-->Dangerous Reactions

The Daily Reckoning

London, England

Wednesday, 3 March 2004


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

*** Gold down big... dollar up big... Big deal? Maybe...

*** A fortuitous encounter, continued... why Harvard
economic professors don't bother with implementation...

*** Remarkable market predictions... does Mars have a sense
of humor?... the legacy of Viet Nam... and more!

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

We have only two thoughts this morning - both of them
arrogantly humble....and both concerning gold.

We admit that there is more under heaven and earth than is
contained in our philosophy... but we give it to you anyway,
because it is all we've got.

In our humble opinion, the tide is going out on the wet,
wild world of American consumer-led global dominance. But
don't worry, dear reader. A tougher, stonier, more
difficult world will be revealed... but it will be a better
one.

The trouble with consumer-led prosperity is that it is a
fraud. You can't spend your way to prosperity; instead, if
you really want to grow rich, you have to avoid
spending... and concentrate on saving, training, investing,
learning... and all the other things that most people don't
want to do.

After all, if getting rich were easy, everyone would be
rich. They're not.

The vast majority of the world's population is poor. The
Chinese, the Indians, the Nicaraguans and people all over
the globe will work for $5 a day and say 'thank you' for
it. If they had the machines, the capital, the skills, the
training, and the luck that Americans have had, there is no
reason that their work would be any less valuable to the
rest of the world than the work of an American. And guess
what - they're getting all those things.

Meanwhile, our fellow countrymen believe that the key to
growth and wealth lies in consumer spending. So, the Feds
lower rates and cut taxes to give consumers more
wherewithal - to borrow and spend.

The U.S. used to make things and sell them overseas.
General Motors was our biggest employer... and our balance
of trade was in our favor. When Eisenhower was in the White
House and William McChesney Martin was at the Fed, the U.S.
had most of the world's gold... and most of the world's
credit. Foreigners owed us far more than we owed them. This
happy state of affairs persisted until the reign of Ronald
Reagan and Alan Greenspan... when the U.S. became a net-
debtor to the rest of the world and Wal-Mart - a retailer,
not a manufacturer - became its biggest employer.

In America's post-industrial economy, consumer spending is
what counts; it is 70% of the GDP. Economists, politicians
and TV teleprompt readers give loud huzzahs at the latest
GDP figures... but numbers themselves have become an
accomplice to fraud. The faster they go up, the faster
Americans ruin themselves with more debt and more spending.

Of course, you can fool economists, the press, and the
lumpen-voters almost forever. But, in the long run, the
splashing waters of the marketplace turn even lies of
granite to powdery sand. The erosion began with the bear
market in stocks of 2000-2002... the bear market in the
dollar of 2001-2004... and the bull market in gold of 1999-
2004.

If we're right, these trends have only just begun. But -
and here, dear reader, we would like to reduce expectations
- these sorts of multi-year mega-tides in the affairs of
men do not lead to fortune easily. There are always counter
currents and riptides... whirlpools and eddies... that make
us doubt ourselves and abandon our positions.

Gold has gone from $253 in the late '90s to near $400
today. It would not be surprising to see a correction down
to say, $350 or lower before the next advance. The dollar
lost 40% against the euro. There, too, a major correction
may be underway.

We say this because, yesterday, gold fell $5.80... and the
dollar rose to $1.21 per euro. These were major moves and
could signal major corrections.

Should you try to trade these moves? Should you sell your
positions and wait until the waters calm? We don't know. We
are neither traders nor clairvoyants. But the tide has
turned, we think. And for our part, we bought more gold
last week. We have set out to sea in our little golden
bark... we will stay aboard and wait to see where it takes
us.

Over to Addison, in Paris, with more news:

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

Addison Wiggin, back in the saddle after a week-long
journey to and from Mexico...

- One question: What is the hapless market observer to do?
Just when we were beginning to enjoy a few macro-trends -
gold going up; dollar dropping down; lumps deluding
themselves en masse in the stock market - we go on a little
junket to Mexico and all hell breaks loose...

