Imagine for a moment you had been in on these deals: Your
investment in real estate makes you a clean 50% in less
than a year...
- A "private placement" home run you've put your money in
turns your $50,000 into anywhere between $250,000 and $1.9
million (depending on when - and if - you sold).
- You're in line to earn between 2.5x and 10x times your
money on another exclusive private arrangement. What's
more, you have a tidy income stream from several very good
businesses...play money...
Sure would beat the pants off the stock market these days,
wouldn't it? You'd have EQUITY OWNERSHIP in a number of
very good businesses. Equity you could sell at any time to
the highest bidder...
*** 'It's the economy, stupid!' That thought must have
occurred to investors in the wee hours of last Thursday
morning. "They were reminded," says the Chicago Tribune,
"that a slowing economy and lower corporate profits were
behind the [Greenspan's rate] cut, and the markets promptly
gave back the rally."
*** Both the Dow and the Nasdaq gave back a little more of
the rally on Monday. The Dow fell 40 points. The Nasdaq
dropped 11. Breadth, however, was reasonably good with
1,613 stocks advancing on the NYSE and 1,330 declining.
*** The winners yesterday were the gold mining companies -
up 6% as measured by the HUI. The losers were the biotechs
- down 5%. Could this be a trend in the making?
*** New Era of Networks announced a larger loss than
investors had expected for the 4th quarter; investors cut
the stock by 44.9%. The world's biggest company, GE, fell
4%.
*** Good old Philip Morris, meanwhile, was the day's top
performer.
*** "It isn't a sure thing," said Byron Wien, investment
strategist at Morgan Stanley Dean Witter & Co., recently
quoted in NYTimes article, "that just because the Fed
eases, the stock market goes up. The key differentiating
factor is whether we are in a recession."
*** As long as the economy is healthy - lowering the cost
of credit will boost economic activity and feed into stock
prices. But after a credit bubble splurge people get spent
out - they lose their appetite and ability to take on more
loans. Even though the Fed lowers its Funds and Discount
rates - the lower rates don't necessarily reach borrowers.
Lenders demand higher rates to compensate the greater risk
of default. And borrowers - faced with falling asset prices
- know that the real rate of return on the borrowed funds
may be extremely negative. In such case, the Fed can cut
rates - but nothing will happen. It is said to be "pushing
on a string" - to use a phrase from the dismal science.
*** Moody's estimates that the rate of default on junk
bonds will rise 50% this year. Personal bankruptcies, too,
are increasing sharply.
*** "Everyone remembers what happened when the Fed eased in
1995 and 1998," Wien explained, "but both were because of
financial crises not recessions."
*** "In June 1989," the NYTimes adds, "after a period of
rising interest rates, the Fed began to ease, initially
cutting the Fed funds target rate to 9.5625%. The day of
the first cut, the S&P 500 stood at 326. About 18 months
later, when the Fed funds were at 7%, and the nation was in
recession, the S&P had risen a mere 2 points."
*** "This economy is unraveling at a very rapid rate," Mr.
Wien concluded. Montgomery Ward is going 'chapter'. There
was one corporate bond default on each of the first 4
business days of the New Year - bringing the total for 2001
to $1.3 billion in less than a week. In the last quarter of
'99, LTV and Wheeling-Pittsburgh filed 'chapter' - bringing
the total to 9 U.S. steel makers to go bankrupt in the last
2 years. Two of California's leading utility companies are
close to bankruptcy. And Xerox is selling off pieces of its
business to try to stay alive...while the entire movie
theatre industry seems to be in ruins. More below...
*** California lawmakers are considering a proposal to take
over the power system. "Deregulation's not working," said
the state's treasurer. The state, of course, has big
advantages...as he pointed out. It can force people to pay
taxes - it doesn't need to wait for permission for a rate
hike. This allows it to borrow at lower rates - permitting
the state to pile up much bigger losses over a much longer
time. Plus, it has the power to ignore its own permit, land
use, environmental, health, safety and other silly
regulations that make it so hard for honest companies to
make money.
*** Russia seems to be on the verge of a default, too. It
owes its western creditors - the 'Paris Club' - about $48
billion. That may not seem like much to you and me - but
it's a lot for a country that, for 70 years, ran everything
the way California is proposing to run its power system.
*** The euro slid a little - but still closed above 95
cents.
*** "The true, key source of this fateful boom and the
bubble is all too conspicuous in the monetary data," wrote
Dr. Kurt Richebacher in a recent report. "Since 1995, broad
money has increased a stunning $2.6 trillion, or 60%. Total
credit supply has surged $9.3 trillion, or 54%, to $26.5
trillion. But the most violent crescendo has taken place
since late 1998, after the Fed's easing in the wake of the
Asian-Russian crisis. Broad money in the short span of time
since then has virtually exploded by $1.5 trillion (27%)
and overall credit supply by $5.3 trillion (25%). Compare
these astronomical money and credit figures with annual
nominal GDP growth since end-1998 of around $775 billion."
(see: Fighting or Hiding Inflation?)
