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Vale of Tears
The Daily Reckoning
Paris, France
Wednesday, 16 October 2002
-------------
*** 'Biggest gain since '33' - now that's
encouraging!...
*** Gold down...bonds too! Could Eric be right about
bonds? Nah...
*** Marginal utility of money increases...camping out in
Germany...and more!...
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"Dow Has Biggest Four-Day Gain Since April '33,"
proclaims a Bloomberg headline, reporting on the return
of insanity to Wall Street.
It seems like all the records, going back to the '30s,
are being broken. Never before or since had investors
lost so much money...never before or since had stocks
gone down for so long, nor industrial production fallen
off for so many months in a row, nor profits dropped so
sharply, nor bond yields hit such lows - until now.
It is almost as if there were something similar between
the two periods...hmmm...
But investors rarely bother with such thoughts. A new
poll shows that nearly 2/3rds of them had come to
believe that this was a bad time to put 'substantial'
money into the stock market. So where did all this
buying come from? Most likely, it is short sellers who
need to cover their positions. Our guess is that the
average investor is not buying, yet. He's still holding
and hoping...
"We've had so many down days," said a Virginia investor
interviewed by Associated Press. "But I still believe
that for the long term some of these blue chips have to
be a good investment."
"Twenty years from now, I think we'll come out OK," said
another investor from Ohio.
Maybe.
The Sunday Telegraph reports that the typical serious
bear market lasts 12 years. But it could be that this is
not a typical 'serious' bear market, but a rather
unusual one. We recall that things did not go
particularly well for investors after 1933...and that an
investor had to wait until after 1954 before stocks
surpassed their '29 peak.
Of course, that was then; this is now. And right now the
shorts are getting squeezed. Nothing fails like success,
as we have pointed out on occasion. The short-sellers
were making so much money, it had become all too easy
and predictable. Stocks went down day after day, month
after month - all they had to do was to go short.
Mr. Bear, seeing his opportunity, decided it was time to
teach them a lesson. Once the shorts are ruined, we
guess, Mr. Bear will go back to his principle occupation
- ruining the longs.
In the meantime, more details on the rally from our own
Eric Fry in New York:
----------------
Eric Fry from the island of Manhattan...
- Another monster rally on Wall Street yesterday - the
sort that terrifies short-sellers. The Dow jumped 378
points to 8,255 - bringing its 4-day advance to nearly
1,000 points. The Nasdaq surged 61 to 1,282, for a
sparkling four-day gain of 15%.
- The stock rally took the shine off of both gold and
Treasury bonds. Gold - the somewhat less precious metal
- fell $5.20 to $313.40 an ounce. The 10-year Treasury
note also plummeted - driving yields sharply higher to
4.03% from Friday's 3.80%. Last Wednesday, the 10-year
yield touched a 44-year-low of 3.56%. The jump in yield
from 3.56% to 4.03% may not seem like anything
extraordinary to investors who are unfamiliar with
typical bond market behavior. But bond traders would
call the recent action "serious volatility."
- (For those keeping score at home, the Daily
Reckoning's New York office enjoys the early lead in our
friendly, cross-Atlantic bond-market debate. I mention
this fact, only because I happen to be the guy in New
York who has been highlighting the possibility of a bond
bubble. The Paris crowd, on the other hand, is partial
to the idea that an unshakeable deflation in the US
might cause bond yields to fall...Despite the bond
market's harrowing sell off over the last few days, we
here in the New York office will not gloat. Certainly,
it is far too early to declare a victory. Deflation may
yet immobilize the US economy in a sort of macro-
economic Ice Age. If it does, however, you can be sure
that I will be silent about this topic and will pretend
that I never mentioned the possibility of a bond
bubble...Stay tuned.)
- The current rally on Wall Street looks very much like
a classic bear-market affair. The Dow has jumped 969
points in just four days. Is that a lot of points in a
little bit of time? Absolutely. But guess what, the Dow
fared even better during the first four days of the bear
market rally that kicked off last July 24th. Back then,
the Dow rallied 1,009 points over the first four days of
the rally. But alas, the gains ultimately evaporated as
stocks resumed their decline and fell to fresh multi-
year lows. We would not be surprised if the current
rally also ends badly. In fact, we would be surprised if
the rally DOESN'T end badly.
