An Incomplete Recession / The Daily Reckoning

verfasst von - ELLI -, 24.11.2002, 18:55

-->An Incomplete Recession

The Daily Reckoning

Paris, France

Friday, 22 November 2002

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

*** Throw in a car...or a house...to make the sale!

*** Hack, hack, hack...rates are coming down...so are
prices

*** Dow soars as the bear market rally continues. Buy
diamonds? Wonder world of derivatives. And Oh, West
Virginia!

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

An article in a Minnesota paper tells of a man who had so
much trouble selling his house that he cut the price and
promised to throw in a new Dodge Durango as part of the
bargain. Still, no takers.

Cut rates further, says a new OECD report.

What worries the OECD is the same thing bothering the Fed
- the threat of deflation. Alan Greenspan was quoted
recently, saying that the risks of deflation are
"extraordinarily remote." That must mean he thinks they
are more remote than usual. An odd thing to say, now that
the economy is closer to deflation than it has been in 60
years!

Consumer prices fell in Hong Kong again last month - for
the 48th month in a row.

Germany is either already in deflation or close to it.

And even in America - where the inflation rate was just
clocked at a healthy 3.6% annually - 40% of all the goods
and services that make up the GDP are cheaper this year
than they were the last.

Meanwhile, America's largest company - GE - announced
lower earnings...the Bank of Japan said that the world's
second-largest economy was doing less well than expected,
too.

So, despite what Alan Greenspan says, central bankers are
worried and are counting on even more rate cuts to boost
the world's economy. The overnight rate is already more
than 2% below the inflation rate in America, but will
probably go lower. And even if it goes to zero - as has
happened in Japan - not to worry. The Fed would still
have plenty of options left, says Greenspan.

Low rates work, proclaimed St. Louis Fed governor William
Poole in a recent speech. Just look what they did for
auto sales.

As we recall, though, auto sales spurted ahead when zero-
rate financing was announced. But they ran out of gas
when consumers began to wonder what the automakers might
offer next.

Since zero-rate financing has lost its magic, maybe the
automakers can learn from the Minnesota example: offer a
new split level with every Explorer and a McMansion as
part of the package with every Navigator.

But even central bankers might learn something: even the
lowest rates in 6 decades won't necessarily lure a man to
buy a car he doesn't need or a house he can't afford...if
he thinks they'll be even cheaper next year.

So much for the sad news. Let's turn to Eric for a happy
report from Wall Street, where a bear market rally turns
all news into good news:

-----------

Eric Fry, checking in from Manhattan...

- Buy orders flooded the NYSE yesterday, as short-sellers
scrambled to buy back stocks they had previously sold
short, and as"true believers" scrambled to buy stocks
before missing any more of the rally.

- The Dow kited 222 points higher to 8,845, while the
Nasdaq skyrocketed nearly 4% to 1,467 - its highest level
since June. Tech stocks led the charge, just like old
times. And semiconductor stocks led the tech stocks, just
like old times. The SOX Semiconductor Index has bounded
57% higher from its early October lows... This is pretty
amazing stuff.

- The spectacular tech-stock rally of recent weeks is
reminiscent of late 1998, when the Nasdaq soared phoenix-
like from the ashes of the Long-Term Capital Management
crisis. Then, as now, the fundamentals underpinning tech-
stock valuations weren't terrific. Then, as now,
investors could not have cared less. Stock prices were
rising, and that was all anyone needed to know. Then, as
now, skepticism toward the rising stock market was a very
expensive attitude to have.

- Bonds responded to yesterday's stock market
pyrotechnics by flaming out once again. The 10-year
Treasury note tumbled more than a point, pushing its
yield up to 4.15% from 4.06% on Wednesday.

- We now return to Chairman Greenspan's Wonderful World
of Derivatives. Upon reading Greenspan's address to the
Council on Foreign Relations, we had the sense that he
was born a century too late. He should have been an
English journalist in 1912, effusively praising the
Titanic's invincibility, immediately before it set sail.
Had the mighty vessel never hit an iceberg, the ship
would have transported thousands of passengers back and
forth across the Atlantic without incident, thereby
perpetuating the illusion of its invincibility.

