The Daily Reckoning

verfasst von - ELLI -, 20.11.2002, 21:21

-->Metal v. Flesh

The Daily Reckoning

Paris, France

Wednesday, 20 November 2002

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*** What went wrong in the 21st Century?...

*** Consumer desire for baubles and widgets slackens...
Financial trouble at J.P. Morgan (again)?...

*** An economist's #1 nightmare...The Flaws of Modern
Capitalism...and more...

------------------

At the end of the last millennium, you will recall as
well as we do, dear reader, the U.S. economy had reached
near-perfection. Dynamic American capitalism was the envy
of the world. As far as anyone could tell, things would
just get better and better, for ever and ever - thanks to
new technology, buy and hold investing, and enlightened
leadership at the Fed.

But here we are, scarcely two years later, and something
has gone wrong. Now, everyone seems to agree that
capitalism needs to be fixed.

President Bush can fix it, wrote David Ignatius in the
International Herald Tribune over the weekend. What's
more, Ignatius infers that Bush would have fixed it
already had it not been for a few recalcitrant Democrats.

And yesterday, Alan Greenspan said he could fix it. True,
he has already cut rates 12 times. True too, overnight
bank lending, at 1.25%, is 2.35% below the inflation
rate, meaning that banks can borrow at negative real
interest rates. And true again, he admitted, that despite
his efforts over the last 2 years, business investment
was in a"very major fallback" position, in which"most
everybody is doing nothing."

But that doesn't mean he cannot still stimulate the
economy, said the best-known public employee since
Pontius Pilate.

And now comes John Crudele in the New York Post. If the
man has not lost his mind completely, he has surely
misplaced it. He offers his own plan to 'fix' the
economy.

How?

By allowing people to take money out of 401k and Keogh
retirement accounts and spend it without tax penalties.

The real problem in America is that on many yesterdays,
people spent too much. Today, they find themselves with
too much debt and not enough savings.

But don't worry about tomorrow, writes Crudele,"America
faces pressing problems today." Crudele thinks the
unemployment rate is nearly 10%"when you count people
too discouraged to even look for jobs."

And he thinks the nation needs another jolt of spending.
But just to make sure the spending would be effective, he
suggests that Congress should tell people what they can
buy.

For example, Crudele elaborates his hallucination, people
might be encouraged to invest in the airline
industry...if the industry promises to create more jobs.

Almost all airlines are suffering because their expenses
are too high as compared to their revenues. What good it
would do to increase their expenses by hiring unneeded
extra employees, Crudele fails to explain. But that's the
nice thing about having a plan to 'Save the Economy'...or
'Save the Planet' for that matter. You can let someone
else figure out the details.

The real problem with these 'fix it' schemes is that
their authors do not understand or appreciate the genius
of capitalism."The Flaws of Modern Capitalism," heralds
an article in the Financial Times. People are not getting
rich; there must be something wrong, the paper presumes.

But the majesty of capitalism is not that it that it
makes people rich, but that it makes them humble.

Of course, it doesn't happen overnight...and never
without pain. What's more, adults resist instruction as
much as a 9-year-old. They fidget and get distracted.
Instead of learning from their mistakes, they lurch from
one illusion to the next until the madness...and the
money...is finally crushed out of them.

"Investors are utterly convinced that policy can fix
anything that ails America," writes Stephen Roach,"from
deflation and asset bubbles to asset liability mismatches
and geopolitical threats (i.e. Iraq and terrorism.)"

The latest 'fix it' illusion will be destroyed, too -
sooner or later. But don't worry. The march towards
humility process poses no threat to the nation. On the
contrary, it is nearly as morally uplifting as it is
entertaining.

Right Eric?

------------

Eric Fry in New York...

- The"Little Consumer That Could" is discovering that he
simply CAN'T. This revelation is causing America's
largest retailers to sweat a bit. Home Depot announced
yesterday that sales would increase less than expected
this year. The downbeat forecast follows hard on the
heels of a similarly pessimistic forecast from Wal-Mart
on Monday. Also, the weekly sales report from the Bank of
Tokyo Mitsubishi showed that chain-store sales fell a
disappointing 1.2% last week.

- Clearly, the consumer is not buying baubles and widgets
- nor even aluminum siding - with his habitual gusto.

- Home Depot's gloomy forecast knocked the foundation out
from under the home-improvement chain's share price,
which tumbled $3.69 to $24.91. The steep drop of Home
Depot's stock - a member of the Dow Jones Industrial
Average - knocked 25 points off the blue chip index all
by itself. The Dow fell 12 points yesterday to 8,475,
while the Nasdaq dropped 1.4% to 1,374.

