Too Big to Succeed
"We are the indispensable nation. We stand tall. We see farther into the future."
A remarkable thought appeared on the editorial page of a recent International Herald Tribune. Your editor has lost the paper somewhere along the way, but he recalls the idea… the way he remembers a particularly bad meal.
Is there a risk that foreigners will stop financing the U.S. current account deficit, the writer wondered. Will they stop wanting to buy U.S. stocks and bonds? The ‘rest of the world’ held $8.2 trillion worth of U.S. assets at the end of 2001… up from $2.6 trillion in ’94. If foreigners decided to lighten up… just a little… the results would be devastating. The dollar, the stock market, the U.S. economy – all would enter a long, dark night… and who knows when the sun would shine again?
But not to worry, concluded the editorialist. The foreigners can’t sell U.S. assets. The entire world economy depends on Americans’ ability to continue spending money they don’t have. For it is Americans who buy the world’s production. America is the world’s biggest consumer. If it ever stops spending… the whole world goes into recession. In short, the American economy has become too big to fail.
The sentiment is widespread in the U.S.: the nation has become so big, so powerful, so technologically, militarily and economically advanced – nothing can stop it now. We Americans have a right to be proud. But pride is a challenge to the gods. We don’t know whether it will be the god of the markets… or the god of war. But, to summarize today’s letter – one of them is bound to take a swat at us before too long.
As we explained earlier this week, none of the world’s armed forces can stand in the way of the U.S. military machine. It rolls wherever it wants… unstoppable, almost unchallenged. It has such an edge over its enemies that more casualties have been suffered at Olympic games than by U.S. soldiers in the War Against Terror (WAT).
The logic of continuing the WAT is simple enough that even a President can understand it.
1. Certain groups of terrorists want to destroy the U.S.
2. They’d use nuclear weapons if they could.
3. They haven’t used them yet… so they must not have them.
4. They must be stopped before they get them.
5. Where might they get them… Iraq.
This line of reasoning is so compelling that it seems to have brought even normally sensible people, such as columnist Fred Reed, to the edge of absurdity:
"We should perhaps remember that large wars happen," writes Reed. "Few wanted WWII or would have in 1932 thought it possible. Pearl Harbor, the 9/11 attacks, a nuclear bomb on American soil – all, before they happen, sound like the ravings of dementia. The world would be better off if these particular things didn’t happen… How can a convulsion be prevented?
"Answer: By taking any measures necessary – any measures at all – to prevent Iraq from building nuclear weapons. If it were not for the nuclear potential, one might argue about the President’s policy toward Iraq. Or one might not. But Saddam Hussein cannot be permitted any possibility of having nuclear weapons. It’s that simple. Whether we like it or not, we need to say "no," and we need to mean it. The potential consequences of not doing so leave no choice."
Our beat here at the Daily Reckoning is markets, not politics. But no matter what wandering path we take, we see the same tell-tale droppings – spoor from that strange animal, man.
Unlike other beasts, we are told, man is capable of rational thought. But whether you look at his behavior in markets or politics, you see the same thing: rational thought yields to hysteria and wishful thinking as readily as a fat widow to a handsome gigolo.
The charm of man’s intelligence is that it is so flexible; he can think himself into any position he wants to take. He is as ready to believe that stocks will rise – even though they are already 2 or 3 times higher than their long term mean – as he is that he needs to go to war. If he is not directly attacked by an enemy, he merely has to stretch his mind a little to find an abstraction… a jingo… that makes war sound, not only reasonable, but irresistible. Does the nation need more ‘living room?’ Must it not help ‘make the world safe for democracy?’ What about the threat of ‘the domino effect?’ Napoleon, after securing all of Europe from Gibraltar to the Vistula, talked himself into attacking Russia – because it represented a threat to his ‘Continental System’ by which he hoped to deny European markets to the British!
Wherever you look, logic follows desire like an inaugural ball after a rigged election.
And thank goodness for popular democracy! In the privacy of the voting booth, people fashion chains for themselves… and willingly drag around heavier balls of iron than a dictator or an emperor could ever put upon them. George III managed to squeeze out a tax rate of only about 3% from the American colonists. Since then, Americans have voted to raise the rate to more than ten times that amount… not to mention death taxes, capital gains taxes, excise taxes, sales taxes, property taxes and so on.
The American colonists also complained, in Mencken’s words, about "making poor people board and lodge a lot of soldiers they ain’t got no use for and don’t want to see loafing around." Now, the people of the American republic support an army that costs more than the next nine largest national defense budgets combined – about a third of the entire world’s defense budget.
