* * * * * * * * * * * * REMINDER * * * * * * * * * * * * *
On the days that I don't publish, like today, you will
receive Bill Bonner's DAILY RECKONING. This will help you
to keep pace with the changes in the markets. Bonner and
I agree on most things in the field of economics, so the
two letters will reinforce each other.
* * * * * * * * * * * * * * * * * * * * * * * * * * * * *
The Great Disconnect
The Daily Reckoning
London, England
Thursday, September 23, 2004
---------------------
*** The "bankruptcy" economy... the steel industry... how
can
GM compete?
*** Fannie Mae stock drops 7% on SEC investigation...
*** The Dutch Antilles... hurricane damage... not
voting... and a disgusted reader!
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Watch those long bonds! Instead of going down with higher
interest and higher inflation rates, they're going up.
They're telling us to beware...
George W. Bush tells us that the economy is strengthening
and Iraq is on the road to peace and ballot boxes. He
appears to be wrong on both points.
Yesterday, the Dow seemed to notice. It slipped toward
10,000 - again.
And all over the country, people are having trouble keeping
up with their obligations.
The city of San Diego has $1.2 billion in pension benefits
it can't seem to cover.
General Motors has a glut of unsold 2004 models - so many
it is offering 0% financing for six years to get rid of
them. But it also owes so much in pension and health care
costs for its employees it is almost impossible for the
company to ever make any money. Over at Honda, each car
costs the company $107 in pension and health care costs.
But at GM, the cost is $1,360. You can imagine what the
cost is for Chinese manufacturers. How can GM compete? How
can it stay in business?
What do you do when you get in this situation?
"Welcome to the bankruptcy economy," says Jim Jubak over at
TheStreet.com. You cut prices... forced by competition, of
course... but you can't cut your costs - especially the
promises you've made to employees. Then, you declare
bankruptcy. What else can you do?
Delta and US Airways, for example, were greased up by the
bankruptcy courts and are now wiggling out of their
obligations to pilots.
The steel industry, says Jubak, showed the way. Nucor, for
example, "employs far fewer steelworkers at far lower total
wage and benefit costs than it did in 1975."
Go bankrupt. Cut costs. Cut payrolls. Cut spending.
Not something to look forward to. But something to expect.
More news, from our man in the action:
--------------
Eric Fry, from Wall Street...
- Fannie Mae got caught with her hand in the cookie
jar... so investors spanked every kid in the house. Fannie
Mae shares tumbled more than $5 yesterday, forcing the
entire stock market to share her pain. Today, they fell
another $1.70, or 2.4%, shortly after open. Crude oil also
took a few whacks at the market's behind, by jumping $1.59,
to $48.35 a barrel. Once all the wailing and sobbing had
subsided, the Dow Jones Industrial Average was nursing a
painful 135-point loss to 10,109, while the Nasdaq was 35
points lower at 1,886.
- Apparently, Fannie Mae is not the squeaky clean, do-
gooder that the well-compensated officers of the company
purport her to be. This sly vixen has been up to no good,
according to the Office of Federal Housing Enterprise
Oversight. After eight months of peeking under Fannie's
skirt, OFHEO published its findings yesterday... and what
findings they were!
- OFHEO informed Fannie Mae's chagrined board of directors
that, on at least one occasion, company executives had
deferred expenses in order to meet executive bonus targets,
while also dipping into improper "cookie jar" reserves to
boost reported earnings. The report also criticized a
corporate culture "that emphasized stable earnings at the
expense of accurate financial disclosures."
- OFHEO insists that its findings "are serious and raise
doubts concerning the validity of previously reported
financial results, the adequacy of regulatory capital, the
quality of management supervision and the [company's]
overall safety and soundness."
- Fannie Mae's shares tumbled 7%, as if the findings were a
complete surprise... they weren't. For many years, rumors
of
accounting impropriety have been swirling around this
company like flies around a cow's flank. Many professional
short-sellers known to your New York editor have been
betting against this stock - unprofitably - on the idea
that the company's impossibly steady earnings growth is
exactly that: impossible.
