From a hedge fund manqger- a bearish article.;
If you ever took the course and paid attention in economics class, a few basic tenets
should be readily apparent. The first is the formula, Savings = Investment. This equates
savings, as foregone consumption, with investment, as necessary capital formation to
build a sustainable economic platform. The second is that you can not consume more
than you produce forever.
Finally, it should be clear that when a country allows a chronic long-standing current account deficit to persist, it sends money out of the country to pay
for the costs of production in the form of wages and other expenses.
These receipts have a multiplier effect that reverberates through the other economy, and those benefits tend to
be sticky to that economy.
US Economic Policies Create an Over-Consumption Monster
These basic economic tenets have been lost to the vast majority of today’s economists when forming economic policy in the US. Our policies are focused on assuring strong stock market performance, revitalizing consumer confidence, and providing liquidity and
credit to the consumer to promote consumer spending at the expense of capital investment and production. In effect, we are eating our own seed corn and buying
consumable items from foreigners, while providing foreigners with the capital to put up
more factories and increase production of goods at our expense. Since we are consuming more than we produce, we must finance this consumption by taking on more debt.
When factories in the U.S. are replaced, by foreign factories, in countries such as China, they
can not be regained, by any amount of currency depreciation because of the advantage
those countries have with cheap labor. This is another source of deflationary pressure
that exacerbates the impact from higher debt that causes potential profit to go toward
interest payments. In addition, if the dollar continues to slide, it is highly likely these
countries would competitively devalue their currencies in response. The Government and
the Federal Reserve's response to economic weakness continues to be; to flood the
economy with liquidity and credit in order to prolong an unnatural consumer binge, even
after an unprecedented monetary stimulus effort has failed miserably. While a turn in
consumer confidence can be important in kick starting an economy, confidence can not
do so alone, if unwarranted and based on fabrications. The easy money of the past
several years since the downturn has resulted in mal-investments, creating excesses in
areas such as housing that will take many years to be worked off. Not only has the easy
money continued throughout this downturn, it appears that policy makers have still not
recognized that it is these very policies that have resulted in the downturn. Historically,
easy money has caused a misallocation of capital which leads to inflation, and ultimately
deflation.
Profits Are Increasingly Squeezed Out for U.S. Corporations
The effects on profitability of tinkering with capitalism, through provisions of cheap capital to
near-dead corporations are devastating. According to Economist Dr. Kurt Richebacher,
pre-tax domestic profits for non-financial corporations fell to $288 billion by the fourth quarter
of 2001, from $518 billion in 1997. During that same period, profits as a percentage of
nominal GDP fell from 6% to 2.8%. More favorable tax treatment of dividends was
lauded as a huge plus for the market, while in fact, retained earnings, defined as profits
after taxes minus dividends, in 2002, were only 0.2% of GDP, the lowest figure in over
50 years. Retained earnings peaked all the way back in 1997 at $220 billion and were
only $18 billion last year despite a decent economy. Investors are still not recognizing
that positive economic growth, in this deflationary environment, does not necessarily
translate to the bottom line, earnings. Corporate profitability and profit margins are at
their worst levels in history in large part due to: higher debt service, even with all-time
low interest rates; higher depreciation charges, due to investment in more rapidly
depreciating high tech investments, rather than longer-lived plant and equipment that
stimulate much larger multiplier effects; and the replacement of domestic factories with
foreign ones, where we consume their products, and cause the multiplier effects of the
spending to take place in their country. If a country with a huge current account deficit,
such as the U.S., is lucky enough to be able to fund that deficit by attracting that money
back into its bond and stock markets, that flow of funds will have a muted, less
multiplying impact than that of the wages received by the foreign worker.
These policies have resulted in a current account deficit in the U.S. exceeding over a half trillion dollars
that must be funded from foreigners, and on their terms.
Savings is Bad? Government Says, “PLEASE SPEND!”
In the late 1990’s, the easy money created a tremendous excess of capacity in two ways;
low rates encouraged companies to borrow to increase production; and large profits in
venture capital created an environment where many companies were funded, that had
business plans not even designed to create profits in the first place. In an interview last
month, former Fed Governor Wayne Angell, referred to saving as "money hoarding". He
seems to believe that if those evil people would only stop saving for a rainy day, then the
rainy day would never come if they would only go out and buy another SUV. After the
tragedy of 911, President Bush implored people to go out there and keep shopping for the
sake of the economy. It seems ridiculous that in a time of national emergency, the
President feels it most important to encourage spending to keep the economy moving.
A Sliding Dollar Is Not a Good Thing
Last month, Secretary of the Treasury, John Snow tried to convince us that the strength of
the dollar should not be measured against other currencies, but rather by people's
confidence in the dollar and the difficulty in counterfeiting it. While a falling dollar can
have very bad implications, one thing is clear; the Fed so far has had little difficulty
convincing people that something is not terribly wrong with the dollar, while there
certainly is. The Fed's answer to the economy's trouble is to take every last piece of
equity of every asset in the US, and leverage it up to the maximum, and by some stroke
of luck a sustainable upturn is going to magically appear, strong enough to whisk away
all of the accumulated debt. A debt bubble this big ends in one way, liquidation. It
appears the Fed is hoping that a sliding dollar will revive the U.S. economy by
stimulating exports. The problem with that theory is that the net effect on the world will
be negative, as foreign economies are more dependent on the U.S. as an importer of their
production, and their economies are in even weaker condition. Just last month, we saw
evidence of this effect as the German central bank said it would revise down its GDP
growth to 0.5% for 2003.
