hazard is what central bankers call the problem — which
they have created — of excessive public confidence that certain
businesses are too big to fail, that the central bank will intervene
to save it. This leads to excessive risk-taking by investors as
well as corporate officers. They discount the possibility of bankruptcy.
This concern now applies to the entire U.S. stock market.
We are seeing a remarkable breakdown in a traditional relationship:
forced reductions in the federal funds rate and a rising stock market.
The old rule was “two cuts and a bounce” has not taken place this
time. When the Federal Reserve’s Open Market Committee (FOMC) has
intervened in the past to buy T-bills with newly created money,
the federal funds rate has fallen, and the stock market has risen.
I think this indicates that malinvestment in the American stock
market has progressed so far that “normal” injections of Federal
Reserve credit money no longer have the old-fashioned stimulus effect.
This is bad news for Alan Greenspan.
The FOMC began injecting new money into the economy 13 months ago
in an attempt to restore a faltering economy. The plan did not work.
The U.S. officially went into a recession last March. Only in the
fourth quarter of 2001 did preliminary figures indicate a slight
increase in the Gross Domestic Product: two-tenths of a percent.
But in most cases, the preliminary GDP figures are revised downward
later. I think this will be no exception.
Despite a record-setting eleven reductions in the ff-rate, the stock
market is below where it was in January, 2001, when the FOMC shifted
its policy and began lowering the rate. As a percentage reduction
of the ff-rate, this has been the greatest, from 6%
to 1.75%. This has reduced interest returns to the little people
who keep their money in passbook savings accounts and money-market
funds. In a nation in which net personal savings as a percentage
of disposable income has gone negative, the FOMC has adopted a policy
to ruin savers. The rate of price inflation (Median
CPI) is well above the passbook savings rate, and then savers
get taxed on this income. They are being penalized for their thrift.
Then comes an offer from the auto industry: free money. Buy a car
at zero percent financing. Americans bought a lot of cars in the
fourth quarter, which pumped up the GDP. But to do this, they went
into debt, and the auto industry forfeited sales in 2002-2005 by
selling at a loss, or close to it, in late 2001. The auto industry
cannibalized its future sales. Managers made this decision in order
to keep plants open, in the hope that the recession would end soon.
It also trained future buyers: “If you wait to buy, maybe there
will be another deal like there was in late 2001.”
When the stock market falls in response to interest rate cuts on
the scale that we had in 2001, something is terribly wrong with
the traditional rules of investing. The last time that we saw interest
rate cuts on this scale and a falling stock market was in 1929-32.
This, according to the Comstock Fund:
noting this event we were interested to see whether the market
had ever been down one year after the beginning of a Fed easing
move, and as usual, we turned to Ned Davis Research. We found
a chart Davis has compiled on the results of the so-called, “2
tumbles and a jump” rule, which states that the market is a buy
after the first two moves by the Fed to lower rates. The data
Davis used goes back to January 1915, and since that time there
have been 20 instances where the Fed has lowered rates at least
two consecutive times, including last January. Of the previous
19 times, in every instance but one, the market was up a year
later, usually by a significant margin. The one exception was
the rate decrease in late 1929 following the October crash of
that year. The second instance is the current one.
We believe that these results are no coincidence. The bubble of
1998 to 2000 bears a resemblance to the period leading up to 1929
in a number of ways that we have written about in past comments.
The boom has left the market and the economy with a number of
important imbalances that have not been corrected by the slowdown
experienced to date, and these imbalances will impede any attempt
to recover until they are corrected.
The FED did lower rates by expanding money after October, 1929,
but this policy was reversed
in 1930. The money supply contracted by one-third, 1929-33,
when 9,000 banks went bankrupt (bank + rupture = bankrupt). Interest
rates continued to fall. What happened in 2001 was therefore unprecedented.
Unlike 1930, the FED intervened more strongly than ever before in
peacetime history, and the stock market still fell.
Part of that fall in interest rates was based on falling demand.
The increase in the money supply (adjusted monetary base) was in
the 8% range, but the fall in rates was far more spectacular than
this normally would have produced. The recession was a major factor.
Rates would have fallen without FOMC intervention, especially long-term
rates. The stock market probably would have fallen even further.
But the point is, the FOMC did intervene, short-term interest rates
did fall, and the stock market went down.
This points to a bear market. The statistics are unfavorable to
stock market investors. First, bullish sentiment among brokers and
fund managers is very high — spectacularly high, given the
previous boom conditions and the indicators of corporate debt. After
the end of an 18-year boom (August, 1982 to March, 2000), the professionals
are telling buyers to load up on stocks, that the boom is just getting
started. This is simply naive. It is the naivete of newcomers who
have not seen 1969-75.
