The Law Of Accelerating Returns / The Daily Reckoning

verfasst von - ELLI -, 28.11.2002, 18:19

-->The Law Of Accelerating Returns

The Daily Reckoning

Paris, France

Wednesday, 27 November 2002

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

*** They've got printing presses at the Fed!
Lenders are flush...but borrowers may already be down the
drain!

*** Foreclosures at 30-year high...bankruptcies hit new
record...profits still going down...

***"Talking your book"...heating supplies
"tenuous"...world's top performing market...a gold
recommendation...and more!

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

After a great and glorious binge - in the late '90s - of
stock-buying and borrowing...lying and cheating...and
living it up as though there would be no tomorrow,
tomorrow came. The nation fell into a miserable slump,
with crashing stocks, disappearing profits,
recession...and titans of industry hauled off in hand
cuffs.

Alan Greenspan's Fed decided it was time to put the
nation into a 12-step recovery program.

Month after month, he cut rates, until there was not much
left to cut. Shortest term dollar deposits earn only
1.25% interest...while the inflation rate is around 3%.
In effect, the central bank is already giving money away.

And yet, where's the recovery? Corporate profits
continued to fall in the last quarter, even faster than
they did in the quarter preceding it. Bankruptcies, in
the 3rd quarter, were rising at a double-digit rate. The
holiday shopping season looks as though it might be grim.
The number of homes in foreclosure is at a 30-year high.
And revenue shortfalls among state governments are so bad
that the governors called it the"worst budget crisis"
since WWII. (See: Stupid Capitalism:
http://www.dailyreckoning.com/body_headline.cfm?id=2674)

"Lenders are flush," says a USA Today article. But it may
be too late for the borrowers. The water is high and
beginning to swirl. They"have so darned much debt that
even at low rates it's hard to pay," reports USAToday.

"Debt hounds those at the edge," says a Chicago Tribune
headline. Freddie Mac, chartered to spread the joy of
debt to the multitudes, decided to turn the hounds loose
on those in the middle, too - raising its limit on
mortgages from $300,700 to $322,700.

But now that Greenspan has completed his 12-step
program...and real rates are well below zero, what next?

Ben Bernanke, one of the Federal Reserve's seven
governors, whom we quoted yesterday, followed up by
saying"The U.S. government has a technology called a
printing press - or, today, its electronic equivalent -
that allows [the Federal Reserve System] to produce as
many U.S. dollars as it wishes at essentially no cost."

"There is virtually no meaningful limit to what we could
inject [from the money supply] into the system, were it
necessary," added the chairman.

Technically correct, for the Fed could always charter a
fleet of helicopters and drop $100 bills over lower
Manhattan, but as a monetary policy, printing money is
not without its drawbacks.

The essential requirement of money is that it be
valuable, which requires that it be of limited supply.
But that is also the essential problem with all managed
currencies. Its managers may create more of it when it
suits them, but never so much that the illusion of
scarcity is destroyed.

The U.S. economy, we keep reminding ourselves, earns less
than it spends. The difference is made up thanks to the
kindness of strangers in foreign countries. If those
foreigners ever begin to feel that the dollar is not what
it is supposed to be, they will dump greenbacks in favor
of other colors, say, the blue and pink of euro notes.

"What the U.S. owes to foreign countries it pays - at
least in part," observed Charles de Gaulle in 1965, a
full 37 years ahead of Greenspan and Bernanke,"with
dollars it can simply issue if it wants to."

De Gaulle was first in line at the 'gold window' at the
Fed, where he exchanged his dollars for gold and brought
the world's monetary system crashing down. Nixon slammed
shut the gold window and the price of gold began to move
upward. Over the 12 years leading to the peak in January
1980, gold gained 30% per year - exceeding the return on
stocks in any 12-year period in history.

