-->Macro Profit-Killers

The Daily Reckoning

London, England

Tuesday, 8 April 2003

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*** War! War! War!

*** Stocks up...gold down. Is the bull market in gold over?
How about the bull market in bonds?

*** Philip Morris as a public utility...and more!

War! War! War!

Here in London, as in America, newspaper and TV stations
talk of little else. Gone from the public eye are the
naughty vicars and corroded town councilmen.

Instead, the old generals and the young reporters enjoy
their moments of glory. The newshounds give us the latest
events from the Tigris and Euphrates...the old warhorses
tell us what they are supposed to mean.

Cynicism and irony seem to have been taken out - perhaps by
a very smart bomb - in the first minutes of the war. Caught
up the spirit of it all, who doubts that the whole thing is
noble and just...rather than sordid and absurd?

And amid all the noise of war, who notices that
unemployment continues to drop...that consumers become even
less able to spend...and that debts continue to build?

"More Job Searchers Just Stop Looking," says USA Today of
the employment situation.

And consumers say they are more likely to save this year's
tax refund than they were last year. And fewer say they'll
borrow this month.

For a huge economy such as ours, says Milton Friedman, the
costs of war in Iraq are negligible. And yet, the $75
billion set aside for the effort so far just covers the
first 6 months. The total price is unknown, but the costs
will stretch far into the future...including the cost of
rebuilding Iraq and pursuing America's new, activist
foreign policy. Look for total deficits of $1 trillion over
the next 10 years, says the Congressional Budget Office,
the same savants who previously projected a $5.6 trillion
surplus for the same period. More like $2 trillion in
deficits, say other analysts. And then along comes Goldman
Sachs with a deficit estimate of $4.2 trillion!

Wow...between the CBO's former estimate and Goldman's
current estimate is a chasm as wide as the entire national
GDP. Which just goes to show, when it comes to the
future...nobody knows anything.

But the war is a great distraction...for the humble and the
great. What national leader wouldn't want to be found ahead
of his troops...rather than behind some scheme to defraud
the taxpayers...and what vicar wouldn't rather be seen with
a colonel in full dress uniform than with the choir
mistress stark naked?

And now over to Eric Fry, with more news from Wall Street:

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Eric Fry, checking in from New York...

- Aggressive and persistent sorties into the stock market
by bullish investors yesterday morning pounded short-
sellers like so many Republican Guard troops. But the
"shorts" held fast and repelled the onslaught, reducing the
Dow's early 240-point advance to less than 30 points by the
closing bell.

- The shorts also repelled the Nasdaq's incursion into
bullish territory, reducing the tech index's advance from
more than 3% to less than 1%. The Dow finished the day
ahead 23 points to 8,300, while the Nasdaq Composite was
better by 6 points to 1,389. The dollar also picked up some
ground for the fifth straight day, ending the New York
session at $1.067 per euro.

- Collateral victims of the bullish advance on Wall Street
yesterday included bonds, oil and gold. These defensive
assets are providing very little defense - acting less like
safe havens than financial death traps. June gold fell
$3.80 to $322.20 an ounce after losing as much as $6 an
ounce; crude for May delivery fell 66 cents to $27.96 a
barrel; and the benchmark 10-year Treasury note fell half a
point, pushing its yield to 4.02% from 3.95% last Friday.

- We suspect that the final epic battle has not yet been
waged between richly valued stocks and lowly valued
commodities. A powerful counter-offensive from the
commodity corps would not be completely surprising.

- Bonds, on the other hand, are a riddle wrapped inside of
an enigma. Is it not an enigma, for example, that a titanic
global borrower like the United States pays less than 4%
per year to borrow money for a decade? And is it not a
riddle that bond yields have been falling, even while the
US government is running up large war debts and large
fiscal deficits?

- The answer to the riddle may be that investors -
individual and professional alike - have been so bloodied
by stock market losses that they've been piling into bond
funds. The bond fund managers, with the cash inflows
burning a hole in their pockets, robotically buy bonds
without worrying too much about the miniscule yields on
offer.

- Give a bond fund manager some cash and he will buy bonds,
just as assuredly as a wife with a platinum American
Express card will buy a pair of Pradas or Manolo Blahniks.
The purchase itself is a foregone conclusion. The only
unknown is the particular"size and style" of the purchase.

- To be sure, we agree with the simple wisdom of legendary
bond fund manager Bill Gross, when he remarked,"I still
prefer an overvalued Treasury to an overvalued stock." That
said, we would prefer a 1% CD to either of the two choices
Gross suggests. Buying an overvalued bond or overvalued
stock or overvalued anything else is like buying a raffle
ticket to win a litter of Siamese cats...winning is losing.