Mounting Debt Can Never Be Repaid (Without Inflating)
In 2002, total credit in the U.S. expanded by $2.3 trillion, while net national savings came
in at only $286.7 billion. The Fed reported recently that 51% of people refinancing
residential mortgages are pulling equity out of their homes. While this has so far kept the
U.S. consumption machine humming, it hasn't stemmed the tide of smaller and smaller
profits to corporations, and they have responded with a continuing stream of layoffs.
Help-wanted advertising is at its lowest level since the early 1960's, and the help-wanted
index is at its lowest level since the Great Depression. The policies being employed to
promote an ongoing manic consumption include:
1) Slashing interest rates and pressuring foreign economies to slash theirs.
2) Keynesian fiscal loosening, highlighted by the upcoming Bush tax cut;
3) Manipulating the yield curve to promote more refinancing and further lending.
4) General debt bailouts such as the issuance of pension obligation bonds by states,
to fix a nationwide bankrupt pension scheme, (that becomes more under-funded
as interest rates drop).
5) Creating inflationary expectations.
Outstanding debt in this country now exceeds $35 trillion, much greater than our $10
trillion economy, and that does not include a host of other commitments that have been
promised such as Social Security and Medicare. A study commissioned by former-
Treasury head Paul O'Neill when he was still in office, estimated that the net present
value of these other liabilities, at a net present value of another $44 trillion. In effect, we
have a $79 trillion debt load to be serviced by an economy of $10 trillion that produced
only $18 billion in retained earnings last year. In addition, a new study by FTI
Consulting looking at the companies in the S&P 500, estimates that they will have to
come up with $36 billion for their pension plans over the next 16 months just to reach
minimum funding levels.
Valuations are Extremely High
The latest movements of the stock market make no fundamental sense if you look at the
companies that have moved up the sharpest in the latest bear market rally. As an
example, let's look at the high tech sector. Even at the height of the boom the sector
never came close to generating even 1% of non-financial profits, while the heavilyweighted
NASDAQ accounted for over 33% of market capitalization. Even when things
were good, profits were mediocre at best. That investors still haven't caught on and are
willing to pay enormous multiplies for companies with rapid product obsolescence, huge
necessary R&D expenditures, and deeply cyclical businesses, should give one an idea of
how much further we have to go. Technology stocks trade at over 70 times trailing
earnings with no recovery on the horizon beyond hope. In addition, government statistics
add to the folly and the outright fraud of the true profit performance of the sector.
Hedonic pricing which attempts to adjust the price that "should be paid" for the additional
computer power you get, totally distorts not only the profit performance of the high tech
sector, but also the overall economy as a whole. Economist Dr. Kurt Richebacher,
recently gave an example of the effects of hedonic pricing on economic statistics. He
noted that between 1997 and 1999 business fixed investment in computer hardware
measured in current dollars was $24 billion, which equaled 3.3% of real growth.
However, by the US Government's calculations, using hedonic pricing, the $24 billion is
magically transformed into $286 billion, which accounts for 55% of real GDP growth
over that period. The big problem with this reporting is that the multiplier effects
throughout the economy of that $286 billion can never happen since the actual dollar
amount is the much tinier $24 billion. As recently as last year's third quarter, this
distortion accounted for almost 25% of the real GDP growth. The result of these
shenanigans is a serious over-reporting of the actual performance of the economy. One
group of investors that are not being fooled is corporate insiders, whom are unloading
shares at a record pace. The only logical explanation for the latest move in the overall
stock market is that it is adjusting to the lower value of the U.S. dollar, while mistakenly,
investors are chasing high-beta stocks that would benefit from an earnings rebound that
has shown no signs of occurring.
Government Is Saying, “YOU WILL SPEND!!!”
We are currently experiencing a stock market melt-up that is clearly not fundamentally
based, as can be seen by viewing the above-mentioned economic statistics and their
further deterioration, This view is further supported by the fact that this advance has been
led by the leaders of the last bull market, especially the ones with the poorest
fundamentals and highest short interest. New bull markets, almost always, are supported
by new leadership and new themes. We believe the advance is being fueled through
liquidity, provided courtesy of the Federal Reserve at key junctures. It is likely part of a
Fed experiment, which was announced at the January 2002 FOMC meeting, which allows
the Fed to take “unconventional policy measures” if nominal short-term rates are already
at very low levels while the economy deteriorates. According to The Financial Times on
May 25, 2002, these measures include pumping money into: U.S. stocks, state and local
debt, real estate, gold mines or any asset. If that does not work, the November 6, 2002
edition of the Wall Street Journal, revealed a scheme that would make use of the metal
strips that now are contained in all U.S. paper currency. The Fed discussed a plan where
the value of the money in your wallet would go down if not spent by a certain date.
Japan has a similar plan of its own to tax savings between 3% and 5% annually, not
interest, but savings! The Dallas Fed in a recent paper, suggested taxing savings accounts
of Americans, 1% a MONTH, to get money working in the economy if interest rates stay
at 0% for too long while the economy remains weak. Central banks are so desperate to
create more artificial demand; they are discouraging the very savings that are lacking
which got us into this mess in the first place. These contingency plans of the Fed, to run
the printing presses and create inflation to solve the world’s deflationary pressures, that
the prior loose money created, will only cause the inevitable deflation to be bigger and
more painful. They may keep consumption going longer and faster than they otherwise
would, but they will do nothing to remove the mal-investments and long-run
misallocation of capital that these policies have encouraged. In addition, the creative
destruction aspects of capitalism are not being allowed to work, as near-dead companies
are given fresh capital, just as in Japan, which prolongs the return to profitability of the
ultimate survivors. You would only need to review your textbook from Economics 101
to identify that bailouts have nothing to do with the efficient allocation of capital, and
everything to do with the wrecking of the profit motive that is the very basis of capitalism
itself.
June 27, 2003 |
