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Welcome to USAGOLD's "Gilded Opinion" pages. We invite you to browse our index of outstanding gold-based commentary.
Storm Watch:
Déjà vu ~ Haven't we been this way before?
(Dec 7, 2001)
by James J. Puplava / Financial Sense Online
History often repeats itself. The characters change. The events are different, but follow similar patterns. It may be a different time and in a different country and involve a different cast of actors on the world stage, but there are similarities. Wars, famines, depressions, booms, and busts are no strangers to historians. They have been repeated over and over again and have been documented by scribes, historians, and authors of the bible. We have had times of peace, followed by times of war. Famine and depression have followed booms and bull markets. What I'm saying here is nothing new to anyone who has ever picked up a history book and studied civilization. Mankind hasn't changed much in thousands of years of recorded history. From events recorded in the bible and hieroglyphics on the walls of the pyramids, to the writings of the ancients, human drive, ambition, emotion, fear, greed, evil, avarice, and benevolence are evident for all to see. In the words of wise King Solomon, "What has been will be again, what has been done will be done again, there is nothing new under the sun".
On Wall Street knowledge of history seems to be a dark hole. Either it hasn't been studied, or it is simply ignored. I find it incredible that no sooner had a recession been officially declared that it had been just as quickly declared over. Apparently, Wall Street prognosticators missed the recession. Barely a year ago, analysts and economists were declaring the US economy would grow 3.5% this year. By mid-year that forecast had been lowered to 1.7%. The reality is we are in a recession that began in March 2001. Experts now predict a quick, V-shaped recovery. Surprisingly, there is little discussion of the reasons or causes which led to the recession-that-began-and-is-now-over. It's like a doctor prescribing a prescription or cure without examining the patient first.
Popular Assumptions of an Uninformed Crowd
The current recession is looked upon as nothing more than an excess inventory accumulation problem. The pat answer is once inventories are liquidated, a round of new production and buying will begin and the recession will be over. The recovery will be led by renewed consumer spending and new capital investment by business. These two assumptions on recovery are never challenged. Money managers have never been more bullish. The indexes are rising again and investors are coming back. The stock market, inherently a discounting mechanism, must be signaling that a recovery lies ahead. The fact that one of history's biggest financial bubbles has burst apparently carries no further consequences. It is out of sight and out of mind. Blind faith in the Fed's ability to cut interest rates and flood the markets with money, and the government's ability to spend vast amounts of money, guarantees a recovery in the minds of analysts and economists.
Ignorance is Apparently Bliss
What is being ignored are the multiple consequences of excessive money printing, deficit spending, and the financial shape of corporations and consumers. The belief is that deficit spending and money printing will shape the actions and response by business and consumers to a directed outcome -- which will be a recovery. Deeper study of the causes leading up to this recession is absent from analysis. Personally, I feel the biggest problems in the recovery scenario are debt and profits. The two are related and will limit both the shape and the outcome of the current recession. At the moment the Fed's money machine is still feeding the financial system and keeping alive three bubbles: the stock market, real estate, and the dollar.
A Tale of Three Bubbles
The fact that stocks are rising, real
estate remains strong, and the dollar is up are taken as evidence
of the wisdom of policy makers in bringing about a recovery. No
time is spent analyzing the events that got us into recession.
To me, this analysis is extremely important, for it shapes the
outcome and direction of the projected recovery with consequences
for all three bubbles. None of these bubbles could exist without
direct government intervention. It is taken for granted that all
three bubbles can remain inflated indefinitely. However, history
shows us that government intervention has its limitations.
Japan is a good example of the limitation of government intervention. Japan's economy and stock market experienced a similar bubble to that of the U.S. in the 1980's. Their bubble popped at the end of 1989. It has never recovered despite low interest rates, deficit spending and every possible manipulation by its government to resurrect it. A view of Japan's stock market over the last decade is a testament to the futility of intervention in keeping bubbles alive.