- The"HMS Global Derivatives" is probably no different.
It is an amazing vessel, as long as it avoids icebergs.
This marvelous ship can whisk millions of investors to
their desired destinations more quickly and efficiently
than any other vessel on the macro-economic seas.
Although Greenspan stops short of declaring derivatives
invincible, he does credit them for staving off economic
calamity during the last two and a half years. And he
praises them for reducing risks within the global
financial system.

- But that's not quite accurate. Derivatives don't reduce
risk; they merely"disperse" it, as Greenspan, himself,
explains:"Our paradigms for containing risk [i.e.
derivatives] have emphasized dispersion of risk to those
willing, and presumably able, to bear it. If risk is
properly dispersed, shocks to the overall economic system
will be better absorbed and less likely to create
cascading failures that could threaten financial
stability."

- Sounds reasonable. But what does it mean to"disperse
risk?" To illustrate, let's imagine that 1,000,000 tons
of raw sewage were dumped on top of your house and yard.
The resulting foul-smelling eyesore would permanently
destroy the value of your home, and probably, the values
of your neighbors' homes as well. But this same 1,000,000
tons of sewage, if dispersed across the Pacific Ocean,
would cause no catastrophic harm to any one party. In
theory, we would all suffer in the aggregate because our
shared ocean would be more polluted. But no single
individual or group of individuals would suffer a
debilitating calamity.

- So it is with derivatives. They disperse the risk.
Therein lies their principal virtue and their principal
flaw. As long as we may dump sewage in the ocean,
everyone is happy. But what if Neptune wakes up one day
and says,"Enough"?

- Somebody has to buy all these semi-toxic financial
instruments in order for the risk-dispersion system to
function. But what if they stop buying derivatives? Up
this point, the biggest end-buyers and guarantors of
derivatives have been insurance companies and other large
financial institutions - the sorts of folks that Edward
Chancellor of breakingviews.com indelicately labels
"naïve money." But now that these large institutions have
incurred substantial losses in the derivatives market,
they have become somewhat less naïve. Furthermore, the
additional losses they've suffered on their plain-vanilla
stock market holdings over the last two and half years
have also served to diminish their appetite for risk. In
short, we cannot count on these vast pools of naïve money
to continue supporting the global derivative structure.
They may say,"Enough."

- Would that be catastrophic? Probably not. But it might
be very painful nonetheless, because it would have the
effect of withdrawing liquidity from the financial
system. Not just anyone has $127 trillion lying around to
replace the global derivatives market.

- Then too, it's still possible that the HMS Global
Derivatives will hit an iceberg one day."But hey, that's
life," the chairman seems to say.

-"As in all aspects of life," Greenspan observes,
"expansion of one's activities beyond previously explored
territory involves taking risks. And risk by its nature
has carried, and always will carry with it, the
possibility of adverse outcomes."...He said it!

----------

Back in Paris...

*** We continue to suffer the slings and arrows of
annoyed readers. What seemed to bother them most were our
reflections on Wild, Wonderful West Virginia. Some
readers were so ticked off they wrote more than once:

"I am writing to apologize for my e-mail yesterday. I was
angered by your commentary on West Virginia and I replied
in anger. I shouldn't have done that.

"My outrage, however, is not diminished. It amazes me
that some people who are well-off have such contempt for
the underclass. Where does that fear come from? It's as
if you suspect that you don't really deserve what you
have."

What is interesting in these retorts is that hardly
anyone took issue with our remarks. Not one wrote to
praise West Virginia vernacular architecture or the local
cuisine. They seemed to admit that, culturally, the place
is a wasteland. But there must be something wrong with
your editor for noticing!

Was he an unfeeling snob, was he an elitist, had he
become a euro-snoot?

"Obviously, it's much easier to acquire wealth than
humility and a generous spirit. In your endless
reflections on the human condition, perhaps you should
contemplate why some people seem compelled to display
their character flaws for all to see.

"If there is any valid point to your insults, perhaps it
is that they are guilty of not trying to improve their
lot? I could sympathize with that point of view; maybe
even agree with it, for all that I fully understand how
limiting it is to be under-educated and perpetually
money-poor. But your opinions, expressed with such
negativity, are un-called-for... Does it really make you
feel better to so brazenly insult hillbillies..."

