are weathering the storm.” The storm they must be referring to is the one that has not hit yet. “Consumers Still Spend” says the International Herald Tribune headline. “The bear market in equities so far has had surprisingly little impact on the broader economy,” the article says… “largely [reflecting] the fact that the stock market weakness has been concentrated in a technology sector that most analysts now agree was vastly overvalued.” Those analysts…always on the job.

*** Yet, “we think it’s virtually inconceivable that the stock market’s plunge won’t lead to a significant weakening in consumer spending,” said an economist to the IHT reporter.

*** Debt as a percentage of disposable income for the American consumer has risen from just over 15% to nearly 22% since the last recession in the U.S. In part, the increase is driven by aggressive marketing of credit cards by companies actively engaged in ‘adverse selection’. “Capital One,” for example, writes Eric Fry, “increased its account base by over 40% last year, to 33.8 million accounts. Providian did not trail far behind, boosting its account base 31% last year, to 16.3 million accounts.” But as the economy slows payment delinquencies on these accounts are on the rise. Look for these ‘cyclicals’ to be the next round of companies to miss their numbers.

*** “Trading with pariah states, manipulating the market for huge personal gain, hiding profits in a thicket of offshore companies…He sees himself as a citizen of the world, unencumbered by the laws of sovereign nations.” Thus does the IHT describe Marc Rich. Sounds like a decent enough fellow; too bad he had to get tangled up with Bill Clinton.

*** “Hoof and Mouth Disease in France!” screams today’s Figaro’s headline. Frantic efforts to prevent an outbreak in Europe failed as the first case was confirmed yesterday. The US banned animal imports from the EU. The EU banned imports from Argentina. Uh oh…I may have to smuggle my pigs home under cover of night.

*** Daily Reckoning readers, while certainly not as astute as your average IHT reporter, are proving themselves quite adept at just the kind of pseudo-intellectualism I admire. Currently, on the discussion board on the DR website, readers are debating the proper way to conjugate Latin verbs, an inquiry into the derivation of the symbols “Bear and Bull” as pertains to stock market prejudices and a correction regarding my use of a quote by Ecclesiasticus Maximus… not exactly the kind of profitable stocks tips most ‘investors’ are wont to find on these boards, but entertaining all the same…

The Daily Reckoning