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* * * * * * * * * * * * REMINDER * * * * * * * * * * * * *
On the days that I don't publish, like today, you 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
reinforce each other.
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Enron and the Bubble
THE DAILY RECKONING
PARIS, FRANCE
WEDNESDAY, 6 FEBRUARY 2002
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*** Stocks stink...but gold, well what can you say about
it?...
*** Has a bull market in gold shares begun? Is the Pope
Catholic?...
*** Record bankruptcies, tougher lending policies,
Enron...long live the Queen...and more!...
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Stocks sink...but gold soars. Element number 79 on
the periodic table rose $9 yesterday. It's up $20 in the
last 2 weeks.
Gold sales in Japan have risen 300%. And mining
stocks are at a two-year high. Goldfields rose 13%
yesterday. Harmony was up 5%. Gold mutual funds have
been the best-performing sector for the past 14 months.
"The new bull market in gold stocks that has been
underway for the past few months is not, however, being
fuelled by us 'bugs'," writes Gary North. "It's not the
gold sector funds or the mining sector funds...the gold
sector funds don't have any money, and the mining sector
funds are skeptical of gold. It is my view that a few of
the more savvy portfolio managers...are buying gold.
"Consider for a minute just how many mutual funds
there are - ten thousand? - and how many trillions of
dollars are invested in those funds. It is only logical
that some of these thousands of fund managers understand
the value of gold and are beginning to move a little
money into gold stocks."
But why gold? Why now?
Because gold is what people turn to when they
become suspicious of other assets. Enron, Global
Crossing, Cisco, Amazon...America's favorite stocks may
get blown away...but gold stays put.
Eric is airborne this morning...so today's Wall
Street notes come from Addison, who is in New Hampshire,
and at least in the same time zone as Manhattan...
******
Addison Wiggin in Waterloo, New Hampshire...
- Not much doing on Wall Street yesterday. The Dow
closed barely changed at 9685, despite another 23% loss
for the beleaguered Tyco. The Nasdaq shed 17 points to
1838 on a heavy 2.1 billion share volume. Telecoms and
Networkers were all suffering again.
- But the HUI...whoa. The gold bugs index stretched its
gains to 46% in just over 2 months. The "barbarous
relic" roared to within a whisker of the magic $300/oz
mark, closing the day at a 2-year high. The index, which
deliberately excludes the big bullion hedging concerns,
is now up 148% in 13 months.
- JP Morgan Chase closed at its lowest price since the
Long-Term Capital Management crisis of 1998. "I believe
we handled everything with integrity, but we had too
much exposure" was all JPM Chase CEO William Harrison
could say to his staff about the company's dealings with
Enron. "Enron was merely the latest in a series of
catastrophes," writes Sean Corrigan, the Daily
Reckoning's London correspondent, "for an entity many
believe was the result of a hasty 1999 shotgun marriage
intended to save the two great banking dynasties of
Morgan and Rockefeller."
- Here at the Daily Reckoning we keep wondering: why are
we hearing so much about Enron? What's the problem?
Fortunes were lost, reputations ruined; people didn't
get what they expected from Enron...but are they not
getting what they deserve? Even senior management - who
seem to have escaped with the loot - have not been
spared.
- "Ken Lay et al will spend the rest of their lives in
purgatory - burned by the courts," suggests your editor
Bill Bonner, "poked by devilish lawyers, harassed by the
hobgoblins of the press, facing time in the hoosegow as
well as the poorhouse. What's not to like?"
- No silver lining comes without a cloud. The Democrats
have seized on Enron as a campaign issue. "The more
people hear [Enron], the more corrosive it becomes,"
says a letter from James Carville to Democratic
troublemakers. He urges the Democrats to use the Enron
issue in the upcoming elections.
- But as Andrew Kashdan points out: "One might not know
it from the media feeding frenzy engulfing Enron, but
this circus had its origins not in politics...but in
economics."
- "At some interest rate," Kashdan continues, "it might
be profitable to trade everything under the sun, as
Enron wanted to do. At some Fed-engineered interest
rate, Enron was certainly given the opportunity to try."
More below...
******
Back in Gay Paree...
*** Layoffs rose 32% from December to January. And last
year more companies went chapter 11 than in 1994, 1995,
and 1996 combined.
*** No wonder business financing has been getting harder
to get. Lenders are getting suspicious.
*** Let's look at one very interesting case: General
Motors is the strongest of the three U.S. automakers.