One reader even suggested that it couldn't be good
business for us to rile readers so. The Daily Reckoning
is, after all, a commercial enterprise. What sense did it
make to aggravate the customers?

Of course, if money were all that mattered, we could have
commented on the beautiful autumn leaves, told people
what they wanted to hear, and let the hillbillies wallow
in their wretched contentment - like pigs in the bridal
suite of a gaudy Las Vegas hotel.

Instead, we permit ourselves to criticize, for your
benefit, dear reader. For rarely did God provide such
stark evidence that money is not everything.

West Virginia must be one of the richest places on earth
- in terms of its natural bounty. What a pity; it has so
much wealth its people are almost ruined by it.

The size of Switzerland, with about as many people, it
sits within trucking distance of the world's richest
consumer markets - with no customs or trade barriers
between them. But instead of making something that they
can sell, the West Virginians content themselves to sell
off what God has given them - the trees on the surface
and the minerals beneath it.

Rich movie stars do not go to the mountains to spend
their summers in beautiful West Virginian chalets. In the
jewelry stores of Manhattan, no one enters looking for a
reliable West Virginia-made watch. No one goes into a
sandwich shop and asks for West Virginia cheese on his
pastrami. Nor do the patisseries of Paris often get
requests for fine West Virginia chocolates, nor do diners
often leave restaurants commenting on the vintage West
Virginia wine they enjoyed.

There are thousands of small town and villages in
Switzerland...throughout Europe...and in many parts of
America...where visitors marvel at how well people live.
Travelers admire the houses, the food, the gardens, the
fields, the local rituals, customs and the views. The
people who live in these downs - especially money-poor,
un-educated places such as southern Italy, Spain, or
Portugal - have built dignified towns on poor land and
created lives for themselves with enough grace and charm
to attract tourists.

Money had little to do with it.

Now, America is entering a dark period, we think, when
GDP per capital may slacken off and debts may have to be
reckoned with. But so what? West Virginia shows that
quality of life has little to do with money anyway.

*** Maria's career as a model seems to be going well.
She's featured as the Model of the Week on Models.com.
More important from her father's point of view: she's
coming home this weekend!

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

The Daily Reckoning PRESENTS: The"post-war period"
ended on March 10, 2000, according to Ray Devoe, sage
of Legg Mason. And while the ensuing recession may have
been officially declared over...it was both a"weird
one" and incomplete...and it did not accomplish what
recessions traditionally do.


AN INCOMPLETE RECESSION
by Raymond Devoe

In my opinion, the"postwar period" ended on March 10,
2000 ("The Crazy Day") when the Nasdaq Composite hit
its all-time high of 5048. Although the recession
officially began a year later, I delineate March 10,
2000 as the end of the 18-year bull market. I put
asterisks next to October 19, 1987 and the second and
third quarters of 1990. The former was more of a
systemic mechanical breakdown associated with
"portfolio insurance," and the latter I attribute to
the temporary dislocations from the Gulf War.

Thus, in my view, the"post-postwar period" began on
March 10, 2000 with the popping of the Nasdaq bubble.
The index is now down 73.7% from that peak - and the
first recession of"the information age" started in
March 2001. Originally only the first quarter of 2001
showed a decline in Gross Domestic Product (GDP), and
many economists asked,"Where is the recession?" when
the following quarters had positive growth in GDP.
Subsequent revisions brought the second and third
quarters of 2001 into declines in GDP. The National
Bureau of Economic Research (NBER) uses other
measurements, including the"3-D's," Depth - how severe
it was; Duration - how long it lasted; and Diffusion -
how widespread it was throughout the economy.

The Commerce Department's release on October 31, 2002
showed that GDP grew at a 3.1% annual rate in the third
quarter, vs. 1.3% in 2Q02. Roughly half of the increase
in the last quarter was attributable to auto sales -
which are weakening for a variety of reasons. The chart
accompanying the release shows four consecutive
quarters of GDP growth, beginning in 4Q01-and it still
shows three consecutive quarters of GDP declines last
year. So, I guess the recession is official, and it's
officially over. Or, is it?

