The Rebirth Of Deficits
The Daily Reckoning
Paris, France
Friday, 7 March 2003
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*** Condition Fuschia. Watch out.
*** Dow down...send weapons inspectors into JPM...
*** The decline and fall...
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Today, we change our investor alert from mauve to fuschia.
It is a more dangerous world than it was Wednesday.
Why? Did we come across some inside information? Did our
macro-economic computer program begin to whistle in the
night?
Nah...we just have a hunch. Stocks fell again yesterday.
And it's Friday. If you had a billion dollars in stocks,
would you want to watch the weekend news...knowing that you
couldn't change your positions until Monday? Suppose the
war begins?
It's all very well to believe in 'stocks for the long
haul'. But over the last 3 years, the Dow has lost nearly
40%. In Europe, the losses have been even worse; stock
market gains since 1997 have been wiped out. Can you blame
investors for getting a little edgy?
Jobless claims rose to their highest level of the year.
Consumers have only been able to maintain their spending by
mortgaging their houses. The recovery never seems to come.
One thing this market has lacked, so far, is a good panic.
Investors have held their positions like good soldiers,
getting cut down one by one. But even the Roman legions
broke and ran from time to time. And it's rare in a bear
market of such magnitude not to have a little panic from
time to time. Maybe today will be the day.
Over to Eric Fry with the market news:
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Eric Fry reporting from New York...
- The stock market, evidently, has no weapons of mass
destruction. So it must resort to inflicting "death by a
thousand swords". The gruesome and excruciating process
continued on Wall Street yesterday as the Dow bled another
100 points to 7,674 - yet another low point for the year.
The Nasdaq hemorrhaged about 1% to 1,303. Gold for April
delivery gained $3.70 to $356.90 an ounce.
- Warren Buffet made headlines earlier this week when he
referred to derivatives as "financial weapons of mass
destruction, carrying dangers that, while now latent, are
potentially lethal".
- Maybe he's right. But the many fans of derivatives might
call them "defensive weapons". Both camps have a point...It
all depends who's holding the weapons. But let's assume
that Buffett is right. What should we do about these
massively destructive weapons?
- My good friend Michael Martin, a broker with R.F.
Lafferty in New York, suggests that we apply the "Bush
Doctrine" to the financial realm. "Let's send 'weapons
inspectors' into JPM and Citibank to inspect their
derivatives books," Martin suggests. "And then let's force
these renegade financial regimes to 'disarm'. And if JPM
and Citi won't disarm voluntarily, by golly, we'll do it
for them!" If we don't do it now, we'll be in trouble
later, right?
- The stock market "acts poorly", no question about it. But
some parts of the market act less poorly than others. Tech
stocks, in particular, have been faring relatively well
lately, while the stocks that populate the Dow 30 have been
"sucking wind". Including yesterday's slide, the Dow has
tumbled 8% year-to-date, while, surprisingly, the Nasdaq
100 is unchanged for the year.
- The divergence between the Dow and the Nasdaq 100
probably reflects two unrelated phenomena. First, tech
stocks are very popular...with short-sellers, that is. Tech
stocks are among the most heavily "shorted" stocks in the
market, which, from a contrarian perspective, is a positive
sign. More about that in a moment.
- Second, blue-chip American companies are under siege - a
profit siege. Most of these companies face rapidly rising
costs - like health benefits for their labor force -
intensifying competition, and slack demand for their
products. The result is a wicked profit squeeze. Throw in
some substantial, and rapidly increasing, pension
liabilities and you've got a pretty toxic mix.
- Best case, who would want to own stocks like these? As
your co-editor has asserted repeatedly to his colleagues at
Apogee Research, the only reason that the Dow Jones
Industrial Average still trades at 7,700 instead of 3,700
is the "pedigree" of its 30 components. It's not easy,
emotionally, for most investors to sell a blue-chip name
like General Electric or IBM or General Motors.
- However, if we were to subject the Dow stocks to a "blind
taste test", most investors would slap a much lower
valuation on them than what they currently possess.
Stripped of their famous, All-American logos and examined
purely on their investment merit, the Dow stocks would
probably be selling for about half their current prices.
Instead, these marquis names receive the benefit of the
doubt.
- Very few tech stocks enjoy such regal treatment. To the
contrary, stocks like Gateway Computer receive little more
than disdain. (In the spirit of full disclosure, your co-
editor owns the stock in his personal account, purely as a
speculation, and he might sell it at anytime...Including
today!).
- To be sure, Gateway's recent history of poor performance
deserves scorn, if not ridicule and contempt. (Wednesday,
the company held a meeting with analysts and investors,
promising to do better. We'll see.) On the other hand, this
"fallen angel" of the tech world is trading well below the
value of the net cash on its balance sheet. The stock,
which is currently selling for about $2.25, holds more than
$3.00 per share in net cash on its books. In other words, a
buyer of the stock theoretically receives more than 75
cents per share "for free", along with the entire company
"for free".