- For example,"against all odds, the dollar is rallying,"
we found ourselves writing this morning. The fundamentals
are no different today than they were on February 18 - when
the dollar reached an historic low against the euro, at
$1.2928. Yet now, the dollar climbs.

- Looking for reasons why, we think we can hear currency
traders whispering."Shorting the dollar is a very 'crowded
trade' these days," they mutter."Perhaps its time to buy,"
one speculates..."The ECB will drop rates when they meet
Thursday," another surmises,"sell euros"..."Japanese bonds
investors failed to show up at a bond sale yesterday,"
still another remarks,"they may be losing interest in the
Nipponese dollar-buying strategy... sell yen."

- And so the dollar gains ground by default. Suddenly,
after sipping a bit of the elixir of success... we're
beginning to feel a little woozy. Gold's nearly six-buck
plunge yesterday came on the heels of a three-dollar rally
the day before. What will happen today? Tomorrow? We're not
sure...

- But neither does Mr. Market seem to have a clue.
Following Monday's big rally to a two-week high, the Dow
shed 86 points to close at 10,591 - its biggest sell-off
since the Fed removed two goofy words from its post-FOMC
press release. The S&P and Nasdaq each got the wind knocked
out of their sails yesterday, too, selling off 6 and 18
points respectively.

- At this rate, only a healthy dose of bad news could get
the markets moving in a comfortable direction again. And
this week... we may just get one.

- It's a big week for economic reports, you see. As Eric
reported yesterday, we learned that in January, Americans
continued to borrow faster than their pay increased.
(That's not good). Jobless claims come out tomorrow (we're
not holding our breath). Today, the Fed's"Beige Book" will
give us a region-by-region report on the success - or lack
thereof - of their current goose-and-pray economic strategy
(not likely to be all impressive, but we do expect it to
smell pretty). Then on Friday, the doozy...

- Early projections show that non-farm payrolls will climb
from 112,000 in January to 128,000 in February. The number
will be an improvement, to be sure, but not enough to keep
pace with"official" immigration. So the"official"
unemployment rate will actually climb a point to 5.7%.
That's a number certain to give pause to those economists
prone to repeating the Greenspan-Bernanke mantra -"jobs
are on the way, jobs are on the way" - even if only a brief
one.

- Last week, on the plane from Paris to Boston - the first
leg of our trip to Puerto Vallarta - we had the fortuitous
occasion to sit next to one of the faithful: an economics
professor from Harvard, whose office is across the hall
from Greg Mankiw, chairman of the president's Council of
Economic Advisors, and who is a neighbor of former IMF
chief economist Ken Rogoff. He even claims to have been
recruited, at one point, by Ben Bernanke to teach at
Princeton.

- A diminutive man of French descent, the professor almost
immediately set upon"chatting up" the woman sitting on his
left. She, it turned out, was an executive with Genzyme,
the biotech firm. Having discovered he was an economics
professor (a fact he was only too happy to reveal), she
wanted to know if"offshoring" was going to pose a serious
threat to wages in the biotech business."Ah, to some
extent," he replied,"but I wouldn't worry about eet... ze
recovery iz underway, and ze jobs picture will eemprove
dramatically very soon."

- The lesser of your two evil Parisian editors could not
resist."I couldn't help overhearing your comment," he
blurted out, despite his best efforts not to."Do you
really think jobs are going to reappear? Seriously? Even
with public and personal debt loads going through the
roof?"

- What ensued wasn't pretty. (Especially since we were
taking liberal advantage of Air France's free wine policy
on the flight).

"The currency markets don't like the federal deficit, so
dollar is falling, correct?" we began our circular
argument."Zat is right," came the reply.

"A falling dollar cancels out gains by foreign investors,
true?"

"Right again..."

"And foreign investment is needed to finance the trade
deficit. So if the dollar continues to fall... interest
rates will have to rise in order to keep foreign investors
interested?"

"Yez..."

"If interest rates rise, won't that impede job growth?"

"Indeed..."