- A sparkling earnings report from Citigroup helped to
power yesterday's Dow rally. The banking giant's shares
gained 13%, thanks to quarterly earnings that beat the
consensus estimate by one magical penny. The euphoria
lifting Citigroup shares also gave a boost to the shares
of JP Morgan Chase (JPM) which jumped 10%. Ironically,
while investors were busy bidding JPM shares higher, the
financial giant was doling out pink slips.
- "Insiders say the Manhattan-based financial giant may
cut as many as 4,700 investment banking jobs worldwide,"
Crain's reported yesterday, "700 more positions than the
widely expected number of 4,000. That would be 24% of
its total investment banking staff. The firm has already
cut about 8,000 employees in earlier rounds of job
reductions. The company started handing out pink slips
today in its Manhattan offices. This round will include
more managing directors, who are among the investment
bank's highest-ranking professionals."
- The job losses at Morgan are but the latest in a
global investment banking industry that has shed about
60,000 jobs since the start of last year. Clearly,
business isn't great. But don't tell that to all the
folks who are furiously buying the shares of JP Morgan
and Citigroup.
- Let's allow the bulls to enjoy their moment in the
sun.
- Bullish investors ought to be happier these days...or
at least less miserable. But what about the bears? How
do they feel?...Suddenly, being bearish on stocks isn't
as much fun as it used to be. Nothing is more
emotionally exhausting for these contrary-minded folks
than to watch stocks go up every day...especially when
they go up a lot every day. But the bears shouldn't let
this rip-snortin' rally get them down. Stocks will fall
again some day...we promise.
- In fact, stocks might start falling again as early as
today. After the close of trading yesterday, Nasdaq
bellwether Intel reported disappointing earnings...very
disappointing. The stock, which had gained $1.42 during
the regular trading session, tumbled $2.13 during after-
hours trading.
- Intel is just one company, of course...But it is one
of the several thousand public companies that is
struggling to make money...Stock-buyer beware.
--------------
Back in Paris...
*** Last week, before the rally began, we sensed that
investors were close to panic. As it turned out, we were
right. They just panicked in the wrong direction.
So far, though about $8.5 trillion has been taken out of
stock market values, investors have been remarkably
sanguine. They have retreated in good order...and have
pulled off several noteworthy counter-attacks.
One explanation for their calm demeanors was that the
money they were losing wasn't really theirs - it was
"house money", paper gains they had made in the boom
phase. "Easy come, easy go," they might have said to
themselves.
Someone won a Nobel prize, we think, for pointing out
that the last dollar a man earns is worth a lot less
than the first one. It was obvious to us. A man with one
dollar treasures it the way a drunk treasures his first
shot. By the time he has his last drink, just before he
passes out, he barely feels it scouring his gullet.
Likewise, when a millionaire adds a buck to his bank
account, he hardly notices it.
The "declining marginal utility of money" works in both
directions. As people lose money, each dollar they lose
becomes more important to them. At first, losses
disappoint them. Then, they annoy them. Then, they get
edgy...and at some point...they panic to protect what is
left.
James A. Bianco reports that investors are near the
panic point. Not since the October 1990 stock market low
has the average mutual fund investor found himself with
no realized profits. The public is now playing with its
own money again. Losses, which may have been an
abstraction until now, have become very real.
*** "It's terrible," said a friend, describing economic
conditions in Germany. The DAX has lost 50% of its
value. The Neuer Markt, Germany's answer to the Nasdaq,
has gone out of business.
"Germany was more than a quarter century behind Britain
at the middle of the last century," he explained. "Then,
Prussia threw out all the old guild restrictions and
opened up the economy. Everybody got rich and the German
economy became stronger than Britain's...
"But now they're putting back all these ridiculous
restrictions... it's crazy. My son's scout troop went
camping in a farmer's field...They had to get a three-
page document signed by the farmer giving them
permission and stating all the things the farmer had to
do...