- In theory, that's a cheap price to pay. But if Gateway's
operations continue to stumble as they have been, even
$2.25 would have been too much to pay for them.
- Gateway shares are but one example of the low state to
which some tech stocks have fallen, especially when
compared to their counterparts in the Dow Jones Industrial
Average. Today, most Wall Street analysts despise Gateway
just as much as they adored the stock three years ago, when
it was selling for more than $80 per share!
- The entire tech sector is receiving similarly brutish
treatment. Indeed, short-sellers have been placing
increasingly heavy bets in the tech sector. Technology and
telecom stocks have become the most heavily "shorted"
sector in the stock market. All of which suggests to this
market observer that tech stocks are likely to fare BETTER
over the coming few months than the rest of the stock
market. Of course, "faring better" might simply mean
falling less.
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Back in Paris...
*** Meanwhile, the day of reckoning approaches. The French,
the Germans, Russians...and even the English...say they
want nothing to do with Bush's war. America's future...its
honor...its integrity is on the line, not to mention the
lives of thousands of people and billions of dollars.
And now the nation's democratically elected representatives
gather to meet in solemn session, taking up the matters
most urgent and most important to the republic's very soul.
The constitution makes it clear that there are some issues
so weighty that they can only be shouldered by the joint
effort of the peoples' Congress. War and peace, for
example. Now that the administration is proposing to the
U.S. a change in military strategy - from one that is
intended to defend the country to one that is designed to
attack - could any more clear or immediate danger present
itself?
Yes, says the distinguished senator from the great state of
California - changes to FASB regulations! Months ago, with
hardly a moment's discussion, Congress gave up its
constitutional obligation to debate the administration's
war aims, to pass a Declaration of War if that is where its
judgment led it, and to raise the troops and money needed
to get the job done. With such issues out of the way,
congresspersons can get down to their real business -
posturing for the lumpenvoters back home and shilling for
their constituents' special pleadings. Thus it was that
Sen. Barbara Boxer declared yesterday that "we can't stand
by and let accountants wearing green eye shade decide who
is going to get the American Dream".
No matter that the proposed change by the Financial
Accounting Standards Board is none of her business (it is a
private organization). And no matter that it has nothing to
do with who gets the American Dream, but with how
corporations treat stock options on their books.
Thus does history move forward like the theater
season...with comedies, tragedies, and gross farces.
The Daily Reckoning PRESENTS: Inflation seems like the only
way out for a government beset by burgeoning deficits.
Meanwhile, gains in retail sales and industrial production
are less than they appear, and businesses are facing a
'perfect storm' with regard to cost pressures.
THE REBIRTH OF DEFICITS
By Andrew Kashdan
In his recent testimony before Congress, Chairman Greenspan
was trying to make a commonsensical point about deficits:
that they actually do have an impact on interest rates. But
then he started talking about accrual accounting...and
everyone stopped listening.
What he said, more or less, is that the government will
have to pay out a lot of money at some point, and that the
long run is indeed catching up to us. In about a decade,
said the chairman, this "relative budget tranquility" will
come to an end. What will happen then? It seems to us that,
at some point - not so far off into the future as many
would like to believe - this debt will be inflated away
(more than usual, that is).
In fact, even now, higher energy prices are showing up in
the indexes, as wholesale prices increased in January at
their fastest pace in 13 years. Of course, higher prices
for any particular good are not the cause of a general
inflation. It is the Fed's "accommodation" of this
increase, through an increase in the money supply, that
will lead to a rise in the overall price level.
But energy prices are only one of the factors prompting the
Fed's inflationary policy. Getting back to the effect of
government borrowing...to run a deficit, the average person
must borrow. But the government can decide to raise taxes.
Or even better, as Fed Governor Ben Bernanke reminded us
recently, it can make use of a "technology called a
printing press". Wouldn't you fire up your printing press
if you could? We are quite certain the federal government
won't let this handy invention go to waste.
Greenspan's immediate predecessor, Paul Volcker, understood
the indirect impact of budget deficits. A few years after
squashing the inflation of the late '70s, Volcker told
Congress that "the actual and prospective size of the
budget deficit...heightens skepticism about our ability to
control the money supply and contain inflation." Does this
mean that the "independent" Federal Reserve is sometimes
pressured to monetize the government's debt (i.e., print
money)?
Say it ain't so, Mr. Volcker!
With the current deficit likely to be just the beginning of
a trend, those hardly-working public servants in Washington
simply don't have a lot of good alternatives to printing
more money.
The Congressional Budget Office projects that the budget
deficit will peak in 2003, and then we'll be back in
surplus-land by 2007. We'll believe it when we see it. The
CBO did include a small caveat with its extraordinarily
optimistic scenario: "That improving outlook...is bound to
the assumption that no policy will change, and as such
should be viewed cautiously." No policy changes allowed?
Perhaps the CBO would care to figure the odds of that
happening.