AN ANALYSIS OF RECESSION: CORPORATE PROFITS
This brings me back to the analysis of events leading up to the present recession. Many of these items have already been discussed and highlighted in my Storm Series and Updates. I want to concentrate on the one element that is missing from present day analysis - corporate profits. As documented in previous installments of this series, profits have been in a step decline since 2000. They have been sub par throughout the 90's in comparison to previous recoveries. In fact, there has been a great disparity between profits and stock prices.
To briefly summarize events leading to this
decline, profits were above normal during the first few years
of the 90's due to the lowering of interest rates. This allowed
corporations to refinance their debt at lower interest rates and
thus lowering interest expense and raising profits in the process.
That accounted for the rise in profits during the first half of
the past decade. The second half of the 90's was characterized
by below average profits in the aggregate as reflected in the
National Income and Product Account reported by the Department
of Commerce. The number reported by the Commerce Department as
shown in this graph were profits in the aggregate for the
economy. Although the chart indicates an increase, it is substantially
lower than expected. The numbers reported in the press and used
by analysts were profits in the form of earnings per share
or EPS. The EPS numbers were higher than the government's
numbers due to financial engineering. Companies used debt to finance
acquisitions or buy back stock which drove up earnings per share.
So the EPS numbers looked higher than the actual profits numbers
for the economy as a whole. This is what accounted for the boom
in stock prices during the bubble years. It became the cornerstone
for the "New Paradigm" theory which was used to justify
higher P/E multiples and higher stock prices.
Bad Habits in Goodwill
The actions taken by corporations to boost profits are now coming home to roost and are responsible for the huge write offs and losses that are so widely reported today. The huge write offs announced by companies like JDS Uniphase are proving that many of those acquisitions are turning out to be worthless as companies shed billions of dollars of goodwill. The write downs of goodwill and the interest expense associated with those acquisitions and stock buybacks are the main reasons that profits have been so savagely ravaged. Since this process began in 1995 to drive up earnings per share, companies have taken on $1.8 trillion in debt. This debt has led to higher interest rate expense which is now hurting the bottom line.
Finagling Their Way to Profits in 2002
So what does this portend for future profits? Wall Street is basing its projections for higher stock prices on higher profits. Corporate debt burdens are going to place limits on those profits. The write offs and accompanying decimation of book value per share is an easy one for analysts to ignore. Nobody seems to pay attention to book value anymore. Today's markets are driven by earnings momentum. In fact the big bath write offs currently taking place are clearing the way for an artificial profit recovery next year. If companies can load up expenses into this year, they will automatically have lower expenses next year. This will result in a temporary increase in profits next year which will be hailed as a recovery. After all, nobody is paying any attention to these huge write offs now. They are dismissed as temporary and can be blamed on the collateral damage of the September 11th terrorist attacks. Corporate management is eagerly loading as much as they can legally write off this year in order to pave the way for a recovery next year. So the stage is being set for a temporary profit recovery in 2002. The huge write downs of the third and fourth quarter will easily make for better comparisons for the second half of next year. That is why the consensus on Wall Street is predicting with confidence a profit recovery for the second half of 2002. Analysts already know that the big bath charges of the second half of this year make for better profit comparisons during the second half of next year.
How to Keep the Ball Rolling?
The problem is going to be a sustainable economic and financial recovery. Government spending and Fed money printing is still holding up the stock market, real estate, and the dollar. Big bath write offs will make a short rebound in profits possible next year. I believe this rosier profit picture is what the markets are responding to now. What happens in the long-term is another story. The debt burdens at the corporate and consumer levels still remain high. It is creating problems that are most evident in the rise in bankruptcies, defaults and delinquencies. A good example is Ford's announcement this week that they will lose $.50 a share more in the fourth quarter due to an increase of loan loss provisions in its financial unit of several hundred million dollars. America's credit binge is going to have to be written off or paid back. What you are now seeing take place at Ford, Providian, and other companies that lend money is the beginning of that process. This is going to limit recovery and profitability for the economy and companies.