What sustains this market? Pension funds. Investors have invested
in government-approved, government-regulated markets. The appearance
of 401 (k) programs in the early 1980’s is the main source of the
boom. It is a bubble based on a time perspective: retirement. People
believe that the good times are well-deserved, despite stagnant
after-tax, after-inflation income, 1973-95. Those people who actually
save — about 20% of the population owns about 85% of the investment
assets — have been persuaded that the boom will be sustained
beyond their retirement years. But it will not be. The baby-boomers
will begin retiring in 2010. They will then have to sell their assets
to gain income. Dividends of 1% — or zero, after fund management
fees are deducted — will not be able to live on the income
generated by these companies, with their pro-forma accounting practices.
If there are no earnings, there are no dividends, except through
the liquidation of corporate capital.
Most men die intestate: no will or trust. They do not like to think
of their deaths. They do not buy death insurance; they buy life
Similarly, few men look at the economics of their retirement. They
assume that their pension fund managers know what they are doing.
This is foolish. If fund managers knew what they were doing, the
NASDAQ would not have become a bubble that popped. The fund managers
would have stayed out. Hardly anyone in the fund industry looks
more than a year out; most managers do not look beyond the next
quarterly report. Even the managers who take a longer-run view find
themselves in competition with other managers whose short-run views
produce investment strategies that look good in the short run and
look bad in retrospect.
Fund managers bought and held Enron. How smart can they be? They
bought and held K-Mart, a loser if there ever was one. My wife quit
shopping there in the mid-1980’s. Service was poor, selections were
limited, Wal-Mart had dramatically better prices, and the K-Mart
stores she visited were run down and sometimes dirty. She would
not go back into a K-Mart store just because the company has closed
the worst-performing stores. There were millions of women just like
my wife. “Attention, K-Mart shoppers” will be heard less and less
as the decade moves forward. You can’t turn around a retail company
whose culture of poor service is at least two decades old. You can
bring in new managers, but you cannot change entrenched habits at
the customer level. A generation of younger women have learned not
to walk into a K-Mart store. Why should they switch from Wal-Mart?
K-Mart is the Montgomery Ward of this decade. Why didn’t the hot-shot
fund managers just talk with their wives or their mothers about
Fund managers at best can match the S&P 500 index. The question
now is this: Where is the stock market headed?
BIGGER THEY ARE. . . .
The stock market has been falling. I don’t much trust the old rule
that if the market falls in January, it will fall for the year,
and if it goes up in January, it will go up for the year. In 2001,
the S&P 500 index went up sharply in January and then fell after
February 1. It was lower at the end of the year than it was at the
beginning of January. But, so far this year, the supposed rule is
operating. The market fell after the first week in January, but
then turned down. February is not looking good.
What the Enron debacle has shown is that the gatekeepers are unable
to spot a disaster in the making. All the government’s regulations,
all of the SEC’s reporting requirements, all of the vaunted expertise
of Arthur Anderson did not save Enron or Enron’s investors.
We are now going to see increased political pressure on Congress
to tighten up on the regulations. This will work to preserve old,
established companies that have armies of lawyers and accountants,
and it will hurt newer, innovative firms that are trying to break
into new markets.
has been the effect of regulation from 1886 (the Interstate Commerce
Commission) until today. Government regulation reduces competition.
This is the opinion of economists from the Marxist side of the aisle
(Gabriel Kolko) all the way over to the free market side (D. T.
Armentano, Sam Peltzman). But regulation makes politicians and bureaucrats
feel as though they have done something positive to protect the
The complexity of the new credit-debt markets is beyond anyone’s
ability to perceive, which is why Enron went down, and LTCM went
down, despite the formulas provided by two Nobel Prize-winning economists.
The leverage today is unprecedented. The problem is, the payments
system is interconnected.
TO THE CHASE!
One study of the newly formed J. P. Morgan Chase banking firm indicates
that the company has written derivatives contracts, based mostly
on interest rate swings, whose nominal market value is over 700
times greater than the company’s capital: $26 trillion vs. $42 billion.
If you want to get a picture of the risk associated with derivatives,
click through and read this article. This may take you 15 minutes.
I suggest that you take a rest room break first; otherwise, when
you read this, you might have an accident. Here is a preview of
financial circles 10 to 1 leverage is considered very aggressive,
100 to 1 is considered to be in the kamikaze realm, but we don’t
ever recall hearing about large-scale leveraged operations exceeding
100 to 1 outside of the horrible example of the doomed super hedge
fund Long Term Capital Management. JPM’s management may have effectively
created the most leveraged large hedge fund in the history of
the world by using $42b worth of shareholders’ equity to control
derivatives representing a notional value of a staggering $26,276b.
