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on most things in the field of economics, so the two letters
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Preparing for a Recovery
The Daily Reckoning
Paris, France
Tuesday, 24 September 2002
-------------------
*** Options Expensing: politics over principle...
*** Stiglitz' recipe for renewal...big wave of layoffs
for Wall Street...
*** Greenspan - our hero? Maybe the ex-Randian isn't so
'ex' after all... small cap recovery... and more, more,
more...
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"As is often the case, politics won over principle,"
says Joseph Stiglitz, explaining away his involvement in
the largest financial bubble in the history of mankind.
It's amazing what comes to light when the shinola begins
to hit the fan, isn't it? In the October issue of The
Atlantic Monthly, Stiglitz, former head honcho at the
World Bank, Nobel Laureate in Economics and chairman of
President Clinton's Council of Economic advisors, chimes
in on a theme that regular readers of The Daily
Reckoning will recognize: employee option compensation
schemes.
As early as May 2000, Bill Bonner suggested,
"capitalists are once again being exploited by the
workers. Management is free to re-price its options to
retain and reward valuable employees. If you are an
investor, however, you should not expect to have your
shares repriced - except by the market itself...and
lower."
In July of this year, Porter Stansberry suggested in a
DR guest essay that "options schemes" had gotten so out
of hand at Maxim Integrated Systems that the sole
purpose of the company's management had shifted from
building competitive products to using complicated
accounting procedures to hide how much shareholder money
they were giving away in compensation. That stock, by
the way, has been repriced 41% lower by the market in
the weeks since Porter's report.
Now Stiglitz offers an embarrassing admission...despite
all their eleventh hour posturing and countless threats
to put all the "bad CEOs" in jail this past summer, NOT
requiring companies to account for their "options
schemes" was an idea pushed through by the government!
"The Treasury and Commerce Departments sent a letter to
the Financial Accounting Standards Board (FASB)," writes
Stiglitz, "arguing against accounting for options. Other
pressures were brought to bear, and the FASB finally
gave in. As the events of the last few months
illustrate, this was a mistake."
"Stock options and other badly designed compensations
proved as problematic in the financial sector as
elsewhere," writes Stiglitz, "with even more serious
consequence." Prediction: as the bubble continues to
unravel we'll see ever more of these 'serious
consequences' ...not the least of which we have evidence
of in Eric's report below.
Eric?
--------------
Eric Fry from the city of New York...
- The cacophonous rattle of sabers in Baghdad and
Washington seemed to rattle investors' nerves yesterday.
Over the weekend, Iraq vowed to reject any new UN
resolutions on weapons inspections, prompting President
Bush to step up his PR campaign against Iraq. The
renewed prospects of an imminent American assault on the
Middle Eastern nation sliced 114 points off the Dow to
7,872, while the Nasdaq tumbled 3% to 1,185...And that,
my friends, is a brand new six-year low for the Nasdaq
Composite!
- But the Nasdaq was not alone in setting new multi-year
extremes yesterday. Over in the bond market, the 10-year
Treasury note yield dipped to a fresh four-decade low of
3.69%, down from 3.77% on Friday. The price of crude
oil, meanwhile, jumped 87 cents a barrel to a new 19-
month high of $30.71.
- Of all the bubbles that folks talk about these days,
almost no one mentions the possibility of a Treasury-
bond bubble. But the Treasury market certainly possesses
some bubble-like qualities - the first being that "price
is no object." Investors are throwing money at the bond
market because it is "safe." And in one sense, that's
certainly true. A bond buyer paying $1,000 for one
Treasury note today will almost certainly receive $1,000
upon expiration. But that doesn't mean that $1,000 in
2012 will buy as many Starbucks cappuccinos as it does
today.
- It's just possible that dollar will buy far fewer
goods and services 10 years from now than it does now.
Furthermore, a 3.69% annual return is pretty meager
compensation for loaning money for ten years to the
world's largest debtor nation - a nation which also
happens to be running the world's largest current
account deficit.
- "On the sentiment side, bonds appear to be setting up
nicely for a major top," Kevin Duffy, a professional
investor told me yesterday. He says that bullish
sentiment in the bond market is hitting extreme levels.