Gold bugs were so excited by this that they bought - even
as gold reached $800...and regretted it for the next 22
years. Now, the price of gold moves up cautiously...the
gold bugs have less money and more sense. Still, on the
open market - if no longer at the gold window - the neo-
de Gaulles of this world have a way to exchange their
dollars for gold. Greenspan and Bernanke must be causing
them to think about it.

Central bankers are as human as gold bugs; the thought
must have occurred to them. If they can manage a
currency, they can mismanage it too. More below...

Eric, give us the latest from the dream capital of the
world...please.

----------

Eric Fry in New York...

- On Monday, Baltimore's celebrated mutual fund manager,
Bill Miller, proclaimed that the bear market is
over...finished...kaput. On Tuesday, the Dow skidded 173
points...Go figure. Miller's"Legg Mason Value Trust
Fund" has outperformed the S&P 500 for the past 11 years.
So that makes him an expert, right? Well...yes and no.

- While Miller's fund may have bested the S&P 500, it has
still managed to fall more than 40% since March of 2000.
Mr. Market doesn't seem to like experts very much...As
soon as somebody becomes one, Mr. Market is sure to make
an idiot out of him.

- Miller is no idiot - not yet anyway - but he is prone
to the sort of myopic optimism about financial markets
that leads a man to pay very rich prices for stocks. And
Miller has paid some very, very rich prices over the last
few years for stocks like Amazon and Tyco, which is why
his shareholders have lost so much money since March of
2000.

- If you had lost 40% of your money buying expensive
stocks, wouldn't you be proclaiming the end of the bear
market, also? Among professional investors, the act of
predicting what you hope for is called"talking your
book." No doubt about it, that's what Miller is doing.
He's predicting the end of the bear market because that's
what he HOPES will happen.

- Here at the Daily Reckoning, we have no"book." We
simply call 'em as we see 'em. And what we see is an
expensive market that should be falling rather than
rising. Yesterday, it did what it was supposed to do. It
fell. The Dow dropped nearly 2% to 8,676, while the
Nasdaq fell 37 points to 1,444.

- Yesterday's selloff was somewhat ironic, given the fact
that so much good news crossed the newswires. First up,
third-quarter GDP was upwardly revised to a 4% growth
rate from the previously reported 3.1% rate. Next,
consumer confidence jumped in November from 79.6 to 84.1
- breaking five straight months of declines. But these
hopeful news items fell on deaf ears, as investors took a
break from buying stocks to buy bonds.

- Despite yesterday's gains, bond rallies have been few
and far between these days. Several weeks ago in the
Daily Reckoning, we raised the possibility of a"bond
bubble." The fact that bond prices have been tumbling
ever since has done nothing to undermine our theory. The
prospect of a bond bubble is alive and well.

- One classic feature of any full-scale bubble is
widespread ignorance about the asset class that the hoi
polloi is so feverishly purchasing. (Remember when folks
paid $71 for each share of TheStreet.com on the day of
its IPO in May of 1999? What were they thinking? Did the
buyers have any inkling what sorts of miraculous feats
the company would have had to accomplish in order to
merit its fleeting $1.5 billion market cap?)

- On the mass-ignorance scale, the prospective bond
bubble qualifies nicely. According to a recent poll by
the Vanguard Group, very few bond fund buyers understand
the connection between price and yield, or, for that
matter, the connection between a rising yield and rising
capital losses. According to Vanguard's online"literacy
test," 70% of respondents did not know that bond prices
and interest rates move in opposite directions.

- Even so, a record $116 billion poured into bond funds
during the first nine months of this year, according to
the Investment Company Institute. The fact that a lot of
"dumb money" is throwing billions of dollars worth of its
dumb money at the bond market is not incontrovertible
proof of a bond bubble, but neither is it a very
encouraging sign...

- Not that anyone cares, but supplies of oil and heating
oil are relatively lean at the moment. U.S. distillate
inventories (that's stuff like heating oil) fell for a
third-straight week, and supplies now stand 11% below the
year-ago level as the market heads into the winter demand
season, according to the American Petroleum Institute.

