Where Does The Money Come From?
I have been puzzling for the last 2 days over an interesting irony of the Information Age, suggested to me by my friend, John Forde.
John noticed that the drive train of the Information Age — information — had become worthless. People now expect to get it for free — like air.
This is an alarming thought for someone who has made his living selling information, ideas and opinions. They are all available — almost any kind of dopey opinion or misleading fact you could possibly want — on the Internet. No charge.
But it costs money to generate information. Whether I send a reporter to Russia, or simply sit in my office in Paris, it costs money. Where does the money come from?
Currently, much of it is coming from investors. We looked at a new competitor recently. It offers information and opinion on financial topics over the Internet. We couldn’t figure out how it would ever be profitable. Even before the Internet Age, we didn’t believe customers would be willing to pay for the information it offered. Now, with the general devaluation of information — it appears hopeless. But this didn’t stop a group of investors from putting $10 million in the project.
They were not thinking like businessmen, obviously. Their hope is to pass the project along to the public at many times their investment. They don’t care if it’s profitable. God knows how it ever could be.
Investors are taking up Internet projects like a Russian soldier might take up an ?clair. They do not worry too much about what is in them.
John remarked that not only was the Information Age destroying pricing power among information companies — it also seemed to be devaluing tangible items. Signing up for a couple on-line video services in New York, John noticed that they each sent him a gift to build customer loyalty. One sent a book. The other sent some sort of gift certificate. How much could a customer be worth, he wondered?
The traditional way to make money is to invest in some plant or equipment that makes something people want. People then buy the stuff you offer. The investor makes a profit.
Time Warner knows how to make money. It invests in, say, a new movie. Then, it sells tickets to see it. Simple enough.
But how does AOL make money? Well, it doesn’t make money. It believes it will make money this year, however, by offering people access to the Internet and charging for it. Of course, you can get on the Internet without paying a dime too. So AOL’s product is a bit like the ideas and information that the Internet has made worthless.
Amazon, meanwhile, believes it is safe because it sells baby carriages, books and other tangible items. The Internet is not likely to make them worthless. But it is likely to reduce the margins you can make selling them. Amazon builds loyalty by dumping products at below-cost prices — transferring investors’ money to the customers. When investors get fed up of having their money given away — the relationship with the customer will go bad too. Amazon says it is investing in that relationship. But it is an investment that is unlikely to pay off.
Capital spending should lead to profits. Stock investors have been dumping huge amounts of money into the market. Share prices have risen 17% per year for the last 17 years. Against this, the GDP has only grown at 6.1%. The share prices are predicting a huge increase in profits and GDP. In fact, the economy would have to grow at about 20% per year for each of the next 10 years in order to catch up to share prices.
Don’t hold your breath. Such a rate of growth is impossible. And a quick look at profit growth over the last few years shows little of that either. Dr. Kurt Richebacher points out that “aggregate non-financial profits… have stagnated for two years now.”
How come? The answer that leaps to the lips is that capital spending hasn’t been very smart. Or there hasn’t really been much of it.
Dr. Richebacher has repeatedly shown how the figures on capital spending are fictions. A relatively small amount of real spending on computers — $7.6 billion — in the first half of ’99 was transmuted into $88.6 billion by the statisticians’ legerdemain. This number then accounted for 78% of GDP growth — which is also a fiction.
And instead of using the capital available to them for real investments, businesses are frittering the money away. The idea, so popular in American business circles, of “increasing shareholder value,” results in a very short-term view. Managers seek to boost profits per share in the shortest possible time. And the way to do that is to cut costs.
This increases profits for the business — for a while. But businesses are both suppliers of products and customers of other businesses. And as the culture of cost cutting spreads throughout an industry, soon the cost cutter becomes the cost cuttee. What goes around comes around. Soon, fewer of his own products are being sold. Cost cutting produces efficiency… but only short term profit growth. To get real profit growth over time you have to invest for the long term.
When the rewards from cost cutting fell, businesses began a wave of mergers and acquisitions. This is a way for a business to buy earnings — and outsource the cost to Wall Street. AOL is buying Time Warner to get a half billion in earnings. It is buying it not with earnings, but with stock. Courtesy of Wall Street, in other words.
But where does the money come from? If wages are not rising at a unusually high rate… nor productivity… nor corporate profits… and certainly not savings (where would the money come from, anyway?)…
Dr. Richebacher has found the source. Credit. First, there was the Japan carry trade. Speculators borrowed cheap yen, and invested the money in the US. Then, when the yen rose against the dollar, they switched to gold. Borrow the gold, sell it, and invest the money in stocks. That blew up when gold rose in price last September. But now, government-sponsored home mortgage lenders “have practically grabbed the credit bubble baton from the leveraged speculators,” says Dr. Richebacher.
Fanny Mae, Freddy Mac and others have been doing home equity loans at a furious pace. In 1998, for example, they increased their assets (loans) by $306 billion. This was at a time when nominal GDP increased by 400 billion.
As a result, the average person traded something real — the equity value of his own home — for the promises of Wall Street. Unfortunately, the money wasn’t invested in new machinery and equipment — which might have made it possible to make good on those promises. Most of it went to pay employees, buy advertising, make venture capitalists rich, or give people something for nothing over the internet.
Maybe I am an old fuddy-duddy, but ‘something for nothing’ usually turns out to be expensive.