- We turn now to an evergreen topic: rumors of financial
distress at J.P. Morgan.

- Yes, it's true, the banking giant is once again doing
what it does SECOND best: denying that it has incurred
substantial losses in one of its areas of operation. What
it does best, of course, is actually incurring all those
substantial losses that it spends so much time and effort
trying to deny. The big bank seems to excel at shooting
itself in the foot.

-"If the denials are starting to ring hollow," the
National Post recently remarked,"it's because J.P.
Morgan has had to issue so many of them in recent
months."

- True. When the Enron crisis erupted last year, JPM
repeatedly low-balled its exposure to the bankrupt
"energy trader." Morgan's CEO William Harrison insisted
that Enron posed no serious risk to its finances. Nothing
could have been further from the truth. The Enron fiasco
not only took a big bite out of JPM's balance sheet, it
also dealt a body blow to its reputation. Next up, Morgan
indignantly denied the prospect of a dividend cut...and
then later acknowledged the possibility. Now the high-
risk lender is at it again - adamantly denying rumors
that it is saddled with sizeable wrong-way bets in the
gold derivatives market.

- These troubling rumors swirled about the stock on
Wednesday, November 6th, causing the shares to fall more
than 6% that day. Immediately, Morgan's PR department
came out with its denial-guns ablazin' by dismissing the
rumors as"false and irresponsible."

- The rumors about Morgan's outsized gold derivatives
portfolio aren't new, of course, they've simply gained a
fresh intensity. They've also gained a fresh
plausibility, given Morgan's recent string of serial
disasters.

- In theory, banks like JPM try to maintain a derivatives
exposure that assumes very little risk. In other words,
they are supposed to be 'market-neutral' most of the
time. But as markets are markets and people are people,
large speculative positions sometimes worm their way into
the derivatives portfolios at financial institutions.

-"As far as most analysts are concerned," says the Post,
"J.P. Morgan's massive derivatives program amounts to a
short position on the price of gold." Therefore, ever
since the yellow metal broke free of its bear-market
moorings last year, suspicion about the bank's exposure
to gold derivatives has surfaced from time to time.
Remember, these are"false and irresponsible" rumors.

- Morgan has assured one and all that it has"stress-
tested" its derivatives portfolio and insists that, even
in a worst-case scenario, there is nothing to worry
about. Wow...that's a relief! And by the way, the bank
really, really wishes - honestly - that it were at
liberty to divulge more details about its gold
derivatives positions. Unfortunately, these are
proprietary secrets.

- But there are a few clues that suggest reasons for
concern. Foremost among them is JPM's oversized presence
in the gold derivatives market."Pick a high-risk banking
sector, any high-risk banking sector, and you are sure to
find a large encampment - if not a tent city - of J.P.
Morgan bankers," Apogee Research quipped several months
ago.

-"In the derivatives market, in particular, Morgan
exerts a particularly commanding presence...Drilling down
a bit into Morgan's titanic derivatives book, we find
that it is the largest U.S. player in the gold
derivatives sector (probably not a great thing to be in a
rising gold price environment, but time will tell on that
score). Based upon notional values, JPM holds nearly two-
thirds of all the gold derivatives held by 369 U.S. banks
and trust companies that hold derivatives of any kind."

- In raw numbers, Morgan's balance sheet is only about
two-thirds the size of Citigroup's. Yet, Morgan's $45
billion gold derivatives book is almost four times the
size of Citigroup. Perhaps Morgan's outsized gold
derivatives exposure is not a MAJOR accident waiting to
happen, but we wouldn't be surprised to see the high-risk
bank stub its toe...at least.

For more on JPM see: Apogee Research
http://www.apogeeresearch.com/dr

------------

Back in Paris...

*** In his speech yesterday, Alan Greenspan referred to
the benefits of"25 years of extraordinary deregulation."
The Fed chief thinks deregulation will help save the
economy. David Ignatius, on the other hand, thinks that
'real regulation' is what is now needed.

We wouldn't bet on either one.

Perhaps the U.S. economy was deregulated in some major
ways in the last quarter century. But in many, many
little ways, it seems there are more people telling us
what to do than ever before...

"We are not close to the deflationary cliff," said Alan
Greenspan. Inflation was clocked in October at a 3.6%
annual rate. But then again,...deflation is an
"Economist #1 Nightmare" says the International Herald
Tribune.

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---------------------

The Daily Reckoning PRESENTS: What, if anything, gives
the West an advantage when it comes to waging war? Dan
Denning tackles the War on Terror and its implications
for investors in defense technology...


