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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 will send 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. Once our factories 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
the policy makers have still not recognized that it these very policies that
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 economy, 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 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 $43 trillion. In effect, we have a $78 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 heavily- weighted 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.
Richard J. Greene
Managing Partner, Portfolio
Manager
Thunder Capital Management
More articles by the author can be accessed by the
"Research Articles" choice at: www.thundercapital.com
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