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Contributed by Bill Bonner
Publisher of: The Fleet Street Letter

OUZILLY, FRANCE 
WEDNESDAY, 21 FEBRUARY 2001 

 

Today:  The Coming Internet Depression, Part ll

*** The Cisco Kids get ponchoed again...CSCO below $27.

*** Mr. Market changes his mind....the Big Techs get 
whacked...and the whole economy heads down...

*** The winner's curse...options hurting capitalists and 
the proletariat...what happened to the Day Traders...'Yo 
Momma's Last Supper'...and more!

*** Reuters reports that the IMF expects the US economy to 
grow at 1.7% this year.

*** The Philadelphia Fed estimates growth at 2.2% - down 
from 3.3% just 2 months ago.

*** Both of these estimates could turn out to be high. But 
even if they are accurate they leave no doubt that the U.S. 
economy has lost its miraculous vitality...and the New 
Economy is not much different from the old one. The 
business cycle lives. But what is new? More below...

*** After investing too much in the latest tech wonders, 
investors are now discovering that their investments are 
worth less than they thought. Not that Mr. Market was wrong 
about Amazon.com when the stock was at $200...and the 
Nasdaq was over 5,000. Mr. Market is never wrong. But he 
changes his mind about things. Yesterday, he took the 
Nasdaq down 4.4% - or 106 points. And Amazon.com he 
repriced at $12.50. 

*** The story was similar throughout the Big Tech sector. 
Companies on which investors had spent billions of dollars 
slipped down to the point where they are worth only a few 
million.

*** Cisco, for example, is a "must own" New Economy stock 
that sits in almost every institution portfolio like a lump 
of old French cheese in a warm room. The aroma was good 
when it was fresh - but now, it stinks to high heaven. 
Billions have been lost on Cisco, whose shares sank 
yesterday to $26.50. The stock has lost 68% of its value 
since it hit a high of $81 last year. 

*** Cisco was singled out for rough handling because its 
CEO dared to speak the truth in Europe over the weekend. 
"It makes no difference what the Federal Reserve or the 
latest statistics say," Mr. Chambers told a Swedish 
newspaper, "What we see now is absolutely not a soft 
landing. Ask anyone in American manufacturing industry and 
they will say that we are in a recession. If the situation 
does not change before the half year stage there is a risk 
of a domino effect whereby the rest of the world will be 
imminently affected." Again, more below...

*** Cisco, Amazon, GE all suffer from what Richard Thaler 
described as the "winner's curse." Thaler noticed that the 
winning bidder for oil drilling rights almost always paid 
too much. Estimates of the value of the rights varied 
greatly, he pointed out. The winner was the one with the 
most optimistic view. But, the most optimistic view was 
rarely the correct one.

*** Cisco, Amazon, and GE - were the big winners of the 
late 90s - each one dominating its space, and paying far 
too much for acquisitions, customers and just about 
everything else. They are all doomed...

*** One thing for which leading companies paid too much was 
labor. Not hourly labor - but top talent, which was 
typically awarded huge bonuses and stock options. 

*** This became a feature of 'late, degenerate American 
capitalism' - companies were operated for the benefit of 
employees and customers, and not for the benefit of the 
capitalists.

*** Chief executives tended to get multi-million dollar 
compensation packages - including bonuses - even when they 
run down a firm's balance sheet. And employee stock options 
effectively redistributed capitalists' money to the working 
stiffs.

*** "As a clear illustration of the latter point," writes 
Marshall Auerback on the Prudent Bear site, "consider the 
case of Microsoft... An owner of 100 million Microsoft 
shares (340,000 initial shares split-adjusted) in 1986 
would have had a 2.8% share in the company at the time. If 
the share count had remained unchanged since 1986 the value 
of this 2.8% holding would have amounted to $8.4 billion if 
today's $300 billion is accepted as fair approximation of 
true market value. However, as a result of the prolific 
share issues to employees, a holding of 100 million shares 
today represents a 1.8% ownership interest and is worth 
approximately $5.4 billion at current market value. 
Shareholder dilution skimmed 36% of potential appreciation 
off the top."

*** "This is the kind of dilution that Warren Buffett, 
amongst others, has extensively criticised.," Auerback 
continues, "But whereas Buffett was a virtual lone wolf in 
respect of his attacks on the practice, the number of other 
market participants critical of the impact of this 
egregiously unfair dilution has multiplied now that the 
costs of such activities are becoming more readily apparent 
in the context of a declining Microsoft share price."

*** But employees, like everyone else, often end up getting 
what they deserve, not what they expect. The Wall Street 
Journal: "As the Internet bellwether's stock has plunged 
more than 80% this year, many Yahoo! employees are likely 
holding options that are currently worthless, or have a 
value that's a lot lower than when they were awarded. With 
options having lost much of their appeal, there's likely to 
be an increased need at Yahoo! to pay out cash to retain 
and attract people."

