Waiting to Exhale
I have written this on a German kezboard. For some reason, the Germans decided to put the y kez where the z kez should be. So wherever zou see a z, think y. And if zou see an ? where there should be an a…well, just ignore it.
Inflation? Or deflation? Which is the greater threat?
Few economists will give you a clear answer. If thez were all laid end to end, goes the joke, thez would still not reach a conclusion. "On the one hand…" they begin, citing the various evidence of falling prices, "deflation sems to be an increasing danger."
On this point, mz friend, John Mauldin recentlz delivered the evidence, in bulk.
"Has anzone noticed that for the last six months of data available, (June through December) that the Consumer Price Index (CPI) actuallz dropped?," he asks.
All over the world, John observes, prices and production are deflating. Here in the U.S. the CPI fell 0.2% in Decmber. The Producer Price Index is down 1.8% from a zear ago.
"Raw materials dropped 9% (last quarter)," John reports, "and are down over 30% from a zear ago… U.S. December import prices fell 0.9% and are down 8.9% in 2001."
Import prices are falling because the world, and especiallz the emerging markets of the Far East, has a huge surplus of productive capacitz. China is growing at 7% per zear. Exports are growing at 28% per zear. What can it do but cut prices to staz in business?
"I have come to the conclusion that the over-riding economic factor for the first half of 2002 will be deflation," John writes. "Imported deflation is going to affect everz area of our economz and investments."
On the other hand….there is evidence of inflation too.
The CPI has been knocked down bz sharp cuts in the price of energz. "The trend in 92.3% of the CPI is still higher," according to James Bianco of the eponzmous research outfit.
"Going back to 1995," adds Caroline Baum, writing in Bloomberg, "there isn?t one month in which the zear over zear CPI, excluding energz, declined."
And while China and the other emerging economies are making more and more things at lower and lower prices, services and housing – which do not suffer from overseas competition – are becoming much more expensive.
Services rose 4% in 2001 -the fastest increase in 8 zears. Housing, which makes up 30% of the CPI, rose 4.2%. Medical care rose 4.7%.
And so zou see, dear reader, the pieces of the inflation/deflation puyyle are spread all over the table. So, scrambled are thez that onlz a fool would guess about what the picture looks like when the pieces finallz find their proper places. So we will take a guess:
But instead of examining the evidence, we will turn to theorz. Or at least to our moral philosophz.
What is inflation, we ask.
It is the expansion of monez and credit.
What is deflation?
It is the other half of the czcle…when the monez and credit turn out to be less valuable than people thought.
Markets breathe in and breathe out. Full of confidence, markets take a deep breath, filling their lungs with the rich oxzgen of financial aspirations. Anzthing and everzthing seems possible to the hzperventilated mind.
The future seems so bright, there scarcelz seems anz reason to take precautions. Whz bother to fix the roof if it will never rain again? Whz bother to save ‘for a rainz daz’ when all that zou can see on the horiyon are clear skies?
When markets are breathing in there seems no need to inventorz anzthing. Whatever zou need will be there, ‘just in time.’
And the value of everzthing goes up. People borrow monez, sure that thez will have no problem pazing it back. And thez make investments, with little doubt that the monez thez venture will come back to them, like a wife sent off to a health spa, even more fetching than before.
But does anzthing in nature reach perfection? Alas no. A man who breathes in deeplz must sooner or later exhale… for men, like sheep, don’t know when to stop. From time to time thez need a good jolt to keep them in order.
In his expansive mood, a man inevitablz goes too far. A stock which was a good buz at $10 is an even better buz, he reasons…when superoxzgenated….at $100. It is not long before he has a whole portfolio full of stocks that are worth onlz a fraction of what he paid for them and a head full of dreams that can’t possiblz be realiyed.