- Petroleum supplies are in a"tenuous situation," one
oil analyst told CBSMarketWatch -"in every major
category, supplies are well below where they were a year
ago. It can't make you feel too warm and cozy as we head
into winter season." I'm feeling chilly already.

---------

Back in Paris...

*** The last shall be first. This from Evan Pickworth,
our correspondent in South Africa:

"Data compiled by Dow Jones Newswires show that South
Africa's JSE Securities Exchange South Africa (JSE) is
the best-performing equity market in the world in US
dollar terms since the start of the year up until the
close on November 22.

"Its gain over that period is 33.15%...almost double
second-placed Thailand's 17.84% gain and in sharp
contrast to the world's largest stock market, the US,
which has slumped by 18.93% so far this year.

"The global index has declined by 16.37%. If the US is
excluded from the global index, the performance is a
decline of 13.46%.

"Most of the rest of the world has followed the US into
negative territory. Of 34 major equity markets tracked by
Dow Jones Newswires, only six (Austria, Indonesia, New
Zealand, South Africa, South Korea, and Thailand) were in
positive territory."

*** Abby Joseph Cohen is still bullish, which confirms
our view that the market has further to fall."Recent
data points," says Goldman's chief seer,"do not support
ugly scenarios."

***"Gold shares may offer light in the equity gloom,"
says a Reuters headline. Britain's only gold fund,
Merrill Lynch's Gold and General, is up 53.9% in the
first 10 months of 2002. Over the last 10 years it rose
400% - while the price of gold actually declined.

Gold shares"have a habit of doing well when other assets
are doing badly," said Graham Birch, the fund's manager.

*** James Grant of Grant's Interest Rate Observer makes a
recommendation: buy the new Newmont. The company is in
the gold mining business. The new Newmont came about when
the old Newmont merged with Franco-Nevada of Canada and
Normandy of Australia; presumably, the people who run the
business are better at mining than geography. Not that
the company makes a lot of money. Au contraire, on a
price-to-earnings basis, Newmont is expensive. But the
company has a lot of gold - an estimated 97 million
ounces of proven or probable reserves. When doubts arise
about the real value of paper currencies, a lot of gold
is a good thing to have.

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year! Gold funds gained 39% through the end of March,
pushing the sector into first place. Precious-metals
funds gained an average of 72% in the last 12 months. And
that's only the beginning of the rally...

Find out how to detect BIG PROFIT buys like these and
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---------------------

The Daily Reckoning PRESENTS: Historically, small caps
outperform larger companies...but it was not so during
the bubble years. Jim Davidson argues small caps will
make a resurgence once a major flaw in tracking of stock
deliveries is rectified.


THE LAW OF ACCELERATING RETURNS
by James Davidson

More than 20 years ago, in 1981 to be exact, a graduate
student produced an important research paper comparing
the returns on stock investment based on market size from
1926 through 1969. Much to everyone's surprise, he proved
that large-cap stocks - the ones that everyone knows
about, such as IBM and GE - significantly underperformed
smaller companies that most people have never heard of.
He showed that small-cap stocks had risen at a compound
rate of return of 12.1%, as compared to 9.8% for large-
cap stocks.

The premium performance of small caps resulted in a huge
difference in wealth accumulation in the long run.
Portfolio theorists were fascinated by the findings and
immediately began to seek explanations for the divergence
in returns. A few simple explanations seemed to account
for most of the difference.

The first explanation suggests that smaller companies can
be more effective than larger ones in evading
competition. Smaller companies can serve"niche" markets,
where they may face less competition and consequently can
charge higher prices. Higher prices then lead to higher
earnings, and thus a higher stock price. For obvious
reasons, large companies are seldom found engrossing
niche markets, although Microsoft might have been an
exception for a time. The idea was that the"niche"
strategy provides a sustainable competitive advantage
that could explain why some small-cap stocks have
outperformed larger companies over time.

