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Contributed by Bill Bonner
Publisher of: The Fleet Street Letter

PARIS, FRANCE 
TUESDAY, 7 AUGUST 2001 

 

Today:  Evolution Not Revolution

*** Productivity miracle to be 'officially revised away' 
today...Market crash risk: high...oooohhh, scary stuff! 

*** Cisco steps to the plate - will they make it 15 in a 
row?...

*** "Financial Whoring" - the world's second oldest 
profession...Twilight of the boomers: meaner and more 
spartan...and so much more it hurts!

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*** Today's the big day...the world will officially 
learn that the productivity miracle - the aegis of the 
American economy - was a "sick joke." And that the 
chimera of a new era was nothing more than...well, 
fraud.

*** You'll recall that Dresdner Kleinwort Wasserstein 
Global Equity Strategist Albert Edwards wrote a note to 
his clients on Friday warning them that today, "The U.S. 
'new paradigm' will then be officially revised away!" 

*** Edwards went on to suggest, "the risks of an equity 
crash are high." 

*** Longtime DR readers will, of course, be puzzled by 
the hullabaloo made out of this story. Aren't these 
Dresdner guys a little late to the table?

*** The "news" of the demise of the American miracle 
economy has long been hammering away at the market. 
Bill, your humbly vacationing editor, penned a dirge for 
the New Era on May 5th, 2000 - over 15 months ago. And 
whatever information is included in the Bureau of Much 
Belabored Statistics report has likely been digested by 
a plethora of Wall Street insiders... 

*** Our prediction: the "news" will be a dud. Heck, we 
might even see a little boost in the markets today.

*** Today too, all eyes are on Cisco...after beating 
estimates "by a penny" 14 times in a row, Cisco Systems 
will report 2nd quarter earnings...will they too lay a 
big fat egg? See Dan Denning's comments in a guest essay 
below. But first, let's see what's shakin' on the 
Street:

*****

Eric Fry reports from New York:

- In the absence of any real news yesterday, several 
negative stories from Barron's over the weekend set the 
tone for the day's trading.

- Notable casualties of the Barron's onslaught included 
GE, Intel and one lesser-known company called 
PolyMedica. "Federal investigators are closing in on 
PolyMedica, the country's largest provider of diabetes 
home-testing kits," reports Cheryl Strauss Einhorn. "A 
federal Grand Jury is looking into possible Medicare and 
investor fraud at the Woburn, Massachusetts-based 
firm..." The stock fell 32% on Monday.

- Concerning General Electric, Barron's writes, "America 
will be awash in electric power soon. Bad news for 
electric utility stocks - and for GE." The stock headed 
south from the opening bell - dragging the Dow down with 
it - and finished more than 3% lower by closing bell.

- Lastly, Alan Abelson poked fun at Intel President 
Craig Barrett's pronouncement that the worst is over for 
the personal computer industry. (Thorough Daily 
Reckoning readers will recall that we too, poked fun at 
Barrett a couple weeks ago).

- Abelson, citing the work of Fred Hickey, writes, 
"...[A]top a 20% decline in June, PC sales were down 
25%, year-to-year, in the first week of July, 47% in the 
second week of July and 38% in the third week...[T]he 
trend is not exactly heartening and, as a matter of 
fact, such gosh-darn awful numbers have never been seen 
before."

- Intel shares slid almost 4 1/2% on Monday, and many 
other semiconductor company stocks suffered even larger 
losses. By the time the dust had settled, the Dow had 
fallen more than 111 points to 10,401 and the NASDAQ had 
dropped 32 points to 2,034.

- Every once in a while, a few female strippers (always 
fully clothed) hang out down on Wall Street handing out 
invitations to "gentlemen's clubs." There are whores on 
Wall Street as well, but they wear suits and ties 
(except on Fridays) and vacation in the Hamptons.

- In fact, on Wall Street, the basic job description - 
sell self, get money - doesn't change much.

- Financial whoring is nothing new, of course. It is 
perhaps the second oldest profession. But it has gotten 
a lot of attention recently under the nomenclature: 
"conflicts of interest." A wide range of abuse is now 
coming to light...the most egregious of which, as we 
pointed out last week, was the habit of some Wall Street 
analysts to buy certain stocks for their own account 
before issuing "buy" recommendations.

- A far more prevalent practice has been the tendency of 
many sell-side analysts to issue and maintain buy 
recommendations - no matter what - on the companies who 
have hired their firm's investment bankers. 

