Waiting for Godot
It’s nearing Fall 2003…and economic indicators are promising. Will this year usher in the fabled second-half recovery, after all? Alas, the devil is in the detail.
"There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of the voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved."
Ludwig von Mises, Human Action, A Treatise of Economics, Yale University Press, 1949
Once again, we are treated to the vaunted "second-half recovery" mantra from the mainstream financial press. Could it be that this year we will finally have our cake and eat it, too? For the benefit of long-time Daily Reckoning readers, we will cut to the chase and dispense with all illusions of suspense: in reality, the U.S. economy is in recession, as reflected in the dismal employment performance.
Pointing to the various statistical adjustments in the price indices that substantially boost America’s real GDP growth, we have argued ad nauseum that the reported U.S. growth rates grossly overstate the reality in comparison to other countries.
Capital Spending Revival: The Bullish Consensus
Of course, it is nevertheless always possible that the economy is embarking on a strong, solid recovery, as predicted and widely expected. The bullish consensus draws its optimistic assessment largely from the belief that a sufficiently strong policy stimulus is now in place and partly from some better-looking indicators.
As to the first assumption about policy stimulus, we can only express our utter amazement. It flatly ignores the extremely poor economic effects of the even more prodigious monetary and fiscal stimulus of the past two-and-a-half years. To us, this recent experience really forbids any optimism in this respect about the future.
Assessing the U.S. economy’s prospects essentially begins with two crucial questions: first, will businesses start hiring and investing again pretty soon? And second, will the consumer be willing and able to keep up his borrowing and spending binge? Please consider that one month of the second half of the year is already behind us.
Looking for the recovery, it strikes us in the first place that the second quarter was no better than the first quarter, if not weaker. Production posted gains of 0.1% in May and June. But it decreased at an annual rate of 3.2% in comparison to the first quarter.
The central assumption behind the consensus’ U.S. recovery forecasts is an incipient, strong revival in business capital spending. In actual fact, it is absolutely indispensable that it materialize very quickly.
Capital Spending Revival: Early Indicators
Since any sign of higher investment spending or even of higher production is so far completely missing, we have to look for early indicators. There are modest improvements in survey indexes, generally considered as leading indicators, but there is no trace of it in the hard data, reflecting current facts.
Capital goods orders and shipments, in our view the best proxy for investment spending, remain stuck in virtual stagnation. In fact, ‘core’ orders for capital goods excluding defense and aircraft dropped 0.4% in May, following a 2.8% decline in the month before. New orders for machinery were 4.3% below their level a year ago, and among those, orders for computers and electronic products were down by 9.6%.
However, the bullish consensus argues that the necessary conditions for the investment revival – above all, higher profits, higher cash flow and stronger balance sheets – are developing.
It is generally agreed that a strong rebound in profits is the key condition for a solid and sustained investment recovery. Aggregate after-tax profits of nonfinancial corporate business, as measured by NIPA, were $197 billion in 2002, even lower than the $205.3 billion in the recession year before. Yet they improved in the course of the year. But as it is so often, the devil is in the detail.
The fact is that profits have been and continue to be heavily inflated by special factors. We note: first, big ‘inventory profits’ deriving from rising oil and commodity prices; second, big gains from financial activity and speculation; third, big currency gains by foreign subsidiaries of U.S. firms; fourth, an unusually large rise in the profits of foreign firms in the United States; and fifth, continuous, heavy underfunding of pension fund obligations.
Capital Spending Revival: The Earnings Management Game
If the poor profit performance needs any further proof, it is in the unfaltering ‘earnings-management game.’ Despite the condemnation of past accounting tricks, the familiar tricks to make profit numbers look better than they are have remained in rampant use. A common ploy is to report fictive ‘pro forma’ profits; another is to measure them against deliberately reduced ‘expected’ profit. For example: the reported profits of Apple Computer topped expected profits by a whopping 67%. In actual fact, they had fallen 41%.
Whenever we read of better-than-expected profits, we presume cheating. Such reports often lead to the systematic delusion of investors. Yet no one protests; instead, they follow after the delusion in the hope that it will mean higher stock prices. Economic reality is too unpleasant to be faced with open eyes. But for people with a bit of common sense, this method of comparison is completely arbitrary and meaningless.
It seems, of course, a fair assumption that a solid second- half economic recovery will not fail to buoy profits. But first of all, we do not believe in this recovery, and second, we fail to see the micro and macro adjustments that are necessary to improve profits.
As we have stressed many times, our own assessment of profit prospects is strictly determined by focusing on the particular flows of business revenues and expenses that generate business profits. Based on this analysis, we see nothing that speaks for substantially higher profits. There is a great risk to profits in a probable, prolonged rise in personal saving from current income. A possible boost may come from the rising budget deficit.
for The Daily Reckoning
August 21, 2003
P.S. Poor profit prospects are not the only reason we are unable to see a solid, sustained investment recovery in the United States. General financial viability, measured by various financial indicators, is another indispensable condition.
How robust are American company finances? The short answer is that balance sheets are not a picture of health. What’s more, whether they are improving or deteriorating remains an open question. We believe in the latter eventuality; at best, there has been very little recent improvement.