Of course, sometimes the"niche" market is also a new
market, and among the factors forestalling competition is
patent protection. Many fortunes have been made on
investments in small-cap companies employing patent
protection to develop niche markets.

The second reasonable explanation shows that smaller
companies are often in emerging industries, and therefore
have the possibility of generating huge earnings growth
in the future. The greatest opportunities for wealth
creation arise from buying the stock of a small-cap
company that has the potential to grow into the next
Microsoft or Intel.

For reasons of simple arithmetic, it is implausible that
an investment in Microsoft or Intel today could compound
as far as investments in companies like GeneMax, a
company developing immunotherapy treatments, can if they
attain their potential.

At $8 per share, GeneMax has a market cap of about $121
million. If its immunotherapy, which has effectively
cured cancer in laboratory animals, works as well in
people, it is easy to imagine that GeneMax could be worth
$80 per share, or even $800 per share. I don't know what
a cure for cancer would be worth. But it could be worth a
lot. GeneMax could grow a hundredfold in value. Or maybe
a thousandfold. To attain a market cap equivalent to that
of Microsoft, GeneMax would have to reach a share price
of approximately $15,500 per share based on the current
number of shares outstanding.

The Microsofts of the world cannot easily grow a
hundredfold in value. At its recent price of $43.77 per
share, Microsoft had a market cap of $234.76 billion.
While it is unlikely that the GeneMax stock price could
appreciate by almost 2,000-fold, it is impossible that
such an appreciation could happen again to Microsoft. To
be more precise, for Microsoft to compound by 1,960
times, equivalent to the growth that GeneMax would
require to become the size of Microsoft now, Microsoft's
market cap would have to exceed the GDP of the United
States by about 45 times over.

It does not take a divine genius to see that that is
unlikely. Put simply, very-large-cap companies cannot
grow much faster than the economy as a whole. They
certainly cannot duplicate the growth rates that are
possible for mini- and small-cap companies.

Given the strong track record of small-cap companies in
the half century prior to 1981, it is hardly surprising
that a number of new-money management firms were founded
in the early '80s with the express purpose of investing
in small-cap stocks.

We know small-cap stocks dramatically outperformed large-
cap stocks from 1926 to 1969, but over the last 15 years,
from 1987 to 2002 - after the small-cap"anomaly" was
discovered in 1981 - the returns have not met the
expectations that the research supported. In fact, after
the experience of the 1990s, most investors probably feel
that large caps outperform small caps. Almost everyone
has had a personal experience of a small-cap holding that
seemed promising but ended up plunging in price.

From 1987 to 2002, the S&P 500 generated a compound
annual rate of return of 12.1%, while the smallest
capitalization stocks averaged only marginally better -
12.6%. The strong performance of the large-cap S&P
relative to small-cap stocks is particularly noteworthy
in that there are strong reasons to expect large-cap
stocks to underperform ever more significantly.

For example, Ray Kurzweil, a computer scientist at MIT,
has recently calculated that we will see a century of
technological change in the next 25 years. Kurzweil
believes that exponential growth of computational power -
up by an astonishing 40 billion times in the past 40
years - has set the stage for ever-accelerating
technological change. This exponential growth, which he
calls"the law of accelerating returns," proved
predictive of many of the technological advances at the
end of the last century.

According to Kurzweil,"the rate of technological
progress is speeding up, now doubling each decade."
Kurzweil believes we will see 20,000 years of
technological progress by the end of the 21st century.
Rapid-fire technological change of the kind foreseen by
Kurzweil turns the logic of 20th century investment
strategy upside down. It makes investment in smaller
companies with simpler business models, paradoxically
more attractive than blue chips like Cisco Systems or
conglomerates like Tyco or even General Electric.

