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-Caveat Lector-
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The Current Account Guessing Game
The Daily Reckoning
Paris, France
Thursday, 3 October 2002
--------------
*** What happened to the rally? This is bummin' our high...
*** Ursa Major is back! Look out! Is this the time to be
borrowing money?...
*** Poor Cisco, down 85%...fund managers prepare to call it
quits...
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--------------
Mr. Bear! That sly fellow...just when you think you've got
him figured out, he does something unexpected.
Yesterday, for example, we were pretty sure we'd see at
least another bullish day on Wall Street. The Dow is far
below its moving average. Prices have been falling day
after day, month after month. It was time for Mr. Bear to
let up.
Not out of a sense of mercy, of course. Au contraire, with
malice aforethought! Investors were getting edgy,
panicky...it looked like they would soon pack up their
picnics, jump in their cars, roll up the windows, lock the
doors, and rush out of the stock market. If they had done
that, prices would crash and the bear market would be over.
But this is no ordinary bear. This is Ursa Major...the kind
of animal you see once in a lifetime. Instead of backing
off...the great bear came out again yesterday, reared up on
his hind legs and ripped into stock prices.
We stand back - well out of range - in awe and wonder. We
have the feeling we are witness to something remarkable.
The greatest bull market in history is now being followed
by the greatest bear market. And the biggest boom seems
likely to be followed by the biggest bust too.
In the economy as in the stock market, people who still
have their wits about them should be making a getaway.
Consumers, already carrying the heaviest debt loads ever,
should be taking off their knapsacks and chucking out
unneeded items. When you are running from a bear, you want
to be as light on your feet as you can be.
Instead, yesterday brought news that the poor hopeless
schmucks were standing in line to get bigger mortgages;
there were a record number of mortgage requests last week.
Refinancings at lower mortgage rates typically help cash
flow even while they make the balance sheet worse.
Consumers end up with a bigger mortgage, but lower monthly
payments. But recently, a hint of desperation has crept
into the refinancing statistics. "They're refi-ing to get
another $40 a month in their check," reports Michael A. J.
Farrell of Annaly Mortgage Management. "Why is that? We
think it leads back to economic weakness."
How can we help these people, dear reader? Or investors who
rush to join every rally in the stock market? We don't
know...
Eric's report...
--------------
Eric Fry from the city of New York...
- As West Coast surfers would say, "That Mr. Market dude is
bummin' my high."
- "Yeah," would come the reply, "He's a real buzz-kill."
- Every time investors start to get a little excited about
owning stocks again - like during Tuesday's 346-point Dow
rally, for example - along comes another big sell off to
"bum their high." Yesterday, the Dow dropped a buzz-killing
183 points to 7,756, while the Nasdaq Composite was also
pretty much of a downer - dropping more than 2% to 1,187.
- The gold market provided a minor rush by gaining 60 cents
to $322.80...
- Let's try not to shed any tears for Cisco Systems. The
shares of this once-and-former leading light of the dot-com
era dipped below $10 yesterday. That's right, the same
Cisco Systems that once boasted a spectacular $575 billion
dollar market capitalization became just another single-
digit stock. But let's not look on the forlorn, broken-down
Cisco that we see before us today. Instead let's remember
the more youthful and confident Cisco of the late 1990s -
the company that inspired us all to hope big hopes and to
dream big dreams.
- Remember how Cisco filled us all with giddy euphoria?
Let's not forget how Cisco inspired us all - an entire
nation of gullible investors - to squander trillions of
dollars buying overpriced and over-hyped tech stocks.
- And let's remember the Cisco of an earlier, happier time,
when the ever-soaring Nasdaq Composite moved us all to feel
much, much richer - if only for long enough to amass
sizeable debts that will weigh on us for the rest of our
lives.
- Ah...Those were the days!
- Cisco shares managed to inch back above $10 by the end of
trading, but the psychological damage had been done: Cisco
shares changed hands at "nine and change."
- What is nearly as remarkable as Cisco's colossal 87%
collapse from its peak of $80.06 in March of 2000, is the
fact that the company still boasts a market cap of $73
billion.
- As the once-titanic market cap of Cisco Systems breaks
apart and sinks into the sea, so do the aspirations of
countless hedge fund managers, particularly those who
forgot to hedge.
- There is no direct connection, perhaps, between Cisco's
sinking share price and the death of numerous hedge funds,
but both are victims of the post-bubble bear market.
- One of my well-placed contacts in the hedge fund industry
tells me that hundreds of managers will be calling it quits
at the end of the year. These well-heeled unfortunates have
lost so much money for their clients that their hedge funds
have become woefully uneconomic propositions.