Debt Doesn't Just Disappear
Goodwill can easily be written off, but debt burdens remain. The unwinding of that debt will take time. Job losses and bankruptcies will begin to accelerate that process and will continue to prick the bubble in real estate and the stock market. Debt isn't as easily written off as goodwill. Goodwill has an element of fluff to it. Debt is a real liability or an asset depending on which side of the ledger it is held. This debt burden is only getting larger and hangs over the economy like the sword of Damocles. American companies and consumers continue to borrow at a furious pace thanks to lower interest rates. Non-financial debt expanded at a $1.3 trillion rate this year compared to $1.2 trillion last year. Mortgage refinancing has risen to $251 billion in the second quarter from $66 billion in the fourth quarter of last year according to the Mortgage Bankers Association of America. The Bond Market Association reports that new debt issuance rose to $3.2 trillion during the first three quarters of this year.
The Point of No Return Approaches
It appears that the American economy is requiring even greater doses of credit to keep it afloat. The Fed is only too eager to oblige. There is, however, a point of no return... a point when debt burdens become too large, a point when creditors are no longer willing to lend, a point when borrowers can no longer make their payments, and a point when bankruptcy and default become the only option and the only way out. It is a time when the bubble can no longer be inflated. The hour arrives when policymakers run out of options, when the consequences of their actions must be faced. It is a time when the strength of the foundational stone is tested and we will learn whether the artifices of modern finance will hold. That time is approaching and it cannot be avoided. All that is needed is an event to bring it forth.
Cleaning Up The Industry
As far as future earnings are concerned, besides the burden of debt, there is the new reality that manipulating earnings may become harder in the future. The widespread abuse of reporting pro forma earnings, which in many cases bears little resemblance to actual earnings, is coming under assault and the scrutiny of government. Congress is looking into how analysts at firms make their recommendations. This is especially true now after Enron where many firms still had buy recommendations on the stock right up to the time of the company's bankruptcy. The Chairman of the SEC, Harvey Pitt, said the agency is considering enforcement actions under security antifraud laws. The SEC may sue companies that mislead investors with bogus "pro forma" earnings reports. This is a signal from the top security enforcement agency that things are about to change. The agency is beefing up the number of personnel at the agency that are looking into the problem of corporations cooking their books.
A Case in Point... Enron
Meanwhile in Washington, Congress is also taking matters into its own hands. Too many companies are manipulating their earnings. This is bothering several key congressmen like John D. Dingell, Democrat from Michigan who feels the SEC and auditors are doing very little to stop the practice. Companies file unaudited quarterly reports, but once a year those reports are formalized and audited by major accounting firms and submitted to the SEC. These reports are supposed to give investors an accurate picture of the financial well being of the companies they invest in or are considering for investment. Now those numbers can no longer be taken at face value. The system seems to be breaking down. If even sophisticated investors can be fooled, what are the chances of the average investor understanding the earnings that are being reported? Even fund giant Fidelity owned 21 million shares of Enron for all of its funds at the end of the third quarter. Companies are stretching accounting rules and accounting firms have become too dependent on consulting fees from companies that are impairing their auditing judgment. In the case of Arthur Andersen, Enron paid the accounting firm $52 million in fees last year including $27 million in consulting fees unrelated to its audit. The SEC has tried to restrict consulting work by accounting firms, but met with stiff opposition from the big five accounting firms. Instead the SEC backed down. Now we have Enron's bankruptcy.
Companies trying to manipulate earnings, and accounting firms and analysts who ignore them, will soon find the government and the legal profession at their backs. The point of all of this is to get more accurate earnings numbers to investors to aid them in their investment decisions. This may make it more difficult for many firms to meet their numbers without resorting to financial engineering. The climate change may be one reason for the rush of so many companies to clean up their balance sheets this year. Getting rid of the dirty laundry in 2001 will make it easier to meet targets next year.
Bursting Bubbles
Even while earnings are being scrutinized, the bubble in stock prices continues to get reinflated with the Dow crossing the 10,000 barrier this week and the Nasdaq jumping over 2,000. Housing is still strong thanks to lower mortgage rates, and the dollar is still holding up against major currencies despite persistent trade deficits. So we still have three partially deflated bubbles that authorities are making every effort to reinflate.