>From a contrarian standpoint, such extreme bullish
sentiment readings often indicate a near-term top. Duffy
wonders: "Is fixed income peaking globally, ushering in
a new era of inflation (the bad kind), increasingly
worthless paper, and rising gold prices?" We bears
wonder and wait.
- On the home front, the latest economic news from the
Conference Board did not give investors any warm and
fuzzy feelings, either. The index of leading indicators
(LEI) fell for the third consecutive month in August.
The LEI slipped 0.2% last month, following a 0.1%
decline in July and a 0.2% drop in June.
- What's more, seven of the 10 indicators in the leading
index decreased in August, indicating that the slowdown
is spreading... and it's spreading all the way to Wall
Street.
- In fact, the slowdown is erasing jobs on Wall Street
like a high tide erases sand castles. A friend of mine
who recently lost his job in the financial services
industry told me yesterday, "The jobs just aren't
there." Worse, some of the jobs that are still there
today won't be there next month. "The dream of retiring
young faded last week for many financiers," writes the
Financial Times, "after several investment banks
inflicted yet another round of job cuts on their
demoralized employees." Goldman Sachs Group, in
particular, is preparing to hand out a fresh slew of
pink slips over the next few weeks.
- "The senior management of Goldman's investment banking
group has told department heads to start assembling
lists of candidates to be laid off," the NY Post
reports.
- Goldman's job cuts are but the latest in a series of
similar cuts elsewhere on Wall Street. Morgan Stanley
fired about 200 staffers in its investment banking unit
a few weeks ago and Dresdner Kleinwort Wasserstein cut
about 500 banking jobs last week. The obvious problem is
that the business simply isn't there. Global mergers and
acquisitions volume has dropped about 30% since last
year.
- Goldman's job cuts, according to the Post, "will be
focused heavily on the firm's senior-level bankers, who
can't produce enough revenues in the current market
environment to justify their eye-popping pay packages.
In good years, managing directors, the highest-ranking
bankers behind senior management, typically earn at
least $1 million in total pay. Some command pay packages
of $5 million to $10 million or more."
- It's debatable, of course, whether these bankers were
ever worth the lush compensation packages they received.
But that's water under the bridge. What happens now?
What does a jobless investment banker do during a bear
market? Does he work in the men's department at
Barneys? Does he mow lawns in the neighborhood? It's
tough to say what career path logically proceeds from a
resume that reads: "Proven talent for secretly offering
'buy' recommendations and other semi-illicit perks in
exchange for investment banking business."
--------------
Back in Paris...
*** You have to hand it to Joseph Stiglitz. Despite all
that has come to pass, he's sticking to the story line
he helped craft last century: "...the fundamentals of
the U.S. economy are strong and they were strengthened
during the 1990s. The New Economy is real, even if its
significance has been exaggerated."
"The fact that the New Economy is real, however, doesn't
mean that we've understood it," Stiglitz says... and
then goes on to prove it.
He admits early in his piece that the fact that
prosperity reigned while he and his cohorts were having
coffee together at the president's behest was dumb luck.
But "in explaining our success in the nineties to
ourselves" ... is apparently where the errors crept in.
"We have largely drawn on a set of myths that
desperately need debunking: that deficit reduction by
itself led to the economic recovery of the 1990s; that
the brilliance of our economic leaders created our
newfound prosperity; that deregulation and self-
regulated markets are the key to sustaining that
prosperity, and should thus be exported to the rest of
the world...
"These myths arguably served a purpose. But no matter
how useful they were in the short term, ultimately they
are harmful. The deficit-reduction myth suggests that
if, say, Argentina or Japan is in a recession and has
large deficits, cutting those deficits will bring back
prosperity. But almost all economists recommend instead
an expansionary fiscal policy, fueled if necessary by
larger deficits." [Are these the same brilliant economic
readers he's referring to in the preceding paragraph?]
"The myth that prosperity was the work of our economic
heroes [whoops... I spoke to soon]...shifts attention
away from where it should be - on policies. [Ah, yes...
the 'policies'] Economic vicissitudes inevitably cast
doubt on our heroes' ability to perform miracles, and a
loss of confidence in these heroes will bring a
corresponding loss of confidence in the economy."
[Gee... you think?!??]