No one has ever become wealthy buying shares in companies
that were already successful. To make big money, you have
to buy when companies look like dogs, and most people
doubt that they will ever succeed. John Templeton based
his fortune on buying shares of the hundred lowest-price
companies he could find listed on stock markets before
World War II. Even during the Great Depression,
profitable stocks did not trade below earnings.

That said, it is important to understand why the over-
performance of small-cap stocks has virtually vanished at
a time when technological change should have given an
added impetus to smaller companies.

This is a complicated issue. Part of the explanation for
the greater performance of large-cap stocks is the
buoyancy of the market itself during the decades of the
1980s and 1990s. During the 1980s, for example, stocks as
a group returned 17.57%. During the 1990s, returns were
even higher - 18.17%. Only during the 1950s did market
returns exceed those in the last two decades of the 20th
century.

Obviously, when markets are compounding at a high rate,
small-cap companies soon become large-cap companies, and
thus escape from the category. Microsoft was a small-cap
company when it began trading on March 13, 1986. But
after the rapid growth of its business and eight stock
splits, it migrated into the"large-cap" category. So
paradoxically, part of the reason that small-cap
investment appeared to be less successful was precisely
because it was so successful.

But there is also a darker subtext to the issue. It
involves market manipulation made possible by well-
meaning institutional responses to the staggering
increase in trading volume on U.S. stock exchanges. Prior
to 1829, total stock trading volume in America never
reached even 50,000 shares a day. By 1886, daily volume
first ballooned to more than one million shares.

Yet even in the heady days of the 1920s, stock ownership
remained relatively narrowly based and volume relatively
small. Indeed, the last time daily trading volume fell
below 1 million shares was in the Eisenhower
administration, on Oct. 10, 1953. By 1972, daily trading
volume exceeded 15 million shares per day. By the end of
last year, volume had exploded to more than 2.5 billion
shares per day, more than a 10-fold increase from the
early 1990s and thousands of times greater than in the
early '50s.

This stupendous explosion of trading volume created a
logistical challenge of the first magnitude, namely how
to transfer stock certificates to reflect the changes in
ownership from sales and purchases by customers. In the
infancy of stock trading, when volume was light, it was
relatively simple to effect delivery of shares.
Messengers scurried around and delivered paper
certificates by hand from one investment bank to another.
In 1924, the Stock Clearing Corporation was established
to facilitate trading. But with trading volume escalating
into the billions of shares daily, securities dealers and
stock market officials sought a better way to clear their
trades. The result was electronic clearing organized
through the Depository Trust Company.

The Depository Trust Company is a trust company organized
under the banking laws of New York State. It is owned by
banks and broker-dealers. It is a custodian of securities
that effects"book-entry delivery" in which"transfers of
securities within the DTC system are processed by debits
and credits to Participants' accounts."

In reviewing a lot of material about the DTC, which I
must say is obscure and boring in the extreme, I got the
distinct impression that its organizers were more
concerned with effecting payment for securities than with
the niceties of securities delivery. The DTC says,"DTC
does not itself guarantee any funds or securities
transfers which its Participants are obligated to make."
The DTC is organized on the assumption that broker-
dealers, market-makers and clearing agents are all
operating in goodwill and need looking at mainly to
ascertain that their wire transfers in payment for
securities don't go astray.

Where this electronic settlement becomes an issue is when
it comes to the shares of mini- and small-cap companies
traded on the Pink Sheets, the OTC and the Nasdaq. The
rules and conventions that have arisen around electronic
settlement effectively permit unscrupulous operators
among the many thousands of broker-dealers to counterfeit
large quantities of stock, which they can sell for
payment.

Given the magnitude of the logistics problem in clearing
trades, it is understandable that this could happen. It
is much easier to monitor the delivery of payment than it
is to authenticate the delivery of shares, especially in
an electronic clearing system where every broker-dealer
has the de facto capability of counterfeiting securities
by simply finding a buyer for them.

