The Death of Literacy
financialsense.com
Weekly Update from Jim Puplava
March 1, 2002
Alice Lives Here in Makebelieve, USA
In today's pop culture, there is no right or wrong. There is no such thing as black or white. It has become a colorless world without shape or form, only shades of gray. Many of the things we read or hear aren’t what they seem to be, but are what people want them to be. This is the hour of the present where thinking is dominated by a particular moment in time. The way we think and the views we hold are shaped by images before us. It is an ephemeral world -- one in which whatever is in front of us is of immediate concern. Links between the past, present or future no longer exist. It is a culture that is dominated by hype and emotion and ruled by the crowd. It is devoid of any intellect and reason. In this new Pavlovian environment, we act on emotion, seldom on reason. We live in a world of make believe.
This hazy existence overshadows our nation from Washington to Wall Street. It pervades all that surrounds us. It is present in the newspaper on the breakfast table and on the television in our homes. It shows up in the form of sound bites on the evening news, clichés in conversation, and in the editorial comment that lies buried in the written news. In this new era in which we live, words have taken on a whole new meaning. They have become Orwellian in nature. The standards and benchmarks which we use to interpret them are fluid and constantly changing. Words can mean one thing today and something entirely different tomorrow. The links between the past and the present have been severed. It is a world devoid of literacy.
In the past, the ability to reason, interpret, and analyze was a natural product of a liberal education. Study of the classics gave us a solid foundation of knowledge and the ability to think. Latin produced a greater understanding of the roots and meaning of our language. The Socratic method of teaching, by using questions and answers, led to greater knowledge and understanding. This classical world is no longer with us. Like its founder, Socrates, it has died, and with it, so has literacy. Socrates was tried for corrupting the minds of the Athenian youth by stimulating them to think. For this crime he was condemned to death. Today, political correctness has become judge and jury of our thoughts. It condemns free thought and along with it, deductive reasoning. It has become the modern version of the inquisition. Its consequence has been the death of literacy.
This lack of qualitative thinking is most evident in the world of politics and economics. What passes for understanding is strewn with emotion rather than reason. In the media age, we have become obsessed with the latest news, none of which is connected in any shape or form to the past. Like Pavlov’s dog, we are taught to respond rather than think. Dramatically, we see this portrayed daily in the financial markets and discussions of national policy and foreign affairs.
Jay Walking Down Main Street
Evidence of this transformation within our culture manifests itself through the today's comedy. "The Tonight Show” with Jay Leno contains a popular segment called “Jay Walking.” During this segment of the show, Jay Leno, the host of the show, goes to college campuses, the streets of Los Angeles, or shopping malls to ask individuals relevant questions of the day. During the Thanksgiving holiday, pedestrians at an L. A. shopping mall were asked to explain the origin of Thanksgiving. This seemed to be a simple enough question, demanding a simple answer. Those questioned displayed a complete lack of knowledge of history or the events that were behind our national holiday. One respondent said that Thanksgiving originated with the Pilgrims landing in New York. Jay corrected the respondent by saying they landed at Plymouth Rock. The individual simply corrected his statement by saying they landed in New York and then took the train to Plymouth.
Jay Walking often features questions on historical events like Who initiated the attack at Pearl Harbor? and Who was our first President? to mundane questions like, How many feet are in a mile? Those interviewed range from teenagers, young adults and baby boomers to senior citizens. They come from all backgrounds of society -- professionals, working class, those who are college-educated, and some who are not. Most can name popular sport figures, entertainers and movie stars, but they can't name our presidents. They were more familiar with Britney Speers than Great Britain. In one episode, I was shocked to hear many did not know from whom and how America gained its independence. It is a very entertaining segment designed to make you laugh. In reality, it is a sad commentary of our times.
It should therefore come as no surprise that with reason and intellect no longer a prerequisite for an understanding of our world, that we operate in a world of make believe. The lack of literacy is found everywhere -- from a discussion of economics and investing in the markets to the operation of domestic policy and foreign affairs. Without the ability to reason, and with only emotions as our guide, any understanding of economic or current affairs is devoid of meaningful analysis. This is no more evident than the current discussion and debate within the financial markets.