In the frantic pursuit of higher stock prices, American managers in the past few years have systematically devastated the balance sheets of their companies. Financial damage that took several years to build up cannot be corrected in several quarters.
Former Fed Chairman Paul Volcker once said: "Sometimes I think that the job of central bankers is to prove Kurt Richebächer wrong." A regular contributor to The Wall Street Journal, Strategic Investment and several other respected financial publications, Dr. Richebächer’s insightful analysis stems from the Austrian School of economics. France’s Le Figaro magazine has done a feature story on him as "the man who predicted the Asian crisis."
Dr. Richebächer continues to warn readers about the follies of the Fed’s current easy-money policies.
Anyone who is watching the stock market carefully is wasting his time, in our opinion.
The important action is taking place elsewhere. The price of gold rose $4 yesterday, to $367. Gold has been in a bull market for the past two years. It has risen more than 40% already. Yesterday, we were hoping it would go down. Our own target for buying gold is below $350. Each time it drops below $350, we tell ourselves we should buy. And each time, we forget to buy. Then, when it rises again, we wonder if we will ever see $350 again.
At $350, gold is a bargain. It is a bargain at $400 too. Recently, on the back of an envelope, we calculated that since Alan Greenspan became Fed chief, $6,125 had been added to the money supply for every ounce of gold brought out of the ground in that period. Even if we were off by a decimal point, gold is still a bargain; it should at least double in price in order to stay even with paper dollars.
Of course, it is not really the price of gold that is out of order, but the purchasing power of the dollar. Dollars…and assets quoted in them…are more expensive than they ought to be. U.S. stocks, for example, trade hands at 33 times earnings. Who would want to wait 33 years to get his money back? The only way to justify the price is by assuming that earnings will rise sharply. But why would they?
Corporate earnings, as a share of GDP, have been going down ever since the Dollar Standard system came into being in 1971. No coincidence. Every extra dollar manufactured by the Bureau of Printing and Engraving encourages someone to lust after it. The pattern of the last 30 years has been for the luster to set up a factory in Japan, or Malaysia or China…and thereby offer something to trade for the money, giving the spender a better bargain for his money than he could get at home. And so, U.S. corporations found their profit margins squeezed by greater worldwide capacity, generally, and low-cost manufacturing from Asia in particular.
The Fed encourages the illusion of an economic recovery…goosed along by more credit from the Fed and more dollars from the Bureau of Printing and Engraving. Investors count on a recovery of corporate profits, too. But each additional dollar only incites the competition…and hastens the day when the dollar finally gets marked to a wicked market. To a point, the Fed can stimulate consumer buying…luring the lumpen deeper into debt. But it does so at the expense of the very profits investors are counting on.
"The outlook for the global economy is profoundly disturbing," writes Richard Duncan in his book, "The Dollar Crisis." "Until the dollar adjusts sharply lower, asset price bubbles and deflation will continue to undermine corporate profitability, banking systems and government finances. When the dollar does fall, as it inevitably must, the global economic slump will intensify as the major exporting nations fall deeper into recession and the overheated U.S. economy deflates."
More on the coming dollar crisis…and Richard Duncan’s excellent book…tomorrow…
But today, here’s Eric Fry with the latest news and entertainment from Wall Street:
Eric Fry in Long Island…
– The stock market muddled through another late-summer trading day. The Dow stumbled 31 points to 9,397, while the Nasdaq dipped half a point to 1,760.
– But the stock market has done very little muddling in 2003 – all the major indices have scaled to fresh one-year highs. Unfortunately, the economy stubbornly refuses to follow the stock market’s lead. The acrophobic U.S. economy prefers, instead, to keep its feet firmly planted on level ground, and simply muddle along.
– So desperately do investors hope for economic growth, that Wall Street’s economists and strategists – like gamblers at a turtle race – verily cheer, holler and cajole the economy to pick up the pace and sprint toward the finish line.
– But this turtle don’t sprint…The proof may be found in Hewlett Packard’s just-released third-quarter earnings report. The diversified tech giant, like the economy itself, is merely plodding along, despite constant sycophantic cheering from Wall Street’s analyst-fans. H-P’s latest report offers a very telling, ground-level snapshot of our economy…and the picture isn’t pretty.
– Many of H-P’s main business units posted losses once again. Personal-systems sales, for example, which include desktop and notebook computers, chalked up an operating loss of $56 million in the quarter, compared to a profit of $21 million in this year’s second quarter.
– Enterprise-system sales, which include storage devices and servers, reported an operating loss of $70 million. That’s an improvement over the $252 million it lost last year, but far worse than the $7 million it lost in the second quarter.
– Hewlett’s imaging and printing group, the company’s most profitable division, managed to grind out operating income of $739 million. But that result pales alongside the $918 million it earned a year ago and also compared to the second quarter’s $851 million profit. H-P’s lackluster result does not bode well for the tech sector, or for the economy at large.
– Elsewhere in the Great American Turtle Race, many consumers are shifting from consumption to conservation. In other words, the nation’s spenders are becoming savers…and that’s not a helpful trend for an economy that subsists on consumerism.