And the descendants of the people who had no use for soldiers eventually queued up – can you believe it – to risk their lives in some woebegone war far from home! What emperor or dictator could get that kind of cooperation?
Every war ever fought – like every bubble market – seemed like a good idea at the time. Measured in audacity as well as stupidity, Japan’s attack on Pearl Harbor was the equal of Napoleon’s march on Moscow. But, it seemed perfectly logical to the Japanese. They were trapped. They had far-flung interests throughout East Asia, but needed access to raw materials to supply its factories. The U.S. 7th fleet was all that stood in the way. Ergo…
Not that we know anything about foreign policy. It is a matter better left to others, we believe – such as mental defectives. Nor do we know whether the world will be a better or worse place following the WAT or an invasion of Iraq. That is not for us to know.
But both stock market and foreign policy float on tides of fortune. Beneath them run deeper currents of popular confidence. Readers are reminded: the currents sometimes shift. It is not man’s power of reason that fails, but his power of imagination. He cannot imagine what will go wrong – until it does.
Your correspondent… stretching his imagination,
March 21, 2002 — Paris, France
"Is the run-up for real," asks FORTUNE, "or are we simply heading for a trading range?"
"If history is any guide," the magazine replies to its own question, "the answer is the latter." Conditions were almost identical in 1975, says Fortune. Stocks had gone down for two years… there was a war overseas, scandals at home… but, suddenly, the Dow jumped up 40% in 6 months. But it was a ‘head fake,’ the article tells us. It suckered investors back into ‘Nifty Fifty’ stocks such as Avon and Polaroid… and then crushed them as the bear market continued for another 7 years.
"We’re back in the ’70s," FORTUNE concludes.
If present prices hold, opined Jim Dines, "I would be looking at a very strong summer rally." But if the market breaks, "run for your life," he continues, "we are in for the father of all bear markets… There are a lot of people who have lost money in this market and just want to get out even."
Meanwhile, Charles All notes that between 1871 and 1997 stocks appreciated only 1.6% per year and traded at an average P/E of only 14.5. Investors who expect to make 20% per year – especially now, buying stocks at 40 times earnings – are not dreaming – they’re hallucinating.
It could take 10 years – maybe 20 years – to brings stocks back to their mean levels. But someday, somehow… they’ll get there.
Smart investors know that you’re unlikely to make money from stocks at these levels. So, what’s happening in the markets is what the Dow Theorists call ‘distribution.’ The patsies’ money is being redistributed to sophisticated investors. That’s why the Dow has moved ahead and why other indexes have lagged. The chumps are moving into the nifty-fifty stocks of 2002, the big names they know and trust, such as Microsoft and GE, while the big-money insiders bail out.
"The average buy transaction [among Dow insiders]," reports Gary North, "took in 3870 shares while the average sale dumped 241,057 shares, a ratio of 62.3 to 1. It gets worse! A grand total of 89,000 shares were purchased [by corporate insiders] versus a grand total of 33,989,000 sold… They are abandoning the ship."
Eric… tell us, what did the patsies do yesterday?
Eric Fry on Wall Street…
– As winter turns to spring, the economy is starting to sprout a few green shoots here and there. But stock market valuations are already in full-bloom. Therefore, it’s not hard to imagine that the stock market’s petals might start dropping to the ground, even as economic growth continues to bud.
– Yesterday, for example, the stock market tumbled despite surprisingly strong housing data (seasonally adjusted, of course). U.S. housing starts in February jumped 2.8% to their highest level since December 1998. No matter, the Dow dropped 133 points to 10,501, while the Nasdaq shed more than 2 1/2 percent to 1,832.
– It’s beginning to look like the economy and the stock market may be a classic spring-autumn romance.
– This ol’ bull market is getting on in years, and may find that it’s not so easy keeping up with the spry, youthful recovery now underway. (Then again, we would not be surprised if the recovery were snuffed out in the prime of its youth).
– Notwithstanding the frequently erroneous blather of Wall Street strategists, economic cycles and stock market cycles rarely stroll arm-in-arm. Rather, as Bridgewater Associates observed recently, "It is now generally assumed that increased economic growth will be good for stocks, [but] this has not typically been the case. Typically, the best part of the bull move [in stocks] occurs when interest rates are being cut, just before the expansion begins… We should be looking to sell on rallies and not be getting more bullish because the recovery is getting stronger."
– To support its thesis, Bridgewater provides a graph that clearly illustrates the tendency of stocks to rise when interest rates are falling, and to fall when interest rates are rising.
– Bridgewater also demonstrates (from various perspectives) a fact that almost no one disputes: Stocks are richly priced relative to their historic norms. At 40 times earnings or so, the stock market seems to have "priced in" not only the present recovery, but also several more recoveries to follow in the distant future.