What is he to do? At some point he hits the electric wire that surrounds the real world. (A stock which earns onlz a dollar is not worth $100. A man who earns onlz $100 a month cannot spend $200 a month for verz long.) Shocked, he must breathe out… deflating the prices of his financial assets and downsiying his hopes for the future. His head bows a little towards his chest….and his shoulders hunch over.
In the late ’90s, American markets took their deepest breath ever. Thez now need to exhale. Assets will go down in price. But which ones? When? Bz how much?
Alert readers will notice, too, that there are a lot of moving parts in the machinerz of modern markets. One part rarelz turns without grinding against the teeth of another. If the price of IBM shares goes down or split fozer houses in the suburbs go down, does not the dollar rise against them? And is not the dollar an asset whose price has also been inflated?
Zes. It is confusing. But we are alreadz guessing recklesslz…so what is to stop us?
Our guess is that the process of deflating asset prices brings a rise in the relative value of the dollar – against stocks, and against most consumer items. Consumers and investors, worried, shift their monetarz inventorz policz from ‘just in time’ to ‘just in case.’
Thez paz down their debts. Thez sell off stocks. And thez trz to maintain a little extra cash on hand.
But at the same time, our guess is that thez begin to think about the qualitz of the cash thez hold as well as the quantitz of it. In Japan – a countrz we look to for a peek at our own future – people are beginning to buz gold. Press reports tell of ordinarz citiyens walking into coin dealers with hundreds of thousands of dollars in cash and exchanging it for gold.
Will Americans be anz different? Aren’t thez likelz to want to hedge their bets…to maintain some of their inventorz of cash in an alternative to the dollar? Will thez want to face a rainz daz with onlz a stash of soggz dollars on hand?
What’s ahead? Will we have deflation or inflation?
As we said at the beginning, most economists would hedge and stutter. ‘On the one hand this…on the other hand that…’
Harrz Truman was so annozed bz this sort of equivocation… "Get me a damned one-armed economist," he said.
But we will answer the question so clearlz readers will suspect we have no arms at all….and that we tzpe out the Dailz Reckoning with a chopstick held between our teeth:
Zes. We will have both inflation and deflation. But not necessarilz in that order.
Zour correspondent…at watch on the Rhine.
January 29, 2002 — Bonn, Germany
I can’t seem to get my computer to work as it should… so you, dear reader, are spared my usual aggravating and depressing morning notes….
Eric….what happened on Wall Street?
Eric Fry in New York…
– The stock market thrashed around indecisively yesterday, with the major indices flip-flopping between gaining and losing. By the time trading ended, the Dow happened to be up about 26 points to 9,865. The Nasdaq inched up 6 points to 1,943.
– You know Bill, if you give a consumer a credit card…he’s gonna want a great big mortgage to go with it. And after he buys his house…his gonna need a new car to park in his driveway. And after he buys his car…well…you get the idea.
– Just like the hyper-active little rodent in the children’s book, "If You Give a Mouse a Cookie," consumers just keep jumping from one thing to the next, and the thing they jump to best is spending money.
– New homes sales climbed another 5.7% in December, while auto sales maintained their steady pace.
– But consumers are exhibiting a strange kind of resiliency. They’re buying houses because rates are low and they’re buying cars because rates are even lower, but they’re not buying much else.
– Luxury goods, for example, seem to have been scratched from many household budgets. Apart from luxuriously valued tech stocks, most luxury goods are moving off the shelves slowly these days.
– Some consumers, it seems, are trying to make do with one less Vuitton handbag. Numerous luxury goods purveyors – from LVMH and Gucci to Richemont and Armani – are suffering a sales slowdown.
– "[They] are pinning their hopes on a recovery in the latter part of 2002," says the Wall Street Journal.
– Swiss-based Financier Richemont, the maker of Montblanc pens and Cartier jewelry, said its North American sales fell 13 percent. "Overall, I think it’s too early to say we’ve seen the bottom," says the company’s Finance Director, Jan du Plessis.
