The Post-War Period
On occasion, we’re tempted to ask: is this time really different? You bet! answers Ray DeVoe, but not in any way "New Era" dreamers would like to hear…
I have been keeping a list of the stupidest things said on CNBC. The list is lengthening. But the one that gets into my mind the way those "Golden Oldies" do are the comments that start with something like: "In the postwar period, the economy (or stock market) has always (or almost always…)" …and then they go into what either always, or almost always, was done in the period since 1945.
To fill in some of the blanks following those "postwar period" lead-ins: "[The economy]…responded to Federal Reserve interest rate cuts and was recovering 6-9 months later"; "[The market] anticipated the recovery and was substantially higher when the economy bottomed"; "[The stock market] was X% higher on average six months after the economy turned Y% higher a year into recovery)"; "bear markets average about 11 months, so we should be…" etc.
My reaction to this is the same as when the people on TV state something like, "The stock market has been higher 65% of the time on the Friday following Thanksgiving, so there is a 2-to-1 probability that it will rise on November 29, 2002." This goes into my "Rule (or, Misrule) of History", which goes, "If the stock market regularly repeated past patterns, the richest people on Wall Street would be librarians and historians – and that’s just not true."
My reaction to those "postwar period"-citing analysts and strategists is: what is so special about the postwar period? Why should the period since World War II ended in 1945 mean that everything will follow those economic and stock market patterns?? How do they summarily dismiss everything that happened prior to 1945??? Could it be that what is going on now is quite different from "postwar period" conditions, that it really is different now????" For the latter – think theme music from "The Twilight Zone" – all is not what it appears to be. Recently, I did an interview for the December issue of a financial magazine profiling "The 30 Smartest Investors on Wall Street." I don’t know how they got my name, since I have done very little personal investing – and my attempts at bottom-fishing have not been particularly successful. I asked who the other 29 were – I couldn’t imagine that many brilliant people this year, since "Genius is a strong bull market", and the opposite is true of a bear market. The interviewer wouldn’t name the others. Since the article was for the December issue, I told her that the Annual Wall Street Christmas Pageant had already been cancelled – they couldn’t find three wise men, or a virgin.
I was asked who the smartest person was I had met in the investment world. That was easy: my professor and guidance counselor at Columbia Business School, Prof. David Dodd of Graham and Dodd’s Security Analysis. Then she asked what I thought was the best book about investing, and why. I thought about it, and answered the question somewhat differently – if there was one book that every novice investor should read, my nomination would be Manias, Panics, and Crashes – A History of Financial Crises by Charles P. Kindleberger.
Why? Behind my reason was the fact that before you can drive a car or fly a plane, you have to have a certain amount of training with an experienced instructor. Then you have to take an examination and a test drive or flight, where you can fail, before you get your driver’s or pilot’s license. For the latter, you also have to keep up with continuing education. To qualify for night, instrument, or non-visual flying, you have to take additional instruction.
Yet neophyte investors, some unable to articulate the difference between a stock and a bond, are allowed to "pilot" their life savings and/or intended retirement portfolios without any form of instruction or training. All they have to do is open a brokerage or mutual fund account and give some (frequently confused) indications about their financial resources and investment objectives. Since this neophyte investing is almost always started in favorable weather, a bull market, they are totally unprepared for what might happen when a storm arrives.
Worse, they have been conditioned (brainwashed?) into believing the mantras of "buy on the dips", "hold for the longer term", and that "there is no long-term risk in stocks, only short-term volatility".
Mr. Kindleberger’s book may not prevent people from making financial fools of themselves, or losing a lot of money. But it will give a new investor a warning and a sense of history. Manias are nothing new and have occurred regularly. However, the one that popped on March 10, 2000 (Nasdaq Composite 5048), others that may be hssssing now, and the housing bubble to deflate some time in the future, in combination, may constitute the largest financial mania in history. A new investor reading Manias, Panics, and Crashes would be alerted to the fact that no mania goes on forever – that some have panics, some have crashes – and others can be followed by years, sometimes decades of stocks going nowhere. I always point out that in the 18 years prior to this bull market (1964-1982), the Dow Industrials sold in the 800-900 area at some point during the year.
