What an amazing week. The data deluge as I came back into the office from Florida was staggering, and I write this letter late at night after a day of reading and thinking.
Is the recession over as every other talking head asserts? Are we on our way to another double-dip recession as others suggest? Or, are we simply going ever further into the Muddle Through Economy? Let's look at the data, answer a few of your questions and then briefly look at a fascinating book which helps us understand how the world ended up with $100 trillion in derivatives, and whether we should be worrying about them.
I should note that I have not written a recent Accredited Investor E-letter. I apologize, but will correct my derelict ways next week. For those of you who are interested in a letter on private placements and investments, you can find out more information about how to get the free letter at the end of this report.
Is the Recession Over?
The Conference Board leading economic indicators are up for a third straight month. Two of my Three Amigo indicators are singing in harmony (capacity utilization is very off-key).
Consumer confidence is up for 3 straight months, and a sharp increase since November. Durable goods rose in December, and housing sales, while slowing slightly, are still at a blistering pace. Consumer spending (see below) is doing VERY well.
Yesterday, the government announced that our economy grew at 0.2% in the fourth quarter, against expectations that it would decrease by 1% or so. What happened? Are we on the way to a rocket like "V" recovery? Or at least a lower case "v"?
Numerous commentators believe so, including the Fed and Alan Greenspan. In a major departure from his speech of only a few weeks ago, he now tells us the "outlook for economic recovery has become more promising." Evidently, things are so good he can stop cutting rates and start slowing the increase in the money supply (see last week's e-letter).
Many of those in the recovery camp are telling us growth will be at 3-4-5% in the last quarter of the year. Then there are those who think we will see a double-dip recession. We will look at their thoughts and then I will weigh in.
The GDP Waltz
I remember as a teenager I played tenor Freddy Eynsford-Hill in My Fair Lady in our high school musical. I had to learn to waltz. I clumsily moved around the floor repeating "one-two-three; one-two-three". Now, looking at the pattern of recent GDP growth announcements, it's like learning to waltz all over again.
First, they make an announcement. Then the next month they lower it. Then the next month they lower it again. By that time nobody cares because it is the end of the quarter and all we are focused on is what is now the last quarter. One-two-three. One-two-three.
Second quarter, if memory serves me right, the number started out at a positive 1.0% and was finally corrected to 0.4%. When the number for the third quarter came out in October, it was down 0.4. I publicly wrote and made a bet with Greg Weldon that the actual number would be -1.2%. He said -1.1%. He was dead on.
This is not a recent pattern. It has been going on for years. It has to do with the way the numbers are estimated.
The actual numbers in a few months will show last quarter to be negative, but less than a negative 1%. The quarter was surprisingly good, given the fact that corporate profits were so bad. But a close look at the numbers gives little evidence for a strong recovery.
Consumer spending grew at an annualized 5.4% last quarter. 94% of that gain was in "consumer durables" with 70% of that being in cars.
Stephen Roach of Morgan Stanley tells us why to keep the party hats in the closet. "Never before have consumers spent with such a vengeance in the depths of recession. In the 28 quarters of the past six recessions, real consumption growth averaged a scant +0.5%. In only two of those quarters did consumption growth come in at 3.5% or greater -- 2Q60 (+5.1%) and 3Q70 (+3.5%). And those spending bursts borrowed from the immediate future; they were both followed by declines in the subsequent quarter that averaged -1.4%. The lesson is clear: With jobs and income under pressure, paybacks are the norm in the aftermath of mid-recession consumption spurts."
He and other articles noted a few other reasons. Government response to terrorism increased spending by 9.2%. State and local construction grew at an annual rate of 35%. Both are temporary growth spurts.
Roach states the case for a double-dip recession as well as anyone:
"The double-dip call, however, is not premised solely on a statistical analysis of the national income accounts. There is, in fact, a much deeper meaning to all this. This recession -- especially if it's now over, as most suspect -- has done next to nothing to purge America of the excesses that built up in the Roaring 1990s. The American consumer remains overly indebted and saving-short; the personal saving rate fell back to 0.5% in 4Q01, and there is good reason to believe it was even lower than that at the end of the quarter. Corporate America continues to be plagued by bloated costs -- from both capacity and workers; the capital spending share of GDP has now fallen from a cycle high of 13.2% in 4Q00 to 11.6% in 4Q91, completing only about half the adjustment that has occurred in past secular downturns in business fixed investment. And America's current-account deficit remains at about 4% of GDP -- a near-record shortfall and in sharp contrast to the near balance that typically occurs in recession.