Please note that the numbers in this quote are from the Q1 OCC
report, and are far worse now as we noted above! As I mentioned
in “Monster,” the doomed LTCM had an inverted derivatives pyramid
of an estimated $1,250b supported by only $3b in owners’ capital
for an extreme implied leverage ratio of 417 to 1. JPM’s implied
derivatives-to-equity ratio was sitting at 712 to 1 at the end
of Q3 2001, a staggering number beyond comprehension!
with hyper-extreme leverage is that even a relatively small unexpected
increase in volatility slamming into the inverted derivatives
pyramid on the wrong side, a moderate sandstorm, can cause crushing
losses at the apex of the pyramid, the capital base of the speculating
bank wielding the hyper-leverage. For example, a 1% fluctuation
in a market price is not a big deal on any given day, it happens
all the time. Yet, with even a “mere” 100 to 1 leverage, a 1%
price move in the wrong direction can totally wipe-out the underlying
capital. If you have $1k in capital but control a long bet worth
$100k, even a trivial $1k price drop to $99k obliterates you.
Hyper-leverage is playing with fire!
matter how intelligent the folks are that are managing these gargantuan
derivatives pyramids. They are probably brilliant rocket-scientist
types, the best in the world. Yet Long-Term Capital Management
also had brilliant rocket-scientists running it too, some of the
brightest financial minds that ever lived. Even with that unparalleled
brainpower, the mighty LTCM was annihilated by a relatively small
unforeseen market event, the Russian Debt Default, that completely
blew-up its fragile inverted derivatives pyramid portfolio.
even the most brilliant market players in the world make mistakes.
JPM issued an official press release on December 19th that claimed
it had $2.6b in loans and other exposure to financial-disaster-du-jour
Enron! Initially, JPM had “only” reported $0.9b of exposure to
Enron. $1.7b more is a BIG difference.
John Crudele wrote a blistering column on January
31. It is aimed at the heart of modern leveraged capitalism.
This includes JPM-Chase.
Back in early December this column speculated that Global Crossing
Ltd. would be the next Enron, bitten by the bankruptcy bug. That
happened this week as Global entered a pre-packaged bankruptcy
with a couple of Far East firms.
In that December column I also speculated on the much more important
aspect of Global Crossing’s problems — that J.P. Morgan Chase,
Citicorp and BankAmerica were each lead bankers for one part or
another of Global’s borrowings.
Global is said to have spent $15 billion in five years building
a fiber-optic cable network around the world. Those banks largely
got the money together, including putting in a lot of their own.
Even though other banks were lured in by Global Crossing’s pitch,
the focus will be on J.P Morgan Chase mainly because the company
has been bathing in misfortune lately — having been heavily
involved in Kmart and Enron as well.
The Chase part of the organization, meanwhile, made heavy and
risky bets in the dot.con bubble a couple years ago. And we all
know how that turned out. Those losses were one of the reasons
Chase ended up in a merger with J.P. Morgan.
And if corporate failures weren’t enough, J.P. Morgan Chase also
was heavily involved in the banking situation in Argentina. Could
all of this lead to a big problem? Yes.
Could all of this lead to — just perhaps — the failure
of J.P. Morgan? Probably not, but only because the giant banking
conglomerate is too big for Washington to allow it to fail. .
Charles Peabody, one of Wall Street’s best banking analysts, agrees
that J.P. Morgan Chase will be preserved by the government, if
it ever comes to that. “But that doesn’t mean it won’t be a $10
J.P. Morgan’s shares were selling at $33 yesterday. But that’s
down from over $40 in December. . . .
Peabody, who works at a investment boutique called Ventura Capital,
recently laid it all out for his clients.
remain convinced that J.P. Morgan Chase will emerge as the poster
child for what ails this economy — excessive leverage, financial
engineering, aggressive accounting and conflicted interests.”
The stock mutual fund managers are not as well-informed as JPM-Chase
managers should have been with respect to their exposure to Enron,
K-Mart, Global Crossing, and Argentina. We cannot expect a fund
manager of hundreds of companies’ shares to match the level of expertise
of a company’s banking agent. The fund managers assume — must
assume — that those who are doing the monitoring are competent.
But Enron has revealed that, however bright these “gatekeepers”
are, they are not smart enough to understand the complexity of the
credit-debt monster that modern industry has created over the last
HAZARD AND LEVERAGE
Central bankers have created the sense that they can keep the economic
system functioning through timely intervention: additional credit
money. They have created the credit money necessary to sustain the
growth of their national economies. Their actions have made debt
— leverage — profitable. Senior managers think, “If central
bankers can reduce corporate risk by intervening with more money,
then why not bet the farm on complex credit-debt arrangements that
can make higher-than-market rates of return?” This is what the central
bankers call moral hazard: a widespread perception of reduced risk
on the down side, and the pressure of an ever-increasing supply
of money and rising prices on the other, driving the entire investment
world into debt, playing the leverage game.