It's been a weird one - and again, unlike any other
recession since 1945. Two of the normal causes of
declines in GDP, housing and autos, remained strong
throughout the recession and subsequent recovery.
Inventories, which fell to their lowest level on record
relative to sales during 3Q02, was one factor. The
other would be business investment, which fell for
seven consecutive quarters before turning in the last
quarter, with an anemic 0.6% growth (annualized). I
don't know where the strength is, since virtually every
company report I see mentions that they are cutting
capital spending. The GDP release also showed that the
trade deficit grew to a new record of $437 billion, at
annual rates unadjusted for price changes. That's
closing in on a half a trillion dollars - but doesn't
seem to disturb many people.

The recession may be over, but it is incomplete, in my
opinion, in that it did not accomplish what recessions
traditionally do. Similarly, the bear market could be
over, but that also has not done what bear markets have
done - bring about"capitulation," among investors,
more reasonable stock valuations, and a widespread
suspicion leading to contempt for stocks. Perhaps, in
the information age, recessions and bear markets will
not behave as in the past, and correct the excesses
leading up to them. Thus, I have gone into why I
believe both are incomplete at this point. Perhaps they
will remain that way, but I am sceptical.

This"recession" began as a bust following the boom in
business-fixed investment, particularly in technology,
telecommunications and information technology. But it
was not confined to those sectors. Virtually every
significant area indulged in over-expansion, fueled by
low interest rates, that in real terms were near zero
and occasionally negative. This led to extensive
overcapacity that will take time to work off.

Much has been made of the bursting of the technology
stock bubble - but in retrospect, the economy was a
bubble itself. That is the main reason why the recovery
has not responded the way it traditionally has done to
eleven interest rate cuts last year. How will business
investment respond to the Fed's decision to cut 50 more
basis points to 1.25%? About the same way as the
reaction to last year's cuts, in my opinion. 25 basis
points was widely expected - but 50 might be
interpreted as an indication of panic at the Fed.
Business investment, with extensive excess capacity, is
not particularly responsive to interest rate cuts.

Prior to the last normal postwar recession (1982-83)
housing was extremely depressed due to 20% and higher
mortgage interest rates (if you could obtain one) - as
then-Fed Chairman Paul Volcker was fighting double-
digit (CPI) inflation. When interest rates were cut
then, housing surged, providing a strong stimulant to
the recovery. Now, twelve interest rate cuts by the Fed
have brought about a continuing boom in housing that in
my opinion, has become another bubble.

Interest rates recently hit a 31-year low of 5.98% -
for a 30-year fixed-rate mortgage - the lowest since
Freddie Mac started tracking them in 1971. The
associated refinancing boom, along with the"cash out"
feature, where homeowners take out increasing amounts
of the equity in their homes, has been a significant
prop for the economic recovery.

How much lower can mortgage rates go? The simple
answer: not much lower. The Federal Funds rate is now
1.25%, or 125 basis points above zero after Wednesday's
cut. However, a comparable decline in mortgage rates is
unlikely. The reasons have to do with fixed-income
investors' balance in portfolios and average maturity.
It is really a question of how much 30-year paper at
31-year low rates an investor wants to own.

Auto sales have also behaved in a non-traditional way,
and the Fed has had little to do with them this time.
Normally, when the Fed raises interest rates to combat
inflation, consumer durables go into the tank - and
revive quickly when the Fed lowers interest rates to
fight the recession they brought about. This time, auto
sales have been in boom, perhaps even bubble mode by
zero-interest rate financings offered by the
manufacturers. Today's headline in The New York Times
is:"Sales Drop 30% In October At Big Three
Automakers," and subtitled"Big Incentives For Buyers
Worry Analysts."

The overhang from high sales volume in previous months
was one factor - but essentially the Big Three (really
the Big 2« - one is German controlled) are buying sales
from the future. They are also wrecking their credit
ratings (Ford-[F-$8.43] most obviously) and drastically
cutting prices by as much as $3,500 per car. That's the
amount that analysts in The Times article estimate that
it costs General Motors (GM-$34.02) per vehicle sold
with zero-interest financing.