- Why then does the bond bull market keep chuggin' along?
Might the reason be that investors are afraid to buy
stocks? The lumpeninvestoriat, after taking their lumps for
three years in the stock market, have been cashing in their
stock funds to buy bond funds. There's nothing quite like
an excruciating 3-year bear market in stocks to goad
investors into bonds and money market funds.

- Individual investors have yanked about $59 billion out of
equity funds and put nearly three times that amount into
bond funds over the past 12 months. And so far this year,
bond funds pulled in $10.5 billion, a record for any
quarter, according to AMG Data Services.

-"In spite of their puny rates of return, money market
funds have surged in popularity," the Financial Times
reports."The relationship of funds in money markets to the
Wilshire 5000 index, which includes all domestic U.S.
common stocks, is up to 28 per cent. That is remarkably
high considering that, for most of the years between 1991
to 2000, the amount of cash in money market funds as a
percentage of the Wilshire never rose above 15 percent."
Just maybe, investors have purchased one bond too many.

-"Is the bond market another bubble that's about to
burst?" wonders Andrew Caffrey of the Boston Globe."Bond
mutual funds are still pumping out profits in the three-
year bear market, and investors are continuing to chase
performance, throwing billions into funds that buy
government and corporate debt. It's a scenario that looks a
lot like that other bubble, the one in the late 1990s when
the herd stampeded into stocks on the promise of ever-
higher returns, and equity mutual funds were awash with
money.

- Amazingly, Caffrey notes, many investors in bonds and
bond mutual funds don't even know the risks they're taking.
According to a Vanguard survey conducted last year, nearly
70 percent of respondents did not understand that when
rates rise, bond prices fall. This widespread ignorance
also suggests that most investors are unaware of the
potential for losing money in a bond fund.

-"Ignorance is bliss" may apply to marital affairs, but
not to financial affairs.

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Bill Bonner, back in London:

*** The price of gold fell again yesterday...dipping down
to $322. Gold buyers are getting discouraged, which is what
happens in the early days of a bull market. Two years ago,
an ounce of gold sold for only $255. Even at today's price,
gold is still up nearly 30% from its low 2 years ago. Is
the bull market in gold already over? We cannot say. But
never in the history of the world has a paper currency
outlived gold. Maybe this is a New Era...but not likely.

*** America's late, degenerate collectivized capitalism is
hardly the paradise investors recently thought it was. More
and more, businesses are run not for the benefit of
capitalists, but for the benefit of workers, voters,
lawyers, politicians and any hack who can find a way to put
his hand in the till.

We say this after reading about the latest multi-billion
judgment against Philip Morris. Big Mo's big crime was that
it sold cigarettes to people who wanted to buy them. Now,
it finds itself attacked by every shyster in the country.
So many parasites have attached themselves to the tobacco
company's hide that the firm is in danger of turning a
whiter shade of pale. Recognizing the risk to their blood
supply, the vermin are now battling among themselves in
order to find a way to keep the blood flowing.


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The Daily Reckoning PRESENTS: Since 1997, US profits have
headed South with all deliberate speed. In searching for
the culprit(s) behind the decline, says Dr. Kurt
Richebächer,"one must examine [the economy] from a
macroeconomic perspective"...


MACRO PROFIT-KILLERS
By Kurt Richebächer

In our opinion, the breaking of the U.S. economy's last
boom had one main cause: a sudden slump in business fixed
investment. But then, what exactly triggered this slump?
The short answer is a corporate profit carnage that has
been lingering for many years, and that has worsened
dramatically in the last few years.

While Wall Street celebrated a profit miracle, the reality
was America's worst profit performance in the whole post-
war period. The present U.S. profit carnage started in
earnest as early as 1997 - that is, at the height of the
economy's boom. In the following four years to 2001,
producer prices for finished goods increased altogether by
6.8%, or 1.7% per year. Over the same period, recorded
productivity in the non-farm business sector increased by
10%, or 2.5% per year.

Under these excellent price and productivity conditions,
profits ought to have soared during these years. But even
though the economy boomed, nonfinancial profits dived from
6% to 3.3% of GDP, their lowest level in the whole post-war
period.

After close investigation, we find that structural, profit-
impinging influences began to develop in the early 1980s,
but that they went to extreme excess during the boom years
in the late 1990s. There is a common denominator to all
such influences: a gross neglect of capital formation. In
the United States, the spending excesses went totally into
overspending on consumption, leaving an economy that has
become extremely lopsided toward consumption to the
detriment of capital investment.

The obsession with shareholder value has given rise to
virtual anarchy in many fields of economics. One of them is
macroeconomics, meaning the study of the economy as a
whole. To understand the U.S. economy's deteriorating
profit performance during the past few years, one must
examine it from a macroeconomic perspective.