"Likewise," we continued, gloriously entertaining visions
of Socrates in our head,"if an increasing money supply
starts showing up as 'inflation' in the CPI, wouldn't that
cause the Fed to raise interest rates?"

"Oui, bien sûr. But eenflation eez still low. And the Fed
must steemulate job growth. They have a théorie: it eez
called the 'licopter théorie'..."

"Bernanke's suggestion to throw money out of helicopters?"

"Yez, that is it... you know 'im? Becauz I know him..."

"No."

"Hee is very smart. The Japaneez could have used the
'licopter théorie... we don't need eet... we only need ze
jobs..." We could tell he was getting impatient... clearly
we just didn't get it.

Still we persevered:"Aren't jobs showing up in India, at
lower wage rates? Won't any new jobs in the U.S. have to be
competitive with those wages? Effectively mutating the
'jobless recovery' into the 'wageless recovery'?" The
Genzyme exec squirmed in her seat a little.

"Besides," we tried again,"at some point, won't the
government, regardless of the party, have to raise taxes -
or, better yet, cut spending - in order to deal with the
deficit? Both of which could effectively put an end to the
stimulus package? And with no stimulus, where will the jobs
come from?"

"Meester Wiggin, my work eez mostly on the teoretical end
of tingz..."

"Well then, theoretically, where will the jobs come from?"

"Meester Wiggin, I leave the eemplementation to other
people. And now, eef you forgive mee, I have a lecture to
prepare for..."

- We tried to put on a movie, but our personalized monitor
was broken. As we left the plane... after several hours of
silence and polite nudges on the arm rest... we scribbled an
e-mail on the inside of the French copy of Financial
Reckoning Day and pressed it into his hand.

- Curiously, he has yet to respond.

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

Bill Bonner, back in London...

*** One of the most remarkable market predictions we've
seen involves a comparison between WWII and the War on
Terror. WWII proved to be a good time to buy stocks, writes
one benighted forecaster, and the War on Terror will prove
to be an investor's pal, too.

We don't know. So far, the forecaster has not been far from
the mark. But from what we have read, the only real
comparison between the two events is the three-letter word
people use to describe them: war.

The thought crossed our mind when we read London's Daily
Telegraph this morning. We normally read the obituaries
first. But here we found a near-obituary... an account of a
the"White Mouse," a WWII heroine who is not dead yet.
Nancy Wake, now 91, was awarded the Order of Australia
medal... to be added to her collection which includes the
George Medal, three Croix de Guerre, the Médaille de la
Résistance, the American Medal of Freedom, and the insignia
of Chevalier in the Légion d'Honneur. At the age of 28, she
"parachuted into occupied France, was machine-gunned by a
German aircraft while escaping in a car, cycled 270 miles
in three days through numerous enemy checkpoints with vital
radio codes, and killed a German guard with her bare hands
while sabotaging a factory."

Her French husband, the report continues,"would later die
under torture refusing to disclose his wife's whereabouts
to the Germans."

*** Below the item about Ms. Wake is a little note about
the War on Terror, from the Afghan front. Seems the spirit
of capitalism has returned to the Hindu Kush:"Cut price
heroin is expected to flood Britain's streets after a huge
increase in poppy production in Afghanistan, the United
Nations says today."

*** And here's a note from our unpaid correspondent, Byron
King, writing from Pittsburgh... and thinking of Mars:

"Does Mars, the God of War, have a sense of humor? Or is he
just mean? Viet Nam screwed up the destinies of the two men
who would one day compete for the presidency of the nation.
Viewed from the very large perspective, Viet Nam created
fault lines in every other aspect of American culture and
politics. And those fault lines still cause earthquakes.

"... The [single most enduring] legacy of Viet Nam is a
mismanaged fiat currency. The three biggest industries in
the U.S. today are government, housing and automobiles,
which are all forms of internal consumption, financed by
cheap dollars. Not to rain on the picnic, but there is no
significant export market for government, housing and U.S.-
built automobiles. What with a merchandise trade deficit of
about $500 billion per year, the nation's biggest export is
U.S. dollars, and these are units of currency now worth but
a fraction of their former value. At some point, sooner or
later - and I think sooner - the false economy will come to
an end.