*** But many of those who were previously attracted now 
have a problem. The New York Times: "Stock option and tax 
experts say thousands, if not tens of thousands, of 
employees are waking up to a real hangover as April 15 
approaches. The reason is that investors generally incur 
taxes when they use their options to buy stock. Even if the 
stock price plummets, the tax bill remains unchanged. 
Whether through bad luck, mismanagement, market 
restrictions, ignorance or greed, many people failed to 
sell enough stock to cover the bill. They treated paper 
gains as real and even borrowed against them. And they 
presumed that when tax time came, the money would be 
there."

"Many people have fallen into the trap where they owe more 
money in taxes than they got out of their stock options," 
said Kaye A. Thomas, an authority on stock options, "Some 
people have basically been bankrupted by their tax 
liability." 

*** The dollar rose, knocking the euro down to 91 cents 
yesterday. Gold, always on the other side of a dollar 
trade, fell $2.20. 

*** "Leading energy research firm Cambridge Energy Research 
Associates said Thursday that world oil production capacity 
will grow from 79 million barrels per day in 2000 to 92 
million barrels per day in 2005," reports Dan Ferris. Dan 
reminds us that Information Technology uses a tremendous 
amount of power. "The Internet's dirty little secret," he 
says, "is that it runs on coal." 

*** "Forget the free-market talk from Curtis Hebert, the 
new head of the Federal Energy Regulatory Commission," 
writes John Myers of Outstanding Investments. "He indicated 
in a television interview this past week that California 
had created its problems, and California was going to have 
to solve them. Then he extended the emergency supply orders 
that makes gas and electrical suppliers sell to California 
utilities even though they don't want to out of fear they 
won't be paid." But there's still room for investors to 
make money... (See: Depression Era Big Government in Force 
in California)

*** What happened to the day traders? We hear nothing about 
them. "Day Traders go back to day jobs," says a headline in 
the Arizona Republic. Day trading was never anything more 
than gambling. But the odds were much better in Las Vegas 
than in Manhattan.

*** Maria prepared a delicious dinner last night. I know 
you don't care what we had for dinner, but I will tell you 
anyway: Salad, duck pate, Brussels sprouts, fried potatoes, 
stewed tomatoes and sausage. Only the sausage was 
bought...everything else came from our own garden, grown 
and preserved by Mr. Deshais. I am bucking the trend of the 
last 2 millennia: I'm going to buy some pigs so we'll be 
able to make our own sausage for next winter. 

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THE COMING INTERNET DEPRESSION, Part II

"What nobody saw, though some people may have felt it, was 
that those fundamental data from which diagnoses and 
prognoses were made, were themselves in a state of flux and 
that they would be swamped by the torrents of a process of 
readjustment corresponding in magnitude to the extent of 
the industrial revolution of the preceding 30 years. 
People, for the most part, stood their ground firmly. But 
that ground itself was about to give way." 

Joseph A. Schumpeter, Business Cycles, 1939 


When I returned from Paris to the little town of 
Montmorillon last Friday night, a cloud of black smoke 
arose from the center of town.

"We had better take the back roads," said Elizabeth as she 
picked me up at the station.

In the center of town, a sleepy little burg whose last role 
on the stage of world events was performed during the 
Hundred Years' War with Britain in the 14th century, when an 
angry mob had formed. And there, where the two principal 
roads meet, a pile of tires burned - sending black smoke up 
over the church spire and Mayor's office.

The point of controversy was the subsidies paid to farmers. 
Most unhappy are the beef producers, who have been caught 
on the horns of the 'mad cow' dilemma. Though only a 
handful of people have come down with the disease, fear is 
widespread...so that the price of beef has fallen. 

And then, last week, a relative of 'mad cow' disease was 
reported in sheep. There is no evidence that anyone was 
ever made sick by the sheep disease, but it was enough to 
throw another panic into the farm community. So, all over 
France, last week, farmers demonstrated for higher 
subsidies. 

"Where you stand depends upon where you sit," goes the 
expression. My neighbor, Pierre, is in favor of more 
subsidies for farmers. Catholic, conservative...he 
nevertheless sits on a tractor a good portion of the day 
and believes the state has the responsibility to make sure 
he gets a fair price for his beef. Already, about half his 
income comes from government subsidies, but he wants more.

"Farmers always complain," said Maitre Boulzaguet at 
Saturday's party...dismissing the demonstrations.

Yes, they always complain about the weather....and about 
farm prices. What is unique to our age is that they also 
expect their success or failure to be a collective 
responsibility.