How much corporate debt? In the January 30 issue of The Reaper,
commodities specialist R. E. McMaster included a graph on non-financial
corporate debt in relation to GDP. In 1951, it was 23%. Today, it
is 48%. It dropped from 33% to 30% in 1975-80. Then it rose to 43%
by 1990. It fell back to 37% in 1995. Then it took off.
Businessmen learn that debt multiplies the rate of return on capital
invested. Because senior managers are rarely senior managers for
more than a decade, they forget what their predecessors learned
the hard way: leverage is a two-way street. That lesson escaped
Kenneth Law and his associates at Enron.
The use of complex leverage schemes always peaks at the tail end
of an inflationary boom. I wrote about the following in my 1981
Investing in an Age of Envy. By then, I had kept the clippings
in my files for 14 years. High school drop out James Ling in 1947
founded what in 1955 became the Ling company, merged with two companies
in 1960 and 1961 to become Ling-Temco-Vought (LTVCQ). He thought
there was no end to the leverage game. From 1961 to 1969, it acquired
33 other companies. LTV was the first company to issue high-risk
“junk” bonds. He told a Newsweek reporter in 1967, “This
process can go on forever. Go to a company, buy it like we did Okonite,
recoup your cash, and start redeploying again, constantly, over
and over.” (Jan. 23, 1967). He also said: “I once heard a man brag
about not having any long-term debt. That isn’t a realistic attitude.
On balance, it’s always better to go into the money market.” (Fortune,
Jan. 1967). By 1969, LTV employed 29,000 workers. Here are the results
of this position in LTV stock:
1962: $15 (1962 purchasing power)
Ling’s strategy was upended by the credit crunch of 1969. By 1970,
the country was in a recession. Then the Nixon Administration threatened
prosecution for anti-trust violations. That did it. James Ling by
1970 had become a whiz kid emeritus. The company demoted him in
1970. He quit, sold all of his stock, and retired rich. His debt
pyramid strategy had worked for him. He was fortunate that the board
kicked him out. The company went through numerous other mergers,
and in 1986 it declared bankruptcy.
Hope springs forever. Facing another bankruptcy, a Japanese firm
bailed out LTV in 1991. The older stockholders lost
The price went to $21 in 1994. No good. Recently, after another
Chapter 11 reorganization, LTV shares were down to a penny. Steel
workers bought 24 million shares last December, driving the price
up to 4
Some people just don’t know the difference between investing and
gambling. Investing generally involves a rational decision you’re
willing to live with for a considerable period of time. Gambling
involves much hope, little thought and leaves you with the irrepressible
urge to repeat your mistakes.
In that light, consider all the people who are purchasing shares
of bankrupt steelmakers such as LTV Corp. (LTVCQ.OB) and Bethlehem
Steel (BS). Last week, as United Steelworkers of America, elected
officials and others worked feverishly to breath new life into
LTV, more than 24 million shares of the troubled Cleveland steelmaker
changed hands, bringing the steelmaker to a Friday close of 4.1
The company’s directors then told the press that investors would
never get any return on their investment. The stock now trades at
The world of leverage is made profitable by credit money. The central
banks have created this brave new world. He who invests against
it must suffer lower returns. But the end of pyramiding comes when
the level of pyramiding expends beyond the ability of the debtors
to assess risk. This is what brought down Enron. The company could
not maintain its fast growth without pyramiding, but pyramiding
brought it down completely.
This is the threat the world faces today. Central banks are in control
of money. They have addicted the whole world to massive debt, ever
more complex. Any slowdown in the inflation of the money supply
threatens the solvency of the entire economy. Ludwig von Mises warned
against this ninety years ago, in his Theory
of Money and Credit (1912). He warned that the government’s
refusal to call a halt to monetary inflation — its return to
credit-money creation — would eventually destroy the currency.
He called this the crack-up boom. In the meantime, we would get
endless boom-bust cycles, he said. So we have.
Let me repeat the journalist’s warning about buying shares of bankrupt
firms: “Gambling involves much hope, little thought and leaves you
with the irrepressible urge to repeat your mistakes.” But what happens
when bad accounting practices, complex debt, and endless monetary
expansion persuade investors to buy what are in effect bankrupt
companies — companies that are kept afloat only by new injections
of bank credit money? The central bankers dare not stop the flow
of money. And so the leverage game goes on and on. We are riding
the tiger, a tiger of endless debt and capitalized future income