- Most of the stories I've heard have been remarkably
interchangeable. They go something like this: "Acme Hedge
Fund" opens for business in 1994 with $1 million.
Throughout the 1990s, the fund enjoys considerable success
by simply riding the bull market ever higher. All the
while, the funds do very little actual hedging. (Short-
selling was self-evidently stupid, most managers believed).
Assets under management at Acme Fund gradually increase to
$75 million by March of 2000. Then, all hell breaks loose.
But Acme doesn't do too badly at first. Stocks are so
obviously overpriced in 2000 that even diehard bulls think
it appropriate to short a stock or two, just in case the
stock market stops going up for a while. After the dust
settles, Acme finds itself with a loss of 15% in 2000. Acme
loses another 15% in 2001 - the results might have been
much worse, but the post-9/11 rally saves the day. Enter
2002, everyone "knows" two things for certain: 1) the
economy will recover by June and; 2) the stock market
cannot possibly fall for a third straight year...Ergo, time
to buy!
- We all know what happens next. The economy doesn't
recover in any meaningful way and stocks collapse. Our not-
so-imaginary Acme Fund is now down another 18% through the
first nine months of 2002, bringing its cumulative losses
since the end of 1999 to 41%. And that's very bad news for
a hedge fund manager.
- Now, the fund must gain 70% just to get back to break-
even, and therefore, back to the level at which the manager
receives 20% of the profits. Until he has made back the
accumulated losses, he receives no share of the profits.
Making 70% might take a while, and many of Acme Fund's
clients don't feel like sticking around. Many of them
withdraw what's left of their money so that they can re-
invest in the "much-safer" real estate market.
- Acme Fund's assets under management have dwindled to $18
million...which means it's time to close up shop and
freshen up the resume...And that can really bum your high.
--------------
Back in Paris...
*** What a central bank does best is inflate the
currency. But there comes a time when even the best of
them cannot overcome the deflating effects of a major
bear market and economic downturn.
When that happens, people with big mortgages come to
grief. Deflation raises the value of money...and,
naturally, claims on money streams - such as bonds and
mortgages. It the rentiers' delight, as it increases the
value of every coupon he cashes in. But, on the other
end, the debtor finds himself doubly damned. His
liabilities increase. And the real interest rate he pays
goes up. Even if the nominal rate is only 5%...when the
CPI is also dropping by 5%, the real rate of interest is
10%.
That is a big part of Japan's problem now...and it could
become America's soon.
*** Paris is beautiful...but gray as a white alley cat.
Here at the Daily Reckoning headquarters, this is our
favorite time of year. The leaves have turned yellow and
flicker in the light breeze, and the dying light of
autumn casts a candle glow over the city like the
viewing room of a mortuary.
But how we admire the city! So beautiful, so
sophisticated, so coy and witty. What a great day to
wink at a homely girl or ask a broker for financial
advice. Not that we would want to follow up on either.
But it is a good day for light-hearted mischief...
*** "What was wrong with that man in front of us,"
Edward, 8-years-old, asked as we got in our car.
"He is very sick," replied his mother.
"What's the matter with him?" came the follow-up.
"He has cancer..."
In the pew in front of us on Sunday, the couple held
hands. Marie-Claude gripped her husband's hand to steady
him, for he could barely stand. But he pulled himself up
at the critical moments and faced his friends and his
God.
The poor man will probably not make it until Christmas.
In the last 6 months his hair has turned white and his
skin has turned yellow. There was the scent of death in
the air.
"Why doesn't he go to the doctor?" the questioner
continued.
"There's nothing the doctors can do."
"Will I get cancer?"
"No, it usually attacks old people."
"How old is he?"
"He must be in his '60s."
"How old is Dad?"
"Not that old."
"Why do people die?"
We had no good answer.
But everything does. Exeunt Omnes. The best you can do
is to do it with grace and dignity.
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--------------------
The Daily Reckoning PRESENTS: Apogee Research's Andrew
Kashdan wonders...now that all those foreign investors who
so generously financed the U.S. spending spree have little
to show for it - what next?
THE CURRENT ACCOUNT GUESSING GAME
By Andrew Kashdan
Murray Rothbard, the noted Austrian school economist, once
said that "more nonsense has been written about balance of
payments than about virtually any other aspect of
economics." At the risk of adding another layer of
gibberish to the mix, we turn our attention to the eventual
"end game" for the U.S. current account deficit. Not that
we're foolish enough to try forecasting exactly how and
when it will end. No, we just want to ponder the big
picture.