METAL v. FLESH
by Daniel Dennning

"It would be a gain to mankind if we could spread over
that country the Idea of America - that all men are born
free and equal in rights, and establish there a
political, social, and individual freedom."

- Theodore Parker,
speech at the Melodeon
Boston, Massachusetts, June 7, 1846

On May 18, 1846, General Zachary Taylor crossed the Rio
Grande into Matamoros, Mexico. And for the first time in
its history, the government of the United States of
America occupied a foreign city. Ten days earlier at El
Palo Alto - under a tradition that Bernard DeVoto
describes as having"emphasized marksmanship, steadiness
under fire, and individual initiative, and courage" -
Taylor's men won the battle.

It was a small battle. But it's hard to overstate its
implications, even for today. First, let's talk hardware.
The American cannons consisted of brass six-pounders and
cast-iron 12- and 18-pounders. Definitely a far cry from
today's 120 mm thermal-sighted cannons on M1A1 tanks. But
the Americans had the Mexicans outgunned and patiently
blew them to bits.

Aside from the tactical victory was a point that only
students of history can appreciate. By most accounts,
Taylor was no military genius. One of Taylor's own
colonels wrote in his journal that if Taylor were to
succeed, it must be by accident. Fortunately for Taylor,
there was substantial military talent within his ranks.

Taylor had a young officer serving in the 4th Infantry,
one Lieutenant Ulysses S. Grant. And in the space of a
few hours, Grant learned enough about massed firepower to
ignite a revolution in military affairs (RMA) that
Secretary of Defense Donald Rumsfeld would be proud of.
Grant learned what Lee would forget at Gettysburg. Metal
is superior to flesh.

It's fair to say that the U.S. military has been
employing that doctrine of superiority ever since.

Sometimes, in our effort to understand what's going on in
the world, we look to musty old history books - but not
to avoid repeating the mistakes of the past. Rather, we
hope to learn exactly how we got to where we are today,
and what, if anything, it tells us about where we're
going.

The years 1846 and 2002 have a lot in common. Both years
found America on the brink of historic changes in its
relationship with the world. And in both years - here I'm
getting ahead of things a bit, but indulge me -
technology and capitalism played/will play the decisive
part in the outcome.

I'm going to avoid any moral discussion of more efficient
killing and just accept it as a fact. Likewise, I'm going
to take it for granted that you know where I'm coming
from philosophically: namely that war almost always makes
the State stronger, and in that sense, is almost always
detrimental to individual freedom. Still, our moral and
ideological objections shouldn't prevent us from
understanding what's going on, or, if possible, from
profiting from it.

In 1846, America was trying on the clothes of a national
power for the first time. Texas had been annexed two
years earlier. New Mexico and California were next. The
Oregon Territory would soon follow. America was a country
just becoming self-conscious of its role on the North
American continent, and perhaps in the world. It embraced
that role with a vengeance. Bernard DeVoto tells the
story in his book, The Year of Decision, 1846.

Thousands of settlers took off across the frontier for
the West. The frontier was the edge of the unknown in
1846. There was no INS, BLM, or Transportation Security
Agency. But when allowed, the free market finds solutions
to almost any problem...even that of arming a vulnerable
population on the frontier of an unsettled country.

From 1836 to 1846, Samuel Colt hand-manufactured about
6,000 of his patented repeating revolvers. Portable, easy
to use, and capable of dispensing six rounds without
having to stop and reload, DeVoto says,"the revolvers
gravitated to the place where they were needed, the
Western frontier."

Colt's company had gone out of business due to bad
management. But by 1846, America was entering the heart
of its industrial revolution. Our own Dr. Kurt
Richebächer often tells us that it's production of
capital goods which creates new wealth. And that is
surely one big difference between America today and
America in 1846. The America of 1846 was bursting at the
seams with inventors, patents, and machines that could
make machines.

Colt's revolvers were a perfect example. When he closed
his original factory in 1842, each manufacturing
operation had to be performed by hand. But in 1846, Colt
teamed up with the Whitney Arms company (the son of Eli
Whitney, inventor of the cotton gin). Colt and Whitney
built machine tooling to automate the manufacturing
process.

Colt's factory was one of the first of its kind. In fact,
when he set up shop in England a few years later, there
were no machine tools to make his guns, or craftsmen that
could make the machine tools. The capital goods to build
the arms industry in Europe had to be imported from
America, where necessity, freedom, and an expanding
nation were producing new goods and services at an
astonishing rate.