"Economies are like large ships: they cannot be turned
around quickly." No doubt, running high deficits...
focusing on 'policies'... increasing regulation...
encouraging consumer profligacy... and glorifying our
'economic heroes' is the way to get this one started in
the right direction.
Following Stiglitz' line of thinking, you get the
feeling we really will need a miracle to restore
confidence in the economy, eh?
*** Speaking of economic heroes... how about this
preposterous idea: What if Greenspan, the former Randian
acolyte, did it all on purpose?
A DR reader passes on this article from World Net Daily:
"...there can be little doubt that the implosion of the
equity markets will soon be followed by the pricking of
the credit and real estate bubbles. As great financial
houses such as Citigroup and JP Morgan Chase teeter on
the edge of bankruptcy, it is well within the realm of
possibility that the triple whammy of the equity, credit
and real estate implosions will lead to the collapse of
the entire global financial system.
"And all thanks to The Genius That is Greenspan (TGTG).
My hero.
"You see, I reject the notion that TGTG is incompetent,
cowardly or vain. I contend that he is a superhero, an
agent undercover, a mild-mannered chairman of the
Federal Reserve Board by day and a freedom-fighting
Randian titan by night. Consider the following quotes:
"'In the absence of the gold standard, there is no way
to protect savings from confiscation through inflation.
There is no safe store of value... The financial policy
of the welfare state requires that there be no way for
the owners of wealth to protect themselves. This is the
shabby secret of the welfare statists' tirades against
gold. Deficit spending is simply a scheme for the
confiscation of wealth.'"
- Alan Greenspan, "Gold and Economic Freedom," 1967
"'The substantive financial powers of the world were in
the hands of these investment bankers (also called
'international' or 'merchant' bankers) who remained
largely behind the scenes in their own unincorporated
private banks. These formed a system of international
cooperation and national dominance which was more
private, more powerful and more secret than that of
their agents in the central banks...They could dominate
governments by their control over current government
loans and the play of the international exchanges.'"
- Carroll Quigley, "Tragedy and Hope," 1966
"It is clear that TGTG, from his humble beginnings as an
acolyte of Ayn Rand, has been secretly determined to
shoulder the weight of the financial world on his
shoulders, then, like Samson in the temple of Dagon,
bring it down upon himself and his fellow Masters of the
Universe who are holding us captive in endless financial
serfdom. Hard days may lie ahead, but soon the day will
come when there will be no more Federal Reserve, no more
confiscation through inflation, no more federal debt,
and no more unconstitutional income tax. America will be
free again, all thanks to my hero, the genius that is
Alan Greenspan..."
Addison Wiggin,
The Daily Reckoning
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---------------------
The Daily Reckoning PRESENTS: James Boric argues that
once the bottom is in, you'll find no better place for
your money than in small caps stocks.
PREPARING FOR A RECOVERY
by James Boric
In 1939, at the ripe old age of 27, John Templeton, who
would become the world's most successful fund manager,
asked his boss to loan him $10,000. John didn't need the
money to pay his rent. Rather, he wanted it to invest in
the stock market.
I can only imagine how that conversation must have gone.
At the time, the Dow was down over 64% from its high in
1929. And Templeton wanted to borrow $10,000 to invest.
Was he nuts?
Templeton's boss didn't think so. He gave it to him. All
ten grand - the equivalent of $126,500 today. Templeton
took the money and bought 100 shares of every stock (on
the major exchanges) selling for under $1. Four years
later, in 1943, the market began to recover. That's when
Templeton cashed out...and quadrupled his money.
Did he just get lucky? Not at all.
Templeton knew something most investors didn't know then
and most don't know now. Following every bear market in
the last 77 years, the quickest stocks to recover have
been - without exception - small cap stocks.
In fact, with or without market tumult, the best stocks
to own for any extended period of time are those trading
for pennies on the dollar. And there's no better time to
buy small cap stocks that just before a market recovery.
>From 1926 to 1996 small cap stocks outperformed all
other stocks - even the stalwart blue chip stocks - 56%
of the time. The average return in any given year was
about 14% for small cap stocks. It was just 9% for large
caps. And the longer you held your small cap stocks, the
better off you were.
