Unreasonable Expectations

“The U.S. economy has surpassed all reasonable expectations,” writes David Hale, chairman of Prince Street Capital hedge fund, in Barron’s.

In our view, both the economy and the stock market flew by reasonable expectations sometime in the middle of the last decade. Both went up when they should have gone down.

Here at the Daily Reckoning, we have a forecasting approach all our own. We do not try to figure out what will happen, for it is impossible to know. Instead, we look at what ought to happen. Without ‘will’ we have only ‘ought’ to do the work of forecasting. ‘People ought to get what they’ve got coming,’ we say to ourselves. In the markets, they usually do.

In the late ’90s, even after the nation’s greatest central banker, Alan Greenspan, noted that investors had become irrationally exuberant, they seemed to become even more irrationally exuberant. And then, when recession and bear market threatened, these irrational investors were sure that the very same central banker who couldn’t stop a bubble could nevertheless stop it from springing a leak.

Japanese Bubble: The Remarkable Lack of Anything Special

Alas, this proved a vain hope; a bear market beginning in March of 2000 reduced the nation’s stock market wealth by $7 trillion – to January 2003. But another remarkable thing happened at the same time – nothing much.

“The 2000-2002 stock market slump failed to produce a financial crisis,” writes Hale. “Wealth losses in the U.S. equity market since March 2002 have been unprecedented. They have been equal to 90% of GDP, compared with 60% during the two years after the 1929 stock-market crash. But during the past two years only eleven banks failed in the U.S. compared with nearly 500 during the 1989-1991 and thousands during the 1930s.”

And in the economy – the same remarkable lack of anything special. Unemployment lines grew longer, but not so much as you would reasonably expect. And consumer borrowing and spending didn’t fall, as you might reasonably expect, but rose. “In 2002, mortgage refinancing shot up to $1.5 trillion compared with a previous peak of $750 billion in ’98,” Hale tells us.

Following a mild economic downturn in 2001…and after the opening shots in the War Against Terror…”it is difficult to imagine a more benign scenario than the 3% growth in output that the economy actually enjoyed during the past year,” Hale concludes.

What bothers us about this situation is precisely what delights Mr. Hale – we could not reasonably expect it. What ought to follow a spectacularly absurd boom is a spectacularly absurd bust.

But the Japanese bubble wasn’t completely destroyed in a year or two either. Economists don’t like to cast their eyes towards Japan – because they cannot explain it. Neither monetary nor fiscal stimuli seem to have done the trick. But if you could grab the back of their heads and turn them towards the Land of the Rising Sun they would see that after a mild recession GDP growth continued in Japan following the stock market peak in ’89 – at about 2% to 3% per year. This went on for several years. But then the economy went into a more prolonged slump. By 2000, GDP per person was back to 1993 levels!

In both cases, Japan and the U.S., what ought to have happened was something very different. Why something different didn’t happen is the subject of today’s letter… along this additional forecast for 2003, or beyond: it will.

Japanese Bubble: Outsiders Need Not Apply

Japan’s example, we are told, doesn’t apply anywhere outside of Japan. Because the Japanese created a form of capitalism which was almost unrecognizable to westerners. It was a system of cross-holdings, state intervention, cronyism, and a stock market that had become a popular sensation. In the financial frenzy of the late ’80s, Japanese companies ceased to act like capitalist enterprises altogether, for they ignored the capitalists. Profits no longer mattered. Assets per share had become an illusion. All that seemed to count was growth…market share…and big announcements to the press.

What kind of capitalism could it be where the capitalists didn’t require a return on their investment? And was it so different from the U.S. model? American businesses seemed to care even less about their capitalists than Japanese ones did. As stock prices peaked out on Wall Street in early 2000, profits had already been falling for the last 7 years. They continued to fall, sharply, for the first 2 years of the slump. Executive salaries soared – first as profits fell… and later as many of the biggest companies in the country edged into insolvency. Plus, the managers gave away the store in options to key employees – further disguising the real costs of business.

Despite all the hullabaloo about investing in New Economy technology actual investment in plants, equipment and things- that-might-give-investors-higher-profits-in-the-future declined. In the late ’90s, net capital investment dropped to new post-war lows.

Instead of paying attention to the business, U.S. corporate executives focused on deal-making, acquisitions and short- term profits – anything that would get their names in the paper.