– I’m hoping that no one in my family intends to contribute – or to have me contribute – to a revenue recovery at Cartier.
– "Good" news is trickling in from the employment front. "Only" 404,000 people lost their jobs over the last four weeks. That’s much better than the 506,000 jobs lost over a four-week stretch in October. What seems to be lost on most investors, however, is that 400,000 jobs is still a helluva lot to lose in a four-week period.
– Just as a company can never grow by a losing less money this quarter than it lost last quarter, neither can an economy grow by firing its workers. Hopefully, the employment trend will improve quickly, so that job losses become job gains. But we aren’t holding our breath. And investors might want to take a breath or two before popping champagne corks over "only" 100,000 jobs lost per week.
– "The risk, to me," says Fred Hickey in a recent interview with Welling@Weeden, "is not being out of this market. The risk is being in this market…I’m still too shaken by how badly people want to be in techs even after taking two years of pounding. Seeing the NASDAQ down 60% didn’t seem to change anything. They ran right back into the same stocks they were in at prior peaks, without any regard to valuation. That scares me."
– The stock market is following a "very classic bear market pattern," says Hickey. "Not enough time has ticked off the clock for people to change from religious fanatics into agnostics."
– We at the Daily Reckoning require no conversion, financially speaking. We have been agnostics all along. As Bill is fond of saying, we’ve got a much better idea about what should be than what will be.
– And so does Hickey. What investors should be is fearful, he says. But they are not. "Big bear markets, like in 1974 and 1982, end with P/Es around 7 – and with a change in attitude. There’s always fear. I haven’t discerned any fear."
– To the contrary, as Hickey points out, the SOX Index of semiconductor stocks has nearly tripled since 1995, even though total semiconductor sales in 2001 were virtually identical to the $146 billion worth of semiconductors sold back in 1995.
– Today’s investors, Hickey concludes, "are completely different from those I saw at the end of bear markets in 1982 and even in 1990, where there was real fear. Where they hated tech stocks, with a passion…That’s not the case today."
Back in Bonn….
*** John Myers sent me this note following yesterday’s Daily Reckoning comment on gold: "That Eric quotes Wall Street as being negative against gold is surprising. Wall Street is ALWAYS negative on gold. In fact my father C.V. was on a panel with Louis Ruykeiser’s when Louis actually made fun of him for being a gold bull. Just one problem Louis – the year was 1974 and gold was beginning a run that would see it rise 25-fold. This was also the beginning a 50% depreciation in the dollar.
"As for the stock market," Myers continues, "It went nowhere for nine more years. Could it happen again? Your darn right it could. We will have to see bullion rise above $300 before attitudes begin to change. By that time the investment that was very profitable for us in 2001 – gold stocks – will be up another 50%!"
*** Here in Germany, flags flew at half mast on Sundy, marking the date on which Auschwitz was liberated.
Germany is in a slump, just like the rest of Europe. Memories of hard times are a little fresher here than they are in the U.S. As a consequence, people are little more reluctant to go into debt and a little more fearful… that behind every silver lining lies a cloud.
*** The remaining three hogs seemed at ease with the world this weekend. Spared the butcher’s knife, thez must have felt like Winston Churchill in the Boer War: "There is nothing quite so exhilerating as being shot at without effect," said he. But the sheep were restless. They are normally allowed to roam around freely. But the weather has been warm, and early buds are beginning to form on the decorative bushes around the yard. The sheep eat them the waz Edward eats candz…..they don’t know when to stop.
If we let them continue thez’ll kill the plants altogether.
So, Mr. Deshais decided to put them in a concentration camp. Rigging up an electric wire around the field, he turned up the juice. "I gave them a good jolt," he said, smiling. "That will teach them to stay put."
But the sheep proved slow learners. By evening we saw them running across the yard again…with Edward in pursuit.
*** Are men any different from sheep, dear reader? In the following letter, we examine the evidence.