It
reminds me of the late 60's and early 70's before the last great
bear market. Looking at this chart, the stock market patterns
of the last few years are beginning to look a lot like the pattern
of the early 70's leading up to the biggest bear market since
the depression. Like then and like now, the market and the economy
were held up by government policies. Nixon took the dollar off
the semi-gold standard of Bretton Woods, enabling government to
accelerate deficit spending without any accountability. Exchange
rates were no longer fixed and currencies were no longer backed
by gold, so spending discipline disappeared.
The Fed began to monetize debt and the money aggregates reflected in the three M's began to rise. Chairman Arthur Burn's Fed was busy printing money and making credit easily available. Those inflated dollars began to show up in rising commodity prices. Back then, people chose to put their money into things instead of paper which was quickly losing its value. After being asleep for many decades, commodity prices began to rise, starting with gold and silver, and then oil.
BACK TO THE FUTURE: The 70's Market
The Nifty Fifty Stocks
The stock market went through periodic gyrations before topping out at the end of 1972. Institutions and investors kept buying stocks during this period. This was the era of the "nifty fifty" -- the big growth stocks of the era. Investors and institutions kept buying these stocks no matter the price. You could hardly go wrong by buying big blue chip growth stocks like IBM, Polaroid, Xerox, Avon, K-Mart, and Levitz. P/E multiples got as high as 90 or more on several of Wall Streets favorite growth stocks. Many of these companies never recovered from their highs of that period. In fact, some of them are no longer around or are near extinction. The prices paid didn't seem to bother analysts or investors because projections called for their earnings trend to be infinite.
Because of the belief in endless, rising profits, investors continued to buy these stocks regardless of their price. These nifty fifty large cap stocks were the only thing holding up the markets. The major indexes rallied and plummeted throughout those years before a geo-political event dealt the final death blow to the stock market in 1973. In October of that year a war began in the Middle East. The U.S. sided with Israel. OPEC's response was an oil embargo against the United States. Oil prices went from $3 a barrel in October to $11.65 a barrel by Christmas of that same year. Even though the embargo eventually ended, prices remained high and went higher throughout the decade. Confidence had been lost in government and in paper assets. The money the Fed created went into things instead of paper.
Confidence is Key to The Markets Ahead
Central banks can create money out of thin air, but they can't always direct where that money flows. During the 1970's the money went into hard assets such as gold, silver, oil, and real estate. That is because investors lost faith in government. Today, we have a similar situation, but in reverse. The money that is being created is going into financial assets instead of hard goods, because investors have a blind faith in the Fed and in government's ability to fix problems. As long as that confidence is maintained, excess money creation will continue to favor financial assets like stocks. The one exception to financial assets is real estate which is now in its own bubble due to excess credit creation and low mortgage rates.
The one event the experts didn't expect or foresee back in 1973 was a war and an embargo. The Vietnam War had already eroded confidence in our ability to wage war. Another event that chipped away at confidence in government was the Watergate hearings and the subsequent resignation of an American president. Watergate and Nixon's resignation, the bumbling Ford and Carter administrations destroyed all confidence -- what confidence that was left in government. So investors sold paper and bought real assets in their place. The dollar was no longer considered sound, so confidence reverted to real money in the form of gold and silver.
The Permutation of Derivatives
One of the great ironies of today is that the abandonment of the Bretton Woods system of fixed exchange rates anchored to a gold-backed dollar added new risks to the financial markets. Since the dollar was no longer backed by gold, and the world financial system went to free floating exchange rates between currencies, new risks were added to world trade. Businesses now had to contend with currency and interest rate risk. In order to hedge against those risks, the world of derivatives was created to allow companies to hedge against currency loss or the risk of rising or falling interest rates. If you did business overseas, whether you were buying or selling, it now became necessary to hedge assets and cash flows. This was done through derivative contacts that hedged a company's currency or interest rate exposure. The business of derivatives flourished with the introduction of the Black Scholes model that revolutionized modern finance. The combination of the Black-Scholes model with probability theory caused the world of derivatives to explode. The use of computer models expanded the derivative markets even further. Complex computer models have since been developed that allow hedgers and speculators to take advantage of every permutation and possibility of every financial instrument in every market in the world. They were designed to hedge against financial risk and make the financial system more stable. The irony is that derivatives could undermine and destroy the very system they were designed to protect.