"And even if you want to be trash collector in Germany
today, you have to go to school for 6 years to get a
certificate..."
*** My son Jules is getting ready to go on an exchange
program with his school. By coincidence, he is going
back to his hometown - Baltimore!
Last night, a group of nervous parents assembled at the
Institut de la Tour: "Is it safe?" they wanted to know.
They knew that Baltimore was not the safest place on the
planet. But now there's a sniper on the loose in the
Washington, D.C. area!
School administrators reassured the parents. The sniper
would almost certainly be caught before the kids arrive,
they said. And besides, he was just killing lone
Americans.
Jules' class leaves next week. He'll be staying with a
family who, we were told, have been brushing up on their
French. "Jules, you should pretend that you don't speak
English very well," suggested his mother. "Otherwise
they might be disappointed."
*** By the way, I will be in Baltimore myself in a few
weeks, too. On November 12th, at our offices there, we're
hosting a VIP cocktail reception just prior to an all-
day "total immersion crash course in venture capital
investing" which will be held at the Baltimore Marriott
Waterfront... both the reception and the investing
course should prove interesting. If you're going to be
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-------------------------
Your editor promised to write no more letters until
January. Hardly had the sun set when he was ready to
break his promise. In researching his new book, he
discovered something that might interest you. More
below...
VALE OF TEARS
by Bill Bonner
"Whereas all capitalisms are flawed," wrote economist
Hyman Minsky in 1985, "not all capitalisms are equally
flawed."
The obvious "flaw" in capitalism is that both the
capitalists and the proletariat are all Homo Sapiens,
not Homo Economicus, the mythical species of economists'
dreams. They do not coldly measure the risk and
calculate the return. Instead, they make their most
important decisions - such as where to live, what to do,
and with whom they will do it - not with their heads,
but with their hearts. A man gets married, for example,
not after carefully toting up the pluses and minuses. He
goes about it not as a machine might - but as a dumb
beast of burden...following instincts he will never
understand. Thus yoked and harnessed, he lumbers into
church as if he were going to war - that is, without a
clue. Men do not usually go to the altar or to war after
much rational calculation and reflection. Instead, they
are swept along by whatever emotional currents come
their way...and risk their lives and their comforts for
causes which, in the calm of retrospect, usually seem
absurd.
"The head is just the heart's dupe," as La Rochfoucauld
put it. Thinking with their hearts...and caught up in
whatever collective madness is fashionable...men do the
most amazing things. But that is this vale of tears that
we live in. And here at the Daily Reckoning we rather
like it.
Minsky's "Financial Instability Hypothesis" set out to
show how capitalism is inherently unstable. He might as
well have set out to show that beer goes bad if you
leave it sitting out too long or that children get cross
if they don't get enough sleep. For capitalism is a
natural thing, like life and death, and like all things
natural, naturally it is unstable.
But what is interesting in Minsky's oeuvre is a little
insight that might have been useful in the late '90s.
Readers will recall that among the delusions suffered by
investors at the time was the idea that American
capitalism had reached a stage of dynamic equilibrium -
where it was constantly inventing new and more exciting
means of making people rich. Boom and busts were thought
to be a thing of the past, first because better
information made it possible for businesses to avoid
inventory build-ups...and second, because the science of
central bank management had attained a new level of
enlightenment, wherein it could figure out precisely how
much credit the economy wanted at any moment and make
sure it got what it needed.
In the absence of the normal 'down' parts of the
business and credit cycles, the economy seemed more
stable than ever before. But Minsky noted that profit-
seeking firms always try to leverage their assets as
much as possible. He might have added that consumers
might do the same thing. Without fear of a recession or
credit crunch, Homo Sapiens, whether in the office or
the den, were likely to over-do it. "Stability is
destabilizing," Minsky concluded.