This may not prevent a new investor from being caught up in a mania, but at least they would be aware of what always happens (i.e. there is never a "New Era") and possibly get out in time or limit their losses. "The market always comes back," another mantra, has been true – but it took 25 years to do that after the 1929 peak. Still, many stocks do not come back. I knew a man who bought Radio Corporation of America (now part of GE-$25.28) in 1928 when it was the cutting-edge technology growth stock of the time. It tripled to the 1929 peak. He held it for over 40 years, until the color TV mania of 1968, so that he could break even. Others were not so fortunate, since thousands of stocks were wipeouts. Overstaying a mania, particularly "holding for the longer term" has approached an ominous point now. Today’s Wall Street Journal has an article by Ken Brown titled "Investors Seem No Longer To Be Big Dippers" that indicates investors no longer "buy on the dips" – but rather, could be poised to sell if the market declines further. James Bianco of Bianco Research tracks the profits and losses of equity mutual fund investors since the final stage of the bull market began in 1990. "When the market hit bottom earlier this month, falling to five-year lows, mutual fund investors, in the aggregate, had a slight loss on all the money they put into domestic stock funds since October 1990", Mr. Bianco reports.
The low point that month in 1990 on the Dow Industrials was 2365.10, vs. 8443.99 now. The reason for the near break- even condition of equity mutual fund investments, with the Dow Industrials 257% higher than 1990, is that very little money was invested in the earlier stages of the bull market, when values were more reasonable. Most investments were made near the top – in 1998 and 1999. In addition, large amounts were switched into previously "hot" mutual funds just as they peaked. Mr. Bianco cited his "casino theory": that investors are much more aggressive with stocks when they have large profits ("playing with the house’s money") and are more likely to become very conservative when their own capital is at risk.
Following my magazine interview, I decided to take my own advice and re-read Mr. Kindleberger’s book. It’s not long, just 197 pages before appendixes and footnotes. My first edition copy (1978) is looking rather dog-eared, marked-up, and the paper has turned orange – so I bought the 1996 third edition. It has an ominous quotation from Prof. Paul A. Samuelson of Massachusetts Institute of Technology (MIT) on the paperback’s cover: "Some time in the next five years, you may kick yourself for not reading and re-reading Kindleberger’s Manias, Panics and Crashes." It took only about four years from 1996 to March 10, 2000 for people to start kicking themselves about Nasdaq. The first three chapters, entitled "Financial Crisis: A Hardy Perennial", "Anatomy of a Typical Crisis" and "Speculative Manias", document almost four centuries of boom-and-bust financial cycles.
The main difference in the third edition is that it includes the rise and fall of the Japanese stock market and property boom in the 1980’s – and the bust that followed-up to 1996. In his "Introduction to the Third Edition", Mr. Kindleberger warned "….and what looks, in the fall of 1995, suspiciously like a bubble in technology stocks." In the book he lays out the classic pattern of boom-and-bust cycles. 1) a fundamental change, such as war or new technology occurs – which creates new investment opportunities, 2) investment expands, often fueled by easy bank credit, 3) investment becomes more speculative, based on overoptimistic expectations of potential growth and earnings, 4) in the latter stage, investment is totally detached from reality and becomes a mania, frequently spreading globally, 5) the excessive borrowing to finance overinvestment brings about excess capacity – and a collapse in prices, 6) eventually the mania ends in a crash, with widespread investor revulsion as investors flee falling markets, and 7) authorites are then left with the problem of how to stabilize and then fix the financial system, with the discovery of extensive corruption and financial manipulation.
Sound familiar? Appendix ‘B’ at the back of the book is entitled "A Stylized Outline of Financial Crises, 1618- 1990" and lists 42 "crises" that occurred during that period. Only four of them are in the "postwar period," including the Japanese speculative peak of late 1989. These "crises," not necessarily recessions or bear markets, include the OPEC-induced recession caused by the embargo and quadrupling of crude oil prices in 1973, the Federal Reserve-induced recession of the early 1980’s to bring double-digit inflation under control, and the "panic" of October 19, 1987, also related to the Fed’s raising interest rates to suppress inflation.