- Thanks to the insights of these astute investors, your
editor remarked one year ago (Aug. 14, 2003, to be exact)
in this column: "Imagine a parent who stores crates of
explosives under his baby's crib and you will understand
something about Fannie Mae's approximate financial profile.
Now imagine that the parents slide the baby's crib and
explosives over next to the radiator (in order to make room
for more explosives) and you will understand something
about Fannie Mae's corporate philosophy... "
- But even those folks who do not read The Daily Reckoning
every day - we call them "infidels" - should have suspected
something ill-becoming at Fannie Mae. Didn't kindred spirit
Freddie Mac admit last year to "smoothing" earnings? And
wasn't this confession the trigger for OFHEO's inquiry into
Fannie Mae? And weren't Fannie Mae's earnings as impossibly
smooth as Freddie Mac's? Hmmm... curious.
- Now that the OFHEO report has piqued the public's
interest, federal regulators are lining up to take a peek
at Fannie's private parts. The SEC is first in
line... perhaps the Fannie Mae saga is closer to its
beginning than to its "unhappily ever after."
- While Fannie Mae shareholders were licking their wounds
yesterday, crude oil investors were rubbing their
eyes... The Energy Department reported a stunning 9.1
million-barrel drop in crude inventories for the week ended
Sept. 17 - the eighth-straight weekly decline. Separately,
the American Petroleum Institute pegged the size of the
week's crude drawdown at a huge 12.9 million barrels. Both
organizations reported total inventories at 266.7 million
barrels - the lowest level since early February, and close
to the lowest level in 28 years.
- Since Hurricane Ivan brought oil importation to a halt in
the Gulf of Mexico last week, refineries and other crude
oil consumers had no choice but to dip into existing
stockpiles. The news of falling inventories sent oil prices
soaring to near-record levels, which also triggered
sympathetic rallies in unleaded gasoline, heating oil and
natural gas.
- "The Gulf Coast needs to pray they don't get any more
hurricanes or tropical storm disruptions, or all bets are
off," says Kevin Kerr, editor of Resource Trader Alert. As
Kevin's subscribers are profitably aware, Kevin has been,
and continues to be, an ardent bull toward almost every
product in the energy complex. He recently closed out a
profitable trade on heating oil and is shifting his focus
now to the natural gas market. "Gas prices will rise sooner
and sharper than most folks expect," the energy expert
predicts.
- October natural gas rose 5.7 cents yesterday, to $5.665
per million British thermal units, capping a three-day, 20%
rally for the "clean fuel."
--------------
Bill Bonner, back in London...
*** Fannie Mae shares crashed 7% yesterday. "Regulators
have found serious accounting problems at mortgage giant
Fannie Mae, prompting an inquiry by the Securities and
Exchange Commission and calling into question its financial
soundness," said Yahoo.
Chris Mayer, Fleet Street editor, sends this comment...
"This was bound to happen. The most aggressive of lenders,
along with Freddie Mac, has swallowed about half of the
U.S. mortgage market. Now we find out Fannie has been
fudging on its earnings. What else are they fudging on? For
years, Fannie has maintained that its book is adequately
hedged against a rise in interest rates. Maybe they
aren't.
You know, Fannie rolls over something like $30 billion in
debt per week. Imagine if the market didn't want Fannie's
paper as much because of concerns over its
creditworthiness? Rates would have to rise to compensate
for the added risk and Fannie's cost of borrowing goes up -
further exacerbating the problem. Given Fannie's high
leverage (they have something like a 3% capital position -
not including off-balance sheet stuff), they don't have a
lot of cushion to fall back on.
Well, they do have the U.S. government (read: the U.S.
taxpayer). But, we all know the U.S. government does not
guarantee Fannie's debt, right? (wink, wink).
*** The electronic mailbag continues to overflow:
Here's a note from a reader in the Dutch Antilles!
"I wanted to offer support to your stance on gay marriage.
I wholeheartedly agree with you and knew your comments
would draw serious flak. This is, though, the reason why I
read your e-mail; I want to read something that very few
will dare write.