Redefining Inflation
It used to be common knowledge that inflation was a monetary phenomenon. Webster’s defines inflation as “A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.” As the graphs below indicate, the supply of money has grown by a horrific rate over the last year and over the last two decades. The monetary aggregates were growing at rates similar to GDP until late 1994 when the monetary aggregates began to accelerate at an above-average level. Over the last twelve months, they have literally gone off the charts with the money supply growing by an incredible $1 trillion dollars.
Includes: M2, Time deposits over $100000,
Term repos. Billions $
The Zero Maturity Money Supply includes M2 minus
small denomination time deposits, plus institutions
Traveling Down Memory Lane
In the past, money creation of this magnitude would be cause for alarm. In the late 1970’s when inflation was running at an annual rate of 14%, the money aggregates were watched on a weekly basis. Any surge in the supply of money could trigger adverse consequences in the financial markets and often, they did just that. The prime lending rate rose as high as 21%. Money market yields were as high as 18% and Treasury bonds offered yields of over 15%. Stocks offered investors even higher returns based on dividends and earnings yields. Most major indexes sold at a P/E multiple of 7 or less which equated to an earnings yield of 14%. Considering that dividend yields were at 7%, stock returns were priced to yield investors a return of 21% to compensate for inflationary risks. Rising gold, silver, and oil prices were a reflection of inflationary times. The late 60’s and the decade of the 70’s were a long period of rising inflation triggered by the U.S. abandoning backing the dollar with gold. After the U.S. went off a gold-backed dollar system, the Fed was free to print money at will, and it did. Inflation levels rose and the price of most commodities also rose to reflect the decline in purchasing power of the dollar.
Confidence -- A Necessary Ingredient to the Economy
During this inflationary era, ordinary citizens and investors lost all confidence in the dollar. Instead, people put their money into hard goods. No one had any confidence in paper, especially government paper. When Paul Volcker became Chairman of the Federal Reserve in 1979, he pursued a restrictive monetary policy to combat inflation. He eventually succeeded in restoring confidence in the dollar which came with the Reagan Presidency. Volcker initiated the policy of using interest rates as a means of supporting the dollar. Eventually Volcker was forced by a stagnant economy and high unemployment to support increased monetary growth during the mid-1980’s. That policy has continued under his successor Alan Greenspan.
Crisis Intervention
The only difference between today and the inflationary era of Arthur Burns, Chairman of the Fed Board of Governors 1970-78 and Volcker’s predecessor, is that under Volcker and Greenspan, confidence was restored in paper. People began to put their faith in paper assets such as stocks, bonds, and money market instruments. Instead of buying tangibles as they did in the 70’s, people invested in intangibles. The government was very careful to keep faith in paper alive. It was possible because the price of gold, an important barometer of inflation, was kept suppressed. Gold became the nemesis of all central banks. If its price rose, it signaled something was wrong with the financial system. As a consequence, it became necessary to keep its priced suppressed. This was made possible by central bank gold sales, gold leasing and the gold carry trade. Through the use of physical gold sales and paper gold sales it became possible to keep a lid on gold prices. These action, combined with discrediting gold in academic and financial circles, made the whole scheme work.
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In fact, the whole financial world was turned upside down. In the last two decades whenever there was a crisis, the financial world clamored for even more money creation. Throughout the 80’s and the 90’s whenever a crisis would appear -- in 1987 with the stock market crash, 1989-91 with the bailout of the S&L’s, 1994 with the peso, 1997 with Asia, 1998 with Russia and LTCM, 1999 with Y2K, and in 2001with the recession -- the standard prescription was to flood the markets with more money. Wall Street never questioned it. Rather, they encouraged it. On Wall Street there was a new love affair with money creation. Analysts and economists on The Street knew that in any crisis the Fed could be counted on to flood the financial system with liquidity and most of that money was injected into the financial markets. A new crisis meant more money and higher stock prices. Everyone was happy with the arrangement. Politicians loved it because it made them look good when the economy and financial markets prospered. Wall Street loved it because rising markets meant more business through stock and debt underwritings and stock commissions. Most investors loved it because they saw their net worth enlarged without saving.