Raising interest rates is what started the decline from the peak of 2722 in the Dow during August 1987. The 508 point decline of October 19th was brought about by a combination of other factors – including the estimated $90 billion in stocks that was "protected" by portfolio insurance. When the triggers were hit on this huge amount of stock, massive dumping occurred, and it overloaded the system. Actually, the one-day decline could have been worse, in my opinion, if the options and futures’ traders had continued to make a market. Instead they disappeared – removing the other side of the "insurance", – and stocks that should have been sold were removed from the market. He labels that a "crisis", which was a one-day bear market, but no recession followed. Thus, two of the three U.S. postwar "crises" were attributable to exogenous variables.
In any case, almost every one of the pre-1945 "crises" listed in the Appendix to Mr. Kindleberger’s book are of the "boom-and-bust" variety. And virtually every recession since 1945 in this country has been brought about by the Fed’s raising interest rates to suppress inflation. Question: how many major stock market bubbles have occurred in "the postwar period?" Only one, during the 1990’s.
There have been other speculative manias, but they were confined to individual sectors – I can list at least four in technology (or, in "The Great Garbage Market of 1968," anything that appeared to be technology, or had a name that suggested it. That was similar to the "dot-com" mania when companies added ".com" to their names and the stock prices soared.) There were others in bowling stocks, uranium, airlines, color TV – but they were confined to those sectors. When the bubbles burst, the major damage was generally limited to the participating stocks, with some fallout. There is always some spillover, since when a bubble bursts, many of those former high-flyers are virtually un-sellable. The liquidity disappears, and large- capitalization stocks with good markets are sold instead.
This time, it really is different. This is not a "postwar period" type situation – it is a "post-stock-market bubble period." The London Economist in a 28-page pullout ("The Unfinished Recession – A Survey of the World Economy, September 28, 2002") points out about Central Bankers: "They do not seem to grasp that this economic cycle is different from its predecessors". As they state, "postwar recessions have been principally the result of increasing inflation. Last year’s recession and current economic stagnation are not the result of inflation, but the result of burst economic and stock market bubbles." This is the first of that type in the entire "postwar period" – and why the economy has not responded to 11 interest rate cuts – which has always stimulated traditional Fed-induced "postwar" recessions and brought about economic recovery.
Thus, this is not a normal, "garden variety" postwar recession. This is more comparable to the traditional boom- and-bust "crises" Mr. Kindleberger has documented for about 400 years. The late Rudi Dornbusch, another MIT economist, once remarked that "none of the postwar expansions died of old age; they were all murdered by the Fed". With the exception of 1973-74, which was due to exogenous variables (OPEC’s embargo and the quadrupling of oil prices) – and the current ongoing experience, every recession since 1945 was preceded by a sharp rise in inflation that forced the Fed to raise interest rates to cool off the economy. There were always two policy errors – allowing the economy to overheat in the first place, then hitting the brakes too hard.
That Economist pullout "The Unfinished Recession" is another suggested reading, not only for a post-mortem of the 1990’s bubble, but for a sober assessment of the current state of the U.S. and world economies. As they state in the introduction, "This is no traditional business cycle, but the bursting of the biggest bubble in America’s history. Never before have shares been so overvalued. Never before have so many people owned shares. And never before has every part of the economy invested (indeed, overinvested) in new technology with such gusto. All this makes it likely that the hangover from the binge will last longer and be more widespread than is generally expected."
This "post-postwar period" is different from the other recessions and recoveries since 1945. This is the only time that a bubble in both the stock market and economy has occurred in 73 years, and burst. As pointed out previously in other reports, investment has fallen for seven consecutive quarters. That’s the longest in the entire "postwar period". Stocks haven’t fallen for this long in that same span. Household net worth rose every year in the "postwar period", until 2000 – and is likely to shrink this year for the third year running. But most significantly, never during the "postwar period" have we had the unwinding of a massive speculative bubble.
for The Daily Reckoning
December 19, 2002
P.S. Those limiting their analysis to the last 57 years are arbitrarily ignoring all previous history of financial crises – as documented by Mr. Kindleberger’s analysis of almost 400 years of "crises". This is an economic "Twilight Zone" fluctuating between recession and recovery – with very poor visibility. It will be different – not necessarily better, or worse, just different – and will take longer to recover from than is generally expected.