"Such profound and persistent excesses are simply not conducive to sustained economic recovery, in my view. They leave the US economy bucking powerful headwinds in the aftermath of any inventory-related pop to activity that may be occurring in the current period. In short, I have a hard time believing that a sustained cyclical lift-off can occur with a zero saving rate, a 4% current-account deficit, and a lingering overhang of excess capacity. Given the likelihood of a demand relapse, these lingering structural excesses provide a seemingly classic set-up for a double dip."
The Middle of The Muddle Through Economy
So, who's right? Rocket V or Double-Dip?
If I had to pick, I would lean to the double-dip. But there is a third choice, and that is muddle through. I think we will find that last quarter was still mildly recessionary, and this one will be only slightly better. Maybe -maybe- we get a slight recovery in the second quarter. Then we get "official" recovery in the last half of the year.
But it won't feel like recovery. Just as this has been the mildest recession in the past 40 years, the recovery will be the weakest. We still have to work through the debt issues mentioned above, plus a growing trade deficit and global deflationary pressures. Corporate profits will not rebound.
Greenspan will keep the money spigot on. Tax cuts, mild as they are, will help. The yield curve is not signaling a recession, which it has one year out from every recession.
The American economy has shown a great resiliency. We will postpone the day of reckoning for another few quarters. We will Muddle Through.
Federal Reserve Oatmeal
When I was a young boy, my mother would mix oatmeal into the ground beef to make it go further. It also made the patties bigger, as it held the grease. This was my first introduction to inflation, although I did not know it at the time.
The Fed is doing everything in its power to make the patty bigger, as deflation sweeps the global economy. That is causing a lot of questions from readers.
"With the money supply rising so fast, how can you predict deflation? Everyone knows that inflation is too much money chasing too few goods.". "Since you said last week that gold is finally ready to rise, does that mean you think inflation is coming back?"
I have been predicting disinflation/deflation for about three years, and so far we are still on track. We have actually had outright deflation for the last 6 months. But the Fed is printing money at a prodigious rate, so the question is: "Where is it going?"
Part of the answer is the current stock bubble. The "oatmeal" is swelling the stock market. I agree with Steve Blumenthal of CGM that "massive liquidity injected into the system will provide a floor to the market on the downside while high relative price valuations will provide a ceiling to the upside. This all equates to a long term trading range as we continue to work off the excess capital of the Internet - IPO craze and the accounting manipulations of our trusted corporations."
I agree that much of the increase in the money supply is going into the stock market. But a lot of it is being absorbed by "paper burning" or bad debt caused deflation.
I read today where Enron owes $30 billion to its unsecured creditors and another $10 billion to its secured creditors. Good luck, guys. You can kiss the unsecured debt goodbye, and probably most of the secured.
John Meyers writes that the adjusted monetary base was about $500 billion in 1998. Today it is pushing $640. That is a huge growth of $140 billion. He argues that is inflationary and will eventually make gold rise. I am not convinced.
Enron wiped out $40 billion in one fell swoop. How much has been lost to Global Crossing, that star crossed company which only a few years ago George Gilder was hailing as among the best and brightest?
These two examples are a tip of the iceberg. Estimates are $25 billion to the US for Argentina and another $45 billion to Europe. Moody's has raised its estimates of global debt default in high yield bonds to 12%, an almost 20% rise. Credit card and other consumer debt defaults are near all-time highs. Mortgage defaults are similarly at high levels.
In the old days, you paid off the farm and celebrated by burning the mortgage. Today, banks and lenders are participating in another type of debt burning, as they burn the paper of those who are left with bankruptcy as their only choice.
This global paper burning is deflationary, pure and simple. Greenspan prints money and Ken Lay, Gary Winnick and their ilk burn it, except for what they manage to put in their pockets.
While I do think inflation could come back some day, my view (stated last week) that gold could finally get up off the mat (in 2003) is related to my concern about the dollar coming under pressure due to the likelihood that the trade deficit will be the highest in history, and will probably be responsible for bringing the dollar down (see last week's issue for a full analysis).
Against the Gods
I read Peter Bernstein's brilliant book, "Against the Gods," this week. It is the historical story of risk. He takes what could be a very boring theoretical subject and turns it into a page turner.
If you want to understand how we ended up with Enron and $100 trillion in derivatives, he takes you back to the Greeks and works his way through the centuries, telling us how each successive mathematical leap changed history, making modern society possible.
I highly recommend you get it and read it. At the very least, go to Barnes and Noble, buy a latte, get the book, sit in their comfy chairs and read chapters 16 and 17 on the psychology of investing and risk.
Modern portfolio theory assumes we are all cold-hearted rationalists. As it turns out, we are far from it. We are all creatures of what burned us most recently. Bernstein tells us how Amos Tversky and friends created "Prospect Theory" or the psychology of financial actions.