- Consider Prudential Securities analyst Nicholas 
Heymann. We have absolutely no doubt that he is an 
honest and upstanding individual. However, according to 
Crain's, Mr. Heymann "keeps a sailboat at the dock of 
one General Electric Corp. executive and his Jet Ski at 
the house of another. There, he spends July Fourth at a 
barbecue swarming with GE execs, many of whom he invites 
to an annual bash back at his house in Vermont. The 
party also includes some of his clients, who just happen 
to be investors in GE stock. No wonder that down on Wall 
Street, the highly-ranked stock picker for Prudential 
Securities Inc. is considered Mr. GE."

- Crain's writes: "The fact is that for people following 
Mr. Heymann's investment advice, his legendary closeness 
to his flagship company has come at a troubling cost: an 
unswerving predilection for positivism. In the nearly 
two decades that Mr. Heymann has followed GE - through 
expansions and recessions alike - he has only once seen 
fit to downgrade GE from a 'buy,' a decision he 
rescinded less than 72 hours later."

*****

Back to Addison in Paris...

*** Okay...so we're not the only ones who think the BLS 
unemployment numbers smell funny. Challenger, Gray and 
Christmas, a consulting firm, released a private study 
that found US businesses cut 206,000 in July - the 
highest one-month hatchet job since the firm began 
keeping track in 1993. So how come the BLS reports no 
rise in unemployment? Well, if you add back in 155,000 
uncountable jobs created - the so-called 'bias' factor - 
voila! Only 50,000 people hit the dole last month. Not a 
noticeable amount; no need to worry. 

*** What else..."If you're like the overwhelming 
majority of boomers," writes Daniel Okrent in Time 
magazine, "your career has hit a brick wall, you haven't 
saved enough, your pension is underfunded, your health 
is deteriorating, even the medical advances that will 
probably extend your life will, in an especially cruel 
paradox, mean that later life will be meaner and more 
Spartan."

*** "I loathe my generation," writes Joe Queenan, age 
50, "we became culturally frozen in time at a very early 
age and continue to think of ourselves as trailblazers. 
It's completely pathetic."

*** According to The NYTimes, Okrent and Queenan are 
purveyors of a new fad among boomers - "literary self-
loathing". 

*** Let me get this straight. On top of saddling the 
nation with a mountain of debt, fulminating of the most 
excessive stock market bubble in history and abusing the 
world with the Bee Gees, we have to spend the next 20 
years listening to boomers whine - and call it an art 
form?!

Yikes...next they'll want something crazy, like 
legislation guaranteeing we'll pay for their retirement 
years.

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The Daily Reckoning Presents: A Guest Essay in which the 
author ponders the impact of red contact lenses on the 
chicken farming business.

EVOLUTION, NOT REVOLUTION
By Dan Denning

After the market closes this afternoon, longtime DR 
whipping-boy Cisco Systems will report its fourth-
quarter earnings. Analysts expect the company to earn 
.02 cents per share. 

But what do analysts know? Not much, if they are the 
same analysts who did not foresee that JDS Uniphase 
would lose $500 million dollars and .30 cents a share 
when it last reported earnings. 

Granted, seeing into the future is a murky business. We 
don't profess to possess the ability ourselves. But 
Cisco has valiantly tried to make things easier. It has 
beaten analysts' estimates with Cal Ripken-like 
consistency. Between 1998 and 2000, Cisco beat analysts' 
expectations by exactly one penny, 14 consecutive times. 

But don't underestimate Cisco's uncanny talent for 
"guiding" analysts to a reasonable facsimile of its 
current financial condition. Cisco's 11-year streak of 
being in the black ended in May, when they announced 
they lost $2.69 billion in their third quarter. 

Nonetheless, odds are it'll come in at three cents later 
today, come deflation, depression, or outright balance 
sheet disembowelment.

I could be wrong. Maybe Cisco will take the write-offs 
that others in the tech sector have. If it did so, Cisco 
would be admitting to what has become embarrassingly 
true: many of the companies it has acquired for stock in 
the last two years are not worth the paper their shares 
are printed on. More likely is that Cisco, like an aging 
Hollywood beauty whose jowls have seen firmer days, will 
opt for one last vanity pose in front of the Wall Street 
paparazzi.

As ghastly as things could get, the company has much 
bigger problems than appearance. Take reality, for 
example. Tech firms are facing a time when it's 
increasingly difficult to know where their core 
businesses are headed, how fast profit margins are 
shrinking, and what their investments in other companies 
are truly worth. Wall Street likes to call this a 
problem of "visibility." It's another way of saying you 
no longer understand what's happening to demand for your 
products. 

Perhaps what's lacking, though, is a proper perspective. 
It's not Wall Street's vision that's poor. It's the 
Street's understanding of the impact of technology on 
profits. If only Wall Street knew the story of the 
chickens with the red contact lenses, their foresight 
might be nearly as good as their hindsight.

