The Last Enron
It is said that God gives people what they need, not what they want. Markets have more of a sense of humor. They like to toy with people a bit… giving them the impression that they are going to get what they want… and then giving them what they deserve, good and hard.
The smartest men on the planet (they had Nobel prizes to prove it)… with access, proportionally, to more of the world’s money than any other group in history… still managed to blow themselves up. And they did so in the middle of the greatest boom ever.
This series of letters began by reviewing the extraordinary achievements of the people behind Long-Term Capital Management. If the world’s smartest couldn’t save themselves, we wondered, what might we expect from others?
Along came the Enron tale. It was a "sex-drenched" atmosphere, says the cover of Newsweek. It bred a "culture of corruption", says a U.S. senator. Each medium describes the Enron story in terms familiar to it.
Newsweek readers are left to imagine the Enron debacle as the product of a power struggle between senior executives in a freewheeling corporate environment. Fast cars. Fast money. Fast women. Is a TV series in the making?
Senator Dorgan believes he has spotted a flaw in capitalism, one that can be corrected by political intervention. "We are determined to understand what happened at Enron Corporation," he says, "and to learn… what if any new policies are needed to ensure that this kind of collapse, under circumstances that enriched those at the top and wiped out the life savings of those at the bottom, never happens again."
During the 1930s, the federal government came to the aid of American workers with laws that effectively stiffened the labor market. In the early 2000’s, will it not succor American stockholders with legislative chutzpah?
The ups and downs of the credit cycle are familiar to few people. Yet, it is there, we believe, that the Enron story makes most sense… and provides the most predictive power.
Contrary to the senator from North Dakota, we suspect that the Enron story is not a show that can be shut down forever… but one that reappears, like a Greek tragedy or sitcom plot, when the public is in the mood for it. Like sex itself, Congress may pass a law making it illegal – but it cannot make it unpopular.
What put the public in the mood for Long-Term and Enron was easy money. Of course, money doesn’t get easy all by itself. It takes a combination of things: the experience of investors over the last few years, the press, the government, the financial industry – all have to blow together to puff up a major bubble. To summarize today’s letter for you, dear reader: we believe that if they blow hard enough and long enough, they will blow up not just a New York hedge-fund and a group of Houston energy traders… but an entire economy.
In the course of the last two decades, accountants invented new ways of reporting numbers. Auditors found reasons for not looking at them very closely. And analysts discovered that their careers were improved by viewing the numbers in the best possible light.
Meanwhile, government statisticians were encouraged to crunch GDP, productivity, and CPI numbers into more likable shapes. Rarely, in private or public sectors were pencils ever sharpened.
But anyone who wanted to look carefully would have seen that the numbers that really mattered got worse. The public went into debt as never before. Credit card debt levels reached new heights. Mortgage debt, too, reached never-before-seen levels.
Foreign manufacturers have been delighted. They increased sales to the U.S. at such a rate that the gap between what Americans buy from overseas and what they sell has widened to nearly $1.5 billion per day! "Unsustainable" is the word economists generally use to describe such a condition… yet almost no one seems to worry about what will happen when foreigner investors eventually refuse to sustain it.
In the corporate sector, the story was the same. LTCM and Enron made the papers only because they did spectacularly what others did more modestly. Throughout the business sector balance sheets deteriorated. IBM, for example, traded at only $20 a share in ’96. Today, it is nearly 5 times more expensive. Meanwhile, the company added $5 billion to its debts, an increase of nearly 25%. Sales have gone up too… but only about half as much.
As reported here previously, GE’s debt to capitalization ratio is 120 times higher than it was in ’29. But the company is even more popular with investors.
Businesses added debt – generally, to make costly acquisitions – while neglecting real investment in capital assets. Other than information technology, which has yet to prove itself, US industry declined to make the kind of investments that might produce greater future profits – new factories, new products, new and better tools. In the late ’90s, business investment, net of depreciation, increased only about 2%.
