This week we further explore the variation in economic forecasts and then finish with Part Three of "How the World Really Works" from my friend, Art Cashin. Many thanks to him for allowing me to use his work so that I could get a little R&R this summer. Next week it is back to the heat of Texas and full weekly letters.
I can't say enough nice things about Nova Scotia, but I will write some more about it later. This will not be the last summer I spend considerable time there. Yet, alas, I did leave this morning and am now on a flight from Boston to San Francisco. I downloaded numerous articles to read as fodder for this week's shortened commentary. I only had to go through the first two articles to get more than I needed.
The first was Harry Dent's latest essay sent to me by a loyal reader (thanks James), which was bullish in the extreme. Dow 35,000 (by 2008, no less) here we come. The second was a research report from the Levy Economics Institute of Bard College, which was quite bearish (as well as somewhat confusing to those of us with less sophistication), suggesting a 500 number for the S&P 500 during the next severe recession.
These were put into context by the in-flight movies which was showing David Letterman and his Stupid Animal Tricks. Both of these reports offer us an opportunity to explore one of the major problems with economic projections: the logical and well documented presentation of facts for which there may or may not be any connection to the logical and well documented conclusion. This is compounded by the problem that we hear what we want to hear, thus giving credence to bad economics when it tells us something that we want to believe. So let's explore Stupid Economist Tricks.
Absurdo Ex Transmissio Economicus
Harry Dent has posted Part Three of "What Happened on the Way to the Roaring 2000s." I did an extensive analysis of his first two parts in the June 12, 2003 issue of this letter, so I won't revisit those comments, but you can read them by going to the archives on www.2000wave.com.
Normally, I don't pay attention to patent nonsense of this type, as there is just so much of it out there. We could spend all year and still not scratch the surface. But Dent wrote a major book in the 90's convincing people to buy the NASDAQ and Dow because the underlying demographics of the Baby Boom would force the economy and stocks to soar. A lot of people bought this book and his research because it sounded so plausible. There has been, however, a small road bump on the way to Dow 35,000.
Not to worry. In part three, Dent gives us lots of charts designed to show us that things will soon return to normal. First, the recent downturn was part of the normal "Decade Hangover Cycle," which Dent has conveniently discovered. At the beginning of each of the last three decades, there has been a recession to correct the excesses of the previous decade. In the 80's and 90's, we went higher and higher. Therefore, since the cause of the boom was the buying power of the Baby Boomers, it follows we will do so again this decade, as the boomers are not yet ready to hang 'em up. In particular, he shows us the relationship between family formation and peak spending, and explains that the chart shows that peak buying power will last until 2009. He finds new spending coming from the Echo Boom, which just started kicking in and is geared to give us the "buying opportunity of a lifetime."
"The reversal of the downward family formation trend into 2001 has provided some positive impact starting in 2002. But the most important insight here is that it will provide growth in spending just as baby boom spending begins to level off."
Then we get to the good stuff. All the above tells us nothing has changed. We are just getting ready to party like it's 1999. I am going to give you actual quotes, just so you can know I am not making this stuff up.
Projections for the NASDAQ and Dow
"We don't have a clear channel for projecting the NASDAQ like we have had for many years for the Dow. Hence, we have to refer to technical indicators that come from comparing the previous advances or waves of the NASDAQ rally to forecast this sector (Chart 17). The first wave, from its bottom in late 1974 into early 1983, represented a six times rise in the market. The last major wave, the third wave, occurred from late 1990 into early 2000 and represented a 15.5 times gain. Technical analysis suggests that the coming fifth wave should, at a minimum, equal the first wave, a six times gain. At best the fifth wave could equal the third wave, for a 15.5 times gain. Another option is a 62% ratio of the third wave (or, similarly, 162% of the first wave) which comes to a projection of a 9.7 times gain, or almost ten times. In our view, this is the most likely projection. A 9.7 times gain would project a high of 10,500-12,000 around late 2008. It is even possible we could see 20,000-21,500 if there is a 15.5 times gain. This is a very reasonable range of forecasts given that the auto index advanced 12 times from 1922 to 1929, when the economy was in the same phase of its 80-year cycle.
