Gary North's REALITY CHECK
Issue 372 August 24, 2004
FAITH IN THE STOCK MARKET
Now faith is the substance of things hoped for, the
evidence of things not seen (Hebrews 11:1).
To get a sense of what the market has done since 1999, click
the link and take a look at the chart of the S&P 500.
http://snipurl.com/8mc2
The peak came in the spring of 2000. It reached 1,540.
Today, it is 1,100. It has been moving down from the 1,150 level
since spring. From mid-2002 until the spring of 2003, the index
bumped around from 800 to 950.
Four years ago, it was an election year. The market bounced
around until late summer. Then it declined through the end of
the year.
Traditionally, election years are economic boom years. The
Federal Reserve System is ready to supply liquidity -- fiat money
-- in order to keep consumers happy and buying, thereby keeping
business income high and the stock market high. Legally, the FED
has no obligation to subsidize stock market investors, but it
almost always does in the first half of a Presidential election
year. The main exception was 1980, when the FED kept money tight
and let interest rates skyrocket. That cost Carter the election.
But 1980 was an exception in other ways. The monetary inflation
of the Carter years had created the worst price inflation of the
postwar era. It could be stopped only by tight money.
This year, the FED is being highly accommodating. The
adjusted monetary base, which the FED controls directly, is up
sharply. Look at the move that began in January.
http://snipurl.com/8mc6
With the FED pumping in new money, the banking system
receives the legal reserves that it uses to expand loans. The
low interest rates that prevail today, despite the half
percentage point increase that took place this year, are being
funded by FED policy. The pair of increases in the federal funds
rate were token increases. The FED is making sure that the
President's bid for re-election is not going to be thwarted by
sharply rising interest rates and an economic slowdown.
INVESTORS LOOK AHEAD, BUT NOT TOO FAR
In 2000, investors looked ahead, months beyond the election.
It was a tight race. Even after the voting was over, it was a
tight race. Investors in mid-2000 could not have foreseen the
outcome. So, the stock market decline that took place, beginning
in late summer, anticipated the recession of 2001, which began in
March.
The year following a Presidential election tends to be bad
for the stock market. The FED usually slows the rate of money
creation in order to forestall rising prices. This slowing
places constraints on bank lending and economic growth.
Consumers cut back, the economy sags, and market forecasts that
began in the second half of the election year are confirmed.
This year, we have another tight race. We had a booming
stock market for one year: 2003. The market in 2004 is showing
signs of investor fatigue. This may be the traditional summer
doldrums, or it may be a forecast of a post-election contraction
in the money supply and the economy.
What is missing this year is evidence of a shift in investor
commitment to the stock market. The market is flat. It is flat
500 points below the peak in 2000.
The chart reveals an unwillingness on the part of investors
to get out of this market in a final bear bottom sell-off. The
presence of stock market mutual funds, especially retirement
funds, has kept the market from entering the final collapse of
hope that marks the end of bear markets. There is a floor under
this market because of the automatic monthly purchases of shares
by fund investors. The "buy and hold" philosophy promoted by
economists, which paid off after August of 1982, has produced
capital losses on a massive scale since 2000.
The typical investor has not lost hope in the economists'
dreamy scenario of automatic wealth through compound growth and
tax-deferred gains in a 401(k) retirement fund. But he no longer
holds this creed with the fervor that he did in 2000. He has
seen the reduction of his index fund's portfolio. It declined
for two years after 2000. The recession of 2001 supposedly ended
in November, 2001, yet 2002 was as bad a year for stocks as 2001
had been.
Where was the stock market recovery that supposedly begins
six months before a recession ends? It was nowhere to be seen.
WHEN WILL THE RECOVERY RECOVER?
The economic recovery has been weak across the board: low
growth in jobs, a low rate of capital formation, and caution on
the part of employers. Who can blame them? Consumer spending
never lagged in the 2001 recession, but consumer spending on
American-made products surely did. With annual deficits in
the balance of payments in the $500 billion range, American
manufacturers have good reason to be cautious. This deficit
is now at its highest level in history. Despite the recovery,
this deficit is getting worse.
There were tax cuts, but they are spent. Bush is not
campaigning on a platform of additional tax cuts. Kerry promises
tax cuts for the middle class and a rollback of Bush's cuts for
the rich. He has yet to show the figures as to how much, when,
and with what effects.