Recall, if you can, the balmy days of the 1990s in which a
virtuous circle of rising asset prices incited rising
foreign investment and U.S. spending, which led to ever-
higher asset prices. Well, it was that bulge in foreign
investment and U.S. spending, much of it on imports, that
produced the huge U.S. current account deficit. But now
that investors have marked down at least some of those
assets to fair value (or closer to it), it seems to us that
the rest of the circle will probably reverse itself as
well. It's all part of the stomach-churning hangover from
the go-go years.
The possibly confusing aspect of this part of the cycle
concerns the narrowing of the deficit - that is, a rise in
exports relative to imports. What is usually seen as a
"favorable" trend may not be, depending on how it comes
about.
The problem confronting the world today stems from the fact
that the U.S. bubble's sheer size made it the engine of the
global economy. On the one hand, the U.S. consumer's
insatiable hunger for imported goods was propping up
foreign economies, while on the other, foreign investors'
insatiable hunger for U.S. assets was attracting investment
funds. But now, post-bubble, all those foreign investors
who generously financed the U.S. spending spree have little
to show for it. So, it's not that the rest of the world is
unwilling to carry the burden of importing (as if
consumption were an act of altruism), but rather that they
are unable.
If the rest of the world is not buying U.S. goods at
current prices, then presumably prices have to drop. But as
FODR (Friend of The Daily Reckoning) John Mauldin explains,
"rather than lower their prices in terms of their local
currency, [businesses] urge their governments to lower the
price of the currency." That description certainly applies
to U.S. exporters. They have long complained about the
strong dollar, and since the party ended, they've been
getting more attention. That brings us to an important
point: when market forces are potentially aligned with
political forces, that is precisely the time the Fed
prefers to act (and so, too, the U.S. Treasury, which is in
charge of manipulating the currency markets, should it come
to that).
Bottom line: With low inflation providing a margin of
safety for monetary expansion, a weaker dollar seems
inevitable. If there were ever a consensus for revving up
the money supply, this is it!
In surveying the U.S. economy last week, The Economist
observed that "debt cannot rise faster than household
income forever. Eventually households will be forced to
save more and spend less." (By using "forever" and
"eventually," the statement becomes a truism and bypasses
the annoying question of "when?".) The same inevitability
applies to the international balance-of-trade situation, as
the IMF acknowledges in its recent World Economic Outlook.
Referring to deficit countries (read: the U.S.), it says
that "current gaps between the growth in real domestic
demand and real output cannot be sustained indefinitely."
In other words, U.S. consumers are living beyond their
means. "The underlying issue," the IMF goes on, "is whether
the eventual rotation in real demand growth away from these
countries to continental Europe and east Asia will occur in
a smooth manner or not." It doesn't quite say it, but the
IMF seems less than confident that the transition will be a
smooth one.
What sometimes gets lost in the focus on the quarterly
flows of imports and exports is a country's net foreign
asset position, which is the result of cumulative current
account imbalances. Take Japan and the U.S., for instance.
The IMF says that based on its forecasts, by 2007 Japanese
net assets, measured as a percentage of GDP, will rise by
about one-third to 40% of GDP, and U.S. net liabilities
will double... also to about 40% of GDP. The numbers would
be unprecedented, the IMF adds, and would occur when even
existing levels are hard to justify in the face of
fundamentals such as government debt, GDP per capita and
demographics.
The implication is that large external adjustments are
needed to stabilize the ratios. There are few historical
precedents of countries running large current account
deficits over a sustained period. Nevertheless, the IMF
concludes, not surprisingly, that the adjustments generally
occur in deficit countries through a combination of slower
output growth and depreciation in the real exchange rate.
Because volumes of exports and imports respond sluggishly
to exchange rate depreciation - i.e., the J-curve effect -
it takes a year or more before the current account is
actually adjusted. To our surprise, the IMF's advice for
policy makers sounds pretty sensible: "medium-term fiscal
consolidation" by the deficit countries, presumably meaning
less government spending, which it says diminishes the
likelihood of a too rapid current account adjustment; and
reforms by the surplus countries to increase flexibility
and competition.
As the U.S. ramps up government spending while Japan and
Europe make little headway on economic reform, the global
economy has obviously seen better days. "[O]ne key aspect
of the legacy of unbalanced global growth," says Stephen
Roach, is "America's gaping current-account deficit... So,
too, is an overvalued U.S. dollar." Accordingly, Roach's
team at Morgan Stanley has just reduced its estimate for
global growth to 3.1% in 2003, a full 0.5 percentage point
lower than the 30-year trend, and the risks are on the
downside. Roach thinks global policy coordination is sorely
needed.
But regardless of what the bureaucrats decide to do, we
know that Mr. Market will go his own way, ultimately fixing
the mess the bubble has left behind. Trouble is, it might
hurt a little (or a lot).
Andrew Kashdan,
for The Daily Reckoning
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