"As it's popular to say in the United States, 'I'm lovin'
it'... keep it coming."
*** A comment on hurricane damage...
"I'm sick of reading how the Florida hurricanes are going
to help the economy in the long run. How stupid. But if
it's somehow true that a catastrophe like this is good for
the economy, then I think I have a great idea to save a lot
of money. How about we abandon all our anti-terrorist
activities worldwide? That would save about $85 billion in
Iraq alone. Then we do away with all this airport security
crap and save another bundle. Then when the terrorists
start blowing up targets around the country, there will be
a great stimulus of the economy as we rebuild. It seems
like a win-win situation."
*** And voting...
"My only purpose in writing today is to beg you to vote,
despite our deplorable choices, because that most important
privilege - freedom of speech - will not fare equally under
Bush and Kerry administrations - see Mogambo's notes re the
importance of lying!
"If Bush stays in - which looks inevitable - human rights
worldwide will be diminished, a woman's right to choose
outlawed and our international allies convinced we're
behind that moron!
"You just THINK you don't have a dog in this fight!!!"
*** And voting for third parties...
"I am completely *disgusted* with your conclusion not to
vote based on only two selections - Bush and Kerry."
"What about other party candidates? Personally, I will be
voting for Michael Badnarik of the Libertarian Party. He
stands for free markets, much smaller government and
minding our own business in foreign affairs. That's what
you guys espouse on a daily basis.
"You don't have to endorse him, but just think of the
contribution you could make to America if you at least
acknowledged the existence of other party candidates and
how they might stack up against the principles you stand
for!
"Even if someone like Badnarik received only 2% of the
vote, it could signal a coming wave of real voter
disenchantment (as opposed to your complete apathy) that
might, just might, begin to change the hopeless policies of
our two default parties. Default - there's a good financial
choice of words!
"Please don't advocate not voting. Instead, advocate voting
for a third-party candidate!
*** And on marriage...
"As to marriage being 'the work of the gods, of Nature...
of
God himself,' I believe marriage was an institution
contrived by tribal people to maintain order in the tribe
and to 'possibly' prevent other male tribal members
stealing one another's women, although there have been
several cultures in which tribal members enthusiastically
shared their women with one another, and apparently quite
happily so.
"I would assume this cut down considerably on the divorce
rate and much male physical conflict if everyone was
'getting some.'
"As far as this 'God' Bill speaks of is concerned, if (he,
she, it) created any of this earthly mess, I simply cannot
see the logic or plan to it, unless it was to punish every
living thing higher on the evolutionary scale than a
gorilla, to show them that this was one project (he, she,
it) totally screwed up.
"It appears that the 'works of man' will in some way soon
decimate the Earth and its beings in such a way as to set
the program back a few million years so it can get a new
foothold on a more productive path. Perhaps by just
stopping with plant life and leaving the crawly, swimmy,
flying things out of the picture in the next round."
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---------------------
The Daily Reckoning PRESENTS: The stock market and the
economy have diverged. So the fundamentals are not being
valued correctly. Gary Shilling explains why there are so
many parties with an interest in keeping it this way.
THE GREAT DISCONNECT
by Gary Shilling
Financial markets and the economy parted company in the
late 1990s. With stock weakness this year in the face of a
strong economy and robust profits, the great disconnect
still exists.
The unwinding of inflation in the 1980s and 1990s spawned
the long 1982-2000 bull market by driving up P/Es and
profits. By the late 1990s, its length and intensity put
fear to flight, leaving nothing but intense greed.
Speculation rivaled that of the late 1920s, and the
subsequent revelations of Wall Street and corporate
malfeasance take the parallels even closer.
So powerful was that 17-year, eight-month bull market that
even a three-year bear market - one which cut the Nasdaq
index by 78% - was not strong enough to bring the financial
and economic worlds back together. And massive monetary
easing and huge fiscal stimuli actively promoted a
continued separation. The nose dive in interest rates
spurred housing and cash-out mortgage refinancing. Tax cuts
and leaps in defense and homeland security spending pumped
big money into the economy.