Economist Hal Varian, writing in The New York Times, quotes
a study co-authored by a Berkeley economist, which uses
somewhat more realistic assumptions than those embraced by
the CBO (for instance, spending growth that is in line with
GDP, the extension of current tax cuts when they expire, a
fix for the alternative minimum tax problem and the
inclusion of Social Security and Medicare obligations that
are bound to explode once the first baby boomers begin to
retire in the next few years). As you might imagine, we're
talking real money here. A $1 trillion surplus over the
next 10 years morphs into a deficit of $5.4 trillion. Oops!
Varian is forced to concede the likely outcome: "Inflation
is all too tempting as an 'easy' way to avoid the political
pain associated with tax increases or budget cuts."
Greasing the inflationary skids may be easy, but we vaguely
recall something about the nonexistence of free lunches.
Meanwhile, we are supposed to be marveling at the continued
strength of consumer spending. But what will happen when
debt burdens and the decline in net worth take another bite
out of wallets' propensity to open themselves? After all,
even a nice yearly growth rate in personal income has not
been accompanied by a similar increase in spending.
"George Orwell lives on at The [Wall Street] Journal,"
observes Northern Trust economist Paul Kasriel, referring
to a recent WSJ headline that read: "Consumer Spending
Showed Unexpected Strength Last Month." Yet, as Kasriel
points out, overall retail sales were actually down 0.9% in
January.
To be fair, stripping out auto sales to get a 1.3%
increase, as the Journal did, might be justified due to the
sector's recent volatility. But we have to be careful when
we start down that slippery slope - it doesn't make sense,
for example, to strip out energy prices from the CPI when
they've gone up and stayed up. For perspective, suppose we
were to strip out all auto sales and gasoline sales (for
which higher prices at the pump boosted the sales figures
in January) from the retail data for the past few years.
Suddenly, the year-over-year growth in sales wouldn't look
nearly so impressive.
The auto sector's unusually large impact can also be seen
in production data. Industrial output surged in January by
0.7%, the most in six months, and businesses increased
inventories for an eighth straight month in December. Auto
products had the fastest growth out of all the components,
with a 4.4% gain.
Motor vehicle output was also the driving force behind two
other monthly gains over the last six months. What will we
do after everyone buys his or her third car at 0%
financing?
What actually seems to be happening is an altogether
different story. It seems that ordinary people have
rediscovered the virtues of saving - not such a terrible
thing in our opinion, but a lot of people will get nervous
when spending increases don't show up in the GDP data.
Economists are already scrambling to lower their GDP
forecasts for the rest of the year, as higher oil prices
and temporary "geopolitical" forces prove to be not so
temporary after all.
We can hardly blame some analysts for getting excited about
improvement in fourth-quarter earnings reports. But the
consensus among the bulls [including our own Lynn
Carpenter] - which seems to be that, without Iraq, the
market would be reaping the rewards from this earnings
performance - isn't quite convincing. "When you look at the
aggregate numbers, three things stick in your craw," says
Chuck Hill, director of research for First Call. "The way
they slashed first-quarter numbers, the way they slashed
second-quarter numbers and [the fact] that pre-
announcements are running more negative than normal the
last three weeks."
Fourth-quarter top-line growth for S&P 500 companies that
have reported so far hit 4% - better than last year's minus
4%, but not very awe-inspiring. There is a consistent theme
here: Better times may be upon us, but for investors
looking at still-high valuations and uncertainty galore,
it's just not good enough.
Businesses are also finding that various costs have been
stubbornly rising. Isn't there supposed to be a whiff of
deflation going around? Richard Berner and Shital Patel, of
Morgan Stanley, note that corporate America is experiencing
a "perfect storm" with regard to cost pressures. While
wages, which make up the majority of costs, have remained
relatively flat over the last few years, costs have
accelerated for health and pension benefits, insurance,
worker's compensation, security services, materials and
energy.
Berner and Shital are relatively unperturbed about the
impact of rising costs on profits, but they suggest two
factors make this non-wage cost acceleration more daunting
than the data suggest: First, the cost increases don't vary
with the number of hours worked - that is, they are fixed.
And since growth remains weak, the costs are spread over a
smaller output, thus pressuring margins. Second, some of
the increases in these categories are quite significant.
For example, health care insurance premiums for large-cap
companies are rising at a 13% rate this year, wholesale
energy prices are up 75% from a year ago, and pension
contributions, says Berner, will eat up about $20 billion
of operating profits in 2003.
Our expert grasp of accounting (profits = revenue minus
costs) tells us that a problem could be brewing.
If you throw in looming fiscal trouble at the Federal and
State level and an obviously inflationary Fed...the economy
- or the stock market, for that matter - doesn't look like
its headed for recovery any time soon.
Regards,
Andrew Kashdan
for The Daily Reckoning
Editor's Note: Andrew Kashdan is a top analyst at Apogee
Research