That's a rather severe price cut to move a car - but
the incentives have had another side-effect, wrecking
the used car market. Since almost all new vehicle sales
involve a trade-in, the used car market is glutted, and
prices are down significantly. When current new car
buyers turn in those cars in the future, the trade-in
value is likely to be well below levels that would have
otherwise prevailed. That's another cost, and another
story - including the cost in gasoline consumption -
since the best-selling items are gas-guzzling sports
utility vehicles (SUVs). The same question as above:
how long can auto sales remain above trendline?

The short answer, briefly, is based on incentives, but
eventually sales over time will revert to trendline.
Prior to the zero-rate financing gimmick, which costs
GM $3,500 per vehicle, the auto makers, their finance
companies and banks featured very attractive promotions
for car leases, rather than sales. Both schemes moved
the merchandise, but the leases are expiring rapidly
and cars/vehicles are coming off-lease. Combined with a
stagnant economy this has also contributed to used car
prices plunging. But it gets worse."Residual value" is
the key in leasing, the educated guess of what the
goods will be worth when the lease expires and the
merchandise comes back into the market. In order to
make the lease deals more attractive two to three years
ago, the auto companies pumped up their assumptions on
residual values, so that the car lessee would have to
finance less, with consequently lower monthly payments.

Thus, the car makers will have 3.3 million cars coming
off-lease this year, into a market already glutted with
trade-ins from the zero-interest financing gimmick. The
fall in used car prices (already down 4% this year - to
the 1999 levels), combined with the overoptimistic
residual value assumptions to facilitate lease deals -
and the inability to find buyers, means that they are
being forced to auction off these vehicles for much
less than expected.

According to the November 11, 2002 'Boxed-In On The Car
Lot,' issue of Business Week,"Art Spinella, President
of CNW Marketing Research in Bandon, Oregon, an auto
industry consulting firm, says that auto makers are
losing an average of $2,400 on every off-lease vehicle
that they sell." But the good news - they had moved the
merchandise two to three years earlier. I consider the
former leasing program and the current zero-interest
promotions by the auto industry as the financial
equivalent of slitting your wrists and sitting up to
your neck in a bathtub of warm water.

Rereading Charles Kindleberger's book Manias, Panics
and Crashes - A History of Financial Crises (Third
Edition 1996), I was struck by another similarity with
what is happening in many sectors of the present
economy - deflationary pressures and the lack of
pricing power. This has occurred in virtually every
pre-1945 recession/recovery where the Fed has not
strangled expansion in its attempts to control
inflation. The $3,500 cost to GM in order to finance a
zero-interest sale amounts to a back-door price cut.

The October 21, 2002 issue of Business Week documents
this widespread price cutting in their article"Prices
Just Keep Plunging" and subtitled"Fears of deflation
are growing as a profits squeeze prompts more cuts."
They cite year-over-year declines of 20.9% for personal
computers (prices almost always decline-but never that
much), -4.0% for telephone services, -3.8% for air
fares - and a half dozen others in the accompanying
illustration. There are also major articles about
deflation in recent issues of The Economist and The
Wall Street Journal.

The Consumer Price Index (CPI) for September 2002
showed an increase of 1.5% (CPI-U) from September 2001.
The four largest gainers for the year, growing faster
than that +1.5% CPI increase are, Housing (+2.3%),
Medical Care (+4.6%), Education and Communication
(+2.7%) and Other goods and services (+3.2%-tobacco,
smoking products, personal care, miscellaneous personal
services). These sectors comprise over half (56.8%) of
the CPI. If these generally service areas were removed,
the CPI would be around break-even year-over-year -
perhaps slightly lower. During September, the Producer
Price Index (PPI) was definitely in deflationary mode,
with the PPI for finished goods declining 1.8% Y-O-Y.

The very significant and much-watched GDP chain-
weighted price index, the broadest indicator of price
levels has been trending lower, but is still in
positive territory. For the third quarter 2002, it was
up 0.8% down from the first half average of +1.3%. This
third quarter reading is the lowest since 1950.
However, the breakdown is not as reassuring - for
goods, the third quarter 2002 showed a decline of 0.8%.
It must be assumed now that deflation is no longer a
theoretical risk - and could become a problem, as it
did in the descriptions in Mr. Kindleberger's book of
pre-1945 experiences.