Governments never tire of trying to rig prices. Politicians 
always try to favor their friends and destroy their 
enemies...interfering in the market as much as they can in 
order to bring about some unnatural result. But never 
before have the markets been so jimmied on such a grand 
scale and at such colossal risk.

What my neighbor Pierre expects from the European Union, 
the average American investor and householder expects from 
the United States Congress...and the Federal Reserve - 
protection from the crises of capitalism and from the 
consequences of a free market.

"In effect," according to economist Paul Krugman, 
"capitalism and its economists made a deal with the public; 
it will be okay to have free markets from now on, because we 
know enough to prevent any more Great Depressions."

The presumption is that while the economists and policy 
makers of 1931 did "everything wrong," those of 2001 will 
do everything right. 

I will put the question to you: Will the same Euro-policy 
makers who react to farmers' demand for higher subsidies 
with promises of more taxpayers' money do 'everything 
right' in a financial crisis? Will the same U.S. policy 
makers who react to every financial threat with promises of 
more cash do 'everything right' when a debt crisis reveals 
itself? Will Japanese officials, who - on the advice of 
American economists - have dropped interest rates to zero 
and taken on more public debt per capita than any nation in 
history...do the 'right thing' in a real pinch?

The question answers itself.

Farmers will act like farmers and politicians like 
poltroons...which has always been the case; but what is 
new?

What is new is the extent to which the farmer's plight and 
the investor's risk has been globalized, securitized and 
derivativized. 

Progress, as I've opined in these letters, depends on an 
increasing division of labor. More and more, people 
specialize...and improve both the quality and quantity of 
their output. They also develop specialized tools and 
equipment that make further productivity gains possible. 

In the Agricultural Economy, few people specialized. Local 
economies were small and relatively self-contained. A 
gardener, like Mr. Deshais, might produce the vegetables 
for a hamlet...while someone else produced the dairy 
products, but that was about as far as it went.

Thus, an economic crisis was fairly small too. A drought 
might affect all of Europe, for example, but the pain would 
be local - each village and farm suffering according to its 
unique situation and how much of previous harvests it had 
managed to save. Little help was expected from the larger 
community. 

But the division of labor got a big boost from the 
Industrial Revolution. Factories, machines, railroads, and 
communications made it possible for people to specialize on 
a grander scale. Just a few shoe factories in New England, 
for example, might provide footwear for thousands of 
people. And just a handful of farmers could feed entire 
cities.

Specialization produced economies of scale - allowing yet 
further improvements in output per unit of investment. It 
also made it possible for most people to forget about 
storing grain for lean years. Henceforth, savings would be 
of a more abstract form - deposits in banks, stocks, bonds, 
and cash.

But "every economic era is afflicted with its own unique 
curse," as Michael Mandel puts it in "The Coming Internet 
Depression."

The grander scale of commerce, labor, and production 
created by the Industrial Revolution produced problems of a 
grander scale too.

The most costly of these was WWI. Before 1914, wars came 
and went in Europe. Armies marched hither and 
yon...fighting, dying, and generally making life miserable 
for everyone.

But the damage was limited. The economy of the pre-
industrial era would only support a limited number of 
people not involved in farming. And part-time soldiers 
could not stay in the field for long. As in ancient Greece, 
wars were often conducted between planting and harvesting, 
guaranteeing that conflicts would be fairly short.

With the Industrial Revolution came the capacity for 
warfare on of a larger magnitude. Not that anyone wanted 
bloodier and more costly wars. But that is the point, 
people do not get what the want. And even if it were 
possible to correct the errors of the past, there are still 
plenty of new ones that can be made.

Not long after WWI came a crisis of capitalism, which, 
thanks to the errors of politicians, developed into the 
Great Depression. This, too, was a depression that couldn't 
have happened in the agricultural age. It was made possible 
by an extended division of labor...which suddenly broke 
down and created an economic collapse on a grander scale 
than had ever been seen before. There had been many period 
panics in the capital markets, of course. But they affected 
relatively few people and tended to be short-lived. 

In the Great Depression, as in previous economic crises, 
savings proved indispensable. And the savings that worked 
best were those of the least abstract form - food, shelter, 
gold, and cash in hand. Stocks and deposits in banks 
proved, very often, ineffective.

And now, 6 decades later, information technology has 
permitted a further extension of the division of labor. The 
whole world economy operates on a much vaster scale than it 
did in 1929. Labor is much more specialized. Wealth has 
become even more abstract - often existing only as 
'information' in electronic form - and savings are few. 
Securitization, derivatization and globalization have 
changed things greatly - but we still don't know to what 
effect. 

What will the next crisis bring?

More tomorrow...

Bill Bonner


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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