Best wishes for a nice weekend.
Paris, France January 14, 2000
P.S. John Forde got together with Lynn and Dan and wrote a paper on where they saw the Internet economy going… and how to profit from it. Send for it simply by writing to Daily Reckoning. Like almost everything else on the Internet — it’s free. (But we have included a pitch for the Fleet Street Letter… whose recommendations are doing very well. Lynn’s steel company is up 188%!)
P.P.S. Steve Case is a genius. He hedged his bets by buying something real — entertainment. Also, he used some of his own money to buy something even more real — property in Hawaii. He is now one of the largest landowners in the state.
P.P.P.S. It has turned cold in Paris. My son, Will, is headed back to school in Santa Fe today. The rest of us will drive out to the country, as usual. But the weather is threatening sleet or snow. And the truckers are threatening too — they’ve blocked traffic to protest something. So, I’ve got my fingers crossed.
*** A slow news day. Or maybe it’s just me. The Dow rose 31 points. The S&P went up 17 points. And the Nasdaq went up 107 points.
*** Nothing much to get excited about. The economic data released yesterday seemed to show that the economy was advancing nicely, inflation was still shyly refusing to take center stage, and things looked pretty darned good.
*** And Alan Greenspan — who must be the luckiest economist who ever lived — said that nothing would disturb the sleep or balance sheets of America’s investors.
*** So the light-headed brigade halted their retreat and headed back into the valley of the shadow of financial death. AOL came back by $4.25. Time Warner rose a bit too.
*** And they were both absurdly expensive even before they started to cotton up to each other. Time Warner was selling for 140 times earnings. And once combined with AOL the company is supposed to sell for 10 times Y2000 gross revenues and more than 200 times profits.
*** What’s more the company would have a market valuation of about $350 billion — substantially more than the entire stock market of Spain. But comparisons are odious. And why shouldn’t an entertainment company with Internet access be worth more than Spain? Most of the Spanish don’t even have Internet accounts. And they cannot even speak their own language without an accent. *** The movement in the techs and nets is an aberration. But there is another movement in the market that may be the real thing. Breadth is improving. For the last 20 months we’ve watched as more and more stocks have lost more and more ground. Day after day, the number of stocks going down in price has exceeded the number rising.
*** This has created a huge distance between the average stock — and the “Rocket Chips,” the high fliers in the mostly tech and net sectors. That distance must narrow somehow.
*** The numbers show that the average stock is rising in price. Even though the Dow was up a paltry 31 points, the number of advancing stocks beat the number of declining ones nearly 2 to 1. And there were 90 stocks hitting new highs yesterday, compared to only 63 hitting new lows. I can’t say whether this will continue.
*** Meanwhile, I suspect that — despite yesterday’s Nasdaq rise — the high fliers are in trouble. Yahoo, trading at 2,000 times earnings, was at 500 on Jan. 4. Now it’s down to 340. Qualcomm rose to 200; now it’s at 140. Richard Russell reports a rumor that if AOL goes below $50 the deal with Time Warner is a “no go.”
*** John Maynard Keynes noted that the more stocks came to be owned by people “who do not manage and have no special knowledge of the business in question,” the more speculative the market became. The amateur speculators had no idea what an investment “is really worth to a man who buys it ‘for keeps.'” Instead they were concerned with “what the market will value it at, under the influence of mass psychology.”
*** What are the amateur speculators doing? Amazon’s shareholders are hardly thinking like businessmen. They are buying and selling the shares as if they were Pokemon cards. 100% of AMZN shares change hands every two weeks.
*** And Steve Briese reported near the end of last year — analyzing the option market in his publication “Bullish Review” — that the small traders had a record high bullish position. The big trading houses themselves, such as Goldman or Merrill, took the other side of the trades.
*** Even gold was feeling pretty good yesterday — rising $1.40. A friend commented that my fidelity to gold made me seem hopelessly retro, fuddy duddy… and even shallow. Everyone knows gold has been discredited, he opined.
*** The argument against gold is that the risk of currency failure, credit collapse, and monetary meltdown can now be hedged with derivatives. Worried about inflation? Just buy a bond indexed to the CPI. The seven largest US banks now have $33 trillion in derivatives on their books — an amount equal to more than three times the total US GDP. Against this, they have total equity capital of $460 billion. In a real meltdown, how many of these deals would pay off?
*** The gold discussion raises deep questions about the nature of markets… and man. Is human financial progress cumulative, like science… so that old theories and old tools can be thrown away, replaced by new and better ones? Or is it cyclical… or episodic… like virtue — requiring from time to time the help of the most basic, primitive and immutable propositions? The prohibition against murder, for example — chiseled in stone many thousands of years ago — has been ignored for long periods, but never replaced. Has gold?
*** The Herald Tribune reports that the First Femme, the Eva Peron of American Politics, did not arrive at the Letterman Show in New York on Wednesday via the NYC Transit Authority. Unlike poor Cherie Blair, wife of Britain’s Prime Minister and 4 months pregnant, who uses London’s crowded and frustrating tube system to get to work, Hillary arrived with an entourage of TEN vehicles.
*** Doug Casey managed to capture the spirit of the Age of Festivus in his latest newsletter. “When you have all the stuff you can use, and more information than you can even comprehend… in 10 lifetimes, entertainment is all there is.” This must have been Steve Case’s thinking too.