Quotes: "The major driving force is LOSS aversion. It is not so much that people hate uncertainty, --- but rather they hate losing."
In a later study, Tversky notes the irony: "It would follow that cutting your losses is also a good idea, but investors hate to take losses, because a loss taken is an acknowledgement of error. Loss-aversion combined with ego leads investors to gamble by clinging to their mistakes in the fond hope that some day the market will vindicate their judgment and make them whole."
" We start out with a purely rational decision about how to manage our risks and then extrapolate from what may be only a run of good luck. As a result, we forget about regression to the mean, overstay our positions, and end up in trouble."
If you have had trouble understanding why you make some of the investment decisions you do, then read these chapters. It helps if you read the whole book, but these are crucial. I can't recommend it too highly.
Interestingly, he wrote the book prior to the 1998 Long Term Capital Management (LTCM) crisis. It would be interesting to get his take on that event. Today, we read there are $100 trillion in derivatives. Derivatives are getting a bad name today, but without them, the modern world and global trade would grind to a quick halt. Risk would be unmanageable, and companies would not be able to function.
Enron is a example of the abuse of derivatives. These were fraudulent from the beginning. That partners from Merrill Lynch could participate, knowing their basis and not alert their clients borders on lack of fiduciary responsibility.
Merill partners evidently put as little as $50,000 into a partnership, borrowed $950,000 which Enron guaranteed, and was paid back to Enron as "earnings". The kicker is that the partnership was to pay the investors 15% or $150,000 per $50,000 invested.
I know that if someone were to offer me such a deal, I would get suspicious. Why did Merrill clients not know of this conflict of interest? At the very least, why did Merrill execs not tell their analysts who should have looked into the situation and warned clients? Inquiring minds want to know.
As bad as the Long Term Capital Management situation was, they only lost about $4 billion on $1 trillion dollars worth of derivatives, or about 4/10 of 1%. These men were not frauds and they actually thought they were limiting risks. To the extent they only lost $4 billion, half of which was their money, I guess they did. They simply did not understand the nature of the risks they were taking, and they had huge egos. This is not a good combination of traits for money managers.
Contrary to rumor, the Fed or the government did not bail them out. The Fed simply made sure the investment banks acted properly to clean up a mess they created by not properly monitoring their loans to LTCM.
What I find interesting is that at every hedge fund conference I have attended or spoken at since LTCM and 1998 has had several sessions on what is called "transparency". That means investors and the banks that lend to or invest in hedge funds want to see the actual portfolios within the hedge funds.
As you might imagine, this is quite the tug of war, as hedge funds all think they have a new twist on the world (I get so tired of the word "proprietary"). But hedge funds are fighting a losing battle on that front, as investors are scared blind because of LTCM. If LTCM, with two Nobel prize winners as winners could go bust, then everyone is suspect.
The investment banks which lend them the capital, and who lost billions on LTCM, are especially cautious. You should hear the hedge fund managers gripe.
My point? These same investment banks who hold the feet of hedge funds to a hot fire are the ones who entered into the "swaps" (or derivative) transactions with Enron. Now, either they once again let a huge client get away without disclosing the risks, or they knew the risks and did not tell anyone else because they were getting huge fees. Either way, it is bad.
If they simply were imprudent and lost money because they failed to monitor risks, that is their own stupidity. After LTCM, anyone who does not monitor the risk of a large client deserves to lose.
But if they knew the deals were risky and failed to disclose to their small clients? They deserve the trial lawyers that will circle their carcasses. As long time readers know, trial lawyers are pretty low on my list. But they are far ahead of financial institutions who do not disclose serious risk, when they know it, to their smaller clients.
Home Again, Home Again
I have been away from home entirely too much this last month, although it has been a very good time. I met a lot of great money managers, and made some new friends as I met with clients and potential clients. I appreciate you taking the time to meet with me. I am glad to be back and sleeping next to the love of my life again, at least for a few weeks.
I will be writing the next Accredited Investor E-letter very soon. If you have a net worth of over $1,000,000 (including everything) you are an accredited investor. I write the letter about private offerings and hedge funds. These private offerings are typically only available to high net worth individuals because of SEC regulations. I don't like limiting the list, but I do not make the rules, I just follow them. If you will send me an e-letter, we will send you a form by email that you can fill out and fax back to me.
Tomorrow I take a day off to be with my twin daughters as they are both on the Homecoming Queen court. Dad will get into his tux (barely - thank God for cummerbunds) and then I am back in the office for a few weeks, where I will get caught up.
I love to get your feed back, and read every letter sent to me. I try to answer as many as possible. Thanks for reading, and I hope I gave you some food for thought.
Your planning to do better than muddle through analyst,
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