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Contributed by Bill Bonner
Publisher of: The Fleet Street Letter

PARIS, FRANCE 
WEDNESDAY, 17 JANUARY 2001 

 

Today:  Failure of Imagination

*** Earnings reports - treacherous times. Fed is fighting 
the credit cycle....

*** Dow up, Nasdaq down...gold goes nowhere - is it out of 
fashion forever?

*** Major defaults...GE...GM...and more!

*** The big boy - GE - was supposed to come forward 
yesterday and make its announcement. Did it 'beat the 
numbers' yet again? Or was this last quarter of the 2nd 
millennium a killer, even for the house that Jack Welch 
built?

*** Here at the Daily Reckoning, we were all sitting on the 
edge of our chaises...for we, apparently alone in the 
universe, are on record saying that GE is overpriced. 
Sooner or later the news will get out, we think.

*** But not yesterday, GE delayed its announcement until 
Thursday. And investors used the occasion to boost the 
stock 4% - a move, I predict, they will some day regret.

*** The Dow rose 127 yesterday. The Nasdaq fell 8. The 
dollar was up a bit - the euro at 94 cents. 

*** Gold rose 20 cents, to $272. "A common feature of 
manias," according to Marc Faber, "is that the asset class 
that was the epicenter of the whirlwind of speculation goes 
out of fashion for a very long time - in fact, usually 
forever."

*** Gold was the epicenter of a bubble in the late '70s. 
Has it gone out of fashion forever?

*** Earnings are falling. Earnings almost have to fall. The 
economy is slowing down, as everyone knows. But beyond 
that, earnings always fall at the end of an asset boom. 
That's how they work. People pour money into capital 
investments - because capital assets are rising in price. 
"In the recent U.S. capital spending boom," wrote Marc 
Faber a few weeks ago, "capital spending as a percentage of 
the economy reached a 40-year high." This created a glut of 
capacity - which could only end in falling prices and 
falling profits.

*** But there's something else at work: accounting. Faber 
explains that profits surged in the first stage of the boom 
because "the sales of business equipment were immediately 
recognized as revenues by the vendors, whereas the expenses 
of the purchased equipment will only gradually be 
recognized by the buying company." Capital assets are 
expensed over time.

*** "When the boom stops accelerating," continues Faber, 
"profits slow dramatically as the back-end expenses rise 
faster than the front-end revenues." We are plainly at this 
stage now. 

*** As of the 11th of this month, a record 624 companies had 
issued earnings shortfall announcements - almost twice as 
many as the year before. The previous high was 554 whose 
earnings fell short in the 4th quarter of '98. Nokia, Yahoo, 
Gateway, Int'l Paper, Ameritrade, Martin Marietta have all 
disappointed investors. And, as one analyst put it, "it's 
still early in the game."

*** The Fed is fighting the credit cycle. It hopes to pull 
off the same 'reliquification' that it managed in 1998 - 
when it was faced with LTCM, Russian debt, and Asian 
currency crises. One of the effects of that reliquification 
was that good money was poured into glutted industries, 
following the bad money that had already been lost. 

*** "Over the past 11 quarters (first quarter 1998 to 
third-quarter 2000), in what has been a key aspect of an 
almost continuous reliquefication, home mortgage lending 
expanded by more than $1.1 trillion, or 30%," writes 
Prudent Bear, Doug Noland. "Predictably, the results of 
this reckless credit expansion have been spectacular home 
price inflation, and resulting overspending (and massive 
trade deficits) by the household sector. ... The question 
now becomes, when does the marketplace discount this 
scenario, and what are the ramifications for interest rates 
and the dollar." 

*** The International Harry Schultz, a man who has been 
logged in Guinness Book of World Records as the "highest 
paid investment consultant" on Earth for over 20 years, 
sees only weakness in the dollar. Schultz: "Why is the US$ 
'weak' when it's not far down from its multi-yr high? For 
some of the same reasons the Nasdaq was weak when it was 
making one new high after another. It was pricing itself 
out of existence. The US$ has priced many US products out 
of world mkts, & US current account/trade deficits are the 
biggest in world history, for any nation or any 5 nations 
combined." 

