This Time It's Different
This week we are going to start a multi-week series centering on a debate that began when Bill Bonner joined John Mauldin and the gentlemen from GaveKal Research for dinner. It is one of the most important debates of this era, as not only does the outcome of the debate touch every part of our investment lives, but it also affects the very social and political worlds we live in. Read on…
A few weeks ago I mentioned a small dinner party in London hosted by Charles and Louis-Vincent Gave, the Gaves of GaveKal Research. They are quite bullish about the longer-term prospects for the world, and as we will see below, argue that something new is happening that may not rhyme with our past economic history. Long time readers know I like history. It is an old friend. It is a very uncomfortable proposition to hear things may be different, as they argue it well. Feeling like having a little fun, I invited Bill Bonner to dine with us, knowing that he takes the very opposite view. With wives and friends there were ten of us. I made certain that Bill sat next to Louis and Charles, knowing his natural inclination to sit next to the ladies which would have been more fun for him, but would have produced no fireworks.
But first, let me thank those of you who bought my new and latest book, Just One Thing, last weekend. For those of you who missed the announcement, I have gotten 11 of my friends to write a chapter on the one investment topic they are most passionate about, and of course, contributed my own chapter.
The discussion at dinner began as Charles and Louis suggested that trade deficits no longer matter. Bill’s eyebrows shot up and he rose to the occasion, coming back with his own arguments. It went back and forth for a few minutes, with your humble analyst egging all of them on. (It was good fun, and Louis was picking up the check. All in all, a most delightful meal at a very great restaurant.)
Our Brave New World: “But It’s Never Different.”
“You’ve got to be kidding,” Bill announced. “You are saying that this time it’s different.”
“That is precisely what we are saying,” shot back Louis.
Bill looked at them like he was seeing someone from outer space. “But it’s never different,” he proffered.
Then Louis gave us a copy of his new book, called “Our Brave New World” where they outline their reasoning. I knew that in Bill’s new book, Empire of Debt, which is subtitled “The Rise of an Epic Financial Crisis” he and co-author Addison Wiggin make the exact opposite argument. History will indeed rhyme and lead to a serious financial situation, destabilizing the global economy.
Now, let’s start with this quote from the introduction of Our Brave New World. It sets the table nicely.
“History never repeats itself; but it often rhymes.
“This simple fact explains why so many financial analysts, market strategists and portfolio managers like to study past economic cycles and market reactions before taking investment decisions. By studying financial and economic history, market participants are able to anchor beliefs on solid facts.
“The reason so many analysts drag their feet in admitting that history has failed to rhyme this time around is that it would lead one to the dreaded conclusion that ‘things are different this time’. But why is this a dreaded conclusion? Because anyone who has spent ten minutes on a trading floor knows that saying ‘things are different this time’ is:
1)the easiest way to get laughed out of a room,
2) the most expensive words ever pronounced,
3)the surest way to lose any kind of credibility,
“And yet, this is exactly what we aim to argue in the following pages.
“Arguing that ‘things are different this time’, we freely admit that we might end up drawing the wrong conclusions, say silly things and establish relationships where there are none. We also realize that some of our more cynical clients (say those sitting in Boston or London), might read the coming chapters and conclude that we have really been drinking the Kool-Aid. These are the risks when one ventures into uncharted territory. We accept these risks gladly, for we are convinced that the first step to successful investing is an understanding of the current world.
“Unfortunately, History is of little help to this understanding. We have to draw solely on logic, and the help of our friends and clients. With this in mind, we kindly ask that you contact us if you see a flaw in any of the arguments that we present. Again, this is a work in progress, the final aim of which is to help us understand the world we live in so that we can deploy our capital more efficiently.”
Our Brave New World: How Is It Different?
So, what makes it different this time? GaveKal suggests a number of things.
First, there is a new business model. Just as industrialists were new in the late 1700s, there is now a new model developing. GaveKal calls this new model “platform companies.”
The old model was to design or find something, manufacture it, market it and sell it. (Think Ford, Caterpillar, 3M, oil, mining.) The new model keeps just the high value added parts and ditches the rest. The new model focuses on research and development, treasury, marketing, and the business process and out sources as much of the low margin work as possible. Think Dell, Wal-Mart, IKEA, Li and Fung. Most hotel chains now do not own their properties.
The new model is to “produce nowhere but to sell everywhere….Platform companies know where the clients are and what they want and where the producers are. Platform companies then simply organize the ordering by the clients and the delivery by the producers (and the placing of their logo on the product just before delivery).”
Production is the least profitable of all the processes. It ties up capital, means a lot of volatile (and costly) inventory, it is labor intensive (and subject to all sorts of problems when there is a slowdown (unproductive labor costs) or a quick need for more product and overtime costs). The market does not give manufacturing companies the same investment multiple as they do the platform companies. Platform companies have more stable incomes and profits.
