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The Great Macro Profit Illusion
The Daily Reckoning
London, England
Wednesday, September 8, 2004
---------------------
*** The prevailing winds... and the rough seas...
*** The Renaissance Fest and the era that no longer
exists...
*** John Mauldin... prehistoric bones... smoking... oxymorons
and more!
---------------------
Oil was supposed to go up. Commodities, too. Gold,
silver... all were on the way up.
Bonds and the dollar were supposed to go down.
All our friends believed it. We still do.
But not necessarily right away.
In our book, we saw the U.S. economy sinking into a slow,
soft slump a la Japan. Of course, we mistrust all
predictions... especially those we make ourselves. But so
far... a slow, soft slump seems to be precisely the sump
hole into which the United States is sinking.
Bonds have been in an uptrend since May. The dollar has
held steady or improved slightly. Gold has gone nowhere.
And commodities seem to be going down, not up.
And oil? It has backed off recent highs... and in real
terms, oil is still very cheap compared to what it was a
quarter of a century ago.
Has the world economy taken a new direction? Is it clear
sailing from here to eternity?
Nope. And nope.
The prevailing winds are still blowing in the same
direction... and they still lead to very rough seas. But
it's a big world. It can take a long time to get where
you're going.
What has not changed is that the amount of debt in the
world is still increasing. In 1952, the ratio of domestic
nonfinancial debt to GDP was only about 60%. Today, it is
more than 160%. In the last three years, the U.S. economy
has added $1.3 trillion to its GDP. But during that period,
it also added $4.2 trillion in debt.
For the 36 years from 1952-1988, a dollar's worth of GDP
meant about an additional $1.50-1.80 in debt. But in the
first three years of the 21st century, $3.19 worth of debt
was added for every extra dollar of GDP.
Why so much more debt/GDP? Because more of the borrowing is
used for consumption, rather than for production. When you
take on debt, you can use it to build a business... or you
can spend it. If you build a business, you employ
people... build factories... buy capital equipment and so
forth. This is the stuff that increases GDP - wages,
profits, capital investments. But if you spend it -
especially now, when so much of what we buy comes from Asia
- the spent money boosts retails sales and then disappears.
The resources that might have been used to increase wealth
are squandered on trinkets, geegaws and calories.
But that is not the end of the story. When you borrow to
build a business, you expect a source of earnings and
profits that will make it possible to repay the loan. But
when you borrow to consume... or borrow for a business that
doesn't work out... you can only pay back the money by
spending less in the future. Sooner or later, you're forced
to cut back.
As the mass of debt increases, the debt itself begins to
exert a gravitational pull on the financial markets. The
whirling consumer bodies... the revolving loans... the
Jupiters of mortgage finance... the Saturns, ringed with
marginal borrowers - the entire solar system of debt gets
pulled in tighter, as if toward a black hole.
In traders' language, people are long inflation (betting
that the money they have to pay back will be worth less
than the money they borrowed)... and short the currency
itself (the last thing they want is for the dollar to go
up).
Mr. Market, in his typically perverse way, always tries to
find a way to ruin the greatest number of investors. When
people are short the dollar (as they are when they are deep
in debt), he creates a "short squeeze" - people desperately
need dollars in order to pay their dollar-denominated
debts! Deflation, dear reader, deflation. Japan-
style... slow, soft, sinking deflation.
Over the long run, though, the dollar can be expected to do
what it ought. The denouement of this drama - when it comes
- will be neither slow, nor soft, but violent and swift.
This from the forward of Pete Peterson's book Running on
Empty:
"America's twin deficits are causing some of the world's
shrewdest financial minds to raise alarm. When two such
experienced and understated executives as Bob Rubin, former
secretary of Treasury, and Paul Volcker, former chairman of
the Federal Reserve Board, join the many others who fear
these twin deficits, I listen. Bob Rubin says we are
confronting a day of serious reckoning. In referring to our
fecklessness, Rubin warns that the traditional immunity of
advanced countries like America to Third World-style crises
isn't a birthright. Volcker predicts we face a 75% chance
of a crisis in five years.
"America's twin deficits are now so large, and our savings
rate so low, that there is a real danger that investors
around the world simply lose faith in the dollar. According
to Steve Roach, chief economist of Morgan Stanley, 'It's
hard to conceive of a more unstable disequilibrium.' For
the first time in his 72 years, Warren Buffett, the
Nebraska sage, is purchasing foreign currencies. Britain's
prominent fund manager and financial commentator Marshall
Auerback says America has entered a banana republic-style
debt trap."