Instead, the titans of industry flattered themselves with the belief that they had developed a higher quality of management which could deliver shareholder value as never before. Americans believed them. For the first time ever, the value of their publicly-traded companies exceeded 150% of GDP.
Of course, the Enron story gives us a peek at what the new, enlightened management was really doing. It is an interesting tale, but the storyline is hardly novel. Enron executives, it turns out, did what managers sometimes did even before the new economy reached Houston; they enriched themselves at the expense of investors.
Nor did they or their colleagues in other businesses really manage to increase profits. Instead, they destroyed them.
"When the economy sharply slowed in the course of 2001, the poor profit performance turned into an outright profit disaster," writes Dr. Kurt Richebacher. Profits in the 3rd quarter of 2001 were below the level of 1995.
"Profit margins are at their lowest levels since the Depression of the 1930s," Richebacher continues. "Moreover, there is nothing in sight that might reverse this progressive profit erosion."
But who noticed? Who cares? The recession is over, says Greenspan. It never happened, says O’Neill.
And even as the economy was supposed to be being purged by recession – in 2001 – the debt build-up continued. Debt increased by roughly $2.3 trillion during the year. And broad money (M3) increased by about $1 trillion – or at a 13.5% annual rate, nearly 9 times faster than GDP growth.
The consumer increased spending last year too – by 6%. His income increased by less than half that amount. But at least his home went up in value. If only he could turn it into a security and sell it to a foreigner!
There may be hundreds or thousands more Enrons. Searching for them, an investor is likely to miss the point. At the top of the credit cycle, US investors thought they were getting what they wanted. Easy money drove up the prices of almost all their assets – stocks and real estate, primarily – while it made their debts an afterthought.
But nothing lasts forever. When the cycle shifts against him, the typical American investor will find his assets marked down sharply… while his liabilities, suddenly, are headline news.
Your devoted correspondent,
March 08, 2002
The dollar fell yesterday. Is the world finally realizing that America’s stock is too high? Maybe. Curiously, the price of gold did not rise.
"During the ’70s," Lord Rees-Mogg reminded me when we dined on Wednesday night at the Garrick Club, "the price of gold shot up from $30 to $800. That shows you the potential. Sooner or later, there will be another bull market in gold. If the pattern of the ’70s repeats itself, the price of gold will go from $300 to $8,000 an ounce."
But inflation worries no one. The Future Inflation Gauge of the Economic Cycle Research Institute hit its lowest level since August 1975 recently. Not for a quarter of a century have inflation expectations been so low.
Instead, it is deflation that economists are beginning to anticipate. January’s increase in the CPI, according to ISI, was the smallest since 1965. The cost of living rose only 1.1% year over year. Wholesale prices fell in January, says ISI – down 2.8% year over year. Not in half a century has the PPI fallen as much.
Even prices fall… the price of gold may still rise. Deflation makes it harder for debtors to make good on their obligations. Creditors begin to worry less about the return on the money and more about the return of their money. Financial assets get marked down relative to their exposure debt. But gold owes nothing to nobody. It went up in price in the nation’s last great deflation of the ’30s and will likely do so again.
The Treasury’s inflation-indexed bonds sell for a premium of only 1.42% for the 5-year securities. Bond buyers are not worried about inflation. Nor are they worried about deflation. Bond prices fell yesterday, as investors seem to believe that the recession that didn’t happen is now over. Higher interest rates are said to be forthcoming.
But bond buyers have been known to err on occasion. And the number crunchers at the Labor Department are neither beyond error nor above reproach.
A prudent investor, alert to the possibility of mistakes, might want to hold some gold – just in case. Eric, what’s happening on Wall Street?
Eric Fry in New York…
– The stock market took a breather yesterday, but the yen, crude oil and unleaded gasoline rushed in to fill the void with breathtaking performances of their own.
– The Dow dropped 49 points to 10,525, weighed down by normally reliable stalwarts like Microsoft and GE. The Nasdaq throttled back about half a percent to 1,882.