Two other factors that were not around in time to be
included in Mr. Kindleberger's book have also exerted
significant downward pressure on prices: the Internet
and globalization. Two of the significant advantages
that retailers have had over consumers in the past
would be consumer ignorance and lethargy.

The Internet can significantly lower these frictional
costs - since a consumer can go online and get an array
of prices for the merchandise desired. Used car prices
for trade-ins are also available online now, for
example. This forces the retailers to compete online
for the best price. It reverses the"advantage-
retailer" factor that existed previously. Lethargy
existed when the consumer negotiated with the retailer,
and when deciding whether or not to buy, considered
that he would have to get everyone back in the car and
drive 5-10 miles to another vendor - only to repeat the
process. The tendency was to avoid the hassle and buy
the merchandise. This is eliminated with Internet
shopping.

The New York Times reported recently that consumers are
increasingly haggling with retailers - even after the
merchandise has been reduced in price, sometimes after
two to three cuts. All these are significant
deflationary pressures that did not exist when Mr.
Kindleberger wrote his book. Globalization would be
another significant deflationary pressure. In the early
postwar period, the U.S. economy was essentially a
closed-loop business, since imports were not a
significant factor. I blamed the auto industry for
wrecking this system after doing a book review of The
Whiz Kids. It described how Mr. Robert McNamara used
the cost-effective methods developed for the Army Air
Corps in World War II to cut costs at Ford drastically
and produce a generation of lemons.

Since the other producers (there were more than three
then) were doing the same thing, the prevalent attitude
was that they had a captive market and the consumer
would have no choice but to take what they produced-
shoddy merchandise. Shortly, the consumer discovered
quality imports - particularly Japanese cars. That was
the beginning of"globalization"...and the pressure has
been intensifying ever since.

China, for example, must export for reasons of
political tranquility. The cost structures of Chinese
manufacturers are not divulged - but most state-run
producers are either marginally profitable or operate
at a loss. They must produce the goods to be exported
and sold. The price is not the primary consideration -
since the alternative is having 10, 20 or 30 million
unemployed workers. That could be an unendurable
political cost. So, they move the merchandise, and
bring about strong deflationary pressures in this
country.

This recession was the first of the post-postwar period
and also the first of the"Information Age." Consumers
are following the economy, not leading it - as was the
case in the past. Instead of a consumer-led
recession/recovery/slump business, investment has led
this one - the way it was done prior to World War II -
as described in Mr. Kindleberger's book. As he points
out, strong deflationary pressures arise after the
economic bubble has popped - and that is taking place
now.


Regards,

Raymond F. DeVoe, Jr.
For The Daily Reckoning

P.S. It is a rather eerie economic picture - and my way
of looking at it is that the three-quarter recession of
last year is incomplete. Traditionally, housing and
consumer durables go negative - but they remained
strong this time. Housing and autos never corrected -
but are looking increasingly shaky now. Consumer
spending never went negative. The trade deficit is
soaring.

Stock market valuations never fell to median historic
levels - much less the compressed values and higher
yields seen at other bear market bottoms. And,
significantly, consumer balance sheets never were
cleaned up. If anything, they are far more leveraged
than ever, unless refinanced mortgages, frequently for
much larger loans, are considered"off-balance sheet."

I am not forecasting deflation, just citing the
pressures existing in this eerie bust of the post-
postwar period. The widespread lack of pricing power
will make it a difficult period for profits, forcing
further cost cutting and particularly layoffs. Because
of the incomplete recession, I don't think there will
be robust growth until the excesses of the past have
been worked out of the system. And that is why the
recessions described in Mr. Kindleberger's book have
lasted longer than those in the 1945-2001 period, and
why recoveries were slower and more labored than the
traditional"V-shaped" ones of that postwar period.


Editor's Note: Raymond F. Devoe Jr. is the writer, editor
and creative genius behind The Devoe Report, published by
Legg Mason Wood Walker. Ray's financial analysis is a
regular feature of the U.S. edition The Fleet Street
Letter. If you're interested in investment ideas
consistent with those you've read here, click on the
following link:

The Fleet Street Letter
http://www.agora-inc.com/reports/FST/SecretLogic/

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• An Incomplete Recession / The Daily Reckoning - - ELLI -, 24.11.2002, 18:55