You’d think an owner would get upset. But none of this mattered to the capitalists – because they had ceased to exist. Old-time capitalists who put money into businesses they knew and understood… with the reasonable hope of earning a profit… had been replaced by a new, collectivized lumpeninvestoriat whose expectations were decidedly unreasonable. The patsies and chumps expected impossible rates of return from stocks about which they had no clue. Management could run down the balance sheet all it wanted. It could make extravagant compensation deals with itself. It could acquire assets for preposterous prices… it could borrow huge sums and then wonder how it would repay the money. It could cut dividends…or not pay them at all; the little guys would never figure it out.

The lumpeninvestoriat in Japan, as in the US, ought to have jumped away from stocks, debt, and spending immediately following the crash in the stock market. The market could have plunged…and then recovered. But government policymakers and central bankers were soon out in force – spreading so many safety nets, there was scarcely a square foot of pavement on which to fall.

Of course, the little guys never knew what they were doing in the first place… was it such a surprise that they did the wrong thing again; holding on… dragging out the pain of the correction…and postponing a real recovery? In Japan, analysts got weary waiting. Then, the slump continued… slowly and softly, like a man drowning in a beer tank.

For the moment, the U.S. economy continues to run ahead of ‘all reasonable expectations.’ Eventually, reasonable expectations will catch up. Or, at least they ought to.

Bill Bonner
Paris, France
January 6, 2003


“Don’t expect another Great Depression,” says economist Robert A. Levine in the International Herald Tribune. “Deflation is neither probable nor the greatest danger,” he continues.

Why not?

Because “Keynes is still with us,” he says.

Last we heard, here at the Daily Reckoning, Keynes was dead. But the great English economist seems to have been pulled from his eternal rest and set to work to help avoid another recession. Keynes’ contribution to economics was his suggestion that governments run surpluses in fat times so that they could run deficits in lean ones, thus counterbalancing the natural cycle of the business sector.

“That lesson was not well learned by policy makers in the 1930s,” Levine explains, “but it was proved by the massive deficits and consequent prosperity of WWII.”

Everyone believes that WWII spending got the nation out of the Great Depression. We are in a very small minority who believe it is not so…so the burden of proof is once again on us.

Rather than take up the burden of proof earnestly, we merely point at it and laugh. In WWII almost the whole nation was set to work producing things nobody really wanted – guns, tanks, ships – things that actually destroyed wealth. The things that people really did want – butter, automobiles and so forth – were in short supply or rationed. Nor as we recall did similar wartime spending by Germany and Japan do much good for their economies.

If WWII America was a model of how to run a successful economy, then the post-WWII Soviet Union should have been the best economy in the world. It spent the next 4 decades producing things people didn’t want…while rationing or forbidding the things they did.

And Japan’s economy should be roaring now. In the 1990s, in addition to the monetary stimulus of near-zero interest rates, the Japanese ran the world’s biggest programs of fiscal stimulus. Everywhere you look in Japan you see a government project under construction – a dam, a road to nowhere, a cement river-bank – things no one really wants except the contractors. Recently, per acre, the Japanese poured 10 times as much concrete as Americans – turning the island into one of the ugliest countries in the world. Levine doesn’t even mention Japan.

Like everyone else. He’s confident: “Conservatives [in Congress and the administration] will practice pragmatic Keynesianism, and another Great Depression will be avoided.” Here at the Daily Reckoning we were not expecting a Great Depression… We expect conservatives and liberals to react more or less as the Japanese did – with massive monetary and fiscal stimulus. And we expect the economy to respond more or less as the Japanese economy did – with ups and downs…and a long, slow, soft depression, not a great one.

U.S. stocks are still ridiculously overpriced…so we buy gold, gold shares, euro bonds…a few very cheap stocks…and we wouldn’t mind being surprised.

Eric Fry with the latest news from Wall Street:


Eric Fry in New York…

– The stock market has kicked off the New Year in grand style. After the first two trading days of 2003, the Dow stands proudly atop a 3.1% gain at 8,602, while the Nasdaq is ahead 3.9%. Encouraged by this promising start, the bulls hope and believe that their suffering has finally come to an end. Three straight years of misery will not become four…or so they believe.

– But weren’t most investors entertaining nearly identical hopes at this same time last year? All of the finest minds on Wall Street predicted that share prices would rise smartly in 2002. “The recession is over,” they promised. “The economy is recovering nicely from the problems caused by 9/11…The tech sector will rebound sharply in the second half of the year.” Such misguided macro-economic forecasts inspired equally misguided forecasts about the stock market.

– UBS PaineWebber’s strategist, Ed Kerschner, expected the S&P 500 to climb 35% to 1,600 in 2002 – almost twice what it is now. Abby Joseph Cohen was looking for the S&P to reach 1,300 by the end of 2002. For a while – a very short while – the bullish forecasts seemed to be on target. Stocks rallied in January of 2002, which seemed to validate the assurances by Wall Street strategists that the market would not – indeed, could not – fall for three straight years. Alas, the January rally faded and the universally bullish strategists were once again, universally wrong.