"Our longstanding Dow Channel (Chart 18), clearly indicates a high of around 35,000 by late 2008 or 2009. This is a four-fold increase in valuation (from recent lows), in less than a decade, a reasonable forecast considering that the Dow advanced six times from 1922 to 1929. But remember that our best forecast for the NASDAQ is a near ten times advance in the same time period. That is still less than the 12x gain in the Auto Index in 1922-29."
There you have it. Growth in family spending (somehow associated with the cool chart on the Echo Boom) is going to cause a return of the greatest economy and bull market in the world. This time it will be a real rise in market value, not like those puny old bull markets of the past. The waves are what we all have been missing. How could I have not seen this? Such a tsunami of a wave that in just five years we will see the NASDAQ at 12,000! This will transform our entire understanding of what value is.
Looking at Carl Swenlin's fabulous database of every chart known to man at www.Decisionpoint.com, I find the current P/E for the NASDAQ 100 is 76. I have been writing that this is in historical nosebleed territory. According to Dent, I (and probably 99% of my more astute readers) don't have a clue about what real values await us in just five years.
Let's be generous and assume the NASDAQ 100 can grow their earnings at almost three times the well-documented national historical average of GDP plus inflation, or about 14% a year. Since there is not going to be a recession because of all the consumer spending (indeed, it will increase dramatically), that means these incredible companies will double their earnings in the next five years. But their value is going to rise ten times under Dent's "best forecast." That means the P/E ratio is going to rise to 385.
It is "even possible" they could rise much more if we see a third wave repeat. A P/E of 600 is "even possible."
It is a tough call to decide which is the sillier use of charts to make a prediction: the use of wave analysis to project the NASDAQ or the use of historical channels to confidently predict the rise of the Dow to 35,000.
Basically, Dent starts with 1982, puts the Dow on a log scale, which conveniently masks the recent drop (on such a scale it looks like just a sideways squiggle), and draws lines along the rise from 1982, creating a "trading channel." Since we have not violated that trading channel on the downside, the trend is still up. Any idiot can see the facts for themselves. The charts don't lie.
Actually, what I see is a man predicting that 30 companies in the Dow will be worth more than the GDP of the entire country in just five years. He suggests the NASDAQ 100 (not much overlap) will also be worth $15 trillion. If you run his numbers through the S&P 500, he suggest that the total market value of the major US companies will be three times the GDP of the entire nation, or around $36 trillion.
(I would use an exclamation point but my web guys tell me when I do it makes some spam programs block the letter. They also tell me to stop using "m*rtgage r*tes, which is also a spam blocker no-no. What a world.)
You could do the same thing with Japanese stocks after their initial drop. Using the same logic as Dent, the chart would look the same and project a Nikkei of 80,000 or some such nonsense. Today the Nikkei is around 10,000. One could find example after example of such "trends" which fail to deliver.
Assuming trends never end and drawing charts to demonstrate that is a Stupid Economist Trick. Showing graphs of two unrelated items (General Motors in 1922) and the Dow in 2003 and concluding that the Dow will rise because GM did is actually beyond stupid. It rises to the inanity of my fake Latin above. There is no fundamental relationship between the two. None. Thus, there can be no real transmission of fact A to result B. Thus, absurdo ex transmissio economicus.
Dent concludes with this breathless admonition. I intend to nominate this paragraph for the "Over the Top" award in the Cheerleaders Hall of Fame.
"The sharp correction in the technology sector that we have witnessed makes this the single best time to buy equities in the entire 80-year new economy cycle. It's also the best time to buy in the 40-year Spending Wave cycle, an even greater opportunity than in 1987 when the Dow reached the lows of its last extreme correction. Comparing our forecasts for the NASDAQ and the Dow, it is clear that while the entire economy will continue to do extremely well, the greatest investment opportunities are in technology. Don't let this sharp correction in these "new economy" equities dissuade you from buying. The more extreme correction in technology suggests much greater gains in the years ahead. As we can see from our S-Curve models for broadband and Internet use, there is tremendous growth potential in this industry over the next 6 to 7 years. Just as the auto industry upstart Cowles Automotive grew into the giant General Motors, many emerging technology companies that survive the current shakeout and stay the course will emerge as clear industry leaders. This dramatic growth in the years ahead, especially in technology, will benefit all consumers. However, the greatest reward will go to the smart investor who takes advantage of this buy opportunity of a lifetime."