– But there was plenty of action over in the futures pits. The Japanese yen put on its biggest one-day gain since October of 1998, advancing nearly 3% against the US dollar to 127.34. The Nikkei’s sparkling 10% rally over the last few days seems to be the driving force behind the yen’s gains.
– While the yen sparkles, the oil price gushes. West Texas Intermediate Crude oil surged to a five-month high of $23.71 a barrel.
– Unleaded gas is also soaring. And that ought to put a big smile on the faces of subscribers to John Myer’s Resource Trader Alert. About one month ago, John’s service recommended buying a call option on unleaded gasoline, and that option has already jumped more than 75%.
– "Post-9/11 fear of flying could mean crowded highways this summer," Myers wrote on February 4th. "In fact, the 2002 driving season just may be one of the busiest on record. More driving means more gas and a rising gasoline demand during the summer. Prices, however, tend to peak much earlier. I took a look at gas prices going back to 1989. Only once did prices fail to rally in the spring."
– Furthermore, John reasoned that gasoline supplies were low enough that any supply disruption, or stronger-than- expected demand, would cause prices to jump higher… just like what’s happening now.
– Speaking of outsized gains, US retailers enjoyed their largest monthly sales gain in almost two years, according to the Bank of Tokyo-Mitsubishi. Same-store sales jumped 6.2%, spurred by a stunning 10% sales increase at Wal-Mart.
– "Americans like to go shopping," said one analyst matter-of-factly. Yes they do. But they don’t like paying their credit card bills. So even though the recession that never occurred is now ending, the unemployment that did occur is still continuing… And that might restrain consumer spending just a bit.
– "We aren’t the only nay-sayers in the Land of Oz," writes Andrew Kashdan of Grants Investor (now named Apogee Research). "Stephen Roach, the Morgan Stanley economist, who often hears himself described as ‘gloomy,’ is still putting a high probability on a double-dip scenario (60%, he told The Wall Street Journal this week). He pointed out the obvious to the Journal: ‘You can’t have a double dip without positive growth, and before any double dip, it always feels like you’ve come out of the recession.’ In his own commentary from Morgan Stanley, Roach went on to say: ‘Even if I’m wrong on the double dip, I see the recovery outcome as decidedly sub-par – well below the growth trajectory evident in the current quarter.’"
– An economy that merely stumbles along will not produce nearly enough earnings growth to justify the market’s rich valuations, according to Laurence Tisch, chairman of Loews Corp.
– "After Sept. 11, I thought anything you bought was OK," Tisch said in a recent interview with Bloomberg News. "Now everything you sell is OK."
– The bearish billionaire does not shy away from putting his (or his shareholders’) money where his mouth is. Unlike most public companies, Loews openly speculates on the stock market with a portion of shareholder funds.
– "The company reported investment-trading losses totaling more than $1 billion in the years 1998 through 2000," says Bloomberg, "most from bets that stocks would decline. Loews’ net investment gains were $792 million last year.
– "Asked about his contention that stocks are overpriced, [Tisch] turned to two flat-panel computer screens in his Madison Avenue office to make his point. Cisco Systems Inc., even with its value sliced by three-quarters since its 2000 peak and its sales down four straight quarters, trades at 52 times projected annual earnings, he noted.
– "And Cisco’s earnings are overstated, he said. Like all companies, the network-equipment maker isn’t required to account for stock options in its earnings. Were options included, as Tisch and some in Congress want, Cisco would trade at about 100 times earnings, he estimates."
– "[Tech stocks] are just as cyclical as cyclical stocks of the past," Tisch winds up. "Why are they entitled to crazy multiples?… I wouldn’t be surprised to see [the Nasdaq] break 1,000. I’m not saying it will, but I wouldn’t be surprised."
Back in Paris…
*** "The contraction phase of the business cycle has not drawn to a close," Alan Greenspan told the senate yesterday, as if he knew. The recovery is "well under way."
*** Productivity rose at a 5.2% annual rate in the last quarter of 2001, nearly 5 times the rate of the previous 3 quarters.
Good news? Yes, if you believe it. Stay tuned…