The world of derivatives is as complex as it is arcane, as it is in size and in scope. The worldwide market for derivatives is estimated to be over $100 trillion. These complex instruments are used as much for hedging risk as they are for taking risk. They allow speculators to amass large positions through the degree of leverage that derivative contracts offer. Derivatives multiply leverage to the nth degree. The opportunities for disaster are everywhere. This is one market where if you make a mistake, it is fatal. LTCM, Barings, Orange County and the recent Enron debacle are examples of what happens when things go wrong. Enron was the seventh largest Fortune 500 company in January of this year. In less than a year, this December, it is bankrupt.
Further Rogue Waves Sure to Hit the U. S. Economy
In my original Storm Series, I wrote that confidence in government and in paper still runs supreme. I felt that way then, and I still do today when I see investors chase stocks and pay ridiculous and absurd prices to own or trade them. But I also felt a day was coming when this tower of babble would crumble. The events that would undermine it I called rogue waves. The first one struck on September 11th. More will follow. In Rogue Wave-Rogue Trader I identified two kinds of rogue waves -- one of them financial (derivatives) and the other geo-political (war and terrorism). Today we have evidence of rogue waves in both the financial and the geo-political world. The 90's were full of them in the peso crisis, Asia, LTCM, and Russia. Now there is Enron.
Today we have both aspects of war and terrorism. September 11th was the opening battle of the War on Terror. It has only just begun. The U.S. is considering widening that war even further and taking it to Iraq, Indonesia and possibly North Korea. The United States is quietly building up its forces in Kuwait with the Army's 1st Calvary Division and the 4th Infantry Division from Fort Hood. There is also the collapse of the Middle East peace process. Extremist elements in that region have no desire for peace, but want nothing less than the destruction of Israel as a nation. Israel is motivated by self preservation. The internal conflicts between the two sides could shortly be decided on the battlefield.
War has a way of extending itself and moving beyond the ability of the politicians or the military to control. World War I started out with the shooting of an archduke that led to general mobilization that quickly led to war. The war to end all wars led to an even more deadly conflict in World War II. The war against terrorism may start off as a campaign to end and cleanse the world of terrorism. It may lead to something even bigger. Meanwhile the dispute in the Middle East is a ticking time bomb waiting for someone to light the fuse. We all know there are plenty of willing candidates.
Just as in war, the complex world of derivatives is equally as explosive. There are plenty of rogue waves lurking on the world's financial seas. The horrors of September 11th were not factored into the complex models that power derivative trades. Someone, somewhere was on the wrong side of a trade. We just don't know who and to what extent. The financial system was able to handle the shock of the first rogue wave. But the financial system is now fragile. A series of rogue waves or The Perfect Financial Storm may be its undoing. Let's pray that these events don't happen.
There are three large financial bubbles seen in the stock market, real estate market and in the dollar. These bubbles are now in the process of being reinflated. The financial system is in a fragile state. It wouldn't take much to deflate these bubbles. Another major terrorist attack, a major derivative fiasco, or series of them since derivative are interconnected, could undo the system. They are all bubbles waiting to be burst. It may take just one or a series of waves to deflate them. Today, December 7th, marks the 60th anniversary of Pearl Harbor. Some saw it coming. Others chose to ignore the signs. What will it take to wake investors to the peril we face in the years ahead? America, get out of debt. Owe no man anything, and return to just weights and measures. ~ JP
by James J. Puplava
December 7, 2001
Financial Sense (a Registered Trademark)
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Please direct corrections and technical inquiries to webmaster@financialsense.com
Copyright © 2001 by James J. Puplava. All Rights Reserved.
Reprinted by USAGOLD with permission of Mr. Puplava. This article may NOT be reproduced without the expressed, written permission of the author. Selective quotations are permissible as long as the author, Jim Puplava, and his web site are acknowledged through hyperlink to: http://www.financialsense.com/
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