Editor’s note: Raymond F. Devoe, Jr. is the writer, editor and creative genius behind The Devoe Report, published by Legg Mason Wood Walker. Ray is also a frequent contributor The Daily Reckoning and:
The Fleet Street Letter
Watch out, Bernanke; Mr. Market fights dirty.
Stocks went down – led by the techs. And the dollar "drifted lower." The British pound, for example, rose to over $1.60, its highest level since 2000.
We can’t prove it, but we think Mr. Market may be wearing gold knuckles.
The Canadian dollar, the ‘loonie’, rose to .6456 cents. The Australian and New Zealand dollars have risen nicely against the U.S. brand, with the Kiwi buck at a 3-year high. But the biggest change has come from South Africa, where the rand has gained 37.7% since the beginning of the year.
Why are all these currencies doing so well against the greenback? They are all natural resource exporters…and most are major gold producers, especially South Africa.
Gold itself shot up $4.20 (Feb. contracts) yesterday.
"People are exiting U.S. dollars and looking at alternative investments," said an economist at Westpac to a Reuters reporter.
Bernanke & Co. can destroy the dollar. But it will cost them. Investors would go elsewhere…taking their money with them. Wall Street would collapse. Americans’ standard of living – which depends heavily on foreign investment – would fall.
Bernanke hopes he can destroy the dollar just a little and avoid these problems while still holding off deflation. And we are the first to admit; anything’s possible. But so far, in this opening phase of America’s long, soft, slow slump, Mr. Market’s gold has been a better investment than Wall Street’s stocks or Bernanke’s dollar. This trend may have years more to go before it runs its course.
And now, over to Eric, just returned from Latin America:
Eric Fry, back in Manhattan…
– While it’s true that my body has returned from Nicaragua, my mind is still drifting somewhere around the 12th parallel north of the equator…It’s difficult to forget the soothing combination of sun, sand, stunning views and superb food, all of which Rancho Santana offers in abundance…More about that unique refuge in a moment.
– Meanwhile, just north of the 41st parallel, near the corner of Wall and Broad, investors found no refuge whatsoever. Stocks fell for the second straight day, as the Dow lost 88 points to 8,447 and the Nasdaq slipped more than 2% to 1,361. The shares of semi-conductor maker Micron headed up a long list of losers by tumbling 23%. It seems that the erstwhile tech-stock icon will lose even more money than previously forecast, which means that the "impressionable" investors who bought into the semiconductor-recovery story will also lose more money than forecast.
– The "semiconductor recovery" has to be one of the most enduring myths on Wall Street. About once a year, the myth emerges from hibernation, mauls a few investors and then returns to its den until the following year.
– Back in the early fall, many Wall Street analysts predicted a recovery in the semiconductor sector. But, as usual, no recovery has materialized. Quite the contrary, as Apogee Research recently observed: "Novellus Systems Inc. (NVLS) is hearing increasingly glum news from the semiconductor industry, but you’d hardly know it from watching NVLS shares trade. Last week, the Semiconductor Equipment and Materials trade group (SEMI) said that total equipment sales this year will plummet 32.4% below last year’s level of $28 billion.
– The group forecasts a ‘recovery’ in demand during 2003, but the so-called recovery is for industry sales of $21.8 billion, which would still be 22% below the 2001 level. In fact, expectations for $26.4 billion of sales in 2004 and $27.5 billion in 2005 still wouldn’t match the 2001 level. Yet NVLS trades at over five times trailing 12-month sales and at 3.3 times its peak fiscal-year 2001 sales. How can that be, we wonder, when the industry is not expected to revisit such levels for at least three more years?
– "Since October, the shares of nearly every company remotely related to the chip industry have risen to valuations that suggest the boom-time party is about to resume. Trouble is, the punch bowl remains depressingly empty." Little wonder that Apogee has taken a very dim view toward the shares of Novellus.
– While many stock market investors are licking their wounds, commodity investors are licking their chops. Life is sweet in the commodity sector these days. Gold and oil both soared to new multi-month highs yesterday. Crude oil for January delivery climbed as high as $30.44 a barrel, a new two-year high. Over on the Mercantile Exchange, gold put on another sparkling performance by jumping $4.70 to $342.70 an ounce.