I am left almost speechless. This stuff must sell. People must desperately want someone to tell them their JDS is coming back and the retirement funds they have watched dwindle are going to rise from the ashes and lead them back to investment Nirvana.
Bubble? What Bubble?
To believe such verbalized investment garbage (not too strong a term), investors must suspend rational thinking. They must believe that the NASDAQ in March 2000 was not a bubble, but just a "way" stop in the ever moving progress of the markets. You must think that value has nothing to do with the stock market. You must believe the stodgy old Dow is going to a P/E of 90 or more in just a few years, valuations that were not even approached in the last bubble top.
Part of the reason that I get more than a little irate over this is that I get the calls almost every week from investors who have seen their life savings demolished by proponents of such nonsense. They now face a far more difficult retirement. Calling for help, many want to know what they can do to get back to just "even." Sadly, I have no magic investment beans. I can only suggest slow and steady when what they want is 20% compounded for a few more years (after-tax, of course).
So they become susceptible to the siren call of those like Dent, who promise them a return to the life of their dreams. If it were not so very, very sad it would be funny.
The Dollar Whiplash
Now we turn briefly to the Levy Institute's recent paper called "ASSET AND DEBT DEFLATION IN THE UNITED STATES: How Far Can Equity Prices Fall?"
Let me quickly say that I hesitated to mention this report in the same letter as Dent, because I do not want anyone to think that the two are even comparable. The economists at Levy are serious, thoughtful and intelligent and approach their subject with academic rigor.
They attempt to show what the effects of a double-dip recession would have on the S&P 500. I have no quibble with many of the conclusions. If there was a severe recession, I do believe that the S&P would drop to 500 or so. Milder recessions would mean smaller drops, as their data tries to show.
Economists all too often try to build models that allow them to forecast things with some accuracy. It is an effort to be scientific. It is no mistake that economics is called the dismal science.
These models have become increasingly complex, in ever greater efforts to measure the future. But they mostly rely on the past relationships within the economy.
In the past decade or so, I have become an apostle of the ever present saying, "Past performance is not indicative of future results." I am a true believer, spreading the word to all who will listen. There are also some corollaries to this Law. One is that past economic relationships will change, and do so just when it is most inconvenient.
In this study, they use many variables and show how changes in the variables effect the price of the market. They assume a dollar dropping 30%, something that I cannot argue with over time. But they see this as a positive for the value of the market.
"In the first scenario, a dollar depreciation of 30 percent is necessary for corporate earnings to recover. Such a huge depreciation may seem paradoxical, but it is necessary for a profit recovery.... A reasonable move in the currency, of about 10 percent, would have a limited effect on the S&P 500, so a huge dollar depreciation would be necessary for higher profitability and for the economy to recover..... The dollar is assumed to depreciate 30 percent from its value in mid 2002. If that assumption did not materialize, the fair value of the S&P 500 would drop to 526, because dollar depreciation is deemed essential to increased profitability and economic recovery."
When you build such models, you have to make assumptions. I can go along with the concept that a lower dollar will increase corporate profits in most of the multi-nationals in the S&P 500, even if I may not agree on the exact amount.
But what the model does not take into account is the effect that a 30% drop in the dollar will have on foreign investment in the US stock market. While it may increase US profits, it also means that foreign investors lose 30% off the top, in addition to the 40% drop in the dollar value of the market. Are foreign investors likely to stay around for such fun? I think not.
In past economic lifetimes, foreign holding was not as high as it is today. It was not a major structural component. Today it is. As noted above, past economic relationships change. I am highly suspect of using such past relationships to predict the future.
Even though I might agree with some of the conclusions of this study, and readily appreciate the work and insights I get, it reminds us all that these models have very real limits, and basing our future investment patterns on such models can be dangerous, even if the conclusions are those with which we generally agree.