*** "The US$ is also vulnerable because of bad US bank 
loans," continues Schultz "derivatives, certain commodity 
shortages, looming recession, the tech stock catastrophe, 
the productivity myth, oil denomination, overvaluation of 
most US stocks, corporate over-merging, endless spin on a 
strong $ which can lead to overnight disenchantment..." 
(see: Complacency Has No Reward)

*** In fact, the news is full of evidence of financial 
distress. Both Globalstar - a giant telecom - and 
California Edison said they could no longer pay their 
bills. The Financial Times reports that the Bank of America 
would write off between $1.1 and $1.2 billion in bad debts 
this week. 

*** The average 401 k fell 4% last year. Owners cut back 
their exposure to stock from 80% two years ago to 70% at 
the end of last year.

*** "There is no evidence," concludes the Financial Times, 
after reviewing a report from Ernst & Young, "that the 
large increases in information technology investment over 
the past 5 years has raised the rate of UK productivity 
growth." 

*** While GE rose 4% yesterday, GM rose even more - 5.4% to 
$55.75.

*** And here's a little item on the indomitable human 
spirit from the Independent Institute. Despite billions 
spent to wage war on drugs...and a prison population that 
is the envy of incarcerators the world over...federal judge 
John L. Kane noted that "about 1.3% of the population is 
addicted to cocaine - the same percentage as in 1979, a few 
years before the Drug War, and the same percentage as in 
1914, when cocaine was sold legally in grocery stores."

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FAILURE OF IMAGINATION

"Half the American population no longer reads newspapers: 
plainly, they are the clever half."

Gore Vidal


There are "minor investment manias" and there are major 
ones. 

"Minor manias," Marc Faber reminds us, "took place in the 
US in bowling stocks and SBICs in 1961, in gaming stocks in 
1978, in the first PC companies such as Commodore, Atari, 
and Coleco (whose original business was above-ground 
swimming pools) in 1983, and in such 'dubious' companies as 
Presstek, Diana and Iomega in 1995."

These minor bubbles are like border wars or revolutions in 
small countries. They attract little attention and are over 
before most people become aware of them. For example, 
Laurent Kabila was shot and killed in the Congo yesterday. 
But who cares? I never met the man.

Major manias - like world wars - are another matter. "When 
these major bubbles (1873 and 1929 in the US, 1989 in 
Japan, 1997 in the emerging economies) are pricked," writes 
Faber, "the impact on the economy is usually felt around 
the world and leads to vicious recessions or depressions."

The world has had some experience with major financial 
manias. But Americans' personal experience is frail. An 
investor would have be to at least 90 years old to recall 
the '29 crash and Great Depression as an adult. There are 
some active nonagenarian investors - but not many.

So what do we have? Books? Histories? Theories? And our 
imaginations.

That is the problem with humans, dear reader. We lack the 
imagination to see things as they really are. How much 
happier a woman would be if she could see her husband as 
the man he really is. And how much more successful her 
husband would be, too, if he could only open his eyes and 
see the world around him as it really is...rather than as 
it is supposed to be.

The boom...and subsequent bubble on Wall Street, '95 to 
'99, looks for all the world like a classic, major asset 
price bubble. Such events are hardly unknown to financial 
historians...nor are their symptoms difficult to spot: They 
usually begin in a low-inflation environment, for example - 
allowing the expanding credit to feed directly into asset 
prices rather than consumer prices. Consumer price 
inflation was low in the 1920s...and very low again in the 
1980s in Japan. 

Likewise, a major boom is almost always accompanied by some 
technological or business excitement. In the '20s, people 
were able to believe that the new machines and appliances 
were the source of the apparent boom. In '80s Japan, they 
believed in the quality of Japanese management, and the 
whole Japanese enterprise system.

The boom actually plays an important economic role - 
focusing resources on an up-and-coming sector and speeding 
its development. Investors are not crazy to put money into 
the boom...the problem only arises after prices surpass 
reasonable expectations.

In the early stages of a capital asset boom, as explained 
above, the feedback loop works to amplify the boom and 
confirm people's wishful thinking. Profits do rise. Asset 
prices do go up. People do seem to be getting richer.

Since these effects are visible, there must be a reason for 
it. The new technology...smarter management...or, as in the 
case of the South Sea Bubble, the opening of a new 
continent.