As a result, financial speculation survived largely intact,
but shifted from stocks to residential real estate and
hedge funds. Those private partnerships - along with banks,
brokers and other pools of capital - took advantage of
cheap short-term money to invest in Treasury bonds, junk
bonds, convertibles, emerging market stocks and bonds,
currencies and commodities.
Evidence is rampant that financial markets remain in their
own levitated world. Sure, like most services, the
financial sector grows faster than the overall economy. As
U.S. business expands, financial services become more
widespread and more complex and make up an increasing share
of economic activity. Still, the continuing upward
departures from early, consistent post-World War II trends
testified to the persistent disconnect from the real
economy. These intact bulges are significant since
corrections of the huge 1990s speculations should have
taken them below their long-term trends for at least a few
years.
The Wilshire 5000 Total Market Index contains almost all
U.S. stocks, so its ratio to GDP gauges the stock market's
value relative to the economy. The ratio is well below its
2000 peak, but at 96% remains substantially above the
1971-
1996 trend projection that puts it at 60%. Similarly,
mutual fund assets in relation to GDP now stand at 64%,
well above the 54% dictated by the 1984-1996 trend line.
The financial services sector, of course, benefited from
the stock surge in the late 1990s, and the market
capitalization of the financial stocks in the S&P 500 index
leaped to 18% of the total. But after a brief setback when
the market swooned, those companies were recharged by
residential real estate and spread lending activity. So
their market caps now account for more than 20% of the S&P
500 total. Meanwhile, the notional value of over-the-
counter derivatives such as currency and interest rate
swaps climbed from $90 trillion at the end of 1999 to $197
trillion at the end of 2003.
Almost no one wants the financial and real estate spheres
to reunite with the economic world, since the fusion could
be bloody. Not the speculators involved. Not the brokers,
banks, hedge funds, money managers, venture capitalists,
financial TV channels, consultants and purveyors of
financial data and research that serve them. Not even the
administration and the Fed.
History says the two worlds will rejoin sooner or later.
Still, the Fed, whether it knows it or not, is trying to
prevent just such a reunion. Here's why.
The Fed has already telegraphed its intentions to raise the
federal funds rate it controls. Futures markets have so
firmly anticipated future credit tightening that if the Fed
does not proceed, it risks losing credibility - a no-no for
the central bank.
But higher rates could be curtains for spread lenders and
house prices. A serious financial crisis could turn my
forecast of the good deflation of excess supply into the
bad deflation of deficient demand as incomes are
shattered.
But suppose the Fed succeeds in raising interest rates
slowly enough that speculators can adapt without major
failures. Most would probably figure that Washington had
again raised the safety net so they could climb to yet a
higher perch from which to take that half-mile dive into a
wet sponge. They'd no doubt take even bigger speculative
positions in real estate, commodities, stocks, junk bonds,
currencies, etc. The gap would widen and the prospects of
closing it painlessly would fall.
Sadly, the Great Disconnect of the last decade between the
speculative financial and the real economic worlds will
probably persist until a lot of people not only lose a lot
of money, but also give up all hope of being bailed out.
Regards,
Gary Shilling
for The Daily Reckoning
Editor's Note: Dr. Gary Shilling is president of A. Gary
Shilling & Co. Inc., an investment advisory and economic
consulting firm and publisher of the monthly INSIGHT
newsletter.
Not only has Dr. Shilling beaten the stock market by a wide
margin over many years, he has provided consistently
accurate forecasts to his subscribers. Twice ranked as Wall
Street's top economist by polls in Institutional Investor,
Dr. Shilling was also named the country's No. 1 commodity
trader advisor by Futures magazine. And last year,
MoneySense ranked him as the third-best stock market
forecaster, right behind Warren Buffett.
A regular columnist for Forbes magazine, Gary Shilling
appears frequently on radio and television business shows
and has written six books, including Is Inflation Ending:
Are You Ready? in 1983 and, more recently, two books
detailing his forecast for the new world order and its
consequences for your wallet. For his very latest research,
see:
INSIGHT
http://www.agaryshilling.com/insightdr.html
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