For me, they study of economics is part science and part "art." The "art" part is why you can get two otherwise reasonable people looking at the same statistic and coming away with different opinions. As a rule of thumb, when an economist tries to make what he does all science and no art, he is on the way to a train wreck. There is simply no way to accurately model all of the thousands of variables to predict the future with any degree of certainty.
Now, deadlines approach and I have to go give a speech. It is time to finish and go to Part Three of Art Cashin's essay.
How The World Really Works, Part Three
To better understand both global trade and the currencies that make it move we must again go back to basics. This time the basic is the very concept of money.
Almost from the time they learned to use language humans have traded with each other. In the early stages it was barter - the exchange of one item for another. If you raised pigs and your neighbor raised chickens you might, conveniently, swap him some bacon for some eggs.
But what if your neighbor does not want bacon. Suppose he wants cheese or fish. You then need to find someone who has what your neighbor wants (cheese) who is also interested in what you have (bacon). Whether your product is shoes or olives, you can see how cumbersome barter can become. What was needed was something that would be readily accepted for almost any good or service. That is what we call money - an "agreed upon" medium of exchange. That last part is important. Like a poker chip on your dining room table, money is worth what we agree that it's worth.
On Tuesday night when Aunt Agnes has "the girls" in, the value might be a penny. On Thursday when the cigar crowd shows up, it may be a dime or even a quarter. It's the same chip. It is the agreed upon terms that differ.
Many things have been used as money. From fishhooks to beads to fur, it was whatever people in that particular trading circle agreed to. On the YAP Islands, long isolated in the southwest Pacific, the islanders used 8-foot wheels of stone for money. That may seem strange to us but that's what they agreed to - and it worked. Well, it worked until some Europeans heard of the system and sailed into the harbor with a boatload of 8-foot stone wheels. It caused a local bout of hyper-inflation that Alan Greenspan has yet to cite.
The search for the right medium of exchange has shifted over time from the useful (fishhooks) to the unique (gold).
Gold has had many attributes as a medium of exchange. It is very rare so small amounts could represent large sums (no 8 foot wheels here). It is virtually indestructible and almost impossible to counterfeit. You can lose it but you can't destroy it. When the Lydians and Phoenicians spread trading across Asia Minor and the whole Mediterranean, they used gold "coins" as the medium of exchange.
But (and I can just see the hate mail coming now) gold works only because we agreed that it worked. The YAK Islander or the Manhattes who sold New York to Minuit would not instantly see the value of your gold. It is pretty, it shines, but what do I use it for?
Gold has over 4000 years of history behind it. That gives it strong cultural credibility and acceptance. And it can't be inflated. But, an ounce of gold is worth only what we agree. Maybe it's a man's suit or a lady's gown or even a small computer. Mediums of exchange are all based on agreement.
Earlier, when we discussed the emergence and evolution of banking, we noted the convenience and safety of keeping the gold in one place and transporting the receipts. These banknotes carried the promise that they could eventually be redeemed for the gold (or silver, tobacco, or tea - a few of the things upon which money has been based).
In the last century, nations have determined that it is the promise that counts more - a promise of soundness. Thus, the U.S. dollar is no longer redeemable for gold. But the government shows its faith in its currency by accepting it in payment for taxes. That gives it both a sense of necessity and some credibility.
Thus, money is the convenient medium that we all (government and citizens) agree to use. If one side is suspected of failing its obligations, the other side will reject the medium (counterfeit, hyper-inflation, etc.). Nations also respect the exchangeability of other countries' currency, although not at a fixed price or ratio.
Money is the fuel and lubricant of global trade. Certainly barter is impossible despite eBay and the searchability of Google. But, if a currency does not appear to perform or conform to its standard as a "medium of exchange," the results can be sudden and violent. The Thai Baht and the Russian Ruble are a couple of recent examples.
Let's take a look at how global trade works - at least in classic theory.
Suppose Americans suddenly went mad for French wine. They import every bottle they can get. They pay the French winemakers dollars - billions of dollars. The winemakers, however, find that the town baker prefers the local francs to dollars (this is pre-Euro).