Say you want to buy a million shares each of GeneMax and
another small cap company. Market maker Doaks has shares
of neither. But, either on behalf of some client or on
his own account, he sells them to you, crediting your
broker's account with 1 million shares of GeneMax and 1
million shares of the other. Your broker now has an
electronic credit for those shares, against which he
wires funds or nets funds against his credit at DTC to
Doaks' Participant account there. Thus are counterfeit
shares created and put into circulation.

Doaks or his client has pocketed a lot of money for
counterfeiting shares he did not have. And your broker
has an electronic credit for those shares at DTC. When
another of his clients dies, the executor of his estate
orders the liquidation of his account, including 500,000
shares of GeneMax. The credit for those shares originally
concocted by Doaks now transfers to the account or
accounts of the participating broker-dealers whose
clients bought the GeneMax shares from the estate. And so
on.

Ostensibly, broker-dealers have the capacity to sell
securities they don't own and don't have to borrow - as
you would if you were selling short - to facilitate
market-making. In theory, the broker-dealers can sell
quantities of stock they don't own in order to make an
orderly market and prevent the price from spiking on big
buy orders. In theory, abuses are limited by the
requirement for the market-maker to post capital and
limit"naked short sales" of any one issue to 10% of the
capital account.

That is the theory. The reality is a bit more ugly. No
one is really monitoring the aggregate impact of the
counterfeit sales on any given issue. It is simple to
confirm that payment has been rendered for a sale. When
the cash credit is transferred between participants
within DTC or the Fed wire hits, the issue is resolved.
But in an electronic, book-entry deposit system, every
credit for a share purchased is indistinguishable from an
actual share issued by the company treasury, even if it
was counterfeited. No one bothers to reconcile the share
credits in the DTC system with the authorized, freely
trading shares of the company.

Consequently, it is quite common for the effective float
of small-cap companies to be inflated significantly by
electronic counterfeiting. In some cases, the total
effective float has been multiplied many times over.

Hence the sometimes weak performance of mini- and small-
cap stocks. Their stock prices plunge because the supply
of stock is artificially multiplied by naked short
selling, better understood as electronic counterfeiting.
Unscrupulous broker-dealers and market makers can
effectively drive the prices of stocks into oblivion by
selling vast quantities of stock not issued by the
company.

Having come to understand this, I see an urgent need to
curtail this electronic counterfeiting of the shares of
small-cap companies. It not only fraudulently deprives
investors in the affected companies of wealth but it is
also destructive to the economy. And the news media
seldom deign to report on it. Other than a few minor
squibs on the news pages of The Wall Street Journal,
there has been virtually no coverage of this issue.

Indeed, it is so obscure that you may not even know what
I am talking about.

If so, that only underscores the need to shed more light
on this predatory practice. I should also say that I am
confident that this problem will be rectified.
Maintenance of honest and orderly capital markets is
tremendously important to the economy of the United
States.

Sincerely,

Jim Davidson,
for The Daily Reckoning

P.S. Having made the argument for small caps, and shed
light on the potential for small cap manipulation...you
should also know that small-cap stocks are more volatile
and"riskier" than large-cap stocks. Small-cap companies
generally are more heavily indebted relative to their
income than their large-cap counterparts, meaning their
earnings are more leveraged. Small-cap companies have
fewer assets than large-cap companies. Small-cap
companies are statistically more likely to go bankrupt
than large-cap companies. So portfolio theorists
calculate that the extra return you get over time is a
result of investors being compensated for bearing more
risks. Keep that in mind if one or more of your"high-
upside" stocks bites the dust.


Editor's note: James Davidson is a best-selling author
and venture capitalist. His articles have appeared in The
Wall Street Journal, Investor's Business Daily, The
Washington Post and USA Today. Mr. Davidson currently
sits on the boards of over 20 small-cap companies, and
has been invited to join Merrill Lynch's technology
advisory board.

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• The Law Of Accelerating Returns / The Daily Reckoning - - ELLI -, 28.11.2002, 18:19