Deflation will slowly squeeze American debtors. Then, when
the debt trap suddenly springs shut, the dollar will do
what banana republic currencies always do: It will slip
away.
More news, from the Baltimore HQ...
---------------------
Tom Dyson, from historic Mount Vernon...
- On Sunday, your editor found himself at "Renaissance
Fest" - a celebration of medieval culture on the outskirts
of Baltimore. Boisterous mobs of surfs, peasants, wenches,
barons, knights and court jesters plodded through the wood-
chipped avenues, kicking up dust with their 16th-century
heels. Thousands showed up, filling an enormous grassy
field with shiny new SUVs.
- Jovial red-faced cider lovers packed the taverns. They
wore patterned tights, medieval tunics, pantaloons and
strange boots. And the women - old hags and comely maidens
alike - wore elaborate corsets and flowing robes, now tatty
from being dragged through the dust. Of course, not having
made the effort to conform to the dress code, it was we who
looked ridiculous.
- Like the fools at the festival, investors are clinging to
an era that no longer exists. We're not talking about
swords and chain mail, but the unerring assumption that the
status quo will be maintained. Nothing will happen. There
may be dips and peaks along the way - and even long,
festering periods of sideways meandering - but America's
long-term projection is assured.
- Nobody seemed to notice, but even the recession of 2001-
2002 and the recovery of 2003-2004 were unlike those cycles
in years gone by. "We've reached a major bottom," the lumps
think. "Now it's time to buy and hold again."
- But one man noticed.
- "It's most important to realize that the U.S. economy's
slowdown over the past few years has nothing in common with
the business cycles of the past," warns economist Dr. Kurt
Richeb�cher. "Literally everything has been running
contrary to the typical pattern of downturn and recovery."
- In the past, central banks hiked interest rates in
response to heating inflation. They put the brakes on
business and the consumer. We used to see a sharp decline
in credit-financed expenditures like consumer durables and
business fixed investment. This was the recession of a
bygone age.
- But not in 2001, says Richeb�cher. The sudden nose dive
in stocks and economic growth clearly had nothing to do
with tight money or credit... the two were expanding in a
fashion without historical precedent.
- "Fed Chairman Alan Greenspan and other policymakers like
to boast that thanks to their policies, America had its
mildest recession in the whole postwar period," writes the
good doctor in his latest diagnosis. "This comparison is a
deliberate delusion. To judge the success of the employed
policies, it is, of course, also necessary to take the
economy's performance during the subsequent recovery into
account."
- "As we have repeatedly stressed," continues Richeb�cher,
"the 2001 recession and the following 2002-04 recovery
years add up to the U.S. economy's worst performance in the
whole postwar period. But being forever flooded with
optimistic comments and forecasts from cheerleaders
Greenspan and Wall Street, very few people seem to be aware
of this fact."
- Certainly not yesterday's investors... they bought stocks.
The Dow added 80 points, to 10,341, while tech investors
pushed the Nasdaq up 14 points, for a 0.76% gain. The index
closed at 1,859.
- And as for gold, well, the metal was once popular. But
not any more. In the Middle Ages, the yellow metal was
coveted, revered and worshipped. In the Information Age,
it's loathed. Now it sells for less than $400 again.
Yesterday, gold declined $3, to $397.6. And the last time
we looked, it was down again.
- But here at The Daily Reckoning, we don't worry about
daily price fluctuations. Instead, we sit and wait for
something big to happen. It's coming. We just don't know
when or how...
---------------------
Bill Bonner, back in London...
*** The financial world is "on hold," as near as we can
tell.
No one knows why. No one knows what will be said when
someone finally picks up the phone.
But for the moment, everything is quiet.
"Nobody has any idea of what is going on," said our old
friend John Mauldin, who stopped by for a visit over the
weekend.
John is a Texas Republican with moderate views on most
subjects. But we like him anyway; he brings BBQ sauce and
chili peppers... and grills the steaks.
"Dubya is no fool," says John. "And if he gets another term
- which I think he will - you're going to see some changes.