2001 was the second highest year on record for auto
sales. And the Fed cut rates 11 times last year - making
it much easier for businesses to finance their debt
loads. Yet, Moody's recently downgraded General Motor's
commercial paper from P-1 to P-2, making it impossible
for GM to sell its debt to money market funds.
*** Result: GM has to pay more for financing at a time
when its profits margins are being squeezed.
*** Why is GM hurting? Because U.S. manufacturers have
been losing market share for years - thanks largely to
the strong dollar. And because selling cars on-the-cheap
does not give the company the profit margins it needs.
*** Why might GM be in even worse shape in a few months?
Because zero financing and other temptations have done
their work - moving auto sales that might have happened
in the next few months to the last few.
*** "We expect a double-dip [a drop back into
recession]," writes Sy Harding, "because of the way
economic activity is being pulled from the future into
the present to pull the country out of its mild
recession."
*** Fifty years ago today, Elizabeth Alexandra Mary
Windsor, 26 years old, took the throne of Great Britain,
following the death of her father. Elizabeth II will go
down in history, we believe, as one of the world's great
monarchs. As we celebrate her golden jubilee, we can't
help but reflect that in half a century, democratically-
elected governments have done much mischief. Elizabeth,
like gold, has done her job.
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The Daily Reckoning PRESENTS: Grantsinvestor.com's
Andrew Kashdan explains why the Enron debacle cannot be
understood outside the context of the Great Bubble...
ENRON AND THE BUBBLE
by Andrew Kashdan
One might not know it from the media feeding frenzy
engulfing Enron, but this circus had its origins not in
politics, although they certainly have helped it along,
but in economics.
Even some of the more serious commentators have
forgotten what kind of environment spawned the Enron
calamity. One who didn't was Paul Kasriel, economist at
Northern Trust Co., who last month chided The Wall
Street Journal for finding a way to blame Bill Clinton
for this mess. A better target, says Kasriel, would be
Fed Chairman Alan Greenspan and his rampant credit
creation. Don't misunderstand. This is not an attempt to
absolve the supposedly oblivious Ken Lay, or the
allegedly more devious Andrew Fastow. What we are trying
to do is look at the bigger picture.
To make some sense of what has happened, it is first
necessary to explain, albeit briefly, the nature of the
business cycle. Many people, mimicking the maestro, will
probably chalk it all up to "irrational exuberance," or
perhaps in the words of John Maynard Keynes, "animal
spirits." But this just begs the question...what is it
that causes the irregular but recurring rise and fall of
this exuberance? Paul Kasriel understands how the
expansion of credit, spurred by the central bank's
creation of bank reserves, gives rise to the business
cycle and to companies like Enron. Enron was not the
first to be revealed as, shall we say, too optimistic,
nor will it be the last.
Before Enron's debt could be magically shifted off its
balance sheet, Kasriel reminds us, someone had to have
been doing a lot of borrowing. And indeed, there was an
extraordinary rise in financial-sector borrowing
relative to non-financial-sector borrowing during the
1990s. When demand for credit rises, the Fed prevents a
rise in interest rates by pumping more money into the
economy through the creation of more dollar reserves -
that is, assuming it is not raising its federal funds
target.
By the end of the 1990s, Kasriel points out, created
credit as a proportion of savings was the highest in
over 40 years. Whether or not one describes Enron as a
"financial" company, which is debatable, its frenetic
derivatives activity eventually led back to the
financial sector. At some interest rate, it might be
profitable to trade everything under the sun, as Enron
wanted to do. At some Fed-engineered interest rate,
Enron was certainly given the opportunity to try.
That said, we can't overlook the fact that another
culprit in this fiasco may well be all those credulous
investors who poured money into Enron stock. During the
bubble, when capital (i.e., credit) was plentiful, most
investors weren't too concerned about the details of
Enron's activities, or anything else for that matter.
But as the investigation unfolds, it appears that a
number of warning signs were ignored.
To pick just one example of something that should have
raised red flags for every investor, Enron "marked-to-
market" its energy trades, using its own assumptions to
determine the value. The models included forecasts of
energy prices for up to 10 years, and even assumptions
on deregulation in different markets. Take a guess as to
whether these assumptions were favorable to Enron.
Certainly, Enron's disclosures were far from
comprehensive, but investors might have been more
curious about the source of the company's massive
revenues.
To be sure, a few skeptical souls did question
conventional wisdom, most notably Jim Chanos of Kynikos
Associates. It was this "gain-on-sale" accounting that
led to Chanos's investigation of the company more than a
year ago. Is Chanos smarter than the average investor?