Who would you rather be? The Chinese and other Asian companies that make the iPod at a 2-3% margin or Apple who sells it at a 40% margin?
But this process means manufacturing jobs leave the developed world (the United States, Canada, Old Europe, Australia, New Zealand and Japan) and move to the developing world, primarily Asia and Eastern Europe. This is not seen be many observers as a good thing. Take for instance good friend Marc Faber’s recent writing:
“I am fully aware that some observers will argue that it doesn’t matter that U.S. companies are increasingly moving their own plants overseas, or outsourcing altogether, because the improved profits that result from the outsourcing accrue to the parent company… However, what about the long term? How beneficial is it going to be for Western industrialized companies if IBM were to lay off 13,000 people over the next twelve months in the US and hire 14,000 in India…I suppose even a non-economist could see that the movement offshore of sophisticated manufacturing and well-paid service jobs has to have some negative macro-economic consequences…”
And indeed jobs have been lost. But more have been found. Some would argue that we are seeing lower paying jobs, but the reality is that tax receipts, at least in the United States, are always and everywhere up, even as the Federal government cut taxes! No one pays more taxes than they absolutely have to. Higher tax receipts means people are making more money. Not everyone, of course.
Our Brave New World: Will the Model Pass?
Is the platform company model something that will pass or is it the new wave? GaveKal asserts that the model depends upon four things.
1. Free trade, so that products can be produced wherever costs are lowest.
2. Technological progress, especially in communications, which allows a company to decentralize its process.
3. Recurrent overcapacity in most industries, which allows the platform company to never run out of goods to sell.
4. The ability to move goods easily (needed infrastructure like airports, ports and highways).
The above items are all part and parcel of a capitalist economy. “So in a sense, ‘platform companies’ are the children of the capitalist system.”
And where does growth in a capitalistic society come from? It either comes from what is called Ricardian growth (from economist David Ricardo), or the growth that comes from a rational organization of talent, where each person contributes at his best level of skill. Countries that do not allow for free movement and advancement of its workers are less profitable than those that do. How much talent is wasted in countries that do not allow women to work, or do not educate their poor universally? Growth is clearly better when those with the best skills and services are allowed to thrive, free of protectionism. This is true whether it is on a personal level or on a country level. If China can manufacture something cheaper than is the case in the United States, then why should consumers be required to pay more? And if something costs less, then more of it will be bought. Thus Ricardian growth.
Yes, that does result in some workers losing jobs, but in a fluid and free economy, they find others. While some find jobs with less income, as noted above, incomes on average are up. And yes, we have fewer manufacturing jobs, but we are manufacturing more “stuff” than ever. We have become more efficient, as technology has made our manufacturing processes in the developed world more productive.
Then second type of growth is what Schumpeter calls creative destruction. It is the growth that comes from new ideas and inventions driven by entrepreneurs. New ideas mean new products that create whole new levels of demand. It can also mean that some products become obsolete. There was a time when my fax machine hummed all day. Now, we get 2-3 faxes a day, at most. I no longer have a home phone, as we all use cell phones. Things change. They go the way of the buggy whip.
For Ricardian growth you need low trade barriers. For Schumpeterian type growth, you need low regulations, low taxes, access to capital and the ability and right to fail. To the degree which countries encourage such things, they prosper or grow more slowly.
The real danger to the platform model? Governments and protectionism. As they point out, a Dell computer says “Made in China” but it is really more accurate to say assembled in China. It is made from parts and software from a score of countries. Of course, the “trade deficit” is counted as China’s. Yet, Senator Schumer regularly bashes China, appealing to his union supporters, but fails to notice things like this. Should we also get upset with Korea and Taiwan and Russia and Sweden and the rest of the countries who contributed? We live in a world where our ability to measure economic reality is becoming more and more limited.
In a world where the U.S. government counts Microsoft physical exports as “plastic” because the disks are plastic and only worth a few dollars at most (Dennis Gartman swears he was told this by a government official who was physically counting export shipping at a port), how can we trust the numbers?
for The Daily Reckoning
Novemeber 15, 2005
P.S. Today, we looked at some of the arguments in Our Brave New World (also co-authored by Anatole Kaletsky, the Kal in GaveKal).
It will take two weeks to cover GaveKal’s thoughts. Then we will turn to Empire of Debt, looking at Bill and Addison’s arguments.
Then I will weigh in with my own. I find there is merit on both views, but think there may yet be a third way to look at our world. And make no mistake, how you come down on this argument is critical. Because the investment strategies one would adopt if you hold these views are quite different. But wait until the series is finished before you tell me I am nuts.