So the winemakers need to exchange those dollars to get francs. They go to their bank who then goes to the Central Bank (there are other means but we're keeping it simple). The Bank of France could sell the dollars to other nations in exchange for francs. Unfortunately, this new supply of dollars would drive down the dollar versus the other currencies. In essence the dollar's purchasing power would decline outside the U.S. So, that bottle of French wine would cost the Americans more. They might stop buying or buy less. That would not make the French winemakers happy. They would buy less bread and cheese. Lot's of folks in France would not be happy.
Thus, the Bank of France has a problem. It can look around for someone (a central bank) who really wants dollars so that they will not drive the dollar down. This is not unlike the farmer with the bacon looking for someone who wants what he has.
The Bank of France has another somewhat less classical, alternative. They can avoid flooding the foreign exchange markets with dollars by buying U.S. Treasury bonds.
Over the last three decades, Central Banks around the world have adopted just that strategy. America has gone from a creditor nation (lender to others) to a debtor nation (borrower from others). The growth in this shift was aided and abetted by the Central Bank strategy cited above.
This buying of Treasuries has had a very significant effect in the U.S. When the Fed buys U.S. Treasuries as agent for a foreign central bank, it has the same impact as if the Fed had bought for its own account. The foreign buying takes bonds out of your bank and leaves it with cash, which it will then try to lend, as you recall from our discussion of banking and the velocity of money.
Thus, foreigners and especially foreign central banks have given the Fed a tailwind in supplying more money. Put another way, they have facilitated the huge growth in debt we have seen.
How much of this is going on? The figures indicate - a lot. Sources tell us that over half the total reserves of all the Central Banks in the world are held in U.S. dollars. Let me repeat that - over half the world central bank reserves are in U.S. dollars. This is both an enormous amount of money and a stunning proportion of world reserves.
You could look at it another way. Let's examine it from the U.S. side.
Foreigners hold between 30% and 33% of all U.S. Treasury bonds outstanding. We believe more than half of that is held by central banks. Foreigners are also said to own 14% of all U.S. Agency bonds. Foreign sources are also believed to own 20% of all U.S. Corporation debt.
These are numbers the size of glaciers. A sudden shift in sentiment or intent among foreign holders could have far reaching impact across the face of America.
Thus, we need to be aware or maybe even wary of how these banks evaluate things.....like our economy and our currency. Some cynics claim we have been "living off the kindness of strangers". I suggest there is nothing kind about it. They are operating in what they believe to be national self-interest. But whatever the motivation, it is the future evaluation that is important.
What events might cause these large holders of U.S. debt to change their minds, or at least their goals?
One might be inflation. At this time inflation is thought to be an unlikely near term outlook. There certainly is a huge amount of excess capacity around - not just in the U.S., but globally. Classically, inflation does not kick in with huge pockets of excess capacity around. It's hard to raise prices when your competitor has room to produce more (excess capacity) and might steal your customers by keeping prices steady.
Yet there is a seeming paradox in the current Fed posture. The Fed openly talks of "reflating" - basically pumping some inflation back into the system. Inflation, as you recall from our earlier discussion, favors the borrower and hurts the lender. The lender gets back money that buys less bread than the same amount of money had when he lent it. So we have the paradox of the Fed stating it wants to lower rates to promote inflation and bonds being bought for the lowered rates with no concern of bond erosion.
What could cause this seemingly counter-intuitive buying of bonds? There are three likely answers. First, the buyers of bonds might think the Fed will fail. Second, the buyers might think the Fed will succeed so slowly, at the speed of molasses, that the bondholders will have plenty of time to exit before they suffer any damage. Third, the bond buyers don't see the risk or, more strangely, don't care. The third alternative seems wholly implausible in the largest most liquid market in the world.
Nonetheless, the Fed is facing a tightrope feat. They believe they need to reflate to help the U.S. economy but cannot allow the huge number of foreign holders to sniff a surge in inflation. It will take historic dexterity and balance. And, we believe it will take better communications. The markets must not mistake the Fed's direction. The stakes are too high. That point was made strongly in the recent Bernanke speech.
Foreign holders (institutions) other than central banks have other motivations. Rates are low around the globe. In Germany rates are the lowest they have been since Bismark was Chancellor. That was a century ago.