>From 1910 to 1943, the price of a dozen eggs in America 
hardly changed. Egg farmers' costs remained constant. 
And as a result, so did profit margins. Margins weren't 
good, either. Egg farming was pretty inefficient. It was 
considered the job of the farmer's wife. And because 
chickens were left to roam the barnyard, they often got 
gobbled up by opportunistic dogs.

But from 1943 to 1986, an amazing thing happened. The 
real price of eggs, adjusted for inflation, fell almost 
80%. This was at the same time that the production of 
eggs skyrocketed. Falling prices on higher volume. What 
was going on?

The answer is simple. Firms producing eggs saw that 
there were profits to be had in incremental 
technological improvements. Aptly-named Darwin Farms of 
San Francisco is the best example. Darwin Lewis was a 
teenager growing up on chicken farm in the 1930's.

In his book, Bionomics, Michael Rothschild tells us the 
first incremental improvement in egg farming came when 
young Darwin realized moving the chickens into a shed 
would enable farmers to find more eggs. Up until then, 
farmers searched the farmyard for whatever they could 
find. What's more, chicken mortality would go down 
because the shed would keep the chickens safe from dogs. 
And yields would go up yet again because more live 
chickens meant more eggs.

Thus began the commodification of the egg farming 
business. Each incremental improvement in the process 
led to falling production costs and higher egg 
production. The firm that accumulated incremental 
changes the fastest always earned a higher profit per 
dozen eggs than other firms. And as volumes went up, 
prices came down for the consumer.

Today, just one Darwin Farms chicken coop houses 280,000 
hens. 160 rows of parallel cages stretch 700 feet. 

Rothschild tells us "the rows are arranged in pairs 
stacked ten high, and each bank of 20 rows is separated 
from its neighboring banks by narrow aisles. Running 
along the floor, down the center of each aisle, is a 
single rail, and atop each rail sits a rather bizarre 
looking contraption - a feed-dispensing robot."

The most stunning improvement? Red contact lenses - for 
the chickens. You see, one of the leading causes of 
chicken mortality in farms is violence. All hatchlings 
at modern chicken farms are debeaked with a hot metal 
blade. It keeps violent hens from literally pecking 
other hens to death.

But chickens, like Baltimoreans, still kill one another 
in confined spaces. Each dead chicken is a profit lost. 
And it's also a cost to remove and replace.

It had been known for years that red light made chickens 
more docile. They spend less time fighting and clucking 
and more time laying eggs. But installing red tints in 
plant lighting wasn't feasible. Human beings can't see 
in red light well enough to function. And when red 
goggles were attached to the chickens, they ended up 
getting caught in cage wire and strangling the chickens.

But in 1987, a Boston firm named Animallens, Inc 
developed a red contact lens for chickens. Rothschild 
reports that "...by using the red contact lenses to 
reduce feed consumption and stop pecking battles, Darwin 
had found a way to slash costs by about 4 cents per 
dozen eggs." This was enough profit for Darwin to 
actually buy back his farm from the bank, which had 
repossessed it earlier.

As Rothschild points out, cost savings rarely lead to a 
permanent profit advantage. In economics, it's known as 
the Fallacy of Composition. You think that because you 
do one thing differently, it will translate into a 
permanently high plateau of profitability over and above 
your competitors. But it doesn't work that way.

Your innovation is imitated and the cost savings accrue 
to other businesses as well. Gradually, the advantage 
disappears. What results for the consumer is an endless 
cycle of falling prices...in fact, most products become 
commodified over time. 

And thus we arrive at the great challenge for today's 
technology companies who wish to survive a sea-change in 
their business. Will they understand that long-term 
business success does not result from having a dominant 
physical advantage? Change in technology is rapid. And 
physical advantages, no matter how dominant they seem at 
the time, are fleeting.

The real truth of the entire New Economy experiment is 
that new technology alone does not create permanent 
profits. At least, not in any way that investors can 
take advantage of over a period of time. Profitable 
businesses are built by steadily accumulating small 
reductions in product costs over time. Businesses 
evolve.

It's a rare company that can prevent itself from 
commodified extinction...even if they do beat analysts 
projections by a penny.


Dan Denning,
The Daily Reckoning

Daniel Denning is the editor of the Daily Reckoning 
Investment Advisory. For investment advice consistent
with the ideas in this essay, please subscribe to the
Daily Reckoning Blue Service: 
http://www.agora-inc.com/reports/STRT/BigReturns
 
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: August 08, 2001

Published By Tulips and Bears LLC