– Two years ago, only gold bulls under the age of twenty dared to imagine that the yellow metal would clear $340 per ounce within their lifetimes. In the opinion of most market "experts", this was not supposed to happen. According to the official Wall Street script, gold was supposed to shrivel up and die while stocks soared ever higher. Instead, gold, oil and numerous other commodities are soaring, while stocks are struggling. Apparently, Mr. Market likes to ad lib…
– If Rancho Santana had been equipped with an Internet connection, you would have needed a crowbar to pry me out of the place. I could have been, "Eric Fry, our man in Nicaragua," instead of "…our man in New York." Unfortunately, Rancho Santana is currently without a connection to cyberspace. However, an Internet connection is coming soon to this remote refuge…I’m happy to be back in New York with my family, but staying in Nicaragua for a few more days wouldn’t have been a BAD thing.
– On my way down to Nicaragua, via last week’s Supper Club meeting in Orlando, I met Larry Holmes, one of the very first residents of Rancho Santana. Larry spends several months a year in his beautiful home overlooking Rosada Beach. He also owns 11 other lots inside Rancho Santana. So Larry is something of an expert about the place. When I asked him how he liked it down there, he replied, "It’s heaven on earth."
– I was skeptical. But after seeing it firsthand, I’ve been converted. Even if Rancho Santana is not quite heaven on earth, it is at least a spectacular purgatory…More tomorrow.
Back in Paris…
*** We are back at our respective desks – Eric in New York and Bill in Paris – but it is as if we never left. Refinancings rose in the latest reported week…vacation homes are selling well…and Wall Street is as bullish as ever.
*** Conseco went Chapter 11 – the 3rd biggest bankruptcy in U.S. history.
*** China announced that its entry into the car business is going faster than expected – with production at the 1 million/year mark. The first few million cars will be sold to the domestic market, while the Chinese improve the quality of the cars and the their own marketing. But how long will it be before these cheap China-made automobiles reach California?
*** California faces a $35 billion budget deficit. Washington State is looking at a $2 billion shortfall. Over on the other side of the continent, New York City ran budget surpluses in the last 2 years. This year, it has a $1 billion deficit to deal with. And next year, the deficit is expected to rise to $6 billion.
In writing our new book, we realized that never before has government displayed such a keen interest in markets and the economy. The politicians, of course, have to face the voters of Shareholder Nation every couple of years. What’s more, their budgets depend directly on how much revenue they get in income and capital gains taxes, and indirectly on how much they can squeeze out of the economy.
No wonder Bernanke, Greenspan, Bush et al are so unwilling to let the economy take a rest; they need the money…and the votes! No wonder government is so ready to intervene in the economy, promising voters gain with no pain, progress without savings…economic resurrection without recessionary crucifixion. But what a pity, too – their meddling only makes things worse.
*** Booms and busts during the 19th century came and went quickly; hardly anyone noticed. Capitalists were rich and few. Who cared if they went broke? But then, the democratization of media, government and the capital markets brought more and more voters and small shareholders. Soon, both government and markets came under the control of crowds…and began to act like all mobs – reckless, stupid and desperate.
The little guys were perfectly happy to join the real capitalists in the profits. But they couldn’t stand losses and demanded that government ‘do something’ to protect them. Creative destruction is all very well, provided no one gets hurt! So, now we have the SEC, the FED, safety nets, bureaucrats by the thousands and laws no one reads or understands. And now we have a new kind of capitalism without real capitalists. Today’s big investors are collectives – mutual funds, pension funds, endowment funds. And now the bubbles are bigger than ever…and the corrections take longer!
*** "We heard from Pierre the other day," Elizabeth reported last night. "Mr. Laporte died."
*** "And I got a letter from my friend Joan," added your editor’s mother, with more bad news. "She went to a funeral for her sister’s father in law. They were all standing around at the funeral waiting for the sister and her husband. But they never showed up. It turned out that the sister’s husband was so distraught over the death of his father, at least we imagine that that’s what it was, that he killed his wife and then shot himself."
"Joan is so nice," she continued. "What a shame things like that happen…"
*** What a shame, we repeat. But maybe Bernanke and his band of miracle workers can bring them all back to life?