"He's basically got the right idea about things. But Karl
Rove got ahold of him. And Karl only cares about winning
the next election. After the election is over, I don't know
if Karl will have a horse in the next election or not... but
it won't be George W. Bush. So Bush will be free to do what
he wants without worrying about re-election.
"He let spending get away from him during the first
term... he was distracted by 9/11 and the war on
terror... but it won't get away in the second term."
Here at Daily Reckoning headquarters, we steer clear of
politics. Money is our beat. But we can't help notice that
it is crowds of people that dominate markets as well as
politics... and that group thinking leads them both, in
similar ways, to do preposterous, absurd things.
"Group thinking" is, like "honest politicians," an
oxymoron. Groups do not think. Instead, they desire. They
fear. They panic. They go mad from time to time - sometimes
believing they can get rich without working or
saving... sometimes believing that they can all live at
someone else's expense... sometimes hoping that expensive
stocks will become even more expensive... and sometimes just
getting lathered up and setting off, hellbent on some self-
destructive mania.
An individual knows - he cannot spend his way to wealth. But put
him in a group, and he's ready to believe that
"consumer spending" can make the whole society rich.
An individual knows he cannot kill another individual
without risking jail... or hell. But put him in a crowd, and
he's ready to declare war on people he's never met for
reasons he's never understood.
Groups - such as stock market investors - are dangerous,
unthinking mobs...
*** In the British press, we find a couple of things worth
mentioning. A study of single people - divorced, widowed or
never married - found that living alone was a bigger health
risk than smoking.
Hmmm...
We've never understood why government was so insistent on
trying to stop people from smoking. It is a "health risk,"
says the anti-tobacco crowd. But there are a lot of things
people do that could shorten their lives. Why single out
smoking?
"Smokers impose heavy costs on public health services," was
the answer. But so do those who eat too much, do not
exercise or never marry (at least, that is the implication
of today's headline article).
*** Elsewhere in the London newspapers, we find that
English researchers working on skeletons in a Mexico City
museum have concluded that the bones found in Baja
California do not belong to the same race of "Native
Americans" who are believed to have come over across the
Bering Strait some 10,000 years ago. The bones in question
have much longer, narrower skulls than those of the
Siberian tribes that settled North and South America. These
people - whom the British researchers believe came here
from Southeast Asia or Australia - were apparently already
in Baja California when the northerners arrived. The Baja
bones have been carbon dated to 12,500 years old. DNA tests
will be forthcoming. Stay tuned.
*** And back in France...
Two things are becoming popular according to today's
papers. First, the film The Choirboys was such a hit in
France that it has set off a whole new mode for singing in
choral groups. New groups are forming all over the country,
with more than 300,000 people participating.
The other thing that has become fashionable in France is
intentionally goofing off at work. A new book, Hello
Laziness, tells how to do it.
Even The New York Times has commented on the new trend.
Because the book's author urged readers to work at
"spreading gangrene through the system from within" by
appearing to work but not really doing anything. This is a
revolutionary doctrine, for the French typically do the
opposite: They appear not to work too hard, while actually
getting a lot accomplished.
What got the book widespread coverage was that the author's
employer, the national electricity company, found out about
it and tried to fire her. Of course, this being
France... even openly advocating internal sabotage was not
enough to make a dismissal stick. She would have had to
murder the CEO and the entire executive board... and even
then she'd probably be back at work in a few weeks, with
her employer forced to provide back pay as well as extra
counseling!
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---------------------
The Daily Reckoning PRESENTS: The bulls have been bellowing
about a superb run of corporate profits over the last few
years. But is it really true? Dr. Richeb�cher picks through
the numbers...
THE GREAT MACRO PROFIT ILLUSION
by Kurt Richeb�cher
Is the U.S. economy stalling out, or is it resuming its
strong growth, gaining traction for a self-sustaining
expansion with healthy job and income growth?
In the consensus view, the economy's weakness in the second
quarter was nothing more than a "soft patch." We are no
less sure that "traction" will remain elusive. It is the
essential outgrowth of an upturn that has been of miserable
quality right from the start.
With its advance estimate of GDP growth in the second
quarter of 2004, the Commerce Department's Bureau of
Economic Analysis also released benchmark revisions to the
national accounts data back to 2001. Notable adjustments
include a markedly lower personal savings rate and a
downward revision to economy-wide corporate profits for the
past couple of years.