Shifting Bubbles
There was only one problem with this whole scheme. Each new crisis required even greater amounts of money to quell it. Eventually, there would come a day when it would no longer be possible to keep inflating without adverse consequences. We are rapidly approaching that day. At the moment inflation is showing up in a new bubble formed after the Nasdaq crash. The Fed money pumping machine lowered interest rates and began a whole new bubble in the real estate markets.
When central banks create money, they oftentimes can’t control where it goes. In the 1970’s the money went into things. In the 1980’s, 1990’s and our current decade, it went into paper. Inflation has two outlets. It can manifest in higher prices of goods and services or in higher prices of paper assets. They are one and the same. The only difference today is that we no longer call it inflationary. It is known as "investment return." If stocks go up 20% for five years in a row, it is called a new era or new paradigm. If real estate prices rise 20% a year, it is called a boom. The very fact that few question the inflationary implications of these two phenomenons is another example of the lack of economic literacy.
John Q. Investor and his cousin John Q. Public know that their monthly bills keep going up. They just don’t know why. Whenever the inflation index rises, we strip it of its meaning by either changing how it is measured or subtracting the elements from the index that make it rise. The result is that most Americans now live on a steady diet of new debt to augment their living needs. As this graph indicates, the ratio of consumer and mortgage debt to disposable personal income is now at 105%. Would anybody argue that a rise in housing prices of over 20% is not inflationary? Inflation has been with us. It's just that we no longer have the intelligence to call it what is. Even the current real estate boom is being explained in terms of rising demographic trends and a new era in demand for housing.
The adverse consequences of these policies can now be seen erupting in Argentina, Venezuela, and in Japan. As a consequence of its ties to the dollar and its own fiscal policies, Argentina is now experiencing rabid inflation. In Japan it has become a deflationary bust. In the U.S. we have the occurrence of both phenomenon in the form of a deflating stock market and inflating real estate bubble. In the U.S. we are likely to see both sides of the coin with the outcome resting on the fate of the dollar.
The lack of understanding in what gives rise to inflation is only one aspect of the degree to which economic literacy standards have deteriorated. There are many other aspects of economics that are no longer understood. The practice of chain-weighted economic measures and the use of hedonics in inflating economic growth are a few other examples of this lack of understanding. It may be one reason why so many analysts, anchors, economists and investors were so surprised by the outcome of the stock market and the economy these last few years. I have already commented extensively on the use of hedonics in inflating economic growth and productivity in my Storm Series. They will be covered under a new light in Powershift.
The absence of literacy carries over to investing where very few investors are cognizant or even familiar with accounting which is the language of business. This has allowed the widespread use of pro forma accounting by companies, Wall Street and the media. A good example of this practice and its consequences was discussed in this Monday’s Market WrapUp, but bears repeating again. On Monday, February 25th, the markets had risen on surprising news from GM that it now anticipated better sales than previously expected in the year ahead.
GM - A Case in Point
GM helped to spark a rally in the stock market by boosting its profit projections and production estimates. GM predicted that profits for the first quarter would be $1.20 a share, which was an increase from the $1 per share estimates predicted by analysts. The company also said it will build 5.1 million cars instead of earlier forecasts of only 5 million, an increase of 100,000 vehicles. This helped to spark a rally in the stock and in the Dow. The GM story was used as a catalyst to back up the economic recovery, and profit turn around that analyst and anchors have been blindly touting.
General Motors is getting ready to sell as much as $3 billion in new convertible debt securities. I suspect this may be one reason the company is now releasing positive statements ahead of the upcoming debt issue. Absent from their press release was the fact that vehicle sales will be down this year to around 16 million from last year's 17.2 million. Earnings for last year will come in at $3.23 a share, which excludes $0.41 a share loss from the Hughes division. This year the company is forecasting profits of $3.50 a share. This once again doesn’t include losses from Hughes. These profit numbers will also exclude costs for reorganizing its European business and additional costs of meeting new European laws requiring automakers to help dispose of used cars. In addition to these exclusions, the company also disclosed that it had $136.2 billion in assets in special purpose entities. It would provide additional information in the future on these partnerships. The company said no officers of the company were involved with the partnerships. In the words of the company, "It’s a convenient way to get very cost-efficient financing."