– Another reason that the stock market might struggle from this point forward is that the big, dominant companies like Microsoft and GE will find it difficult, if not impossible, to produce earnings growth that comes anywhere close to matching their strong growth rates of the past. (At least, that’s what Warren Buffett thinks).
– Yesterday, the Daily Reckoning chastised General Electric for its less-than-full disclosure about its "impeccably well-groomed earnings growth." Following close on the heels of our comments, a well-known bond fund manager issued a stinging critique of the industrial giant.
– Bill Gross, managing director of Pimco, the nation’s largest bond fund, brought GE to task for toying with investors.
– He punctuated his caustic remarks by promising, "PIMCO will own no GE commercial paper in the foreseeable future."
– "Life’s charades are ultimately exposed for all to see," writes Gross, sounding like a Daily Reckoning columnist, "and it ‘pays’ to put the facts up front, because the repercussions of falsehoods are often fatal, whether it be by the guillotine of public opinion a la ENRON, or a death by a thousand cuts…
– "One could not find a more exemplary ‘Honest Abe’ in the financial world than Warren Buffett. His annual reports are legend and they contain not only words of bonafide investment wisdom, but self-recrimination when deemed necessary.
– "In stark contrast, however, has been the deceptive and in some cases, illegal information disseminated by some of our New Age corporate elite. The Economist in a February 23rd issue reported that the companies in the NASDAQ 100 for the first three quarters of 2001 reported combined losses to the SEC of nearly $82 billion, while at the same time promoting profits of $20 billion to their stockholders. The Economist explained the discrepancy by the companies’ use of generally accepted accounting principles for regulators, and the distinctly more favorable New Age "pro forma" accounting for owners of their shares."
– Warming to the topic, Gross continues, "Nor do I think, have Jack Welch and his successor Jeffrey Immelt been totally forthcoming in the explanation for why GE has been able to grow earnings at nearly 15% per year for the last several decades… It grows earnings not so much by the brilliance of management or the diversity of their operations, as Welch and Immelt claim, but through the acquisition of companies (more than 100 companies in each of the last five years) using high-powered, high P/E multiple GE stock or cheap near-Treasury-bill yielding commercial paper. In the use of that CP, GE Capital is using near hedge fund leverage of 7-8 times at what appears to be (based on its AAA rating) non- hedge fund risk…
– "GE is still no Berkshire Hathaway. I want companies to face up to their owners and yes – their creditors. I want management to focus not on THEIR options, but on mine and that of other investors. We have the option to buy or to not buy your securities. And that option should be based not just on the increasingly revealing financial statistics that have had to be dragged kicking and screaming out of the bowels of corporate back- offices, but on the investor friendly/investor honest/investor first attitudes of management… Value and honesty should dominate corporate decision-making just like it does at Berkshire Hathaway."
– Amen, Reverend Gross!
Back in Paris…
*** "Give me your tired, your poor, your huddled masses yearning to breathe free, the wretched refuse of your teeming shore… " and we’ll send them right back! Today’s Herald Tribune reports that the Immigration and Naturalization Service is contemplating a change – limiting visitors to a 30-day stay in the land of the free. We recall that one of the many kvetches aimed at King George in the Declaration of Independence was that he had "endeavoured to prevent the population of these States."
But who cares about the Declaration of Independence now. Heck, with all those big words and dependent clauses, most people probably can’t even read it. "Since the great majority of Americans now speak a tongue that differs materially from standard English," wrote H.L. Mencken, he translated the passage into language that even a president might understand:
"He [King George… Hanover, not Bush] tried to scare people outen moving into these States, and made it so hard for a wop or one of them poor kikes to get his papers that he would rather stay home and not try it, and then, when he come in, he wouldn’t let him have no land, and so he either went home again or never come."
*** Today is the first day of Spring. The outdoor cafes in Paris are filling up. Already, on a nice day I can hardly get a good table across the street at the Paradis – where we do our heaviest reckoning.
Writers used to crowd Paris bars – because the city was cheap. In the 19th century, Americans and Englishmen would bring their families to Paris… because here they could live in style for less than it would cost at home. It was partly the lure of decent food and cut-rate booze that brought Baldwin, Burroughs, Styron, Ginsburg and other American writers to Paris in the post-WWII era. In the ’70s the dollar fell, and Paris got to be expensive… but thanks to the high dollar, an American can once again live better and cheaper in Paris than in London or New York.
Maybe that’s why the writers are coming back. In fact, my friend Adrian has organized a Travel Writers Workshop – teaching the secrets of the travel writing trade – for next month.