"My concern is that, when things start to unwind, the
nation will be led by one or the other of two men and two
political parties for whom Viet Nam was formative. The Viet
Nam War will have come full circle, and Mars will be
standing at the door, demanding payment in full... and
probably in gold."

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

The Daily Reckoning PRESENTS: Are we in the middle of a
secular bear market? You may be tempted to underestimate
the significance of the downturn in 2000... and, as John
Mauldin implies below, you'd be in good company. But don't
be fooled... what goes up must still come down.


DANGEROUS REACTIONS
By John Mauldin

It is my contention that we are in a long-term secular bear
market cycle, speaking for the broad market averages that
are basically comprised of large companies. In this cycle,
I believe, we will see the price to-earnings ratio - the
'value' - of these index averages slowly come down.

The P/E ratio of the S&P 500 on March 31, 2000, was 29.41.
Today the level is at 29.46. That means the P/E for core
earnings (which is accountant speak for cash-in-your-pocket
earnings) is somewhere north of 35.

The market is still irrationally high, based upon historic
trends. It does not mean it cannot go higher. But it does
mean it will go lower eventually. History shows us that
valuations will revert to the mean over time and even move
significantly below trend. There has never been a time in
history when P/E ratios hit a range around 30, as they did
in 1999 and again at the end of 2003, that the broad stock
market outperformed a money-market fund over the next 10
years. Never.

Yet investors keep running stocks up to nosebleed
valuations and somehow expect that this time it will all be
different. It never is.

Let's look at some of the reasons for such behavior. They
are rooted not in mathematics and economic foresight, but
in psychology.

Economists Michael Kilka and Martin Weber provided a clue
to why investors go wrong in a paper called"Home Bias in
International Stock Return Expectations." They compare
German and U.S. investors. Each group feels more competent
about their home markets and stocks. And each group
assesses the probable future returns for their"home"
stocks to be higher than the foreign stocks. In other
words, simply because they are more familiar with a stock,
investors think it is more likely to go up than another
stock with which they are less familiar.

This is not just a German/U.S. issue. Another study in 1996
shows the exact same response from institutional investors
with regards to Japan and the United States. Yet another
study shows that the more we know about a stock, the more
likely we are to be optimistic and the more likely we judge
ourselves competent and to trust our analysis.

Familiarity in stocks does not breed contempt. It breeds
confidence. Worse, given enough time, it can breed
unreasonable confidence.

Keeping this in mind, I note that it typically takes years
for valuations to fall in bear markets to levels from where
a new bull market can begin. Why so long?

Because investors overreact to good news and underreact to
bad news on stocks they like, and do just the opposite to
stocks that are out of favor. Past perception seems to
prophesy future performance. And it takes time to change
those perceptions.

The power of investor overreaction and underreaction is
forcefully borne out by a study in 2000 by David Dreman
(one of the brightest lights in investment analysis) and
Eric Lufkin in"Investor Overreaction: Evidence That Its
Basis Is Psychological."

In any given year, there are stocks that are in favor, as
evidenced by high valuations and rising prices. There are
also stocks that are just the opposite.

Dreman and Lufkin (or DL for short) looked at a database
for 4,721 companies from 1973 through 1998. Each year, they
divided the database into five quintiles, based upon the
stocks' perceived market valuations. They then studied
price-to-book value (P/BV), price to cash flow (P/CF) and
the traditional price-to-earnings (P/E) results separately.
This created three separate ways to analyze stocks by value
for any given year, so as to remove the bias that might
occur from just using one measure of valuation.

The top and bottom quintile become stock investment
"portfolios." You might think of them as a mutual fund
created to buy just these stocks. From the time of each
portfolio's mock-creation, they then looked back 10 years
and forward five years to measure trends in price and
value. There was enough data to create 85 such portfolios
or funds.