What gets reported and what is reality is as wide as the Grand Canyon. GM actually lost money during the third quarter after writing off $753 million to close down a Canadian plant. In reality for 2001, revenues fell from $183.3 billion in 2000 to $177.3 billion in 2001. Actual profits weren’t the actual pro forma number of $1.5 billion or $3.23 a share. The actual bottom line number was a profit of only $601 million, or $1.77 a share. A b-i-g difference! Those per share numbers have also been helped by share buybacks, which otherwise would have made the EPS numbers per share much worse. GM’s debt has also been rising especially in its finance division, which has increased liabilities from $147.9 billion to $166.4 billion. Liabilities in the car business have risen slightly from $117 billion to $119 billion. One wonders in which set of books the $136.2 billion is included and what its composition is. Is it off-balance sheet debt?
The company is doing so well that it has bought back 171 million shares of stock, yet it finds it necessary to issue $2.5 to 3 billion in new debt to strengthen its liquidity, reduce underfunded pension liabilities, and fund post-retirement health care obligations. These are real costs that can’t be paid for with pro forma earnings. That is the trouble with pro forma earnings or excluding losses of $753 from the profit numbers. When you don’t have real profits, you are forced to go get real cash which is needed to run the actual business. What’s next -- pro forma debt?
It will be interesting to watch the profits coming from GM’s finance unit this year. What will the profit contribution be now when they are offering customers zero percent financing? This becomes important since GM’s profitability margins are so terrible. As viewed below:
Operating Margin
5.70%
Pretax Margin
0.77%
Return on Assets
0.16%
Return on Equity
2.01%
Return on Capital
2.41%
Asset Turnover
0.57%
Financial Leverage
12.57X
Source: Bloomberg
Duped Markets on Duplicitous Numbers
Nonetheless, the markets bought into the "Things-are-getting-better" story at GM, which sparked a rally in blue chips. In the words of one analyst, GM’s numbers mean the worst is over and blue skies are ahead. An improvement in the housing numbers also helped to lift the markets. Sales of previously owned homes rose more than expected in January to a record pace by increasing 16.2% to an annual rate of 6.04 million units. Home sales increased in all regions of the country. GM’s numbers, combined with the news on housing, helped to spark a big rally in blue chips, pushing the Dow into positive territory for the year by 1.2%. The Nasdaq also got a lift from Qualcomm, which said it will meet its forecast for profit after excluding certain costs. Total sales for Qualcomm this quarter will fall below sales of the last quarter. The result of those lower sales is forcing the company to slash 9% of its workforce and close five customer service centers to lower costs. The markets took that as good news with the NASDAQ gaining 2.63%. The Nasdaq rallied, but is still down by 9.3% for the year, and the S&P 500 has lost 3.4%. The housing numbers and the rising level of debt held by corporations and consumers are raising doubts as to the durability of the recovery. Corporate debt to equity has now risen to 60% from 45% back in 1995. One wonders where all of this growth will come from and how much further the consumer debt spending spree can continue.
Back to the world of make believe. Analysts have now lowered the rate of decline in earnings for the first quarter from 8.4% to 8.1%. At the same time, they have raised profit projections for the second quarter to a gain of 8.6%. Analysts cite cash flow numbers now, which are different than earnings. One analyst said that aggressive accounting used to report earnings are less than reliable, so operating earnings will now be used.
Massaging The Numbers = A Pre-Determined Outcome
This repeat of Monday’s WrapUp is a good example for what poses as analysis on Wall Street. We have even gone as far as stripping out the bottom line number when reporting on P/E multiples on the S&P 500. If you wonder why P/E multiples have suddenly dropped on the S&P 500 over the last month when you read Barron’s, it isn’t because of increased earnings or the fact that stock prices have fallen. Nether have occurred. Earnings have actually gone down, while stock prices - even though they are still negative - have risen over the past few weeks. It is because earnings are now reported on an operating income basis before big bath expenses, write-offs, interest and other big expenses that impair earnings.