We don't doubt it. After all, he read the same financial
statements that were available to everyone else, but he
came to different conclusions than most.
Another warning sign, says Gretchen Morgenson of The New
York Times, came during the California power crisis,
when energy costs were rising and profits should have
rolled in. But Enron was earning only one-half of 1% on
its sales. Morgenson further notes that investors could
have seen a wide discrepancy between reported earnings
and retained earnings - the profits that Enron made
after all expenses and costs (like stock dividends) were
paid - if they had been willing to look.
True, the cash-flow discrepancy was partially hidden by
the extraordinary array of off-balance-sheet
partnerships that are now coming to light. Nonetheless,
as an accounting professor told the Financial Times, the
ratio of operating cash flow to income declined in 1997,
1998 and 1999, before improving in 2000, due partly to a
sharp rise in accounts payable. The ratio then declined
again in the first two quarters of last year. Did anyone
notice?
We might add that when a CEO uses a vulgarity to
describe someone who asks about the balance sheet, as
Jeffrey Skilling did during a conference call last April
(as The New York Times has reported), that in itself
should have been cause for alarm. (Unfortunately, this
informative exchange is not available in the conference
call archive on Enron's Web site.)
Just this week, The Wall Street Journal related the tale
of Monthly Income Preferred Shares, or MIPS, a type of
security created by Goldman Sachs that could be
considered as equity or debt, depending on a company's
needs. "Standard & Poor's, in its rating of November
1993 of the first MIPS deal, cautioned that Enron's
financial maneuvers were 'aggressive and not
particularly supportive of credit quality,'" the Journal
said. When the Treasury asked the SEC to stop the
practice, "one of the pitches the Treasury made was, 'Do
you realize that companies have billions of dollars of
debt that isn't showing up as debt?'" So why did so many
people not bother to follow up on their concerns over
the next eight years? Enron's skyrocketing stock price
and its ambitious plans apparently worked like a tonic
in soothing any skepticism, when they should have had
exactly the opposite effect.
Incidentally, the fact that Wall Street analysts were
bullish on the stock until the very end is really a non-
issue. Even before the bursting of the bubble in 2000,
no serious investor over the age of four took sell-side
recommendations at face value (my apologies to any
toddlers who know better). If investment banks want to
pay their analysts exorbitant salaries to be
cheerleaders, that's their business. But that doesn't
mean that investors should listen.
At the risk of sounding heartless, it should also be
understood that the outcry over the victims is yet
another symptom of a misunderstood financial
environment. We've heard that the government needs to
"bail out the victims," or that "these workers need to
be made whole." No one likes to see small investors lose
money while top executives stash away millions. Yet such
pleas overlook the fact that many held on to Enron
shares when they didn't have to, and many others have
lost jobs at companies that have blown up (if less
spectacularly and with fewer congressional hearings). At
what share price would workers be "made whole"? Might it
be at some number bandied about at the height of the
frenzy, when investors were far too optimistic about
Enron's legitimate business prospects and the company
itself was reporting illusory profits?
The issue of possibly illegal acts or liability to
workers and shareholders - essentially whether Enron's
actions reached the level of fraud - will be settled in
the courts. Rest assured, the lawyers will be quite busy
for some time to come. But those issues should be kept
separate from the issue of an overvalued company, of
which Enron was only one of many in the Great Bubble.
Bridgewater Associates got it exactly right when it
said, "Enron's problems, and those of similarly
aggressive public companies, are more symptomatic of
post-bubble periods than they are unique."
The point is that financial manias bring with them a
huge misallocation of capital. In other words, we see
businesses that never should have expanded into certain
areas, and many that should never have been born. The
investors, and unfortunately the employees, will all pay
the price. In hindsight, many of the rationalizations
and assumptions will come to look ridiculous, as past
bubbles illustrate.
In that sense, "irrational exuberance" is an apt
description. But dumb ideas by themselves are not
enough. They are far too plentiful. In the end, it's all
about the money. In the immortal words of Pogo: "We have
met the enemy and he is us" - in this case, aided and
abetted by the Fed.
Andrew Kashdan,
for The Daily Reckoning
Andrew Kashdan is an integral part of the team at
Grantsinvestor.com. With offices at 30 Wall Street, the
analysts and writers at Grantsinvestor.com serve as the
Daily Reckoning's eyes and ears in the heart of the U.S.
financial industry. For crack research, independent
analysis and profitable recommendations from a team that
isn't afraid to say "Sell!", please visit:
http://www.grantsinvestor.com
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