Let me describe what I think are the more pertinent facts
that leap out as we go through their presentation.

Most notably, almost immediately upon creating the
portfolio, the price performance comparisons change
dramatically. The"in-favor" stocks underperform the market
for the next five years, and the out-of-favor (value)
stocks outperform the market.

I should point out that other studies, which Dreman does
not cite, seem to indicate that the actual experience of
many investors is more like these static portfolios than
one might first think. That is because investors tend to
chase price performance. In fact, the higher the price and
more rapid the movement, the more new investors there are
who jump in.

Remember the first study I mentioned? Not only do
perceptions of the past color the future, but those stocks
also become most familiar. And the more we learn about a
stock, the more we think we are competent to analyze it and
the more convinced we are of the correctness of our
judgment.

At five years prior to the formation of a portfolio, the
trends of each group were set in place. The next five years
just reinforced these trends. This, in turn, reinforces the
perceptions about these stocks and increases the level of
confidence about the future.

So to the bottom line... How much better did the highly
valued stocks do than the low-valued stocks in the 10 years
prior to creating the portfolios? The highest P/BV (price-
to-book value) stocks outperformed the market by 187% in
the 10 years before they were selected as top-quintile
portfolio stocks in the DL study. The lowest stocks
underperformed the market by -79%, for a differential of
266%! If you look at the P/CF (price to cash flow), the
differential between the two is 172%.

But what happened to investors was a different story. In
the next five years, the hot stocks underperformed the
market by a -26% on a P/BV basis, and -30% on a P/CF basis.
The out-of-favor stocks did 33% and 22% better than the
market, respectively. This is a HUGE reversal of trend.

So, what happened? Did the trends stop? Did the former
outcasts finally get their act together and start to show
better fundamentals than the all-stars? The answer is a
very curious"no."

In nearly every test DL made, the fundamentals for 'growth'
(high P/E, etc.) stocks are better than those for 'value'
(low P/E) stocks both before and after portfolio formation.

"Although there is a major reversal in the returns to the
best and worst stocks, there is no corresponding reversal
in the fundamentals [valuations]." [Ed note: In this study,
"best" means highest P/E, etc.] In fact, in many cases the
fundamentals continue to improve for the growth stocks and
deteriorate for the value stocks.

And yet, there is a very stark reversal in price. Why, if
not based upon the fundamentals?

Dreman and Lufkin conclude that the cause of the price
reversal was not, in fact, a change in fundamentals. Nor
was it risk. Instead, it was persistent investor
overreaction or underreaction.

The overreaction begins in the years prior to the stock
reaching lofty heights. As Nobel Laureate Hyman Minsky
points out, stability leads to instability. The more
comfortable we get with a given condition or trend, the
longer it will persist and then when the trend fails, the
more dramatic the correction.

When the correction first comes, we tend to underreact.
While we do not like the surprise, we tend to think of it
as maybe a one-time thing. Things, we believe, will soon
get back to normal. We do not scale back our expectations
sufficiently. It apparently takes years for this to work
itself out.

As DL note in their conclusion,"The [initial] corrections
are sharp and, we suspect, violent. But they do not fully
adjust prices to more realistic levels. After this period,
we return to a gradual but persistent move to more
realistic levels as the underreaction process continues
through" the next five years.

Would not, I muse, this apply to overvalued markets as a
whole? Might not this explain why bear market cycles take
so long?

Thus my contention that we are just in the beginning stages
of the current secular bear market. These cycles take lots
of time, anywhere from eight to 17 years. We are only in
year four, and still at nosebleed valuation levels. The
next surprise or disappointment will surely come from out
of nowhere. That is why it is called a surprise. When it is
followed by the next recession, stocks will drop one more
leg on their path to the low valuations that are the
hallmark of the bottom of secular bear markets.

Given the level of investor overconfidence in the
marketplace, and given the length of the last secular bull,
it might take more than one recession and a few more years
to find a true bottom to this cycle. It will come, of
course.


Regards,

John Mauldin,
for the Daily Reckoning