DeVoto calls the American embrace of industrialism in
1846 the beginning of"the American System." The
"American System" was best exemplified by the National
Fair, which was held that year in Washington on May 22.
At the fair, President James K. Polk reviewed an immense
variety of manufactured goods. It's doubtful that anyone
realized the economic implications of a country that was
suddenly producing everything from window shades and rice
flour to portable steam boilers and tobacco presses. But
the implications were immense.

America was beginning to get rich by turning raw
materials into finished goods - capital goods that could
be exported for profit and used to produce more goods.
There was a tremendous boom in individual innovation -
the kind that is only possible when a man owns the rights
to his invention and is free to profit by selling an
improved product or service to his friends and neighbors,
or even to total strangers.

Part of what made the country such a dynamic place in
1846 - perhaps the greatest part - was the energy of its
people. Henry David Thoreau tried to put his finger on
what it was that was driving America. He knew it wasn't
the government. Of the government he said,"It does not
[and will not] keep the country free. It does not settle
the West...The character inherent in the American people
has done all that has been accomplished; and it would
have done something more if the government had not
sometimes got in its way."

It was then, for lack of a better word, character - the
same kind of individual initiative and courage that had
served Americans so well in their war for independence.
But as Thoreau sensed, an economy that has embraced
technology and married it to a desire for foreign
conquest - or at the very least, a dangerous belief in
the rightness of one's own convictions in foreign affairs
- suddenly makes a free people a lot more dangerous, and
lethal.

Of the Mexican War, John C. Calhoun said,"it has dropped
a curtain between the present and the future, which to me
is impenetrable...it has closed the first volume of our
political history under the Constitution and opened the
second and...no mortal could tell what would be written
in it."

Calhoun may not have precisely known what it was he
feared. But his fears turned out to be justified. The
Western way of shock-infantry battle supported by
mechanized artillery was destructive enough when deployed
against Mexicans who weren't equally armed. But once
those cannons got bigger and more powerful and were
turned against one another on the battlefields at
Antietam, Chancellorsville, and Gettysburg, the horrible
logic of what Grant had discovered hit home.

World War I took the grim reality of shock combat with
heavy artillery to its logical and near apocalyptic
conclusion. But what was that conclusion? And what made
the Western way of war so different from anything else?
Why was the carnage in the American Civil War and World
War I so much worse than in other wars?

Victor Davis Hanson gives an interesting answer in his
book, Carnage and Culture. Hanson identifies key elements
in the tradition of Western warfare, starting with the
Greek hoplites, through the Macedonian phalanxes, the
Roman legions, the Spanish conquistadors, and the
American military at Midway.

The argument is simple: capital wins wars. And free
societies produce capital and capital goods in much
greater abundance than non-free societies. Almost all
instances of a non-Western power defeating a Western
power in combat usually involve the use of Western arms
by the non-Western power. In few cases has a non-Western
army used its own weapons to defeat the West. And in
fewer still has a numerically inferior non-Western force
traveled a great distance and defeated an indigenous
Western foe with non-Western weapons.

Vis-à-vis the current situation, the West still has an
overwhelming superiority in the manufacturing of capital
goods, especially sophisticated capital goods. Virtually
all of the equipment used to pump the oil out of Arab
wells was designed and built by Western-trained
engineers.

Only in the West does the spirit of rational inquiry and
scientific experiment produce such measurable
technological progress...and therefore the ability to
corral such incredible violence in support of its
political ambitions.


Regards,

Daniel Denning,
for The Daily Reckoning

P.S. The West still produces the bulk of the world's
arms. And here, a genuine lover of freedom might feel
some cause for shame. The numbers don't lie. America is
the world's largest exporter of arms. It also devotes a
larger portion of its gross national product to defense
spending than any other nation on earth.

But for now, what gives the West its advantage over Iraq?
What leads me to believe we'll win a war there quickly,
as we have in the past? And what can you as an investor
do about it? I'll debut 4 defense stocks which have
cornered niche markets in the defense industry in the
December issue of Strategic Investment. (If you're not a
Strategic Investment reader and you'd like to give it a
try, please read:

Blood In The Streets
http://www.agora-inc.com/reports/DRI/GainQuick/

Editor's note: Dan Denning is the editor of Strategic
Investment. You may remember Dan from his earlier
investment advisory service. His focus on little-known
stocks led investors to profits as high as 5,182%...as
well as over 570% on Isle of Capri Casinos, 457% on Big
Entertainment, 411% on Gentner Communications and 130% on
Total Research Corporation. Today, Denning is the
architect of Strategic's winning portfolio - up across
the board while Wall Street's finest take it on the chin.

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• The Daily Reckoning - - ELLI -, 20.11.2002, 21:21