This manipulation is all possible because of the death of literacy. It would not be possible if investors were taught how to read financial statements. I am reminded of a poignant scene in the movie, “Dave”. The main character is an imposter in the role of the President. In order to find money to save a pet program for the comatose President’s wife, Dave invites his best friend and accountant, Murray, to the White House to look at the budget numbers. After a thorough review of the government ledger, the accountant responds with, "I’ve been over and over this stuff. It doesn’t add up. Who does these books? If I ran my office this way, I’d be out of business.” In the boom years of the 90’s, many companies ran their business and books this way. We are now seeing them go bust. Virtually ignored at the moment is the number and size of corporate bankruptcies. It has become apparent that many of these companies took on huge risks that were covered up through financial engineering and the management of their earnings. Instead of questioning their practices, Wall Street analysts cheered them on. We are now witnesses to the fallout of these practices with the failure of Enron, Kmart, Global Crossing, and Williams Communications.
Conflicting Signals - Investor Beware
We are at a crossroads in the financial markets and the economy. Many are telling us that a recovery and new financial boom lie directly ahead of us. However unlike past recessions, the cleansing process inherent in a recession hasn't taken place. Debt hasn’t been paid off. It has actually increased. Savings haven’t been replenished. They’ve been depleted. Demand hasn’t retrenched. It has continued with the consumer still in a high state of consumption albeit through debt. In reality, by inducing consumers to take on more debt and continue spending, the bubbles in stocks and real estate are being fed. So far, the bubble in stocks has failed to reinflate. All that has been accomplished is that a floor has been put underneath the financial markets, the so-called Greenspan Put. Real estate still remains in a bubble state with easy credit terms and low rates of interest. The dollar still remains strong propped up by hot money from overseas. It is kept aloft by the illusion of new paradigm theories. Despite the drop in the financial markets and slippage of the economy into recession, adherence and belief in the “new paradigm” is still widely held.
We are living under illusions of economic and profit miracles. Any sign of an economic number that is improving is quickly seized upon as evidence supporting a recovery no matter how flimsy. On Thursday, GDP figures were revised upward; while on the same day, February auto sales dropped because of lower sales to rental car companies and a lack of interest by consumers. Also on Thursday, many companies warned of future profit shortfalls and a market rally was quickly routed. This recession has seen the greatest drop in corporate profitability since the Great Depression. We continue to find new evidence of corporate duplicity. Enron may grab the headlines, but the practice of aggressive accounting and various shenanigans to deceive investors is still widespread. It may be one reason that the establishment has had problems with reinflating the market. At the moment, investors seem to be putting their faith in tangibles in the form of real estate. In the boardrooms on Wall Street and in the Federal Reserve they must shutter at the fact that gold and silver shares have been rising again along with the price of the metals. It is their greatest fear. Once confidence is lost, it isn’t as easily regained.
This is what is behind the mammoth effort to keep hopes of the “new paradigm" alive. With the lack of literacy in economics and accounting, it is still possible to keep that hope alive. We are simply changing the benchmarks and standards by which we measure things. In that process, we distort and obfuscate reality. Investors are told to take comfort in the recession’s unusual brevity as evidence that today’s lofty stock prices are still justified. We still live in a financial world that is surrounded by unsubstantiated, multiple bubbles. Excesses can be found everywhere throughout the financial system. All that is needed to deflate them is another shock to the system. I shudder to think how its failure and breakdown will be explained. With the public no longer economically literate, and with Congress completely oblivious to the perils that surround it, a scapegoat and simple explanation will be given for its failure. Enron is the first of many that will be pilloried. With the death of literacy, the real reason for the system's failure will be conspicuously absent. It was the creation of economic and financial fiction made possible by the greatest monetary and credit boom in history. ~ JP
Please refer to today's Market WrapUp for Jim's stock market summary.
I find it interesting that my article appeared Friday and Fox News features the same topic in their Sunday edition. Read on...
March 3, 2002 FoxNews.com, "Financially illiterate: Schools Not Teaching Personal Finance"
© 2002 James J. Puplava
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