Minsky refers to Keynes' concept of a 'veil of money'
between real assets and the ultimate owner of the
wealth. Assets are often mortgaged...financed...
leveraged or otherwise encumbered. This 'veil of money'
gets thicker as financial life becomes more complex and
makes it hard to see who is actually getting rich and
who is not. When house prices rise, for example, it
seems that the homeowner should be the beneficiary. But
homeowners now own much less of their homes than they
did a few years ago. Fannie Mae, banks and other
intermediaries have a strong stake in home values. In
recent years, Fannie Mae has worn a veil of money as
sticky as flypaper. The poor homeowner hardly had a
chance. He got stuck almost immediately. Now, he's
hopelessly glued and won't be able to get away without a
lot of ouches. But who will feel the most pain? If home
prices go down, who will ultimately be left holding the
bag? Hard to say...
Instead of coming up with innovative new ways to make
people rich, America's financial intermediaries -
notably Wall Street and Fannie Mae - came up with ways
to make them poor.
"The financial instability hypothesis," Minsky explains,
"is a theory of the impact of debt on system behavior
and also incorporates the manner in which debt is
validated. In contrast to the orthodox Quantity Theory
of money, the financial instability hypothesis takes
banking seriously as a profit-seeking activity. Banks
seek profits by financing activity and bankers. Like all
entrepreneurs in a capitalist economy, bankers are aware
that innovation assures profits. Thus, bankers (using
the term generically for all intermediaries in finance),
whether they be brokers or dealers, are merchants of
debt who strive to innovate in the assets they acquire
and the liabilities they market..."
In Minsky's mind, capitalism is naturally unstable and
needs government to stabilize it. Roughly, this is also
the view of the Democratic Party. In the more orthodox
economic view, capitalism is naturally stable and
government destabilizes it. Traditionally, this is
closer to the Republican Party view. But in the 1990s,
even Republicans came to appreciate the stabilizing
influence of Alan Greenspan. And now, under pressure
from the voters, both Republicans and Democrats cry out
for "new policies" to fight the bear market and rescue
the nation from deflation.
Here at the Daily Reckoning, we agree with Minsky up to
a point: capitalism is naturally unstable.
Unfortunately, government only makes it worse.
As we have seen over the last 16 years, public servant
Alan Greenspan exerted a stabilizing influence on world
markets. When the markets needed credit, he gave it to
them. During his watch at the Fed, the Long Term Capital
Management blew up. So did the Asian economies. And
then, there was the Russian Default...and the Y2k Scare.
Finally, there was the collapse of the Nasdaq and the
Great Bear Market. Greenspan met each new threat as he
met the last one - by offering the market more credit.
Each time, his intervention seemed to stabilize the
market. And each time, the financial intermediaries
found new and innovative ways to pad out the "veil of
money" between assets and their beneficial owners. In
the end, if this is the end, Greenspan's efforts were so
successful that they led to the biggest economic
disaster in world history.
"In an effort to stabilize the economy," writes Janelia
Tse in the Winter edition of Oeconomicus, "policies are
implemented. If policies are successful, the economy
booms. Expectations about the expected future returns
become increasingly optimistic...riskier behavior is
rewarded. This leads to fragility in the economy."
"From time to time," Minsky elaborated in his "Financial
Instability Hypothesis," "capitalist economies exhibit
inflations and debt deflations which seem to have the
potential to spin out of control. In such processes the
economic system's reactions to a movement of the economy
amplify the movement - inflation feeds upon inflation
and debt-deflation feeds upon debt-deflation. Government
interventions aimed to contain the deterioration seem to
have been inept in some historical crises.
"In particular, over a protracted period of good times,
capitalist economies tend to move from a financial
structure dominated by hedge [conservative] finance
units to a structure in which there is large weight
given to units engaged in speculative and Ponzi
finance..."
In Japan's boom, Ponzi finance was offered by banks to
their favorite corporate customers. More than a dozen
years later, the loans still go bad...and now threaten
to bring down the banks themselves.
In America's boom, it was consumer lenders - notably
Fannie Mae - who played Ponzi's part. Someday, perhaps
soon, consumers will regret it. For they must pass
through a vale of tears to find their way out.
Your editor, unable to resist...
Bill Bonner
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