The biggest surprise in the GDP data was the reported sharp
slowdown in consumer spending to just 1% at annual rate.
But what about the other major demand components: business
fixed investment, residential construction and inventories?
Most important next to consumption is, of course, business
fixed investment. In the consensus view, business
investment spending continues to post healthy gains, thanks
to exceptionally strong profit growth in the past two
years. We have strong reservations about both the strength
of investment spending and the exceptionally strong profit
growth.
Over the full year to the second quarter, nonresidential
fixed investment rose by $108 billion, a remarkable rate of
about 10%. That is, in fact, a healthy gain. But as already
pointed out, the stellar aggregate number conceals an
unusually lopsided investment pattern. The outstanding
contributor is computer investment, thanks to hedonic
pricing. Investment in industrial equipment, the key
component for industrial production, was virtually stagnant
over the year.
In addition, the accelerated depreciation allowance for
capital investment spending that was part of the last tax
package will expire at the end of this year. If businesses
have pulled forward investment projects from 2005 into 2004
to qualify for the tax break, investment spending might
slow sharply after the turn of the year.
Another highly popular argument of the bulls is the U.S.
economy's excellent profit performance in the past two
years, as trumpeted by most Wall Street analysts. Here
again, we must plead to keep things in perspective. Overall
corporate profits peaked in 1997 and hit their low in the
fourth quarter of 2001, virtually the end of the recession.
Our focus is always on the profits of the nonfinancial
sector. At their high in 1997, they amounted to $504.5
billion. In the first quarter of 2000, just before the
start of the economy's downturn, they were down to $426.2
billion. At their low, in the fourth quarter of 2001, they
amounted to $236.5 billion. In the first quarter of 2004,
they had recovered to $420.7 billion.
>From the low to the new high, they increased by 77%.
Given the simultaneous steep fall of share prices, this
number certainly has a highly bullish flavor. On closer
look, the steep rise was rather more bearish than bullish.
First of all, the profit level of the first quarter of 2000
was manifestly nothing to crow about. It ushered in the
economy's downturn. Drawing this comparison, a further
point to be taken into consideration is that today's
nominal GDP is up almost 20% since then. In 2000, those
profits were equivalent to 4.4% of GDP. Presently, they are
3.6%.
Bearing the structural distortions in the U.S. economy in
mind, a most important aspect is the changes in profits
between different sectors. They are, really, the numbers
that matter most. For us, most striking, and also most
telling, is the difference in the profit performance
between manufacturing and retail trade. In 1998,
manufacturing earned $157 billion, far more than retail
trade, which earned $66.4 billion. But just six years
later, in the first quarter of 2004, manufacturing profits
were drastically down to $81.5 billion and retail profits
sharply up to $80 billion.
There is a similar drastic divergence in profit performance
within the manufacturing sector. Profits of the producers
of consumer durables and capital goods have generally
collapsed into persistent losses. In 1998, they earned a
collective net profit of $83.4 billion, accounting for more
than 50% of total manufacturing profits. By 2000, this had
shrunk to $60 billion. But in 2003, a year of recovery,
they ran a collective net loss of $3.5 billion.
It is most important to realize this extreme divergence in
the U.S. economy's profit performance because it is
symptomatic of the marked, structural distortion that has
been going on in the U.S. economy. Most remarkable,
certainly, is the persistent savage profit deflation of the
producers of high-tech equipment, unquestionably due to
fierce competition. It is needless to say that persistent
losses are prone to choke new investment.
Yet most conspicuous from a macro perspective is the
flagrant diversion in the development of profits between
manufacturing and retail trade. We looked back into the
mid-1980s and noted that manufacturing profits were then
about four times those of the retailers. Today, they are
equal.
That is, of course, what has to be expected in an economy
in which consumer borrowing and spending reign supreme.
Regards,
Kurt Richeb�cher
for The Daily Reckoning
Editor's note: Former Fed Chairman Paul Volcker once said:
"Sometimes I think that the job of central bankers is to
prove Kurt Richeb�cher wrong." A regular contributor to The
Wall Street Journal, Strategic Investment and several other
respected financial publications, Dr. Richeb�cher's
insightful analysis stems from the Austrian School of
economics. France's Le Figaro magazine has done a feature
story on him as "the man who predicted the Asian crisis."
This essay was adapted from an article in the September
edition of:
The Richeb�cher Letter
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