Applying this perspective boils down to posing and
examining one single and simple question to all corporate
activities: How do such activities impact business revenues
in the aggregate? The emphasis here is on the word
aggregate. Changes in spending, saving, investing and, most
important, taxing cause changes in profits through their
effects on certain flows.

From the perspective of a single firm, firing labor, for
example, seems a straightforward device to boost a firm's
profits as it reduces costs. But looking at the economy as
a whole, the lower wage costs mean an equal lowering of
consumer incomes which, in further sequence, reduces
consumer spending at the expense of other firms' revenue
and profits. For the economy as a whole, wage-cutting is
clearly self-defeating as a device to increase profits.

Keeping this macroeconomic perspective in mind, let us
examine the provenance of business revenues. Examined in
the aggregate, business revenues have one major source that
is generally crucial for profit creation: their own net
capital investment.

Net capital investment is typically the single most
important profit source because - looking at the business
sector as a whole - it creates business revenue without
generating expenses. The reason is that the investing firms
capitalize this spending in their balance sheets. But to
the manufacturer who produces and sells the machine, it
generates a sale and revenue. No expense is incurred until
the first deprecation charge is recorded. A very high
correlation between movements of net investment and profits
is historically notorious.

As noted earlier, Corporate America's profitability turned
ominously bad during the 1980s. As you will remember, the US
was famous for its supply-side Reaganomics. In actual fact,
there was no supply-side improvement in resource allocation.
Fueled by easy money and wealth effects in the stock market,
consumption increased its share of GDP growth over the decade
by seven percentage points to 70%. Net nonresidential
investment, on the other hand, increased modestly between
1980 and 1989 from $129.2 billion to $153.4 billion. As a
share of GDP, it fell from 4.8% to 2.9%.

What actually happened during this decade was an unusual,
sudden sharp divergence between gross and net investment,
reflecting a massive shift in Corporate America's fixed
investment stance towards short-lived investment, mainly
high-tech equipment. Gross investment rose by $252.5
billion over the decade, or 70%, but depreciation charges
soared by $228.3 billion, or close to 100%, leaving very
little net investment. Only net investment, however, adds
to profits, while depreciation charges add to expenses.

As earlier explained, net business investment is typically
the economy's largest profit source. But this profit source
literally dried up in the 1980s. In the early 1990s, net
business investment performed splendidly - and so did
profits. But while net investment didn't turn sharply down
again until the great bust - when it crumbled from $407
billion to $268 billion in one year - profits began to fall
abruptly beginning in 1997.

A major culprit behind this downturn was clearly the trade
deficit. Over the 1980s and violently toward the end of the
1990s, profits came under heavy attack from the emerging
and soaring trade deficit, as consumers began to spend an
increasing share of their income on imported goods. The
crucial point to keep in mind here is that in the
aggregate, all incomes in an economy derive ultimately from
business costs. The problem with a big trade deficit is
that it diverts domestic spending towards foreign
producers.

Conventional opinion holds that the soaring trade deficit
squeezes business profits through price effects. It says
that cheap foreign competition deprives domestic producers
of their pricing power, as reflected in the declining U.S.
inflation rates. No doubt, this contributes to the profit
squeeze, yet it is not the main cause. By far the greatest
part of the economy - services, retail and transportation,
apart from airlines - is sheltered against foreign
competition.

Nevertheless, we share the view that assigns a key role to
the soaring trade deficit in hammering U.S. corporate
profitability. But the devil is not in the price effects of
the higher dollar. Rather, it is in the massive loss of
revenue that American businesses incur due to the outflow
of domestic spending to foreign producers. The problem is
that much of the money spent on foreign goods comes from
the wage expenses of American companies. If it were not for
the trade deficit, all this money would return to these
companies as Americans purchased domestic products,
bolstering domestic revenues and profits. Instead, the
trade deficit slashes U.S. business revenues in relation to
expenses.

But didn't all the money that exited through the current
account promptly return through the capital account, as
foreigners bought American assets? Yes, but again, from a
macroeconomic perspective, these flows match only in the
balance of payments, not in the economy. Capital inflows do
not invalidate spending outflows. Foreign purchases of U.S.
assets may boost asset prices, but they add nothing to U.S.
domestic incomes.

The steep slide of profits since 1997, happening against
the backdrop of extreme monetary looseness, low interest
rates and a booming economy, is shocking and indeed,
portentous. Altogether, it allows no further doubt that the
U.S. economy's protracted profit stress is not cyclical,
but of deeper-seated, structural nature.

This is a point that we have been emphasizing for years,
pointing also to the two major macroeconomic causes - a low
rate of net investment and the exploding trade deficit. It
has been and still is strict macroeconomic considerations
that induced us years ago to flatly disavow the brouhaha
about a profit miracle in the United States. And the same
considerations suggest to us that there is worse to come for
profits and the economy.


Regards,


Kurt Richebächer
for the Daily Reckoning