We are now facing a new reality. The trade/payments deficit
now appears to be permanent. Consumers are going to buy cheap,
and this means buying Asian. Consumers are in charge in
capitalism, and they want bargains. American suppliers are
either going to supply these bargains or else foreign sellers
will.
Blaming "corporate America" for going abroad to hire low-
paid workers is like blaming New England merchants in 1800 for
importing slaves for Virginians to buy. The merchants, then as
now, are just following orders. Buyers want deals. They don't
care who provides these deals.
There was a two-evening segment last week on PBS's "Lehrer
News Hour." It dealt with Wal-Mart. It showed how Wal-Mart cuts
costs by better inventory control. But then we were told that
Wal-Mart exploits its workers. Odd; the company seems to be able
to hire all the workers it wants. It appears that workers would
rather be exploited than out of work. But the old Marxist
language remains. They interviewed several sociologists, a
profession completely dependent on taxpayer funding of sociology
students and taxpayer funding of sociology professors. No one
asked them about the exploitation of taxpayers who don't want to
fund sociologists.
Then came the section on exploited foreign workers. The
reporters could not find any to interview, but a Berkeley
professor hinted that they are probably out there somewhere.
The interviewer spoke with a yuppie couple that had just
purchased a pair of bicycles and helmets for $216, total,
including tax. He asked them if they had thought about the fact
that Wal-Mart bought these bicycles from companies that paid
their workers 31 cents an hour -- and sometimes less. They
admitted that they had considered this, but then the decided to
buy anyway. It appears that yuppies are like the rest of us.
They want low prices, always.
The growth of the payments deficit is said by some to
represent a shift in the buying habits of Americans. This is
nonsense. Americans have always been aggressive discount-
seekers. What has changed is Asian economic policy. By freeing
up the economy -- by adopting capitalism -- mainland Asian
politicians have made it possible for mainland Asian producers to
enter western markets as sellers. It is not that American buyers
have changed their buying habits. It is that Asians have changed
their selling habits. They have generated a surplus of
production over mere survival.
Like every auctioneer, we Americans have something to sell.
The main thing we have to sell is a dream: the dream of investing
in America, of getting in on the deal. So, Asians and others
sell us goods, and we sell them a dream. It is the same deal
that the Indians used on Manhattan Island in 1624. Well, not
quite: the tribe that sold the island for trinkets actually
didn't own it. But it's the thought that counts.
The problem is, the dream is looking more and more risky.
To buy into American markets means buying claims on future wealth
-- wealth denominated in dollars. But that means wealth supplied
by workers who are no longer competitive in world markets. It
also means wealth supplied by the Federal Reserve System.
Yet the dream remains a powerful one. Foreigners are
enchanted by it. They can't move here, but they can buy promises
to pay dollars (bonds) and the hope of capital gains in dollars
(stocks). They, too, trust Alan Greenspan and his colleagues.
But for how long?
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PRODUCTION GOODS, NOT CONSUMER GOODS
Dr. Kurt Richebacher, a former central banker, has been
sounding the alarm against the reality of this recovery. Last
February, he warned that asset inflation is not a productive
substitute for thrift.
America's policymakers and economists view asset
inflation as wealth creation as if this were a
self-evident fact. What this asset inflation truly
generates is phony collateral for runaway consumer
indebtedness, luring the consumer into unprecedented
debt excesses. It is phony wealth creation because
unlike the real wealth creation through capital
investment, both its creation and its use involve no
income creation.
This perception of wealth creation, actually, runs
completely counter to traditional thinking in
economics. It has always been apodictic in economics
that there is but one way to create genuine wealth for
an economy as a whole, and that is to consume less than
current production or income. Wealth creation from the
macroeconomic perspective essentially occurs through
saving and investment in tangible, income-creating
plant, equipment, and commercial and residential
buildings.
Asset inflation is not the same as capital formation. This
has been his point for a decade. Capital formation represents a
willingness of consumers to forego present consumption. They
make money available to producers so that the latter can provide
tools for their workers to produce wealth. Asset inflation does
not result in future economic growth, because it does not require
a reduction of consumption -- thrift. It is the result of more
fiat money being injected into the economy.