John Mauldin is the creative force behind the Millennium Wave investment theory, author of the weekly economic e-mail Thoughts from the Frontline, JohnMauldin.com, and a private letter for accredited investors. As well as being a frequent contributor to Capital & Crisis and Strategic Investment, Mr. Mauldin is a New York Times best-selling author with a unique ability to present complex financial topics and make them understandable to the lay reader with insights into the current economy and hedge fund industry. His latest book, Just One Thing, is due out in December.
Today, on our way to work, we were stopped by a woman dressed as a banana. It reminded us of other odd people we have been privileged to know…about which, more below.
But such is the nature of our world that strange things happen from time to time. History records many episodes of aberration and many spasms of excess. We looked at one of those curious phenomena yesterday – the bubble in farmland in the otherwise monotonous western plains during the 1880s. So feverish were the borrowers and lenders back then, and so sure were they that land prices had nowhere to go but up, that there was soon one mortgage for every two adults. Per capital, debt levels in western Kansas rose over $347, or about four times as much as the nation as a whole.
And who could argue with the speculators? Everybody knew that the United States of America was filling up. And everybody knew that these new Yankee Doodles needed to be fed. Everybody also knew that the supply of farmland was not infinite. Out beyond Kansas, the land turned so dry that you could only graze cattle on it. This was the last big patch of earth on the whole continent that had not yet been put to the plow.
And yet, by the end of the decade the rains failed, the crops failed, the mortgages failed, the bubble failed, the New Era failed, and the farmers went back whence they came. One half the population of Western Kansas left the territory, says a source quoted by Grant’s Interest Rate Observer, “as they had entered it only a few months before, each with his family and his total worldly possessions in a single covered wagon, drawn by two gaunt ponies.”
But, of course, all of that happened before the invention of the Federal Reserve System.
Money grubbing is as old as pitching woo. Speculating predates spats. Bubbles have been around since the days of Bathsheba.
By contrast, the phrase, “the Great Moderation,” entered the history books only recently.
It is meant to describe what has happened in the financial markets during the reign of the best-known civil servant since Pontius Pilate, Alan Greenspan. During his time in office, it is widely believed the sturm und drang (storm and stress) of the markets gave way to stability and predictability. It was as though a marching band had switched to playing E-Z listening elevator favorites, and the parade that normally followed – with clowns, acrobats, and soldiers in gaudy uniforms with weapons on their shoulders, and smelly crowds lining the sidewalks – had been replaced by accountants, economists, and investment quants armed with laptop computers and spreadsheets, in an air-conditioned room. The thrill went out of the whole thing, but so did the risk and surprise. With sophisticated modern financial instruments, and enlightened management, any risk can be hedged. There is no longer anyone to laugh at, they say, or anyone to feel sorry for. If a man goes broke today, it is his own damned fault.
That is the wonderful world in which we find ourselves today, or so we are told.
But that was also the world as it existed, more or less, in 1987. This was at the beginning of Alan Greenspan’s term. Then, as now, investment professionals had computers and the Black-Scholes option pricing theory. And then, as now, a lot of people were prepared to believe that investing was a science that could be modeled and controlled so as to eliminate risk. A few innovators had even come up with “portfolio insurance,” which offered investors a way to stay in the stock market without worrying about a decline in prices. Another new era had arrived for investors.
Dr. Bruce Jacobs describes how it worked:
“An actual put on an underling stock portfolio protects the portfolio from stock price declines below a certain level while leaving the portfolio open to stock price advances. Using computerized rules and program trading (again, like today), portfolio insurance aimed to replicate the behavior of a put option by selling short stock index futures.”
Dr. Jacobs also put his finger on the fly in the ointment:
“Option replication requires trend-following behavior – selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends.”
One investor could hedge his exposure. All could not. Who would be on the other side of the trade? The more the idea of “portfolio insurance” took hold, the less insurance there was. In fact, the more people tried to protect themselves from falling prices all at once…the more they suffered losses. When “Black Monday” came, Dr.Jacobs describes what happened:
“Portfolio insurers sold futures equivalent to $530 million, $965 million, and $2.1 billion in stocks on the Wednesday, Thursday, and Friday preceding the crash (SEC 1988: 2.6, 3.9). The market fell 10 percent in this same period. A typical portfolio insurance strategy would have called for the sale of 20 percent of the equities in response to a 10 percent decline.”
Then, on Monday morning…
“From 9:30-9:40 a.m., program selling constituted 61 percent of NYSE volume. Between 11:40 a.m. and 2:00 p.m., portfolio insurers sold about $1.3 billion in futures, representing about 41 percent of public futures volume (Brady Comm. 1988:36). In addition, portfolio insurers sold approximately $900 million in NYSE stocks. In stocks and futures combined, portfolio insurers had contributed over $3.7 billion in selling pressure by early afternoon.