Not everyone is a fan of low rates. Think about senior citizens. They have already made most of the purchases they might have to borrow for. They look to their lifelong savings and perhaps the proceeds of a house to provide them income. Low rates offer no benefit. This problem for seniors is also a global problem at least among the "developed nations".
With roaring stock markets mostly a memory, low rates are a problem for pensions, also. How can you "catch up" with rates so low? This is a major problem as the globe divides into "the old world" and "the new world." We are not talking about geography but rather about population and aging.
Here is how the Economist assessed this topic of aging populations in a recent edition:
"Fertility rates across Europe are now so low that the continent's population is likely to drop markedly over the next 50 years. The UN, whose past population predictions have been fairly accurate, predicts that the world's population will increase from just over 6 billion in 2000 to 8.9 billion by 2050. During the same period, however, the population of the 27 countries that should be members of the EU by 2007 is predicted to fall by 6%, from 482m to 454m. For countries with particularly low fertility rates, the decline is dramatic. By 2050 the number of Italians may have fallen from 57.5m in 2000 to around 45m; Spain's population may drop from 40m to 37m. Germany, which currently has a population of around 80m, could find itself with just 25m inhabitants by the end of this century, according to recent projections by Deutsche Bank....."
"Combine a shrinking population with rising life expectancy and the economic and political consequences are alarming. In Europe there are currently 35 people pensionable age for every 100 people of working age. By 2050, on present demographic trends, there will be 75 pensioners for every 100 workers; in Spain and Italy the ratio of pensioners to workers is projected to be one-to-one. Since pensions in Germany, France and Italy are paid out of current tax revenue, the obvious implication is that taxes will have to soar to fund the pretty generous pensions that Europeans have got used to. The cost is already stretching government finances. Deutsche Bank calculates that average earners in Germany are already paying around 29% of their wages into the state pension pot, while the figure in Italy is close to 33%."
Japan is in the same shape. It is tough to make your economy grow when your population is stable or even shrinking, as they grow older and older. Where will the new family formations come from? A new family needs a new fridge, a new TV, etc. Static families only buy to replace what has worn out. Demand slows, then shrinks.
There are even terror-related issues that underlay the economics. In July of 2001, when the Twin Towers still stood, the CIA wrote the following:
"Dramatic population declines have created power vacuums that new ethnic groups exploit. Differential population growth rates between neighbors have historically altered conventional balances of power....Our allies in the industrialized world will face an unprecedented challenge of aging. Both Europe and Japan stand to lose global power and influence...." "The failure to adequately integrate large youth populations in the Middle East and Sub-Saharan Africa is likely to perpetuate the cycle of political instability, ethic wars, revolutions and anti-regime activities that already affect many of these countries. Unemployed youth provide exceptional fodder for radical movements and terrorist organization, particularly in the Middle East."
These factors, aging and large dollar holdings have enormous economic and societal implications.
Home Again, Home Again, Jiggety-Jig
Sunday I return to Texas, where I have promised my publisher I will not leave until they have a draft manuscript of my book in their hands. Then we will crash through the actual editing and printing to get it on bookshelves as soon as possible. Within a week or so, we will finalize on three titles and let readers vote. Thanks for almost 1,000 suggested titles. It was quite overwhelming.
School starts on Monday, and for the first time in decades I will be faced with tests and studying. I have told my son (going into the 9th grade) I will "take" Spanish with him, taking his tests just as he does. If he beats me, it will cost me $10. Part of the motivation is to do something with my son and help him, and the other part is to finally give me the incentive to do something I have wanted to do for many years - learn Spanish. In an odd way, I guess, I don't think about giving my son $10 when he needs it, but giving him $10 when he beats me on a test is something that will not sit right. He has long been able to out-run me, is getting close to out-driving me. This is my last chance to stay even with him. (Side bet: my wife has indicated an interest in learning with us. She will be fluent far before either of us can say complete sentences.)
Next week, I will be back on the writing schedule as we explore the world of investments. It will be good to be home, as much as I loved Nova Scotia.
Your looking forward to his own bed analyst,