Guided by the Greenspan Fed, America is practicing a
radically different pattern of "wealth" creation. An
extremely loose monetary policy forces up asset prices,
providing both the impetus and collateral for higher
borrowing. Being offered almost limitless credit at
rock-bottom interest rates, the consumer responds with
a frenzied borrowing and spending binge. . . .
The crucial concern is the inherent effects of this
so-called wealth creation to the economy. Asset
inflation by itself has no effects at all. Its economic
effects arise only from the associated increase in
consumer borrowing and spending. But that has two
highly malign effects. An endless escalation of
unproductive debt is one. The other is that consumption
takes an ever-greater share of GDP. Overconsumption is,
really, America's deep-seated, structural disease, and
asset inflation is worsening it.
This "disease" is iatrogenic: created by the "physician" who
is supposed to be curing the disease.
U.S. economic growth is no longer based on saving and
investment. Its essence is that credit excess provides
soaring collateral for still more credit excess,
creating still more asset inflation for still more
borrowing and spending excess. It seems like a
perpetual motion machine that just goes on cranking out
wealth and spending. It is important to see that the
true name of this game is bubble-driven growth, and all
bubbles end by bursting. America is the next Japan.
http://snipurl.com/8mcx
Consumption today is an enticing opportunity. But it
involves a cost: foregoing future consumption. The corn you eat,
you cannot plant.
The American consumer has been subsidized by fiat money,
which has produced lower interest rates. When the price of
something falls, more is demanded. When the price of borrowed
money falls, more is demanded. The rate of interest is the price
of money.
The consumer is told by economists (Keynesians) and
incumbent politicians that he should spend more, even if this
means borrowing more, in order to keep the economy booming. He
owes it to himself to have a good time. He owes it to the rest
of us to turn loose of his money -- not to buy producer goods but
consumer goods. The consumer likes what he hears. He is being
told that present-orientation is more productive than future
orientation. We have heard this before:
Come ye, say they, I will fetch wine, and we will fill
ourselves with strong drink; and to morrow shall be as
this day, and much more abundant (Isaiah 56:12).
This way of life always produces the same outcome: a bad
hangover.
CONCLUSION
Faith in the stock market continues, but it is a weakening
faith. The "buy and hold" strategy has produced losses over the
last four years. Fund managers are still being paid well. Fund
expenses are still as large as dividends. But the dream of
asset-inflated wealth is fading, just as it faded in Japan after
1989.
Men will stick with a plan that used to work out of habit's
sake, and also out of a desire to be proven right. But if the
market does not recover its 10% per annum increases, the old
faith will die. It is already fading. Asset inflation will not
make the middle classes rich after all. When this message
finally penetrates the minds of millions of retired people, they
will be driven psychologically to unload ownership of assets that
do not produce income (dividends) for retirement living. They
will sell. Asset inflation will become asset deflation.
You can't eat dreams.
**************
APPENDIX 96
This is a continuation of Abraham Case Study #417 (Issue
367). It comes from a professional marketer.
Customer Problem: New investment management firm having
difficulty getting clients to believe they would be
successful with their advice. The investment
management company was relatively new in the management
business and had very few clients. Mainly the clients
were relatives and friends of the money managers. They
needed new clients in order to grow and they needed
customers to refer their friends and relatives.
So, the problem was lack of trust/belief by new clients.
The company knew little about marketing. Their fee structure was
not tied to performance. Here the marketer saw the weak spot.
Solution: The money managers were asked how much they
believed in their recommendations. They indicated they
had tested their advice with their own money and
referred their relatives to their company. However,
their fees were structured where they took a percentage
of their clients' account each month regardless of how
much money they had made or loss for their clients.
The proposed solution was the adoption of some form of risk-
reversal.
The money managers were sincerely convinced they
methods would continue to be successful. The
recommendation was to change their fee schedule to be
on an incentive basis. That is, their fees would be
totally based on the success or profits they made for
their clients.
Results: The fee schedule that was recommended was on
a progressive basis, i.e., the more profits made for
the clients, the larger the incentive fee. This worked
so well that the new fee schedule brought in more new
clients and higher profits than the original fee schedule.
By showing their customers that they were willing to
take risk by managing the accounts for free if there
were no client profits and higher fees the more profits
made for their clients.
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-----------------------
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