“From 1:10 – 1:20 p.m., program selling constituted 63.4 percent of NYSE volume and over 60 percent in two intervals from 1:30 to 2:00 p.m. In the last hour and a half of trading, insurers sold $660 million in futures. The DJIA sank almost 300 points in the last hour and a quarter of trading.”
Sophisticated investment tools did not make the situation better. They made it worse, but the bank of Alan Greenspan was ready. In this crisis, as in every crisis over the next 18 years, the Fed provided credit when credit was wanted. It encouraged speculators and homeowners to believe that credit would always be forthcoming, only more abundantly than before. After the crash of ’87, the LTCM collapse, the Russian bonds, the tech bubble, Argentine debt, and the recession of ’01-’02…after each crisis people let out bigger sigh of relief. There seemed no crisis so big that the Fed could not handle, no risk so great that wasn’t hedged by the maestro himself, and no real danger to the economy or its speculators. The Great Moderation had arrived…this time, a new era for sure.
More news from our team at The Rude Awakening…
Chris Mayer, reporting from somewhere in the Far East:
“Corporate America is flush with cash…Lots of it. This little-noticed fact could create great opportunities for value investors like ourselves.”
Bill Bonner, back to London for various reflections…
*** “Ben Bernanke is going to have a challenge,” said Joseph Stiglitz, a Nobel-prize winning economist at Columbia University in an interview yesterday. “He’s inheriting an economy that has some fragility going forward. The high level of debt, rising interest rates, problems of oil – all of this means he is going to have to manage the economy in a very difficult situation.”
Really. Good thing Bernanke is lily footing his way around the Senate then, huh? Yesterday he promised to “maintain continuity with the policies and policy strategies established during the Greenspan years.” Bravo. Can’t wait.
For our part in the circus, we sent – as we’ve been threatening to do – 537 copies of our new book Empire of Debt to all the Senators. And their cohorts across the rotunda. And the Commander-in-Chief down the street.
The cover letter we sent with the book suggested that continuing the policies of Alan Greenspan, while it might be what the country wants, is not likely to yield the desired result.
*** John Mauldin recently came to London. We were invited to have dinner with he and the GaveKal crew.
It was a troubling dinner. Because they – Charles Gave and his son Louis-Vincent – are very persuasive. Gave is French, and lives right around the corner from us in Paris!
He suggests that a new kind of business model is transforming western economies: the platform company. These companies don’t make anything. They leave the manufacturing to Asia. Instead, they focus on branding, marketing, designing, and retailing, without the capital expenses, nor the high labor costs of manufacturing. They are relatively insulated from economic downturns, and they are very profitable. Don’t worry about trade deficits or consumer debt, he says; this new model will keep the U.S. economy on top of the world for a long, long time.
The platform concept is the least disturbing part of the model. We were ready to go along with it, more or less. It does seem to describe a stage in the evolution of late, decrepit American capitalism…which is a little like the stage of late empires generally where they outsource almost everything …including the fighting.
Still, the description of ‘platform’ companies is mostly accurate in description…even if misleading in prescription.
*** A U.S. trade official says he expects the U.S. trade deficit with China to top $200 billion this year.
Meanwhile, foreigners may be getting tired of financing this deficit. Alan Greenspan said so himself: “At some point investors will balk at further financing.”
The Bank of International Settlement keeps track of cross-border capital flows. They note that more and more of them are being made in euros. In the first three months of this year, says BIS, 42.5% of foreign investments were in dollars, 39.3% in euros. The dollar portion was down 4%; the euro percentage was up 5%.
*** The woman dressed as a banana reminded us of other eccentrics we’ve been happy to know. One acquaintance always wore his clothes backward. He had also learned to read and write upside down and back to front. He was a hobo who liked to hitch rides on freight trains.
None of this is particularly commendable. Like most extraordinary achievements, such as stuffing billiard balls in your mouth or learning the logarithmic tables by heart, it is probably not worth doing. Still, in a world dominated by people as grey and monotonous as a Senate hearing, a little lively color is a relief.
Another acquaintance would never say a word that began with the letter ‘F’. We wondered why. It was as if he had missed a day of school as a very young man and never caught on to ‘F’. All his life, he dodged the letter ‘F’. He never sat “on the fence,” for example. Instead, he sat on the enclosure or the wall or the barrier. Nor did he ever “have a little fun.” Instead, he enjoyed himself, or he amused himself. Or he merely had a good time. The poor man couldn’t even count properly. “One, two, three, quatro, cinco, six, ” he would say.
Finally, we asked him why he never said a word that began with ‘F’.
“My mother told me never to use the F-word,” he replied. “I never have.”
“Maybe she didn’t mean all words that began with ‘F’,” we suggested. “Maybe she just had a single F-word in mind.”
“I never thought of that…”