*** We drove back into Paris on Sunday night. There was a
lot of bellyaching, but all of the children headed off for
school on Monday morning without a hitch. Paris is cold,
gray and rainy - wonderful weather, actually, for sitting
in a brightly lit bar (such as the Le Paradis next door)
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She referred to my son Will, who joined in our dinner party
on Saturday night. As I explained to her, Will graduates
this year, with a degree from St. John's College. After
about 4 times as much formal schooling as Abraham Lincoln,
Will is prepared for almost nothing. But at least he has
read the classics and can quote Aristotle to provoke bar
fights.
In France, students are not educated. They are 'formed,'
prepared to do something. A young man without a 'formation'
is forced to become a manual laborer.
"Well, he as a good foundation in the humanities," Anne
said generously.
"Yes," I replied, "he has intellectual capital."
And so, dear reader, I come to the subject of today's
letter: intellectual capital. Does it really make
businesses more valuable than their balance sheets reveal?
Le Monde, France's equivalent to the Washington Post or New
York Times, adds to readers' intellectual capital every day
- giving them ideas, information, and misguided opinions
masquerading as news. Colleges and universities add
billions of dollars worth of intellectual capital to the
nation's stock every year. Does it really pay off? Is
intellectual capital something real - or just another big,
empty phrase? I will leave that for another day and stick
to investments today.
The q ratio compares the price of a company's stock to the
replacement cost of its assets (roughly, book value). Over
the long haul, the q ratio has been fairly stable and had a
predictive quality. Whenever stocks were extremely
expensive relative to their underlying asset value - or
extremely cheap - the odds increased that stock prices
would soon move to bring q back to its mean.
As I have previously reported, q is now very much in
overvalued territory and seems to be anticipating a return
to much lower stock prices. In fact, in their book, Valuing
Wall Street, authors Andrew Smithers and Stephen Wright,
calculate that the Dow should fall to somewhere between
1620 and 4590 in order to bring it into line with previous
correction episodes.
But an alert DR reader reminded me that James Tobin
himself, creator of the q ratio, came to believe that it
had become irrelevant to the New Economy. His point was
that businesses had much more "intellectual capital" than
appeared on the balance sheets. If you increased the
denominator of the ratio - that is, the replacement cost of
the business - by the actual value of this intellectual
capital, the ratio would fall into more common territory.
It would show, perhaps, that stocks are not overvalued
after all.
Intellectual capital is not something new. One has only to
gaze at the face of Notre Dame cathedral a few blocks from
my office to see that even hundreds of years ago people
knew how to do extraordinary things. Stonemasons and
architects spent their lifetimes perfecting their skills.
If you had put a value on their enterprises - you would be
a fool to neglect the level of craftsmanship they could
turn out.
But why would you ignore it? You could see from the output,
comparing my stonewalls to the fa‡ade and flying buttresses
of Notre Dame, that the medieval builders had far more
intellectual capital than I do. I may know more about the
derivatives market...or more about tobacco farming...but
intellectual capital in the abstract is useless. It only
has value when it is applied to a specific purpose. It is
the output that gives it value. A man could 20 years
studying computer science at MIT - and then get a job
tending bar in Cambridge. Of what value is his intellectual
capital?
People have always had intellectual capital - and always
applied it to improve their standards of living. They built
pyramids and bridges, raised crops and laid out
railroads...they turned out TVs, radios, automobiles,
microwave ovens - and all manner of other devices - by the
millions. Yet only now, in another humbug contrivance of
the Information Age it is thought that businesses might be
worth more because of the "intellectual capital" held by
the workers behind the scenes.
If the capital is worth anything at all, it has to be
because makes things better in the real, physical world.
Otherwise, it might be like faith or sunrises - which make
things better, but not in a way you can capitalize.
"The Labor Department's figures [for] 'average gross weekly
earnings' ...for the 10 years since 1990," reports Dr. Kurt
Richebacher, show "an overall increase from $259 to $271.
This was a gain of 4.6% over the whole period, or less than
half a percent per year."
If this intellectual capital has any value, it's not doing
the much good for the people who are supposed to have it.
But if employees are not getting the money, maybe it is
showing up in earnings? Earnings have been rising by 15%
per year since 1990 - twice as fast as GDP. But it appears
to have little to do with extra productivity. "The main
source of the prolonged profit improvement during the
1990s," notes Dr. Richebacher, "was a sharp decline in the
corporate interest bill...In 1990, corporate interest
accounted for 6.3% of national income, in 1995 for 3.7% and
in 1998 for 3.3%. This decline has actually provided two-
fifths of the profit advance over this period."
What's more, a look at Price/Earnings ratios show stocks to
be extremely overvalued - even after the bear market of
last year. The Dow is trading at nearly 19 times earnings -
or 50% above its average. Even if there is intellectual
capital at work - it is not enough to bring the P/E ratios
into line with historical standards.
So, if there is intellectual capital lurking under the
balance sheets of U.S. firms - what does it do?
Unless there is a measurable output - intellectual capital
is a worthless as an analyst's recommendation. And if there
is measurable output - there is no need to pretend that the
business is worth more than it appears to be worth, thanks
to the illusive "intellectual capital."
Stay tuned...more tomorrow from your very own intellectual
capitalist,
Bill Bonner
"Dad, could I get a job in your business?" Will asked me.
"Of course," I replied. "But it might be better to work for
one of our competitors; wreck their business first."
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Last modified: April 01, 2001
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