– Saving money – like abstaining from alcohol – is a healthy trend…unless you happen to be a bar owner. And it’s no secret that the U.S. economy, if it is to grow, needs folks to continually ‘belly-up’ to the consumer- spending bar and buy stuff. Unfortunately, the American consumer is learning temperance.
– For example, nearly half of all Americans who have received their tax rebate checks said the funds went to pay bills. Another 29% said they’ve saved or invested the rebate money, while only 18% said they’d spent it. "The results are at odds with the Bush administration’s – and certainly retailers’ – hope that Americans would quickly spend the windfall and stimulate economic recovery," the Financial Times notes.
– Meanwhile, demand for credit-card debt and other forms of revolving credit fell more than 2% in June. It’s possible, of course, that the last gasps of the mortgage refi boom have skewed the consumer credit numbers somewhat, as borrowers have been applying part of their refi proceeds to paying down credit-card debt.
– However, the Cambridge Consumer Credit Index, which measures credit-card use, fell from a reading of 60 in July to 55 in August. What’s more, the percentage of respondents in the Cambridge survey who said that they have taken on more debt declined from 30% in July to 25% in August.
– It looks like the nation’s new frugality fad is for real. But unfortunately, this new debt conservatism is heavily focused on the "haves." The "have-nots" are still borrowing money at a rapid clip in order to make ends meet.
– "The so-called sub-prime market is a different ball game," one analyst correctly observed. "What we have seen there is significant collateral deterioration, because the borrowers in that segment have been much harder hit by the downturn in the economy in terms of losing their jobs."
– This is not a healthy trend for the sub-prime lenders. Then, too, we would not be surprised if a growing percentage of the nation’s prime borrowers were to begin resembling their sub-prime counterparts…There’s a lot of risk out there in "Lending Land."
Bill Bonner, back in Paris…
*** "Housing’s last hurrah," says a CNN headline. Consumers fear rising mortgage rates; if they were thinking of buying a new house, they are making their move now rather than later.
"Mortgage applications drop further," is another CNN headline.
*** We love the new-born, fresh-faced innocence of the financial press. "Credit binge faulted for rising bankruptcies, loan defaults and repos," remarks a headline from yesterday’s Bremerton SUN. What a delight it must be to discover the entire world as though it had been created yesterday; it is all so new and fascinating. ‘Who would have imagined that borrowing so much money would lead to trouble?’ this journalist must have said to himself.
What can we expect next? We can almost guess at tomorrow’s headlines:
"Housing glut blamed for price collapse.."
"High prices on Wall Street seen as cause of bear market…"
"Too many dollars led to decline, say economists…"
"Record debt levels caused recession…"
*** "Service Industries Go Global: Skilled white-collar jobs are starting to migrate to lower cost centers overseas," says one Financial Times headline.
"U.S. banks transfer analysts’ work to India," says another.
But don’t worry about this trend, dear reader. The Fed can always cut rates!
*** "Errors always come along when you need them." We quote a line from our forthcoming book, Financial Reckoning Day. In it, we describe how you can always count on people to do the wrong thing, sooner or later. We cite, for example, the Japanese in 1941. They were masters of the entire Asian side of the Pacific Rim. The only potential competition they faced was remote and reluctant: the U.S. So, what do they do? The one thing…and perhaps the only thing…that could ruin them – they bombed Pearl Harbor. Tojo immediately recognized his mistake. "I fear," said he, "we have awakened a sleeping tiger."
Nature hates monopolies; every niche is balanced by competition. Every hero has his nemesis. Death stalks every bull and every bear market…and there are sleeping tigers everywhere.
And yet, at the debut of the 3rd millennium, it appeared that the American military had no rival.
A visitor from Mars or West Virginia might have looked at the world and wondered: what could stop the U.S.?
And then came the War on Terrorism. It was a popular project for the Bush Administration, but there was just one problem: a shortage of terrorists. If you’re going to have a war against someone, you must have someone against whom to make war. The American people had all been marshaled to fight terrorism…but, after the 9/11 strike, the terrorists disappeared. They did not take out bridges, or buildings, or even blow up tin cans in municipal dumps. Logical inference: there were very few terrorists.
But then, the Bush Administration may have found the mistake it was looking for: it invaded Iraq. There were no terrorists there either, it turned out. (Nor any weapons of mass destruction.) But the occupation of Iraq may still provide the competition a great power needs. Recent news accounts suggest that the U.S. presence in Iraq is creating terrorists. Arab fighters, says the BBC, are leaking into Iraq, starting new groups, sabotaging pipes and blowing up things. The U.S. military is creating a bull market in terror; every crackpot with a grudge seems to be setting himself up in the business.
Has the U.S. awakened its sleeping tiger? We don’t know. But it has certainly rousted more than a few muslims out of their hot slumber. Now they have a cause…and a target close at hand.
The American military machine may work well against conventional armies, but it has no advantage against determined guerrillas.
"The lesson of Algeria," said a French friend, "is that if they want you out…you should leave sooner rather than later."