Over any five-year period from 1926 to 1996, small cap
stocks outperformed large cap stocks 58% of the time.
And investors made almost 18% more than their large cap
friends. One dollar turned into an average of $7.48 in
five years for small cap investors - just $6.34 for
large cap investors.
If you held a basket of small cap stocks for 15 years
you beat out your large cap-investing counterparts 70%
of the time. And if you held for longer than 25 years,
you won 100% of the time.
That's right. Since 1926, there has NEVER been a period
of 25 years or more where investing in large cap stocks
has proven more lucrative than investing in small cap
stocks.
That's a fact. So why don't more people invest in small
cap stocks? The answer is simple. They are intimidated.
And small caps can be risky. People are scared of things
they don't know or understand. And the popular media
rarely ever mentions investing in anything other than
Fortune 500 companies.
If there was ever a time to get over that fear, that
time is now - before the market begins to recover. Since
January 2000, the Dow is down 31%. Only twice has there
been a bigger drop. Once in 1929 and once in 1973-4. And
in the years following both those crashes, small cap
stocks were the quickest stocks to recover.
I've already shown you how Templeton quadrupled his
money during the recovery period following the crash of
1929. You could have done it again following the crash
of 1973-4.
>From 1973-4 the Dow fell 44% from 1,051 to 587. And in
the recovery years of 1975-1980, small-cap stocks took
off. They grew 349%. Meanwhile, blue chip stocks went up
a meager 58.5%. The surest and quickest way to multiply
your money is to invest in the cheapest stocks with the
best valuations. It was true in 1939. It was true in
1975. And it's still true today.
As of right now there are 6,500 companies listed on the
major stock exchanges. Of those, 5,402 have market caps
of 1.5 billion or less. Those are your small cap stocks.
That leaves only 1,098 large cap stocks.
A quick study reveals some interesting facts: 1,289
small-cap stocks have a P/E ratio of 15 (about the
historical average) or less. Only 245 large cap stocks
can say the same. Digging even deeper I found that 657
small cap stocks had a P/E of 15 or less AND a price-to-
sales ratio under 1. Only 114 large cap stocks made the
cut.
Now for the clincher. An anemic 26 large companies have
a P/E under 15, a price-to-sales ratio under 1 AND a
price-to-book ratio under 1. On the other hand, you can
choose from over 299 small-cap companies that meet all
three criteria.
As we begin to recover from this current bear market you
will have about ten times as many opportunities to grow
your money in small cap stocks compared to blue chips.
So as you prepare for the future think about John
Templeton and how he quadrupled his money in 1943. He
didn't wait around for anyone to confirm his thoughts
about a recovery. He went ahead and invested in the
cheapest stocks when no one else was investing. Then
when the recovery finally did hit, he cashed out for
four times his original investment.
It's impossible to know when the recovery will
start...or if it has already begun. But one thing is for
sure: When the recovery does set in, the brave investors
who put their money in small cap stocks will walk away a
lot richer than those that don't.
So when will the recovery begin? I don't know for sure.
No one does. But the good news is it doesn't matter. In
1939, Templeton didn't know when the market would
recover. He just knew that eventually it would, and the
best stocks to own when it did would be small caps. As
it turned out, the Dow actually fell another 40% from
1939 to 1942.
But in 1943 the recovery hit. And he quadrupled his
money. If I could predict when this current bear market
would turn around, I would tell you. But I don't know.
The only thing I do know is that if you buy small cap
stocks now - and can stomach some short-term volatility
- you will be in position A when the recovery does hit -
maybe even in position to quadruple your money.
For now you should look for small cap stocks trading for
bargain prices. That means looking for companies selling
for under $10 a share with a P/E under 15, a price-to-
sales under 1 and a price-to-book under 1. Two other
things to look for are double-digit revenue growth and a
rising net income.
Find these gems now and you'll be rewarded later.
James Boric,
for The Daily Reckoning
Editor's note: James Boric is editor of the small cap
advisory letter Penny Stock Fortunes, where he looks for
great companies at penny stock prices. James also writes
a weekly e-mail called the CXS Alert. For more advice on
how to profit from small cap stocks, see:
Penny Stock Fortunes
http://www.agora-inc.com/reports/PNY/OneDayWonder/
---------------------
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