– Jim Stack, editor of Investech Research, examined the stock market forecasts for 2002 offered by 22 panelists appearing on Wall Street Week with Louis Rukeyser. “Not one analyst guessed that the Dow would close 2002 under 10,000 (let alone under 8,400),” Stack writes. “That followed an equally embarrassing year in 2001, when not one of the 22 panelists thought the Dow would close under 11,000 (it actually finished at 10,021).”

– For the record, of the 22 panelists on Rukeyser’s show to make a forecast, Marty Zweig called it best, with his prediction that the Nasdaq would finish the year at 1,700. Most forecasts were 700 to 1,000 points higher than Zweig’s. The Nasdaq’s actual closing level at year-end was 1,335. After such an abysmal record of forecasting, are the strategists acknowledging their error and adopting a bit of humility? Of course not. They are simply teeing up their new bullish forecasts and letting them fly, just like they did in 2000, 2001 and 2002.

– Unfortunately, richly priced stocks tend to fall, not rise…And the stock market is still pretty pricey. “U.S. stocks may have already had their January rally,” Bloomberg’s Justin Baer grimly predicts. “The Standard & Poor’s 500 Index jumped 3.3 percent during the first two trading days of 2003. That’s more than double the average for the month during the past half-century, according to Ned Davis Research.”

– Bloomberg’s Baer bases his downbeat call on a familiar litany of non-bullish items like disappointing corporate earnings, soaring oil prices and saber-rattling in North Korea. Baer didn’t mention the fact that the stock market still seems pretty richly priced at 30 times earnings. But he could have. Even after three straight down years, US stocks are expensive. At best, they aren’t cheap.

– And yet, Wall Street strategists predict higher share prices ahead in 2003, just like they did in 2000, 2001 and 2002. In fact, they’ve been predicting pretty much the same thing year after year, ever since there was an actual wall on Wall Street. Al Goldman of AG Edwards, Joe Battapaglia of Ryan Beck & Co., Global Partners Securities’ Peter Cardillo and UBS’s Tracy Eichler are among the non-descript gaggle of strategists who are predicting gains that range from 8.5 to more than 20 percent.

– “The last time the market fell for four years in a row was in 1929-1933,” says one hopeful strategist, “and, by no stretch of the imagination, do we see economic conditions comparable to that in the period ahead.” That’s a comfort. Aren’t these the same folks who “by no stretch of the imagination” foresaw the stock market falling over the LAST three years?

– The hopeful strategist concludes, “Strategists who guessed wrong for the last three years should have the odds with them for 2003.” Unfortunately, the forecasters in 2002 also believed that the law of probability was on their side. And it was. But the stock market fell anyway. Richly priced stocks tend to fall…And those are the only odds that an investor should care about.


Back in Paris…

*** Gold closed over $350 for the first time in 5 years.

*** “Dividends are coming back in style,” says John Shoven, economist at Stanford. Baby boomers, beginning their retirements, are going to need income. Despairing of selling stocks for big capital gains, they’re going to look to the stock market for income.

But where will the income come from? S&P stocks are already paying out 53% of their earnings – up from 45% they paid in 1981, when you could get 6% dividend yield. In order to increase dividends just to 3%, they’d have to pay out every penny in earnings.

There are only a couple of ways in which dividend yields could rise – either companies have to earn more money, or stock prices have to fall.

Don’t count on higher earnings. So far, during this ‘recovery’ stage, profits have been falling – an unprecedented experience. And there is not much reason to think they will get much better soon. Businesses have already cut expenses. Expense cuts produce quick increases in profit margins for an individual company. But one companies expense is another’s income…so the net effect throughout the economy is negative. What produces profits is capital investment…of which there has been very little. Companies typically build new factories, hire new workers, and sell new products at a profit – that is what gives them earnings to distribute to their shareholders.

But policy makers have encouraged consumer spending, hoping to hold off a worse recession. This consumer spending by Americans has done wonders for the Chinese economy – currently expanding at an 8% rate. But it merely deprives the U.S. economy of the savings and capital investment it needs to produce profits.

Since earnings are not likely to increase, the only way dividends might go up would be for stock prices to do down. A 4% dividend yield would imply a Dow below 4,000.

*** Paris was a winter wonderland over the weekend. It began snowing on Saturday. Roads closed. Neighbors from out in the country spent 20 hours, with small children no less, in a traffic jam-up on the toll road to Paris.

The Daily Reckoning