The media reinforces whatever delusion is popular at the 
time - providing investors with plenty of information with 
which to support their favorite fantasy. Thanks to the 
media and the mob, people do not have to open their eyes or 
flex their imaginations.

Information, as I have said many times, is cheap. But 
wisdom is dear. And unfortunately, there are many things 
that have to be learned the hard way. 

You can read about sex in books. You can study ice-skating 
in manuals. You can find detailed studies on bear markets 
and depressions on the worldwide web. But to really 
appreciate them, dear reader, you have to experience them 
for yourselves. Our imaginations cannot do justice to real 
life. 

In real life, it is not central bankers' rate hikes that 
kill asset bubbles - they die from natural causes. As asset 
prices rise, the expectations of profit rise with them. 
Finally, they become so wildly optimistic that there is no 
chance they can ever be realized. 

"Just think for a minute about the last great investment 
boom in the oil and gas industry in the late '70s," Faber 
suggests. "It came to an end in Houston and Dallas once the 
oil price failed to rise after 1980."

Why did the price fail to rise? Because oil-producing 
assets had been marked up to such levels that they drew in 
billions of investment capital, which increased supplies to 
the point that prices had to fall.

"When oil prices collapsed in '86," Faber continues, "the 
drilling industry experienced a terrific slump. This would 
have happened even if interest rates had been at close to 
0%, because when an asset declines in value, interest rates 
even close to zero can be high in real terms."

"It isn't rising interest rates that prick an investment 
bubble," Faber observes, "but widespread losses by 
investors."

Rising rates do not bring an end to asset bubbles, nor do 
falling rates protect them. This is the lesson of 
experience and logic. But it might as well be Aristotle's 
Poetics in the original Greek - so remote and foreign is it 
to most investors. 

At this stage, most investors still cannot imagine that 
they have been caught up in a massive bubble...and most 
cannot imagine how it will end. In their minds, Alan 
Greenspan raised rates last year because he thought the 
economy was "overheating." Now, having seen it cool off, 
he's lowering rates...which will put things back on course 
for double-digit stock market gains, year after year.

Yet, Bill King recently described how America's last major 
asset bubble actually deflated: 

The S&P 500, like today's Nasdaq, was down 44.5% when the 
Fed decided it was time to cut the discount rate 50 basis 
points to 4.5%. Two days later, stocks rallied. The Fed cut 
rates in February and March, 1930.

Then, as now, investors were pretty sure that the worst was 
over. There were plenty of bulls back then too...and 
newspapers...and brokers...and Fed chairmen. None of them 
could imagine what lay ahead. Stocks rallied until April 
10, "then," says Bill King, "they started their death 
march." The Fed continued cutting rates - in May, June, and 
December of 1930...and then again in May of '31 and 
February of '32. Stocks just kept going down until, finally 
exhausted, the S&P hit bottom on June 1, 1932 after 8 rate 
cuts.

Your reporter...flexing his imagination...

Bill Bonner
 
 
 
 
About The Daily Reckoning:

Daily Reckoning author Bill Bonner

Bill Bonner is, in spite of himself, a natural born contrarian. Early each morning, Bill writes The Daily Reckoning—his take on the financial markets and what’s going on in the world—and sends it off by e-mail before most Americans’ alarm clocks have buzzed. Many readers say it's the first thing they want to read when they get up—not only because it's informative and thought provoking, but also it's inspiring, in its own quirky and provocative way.

Of course, there's much more to Bill than his daily market commentary. He's also the founder and president of Agora Publishing, one of the world's most successful consumer newsletter publishing companies. Bill's passion for international travel and big ideas are reflected in the company he's successfully built. In 1979, he began publishing International Living and Hulbert's Financial Digest . Since then, the company has grown to include dozens of newsletters focusing on health, travel, and finance. Bill has vigorously expanded from Agora's home base in Baltimore, Maryland since the early ’90s—opening offices in Florida, London, Paris, Ireland, and Germany.

Agora's publication subsidiaries include Pickering & Chatto, a prestigious academic press in London and Les Belles Lettres in Paris, best known as a publisher of classical literature in bilingual editions.

 

 
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Last modified: April 01, 2001

Published By Tulips and Bears LLC