Part 10 - Riders on the Storm - Complete Article
August 16, 2001 © Copyright 2000 James J. Puplava
Introduction
The ocean and the atmosphere form a two-layer system that produces what we call climate or weather. The interactions that take place between these elements produce heat or cold, rain or drought, calm or storms. Climate is often referred to as the prevailing weather in a region. Weather is of interest to those who make their living on the sea as well as on land and it impacts every industry from agriculture to tourism.
The main problem with forecasting weather is it has too many variables. It involves an educated interpretation of air mass movements throughout the atmosphere. At best, forecasting boils down to educated guessing based on fundamentals and what is likely to occur.
Everyone is familiar with climatic seasons caused by the rotation of the earth's axis around the sun. The angle of the earth relative to the sun's radiation affects the amount of heat energy received, which in turn impacts weather patterns. During the winter months, the earth is tilted away from the sun; while during the summer, it is tilted towards the sun. So one man's winter can be another man's summer.
While it's summer or winter, the weather patterns are more predictable. We expect colder temperatures during the winter and warmer temperatures during the summer. It is when we transition from one season to another that unpredictable variations occur. If everything remained constant, we would have only one weather chart with few changes.
However in the real world, variations in the sun's output of energy, evaporation rates, tidal flows, and a host of other factors make many weather forecasts unpredictable. This results in constant weather variations that produce an alternating mix of weather. The same holds true for the economy. Like the weather, it too has its seasons. We have recessions. We have recoveries. And busts always follow booms. The nature of our economic cycles also varies. Some are mild, while others are more severe. Our downturns (winters) have been recessions. When they become severe, they have turned into depressions. Our upturns (summers) have been recoveries. When they become severe, booms turn into bubbles.
In writing The Perfect Financial Storm series I have used the analogy of weather because it has many similarities to our economic cycles. I felt early last year that our economic cycle was changing. There were too many people talking about summer when we had summer for far too long. Wall Street and Washington were telling us that summer was a permanent condition. I saw too many telltale signs that the financial climate was about to change. Just as climatologists use barometers, anemometers, Doppler radar, satellites and other instrumentation to forecast weather, financial indicators were giving warning signals that a storm was brewing in the world's financial system. The epicenter of that storm had its origin in the United States.
As with any storm, the severity, the duration and the direction are hard to predict. For these reasons I have discussed alternate courses that this financial storm may take. The storm's path could end up being deflationary or inflationary in nature. Or something else may be brewing – something we haven't experienced before – The Perfect Financial Storm, the simultaneous occurrence of two storm fronts that collide with each other to form The Perfect Storm. I do not pretend to have the answer as to the exact outcome or severity of the current storm that is now in its formative stages. There are others far smarter than I who may know the path this storm may take. However, I believe the financial maelstrom that is currently brewing will end up being of the Nor'easter variety. The severity of a recession or bust is oftentimes determined by the boom that preceded it. In this case we've not only had a boom, but that boom that grew into a bubble has rippled throughout the financial system inflating financial assets and real estate prices. In this final installment, I hope to help you chart your course so that you will be able to ride the storm.
I. Where We Are Today
The Bubble is Still With Us
The boom that grew into a bubble is still being fed by a constant infusion of credit. We've seen the money recycled between the stock and bond markets with derivatives and day trading steroids adding volatility to the mix. It is also visible in real estate where new home sales, sales of existing homes, mortgage refinancing, and credit expansion continues unabated. Americans persist in spending money as they expand their balance sheets with debt. Consumers want to borrow more money and credit card companies are only too willing to lend it to them. Government Sponsored Entities (GSEs) such as Fannie Mae and Freddie Mac are still expanding their balance sheets providing ready credit to the housing market.
The bubble in technology stocks may have collapsed, but the daily actions of investors (speculators would be a better term) have turned our financial markets into a casino. Investors are treated to daily doses of irrationality as money jumps from one sector to the next and then back again. The constant need to buy stocks is consistently being fed through various media outlets from the Internet to cable TV.
In his July 2001 issue, Robert Prechter of Elliott Wave International has illustrated the mania in headline form. Click for a larger view.
Nothing much has changed since I first wrote my first installment of The Perfect Financial Storm in July 2000. The Fed and GSEs continue to create money as if there is no tomorrow. Since last fall, the money supply has grown by $697 billion with an annual growth rate of 15 percent. The bubble in the NASDAQ has popped, but we haven't seen similar outcomes for the Dow or the S&P 500. Both indexes peaked last year and have gone sideways ever since.
"Political Correctness" Enters The Financial World
No one mentions the R- or B-word. We're still talking summer here. The mantra may have changed from second-half recovery to fourth quarter, but even the fourth quarter mantra is subtlety changing to recovery next year. Political correctness has invaded the financial world. Words such as bear markets; recessions, unemployment and losses have been replaced by euphemisms. We now refer to these situations as corrections, soft landings, recovery, and restructuring. I'm not sure that the investors who have lost trillions of dollars in the stock market tech bubble or the hundreds of thousands of workers who have lost their jobs would find the words "correction" or "restructuring" to be very comforting. See CBS Marketwatch's "Shadow of Recession".
Rough Weather Lies Ahead
As I wrote in Part 7, 2001 is the last of "The Seven Fat Years" that began in 1995. Right now times are still good with the last remaining pillars of the economy, consumer spending and housing, remaining strong. The Fed's rate cuts and the tax rebates promise to hold up the economy for a while longer. As these graphs indicate, the housing market still remains strong fed by a constant influx of new mortgage money. Government Sponsored Entities such as Fannie Mae and Freddie Mac continue to expand their balance sheet with new debt issuance. This expansion of credit has fed into the housing market. Housing starts, existing home sales, and the average sales price for existing single-family homes rise unabated. The stock market may be down, but evidence of the credit bubble can clearly be seen in our housing markets.
Credit expansion charges ahead. This year's domestic debt issuance is expected to top $1 trillion dollars. Asset backed securities are growing at an annual rate of 17 percent and should top $265 billion this year. Credit card borrowing is up 56 percent year-over-year. Personal income for the average American continues to grow at an above-average pace, but personal spending is outrunning it. Each month consumers go deeper into debt to support their lifestyles. The American credit machine is running nonstop. The money may not be going into the stock market like before, but the money has definitely found a home in the real estate market and in consumer spending.
TAX, SPEND & INFLATE
To better understand the course this storm is likely to travel, it is important to understand the storm's origination. Its epicenter is located in Washington and on Wall Street. The credit creation mechanisms of the Fed and Government Sponsored Entities inflated our nation's money supply. The result was an abundance of money made available at artificially low rates. This helped corporations to refinance existing debt at much lower interest rates. In addition, cheap credit allowed companies to finance acquisitions and buy back stock. Money was also made available for speculation in the financial markets helping to fuel a boom in stock prices that went well beyond profit fundamentals. At the same time, lower interest rates allowed consumers to refinance mortgages and take on additional debt to finance consumption and speculation in the stock market.
The 90's – A Decade of Mounting Taxes
While credit creation was feeding a constant flow of money into the financial system and the economy, government taxes were siphoning off a good portion of that excess money in the form of taxes. President Bush increased tax rates in 1990 from 28 to 31%. In addition to an increase in the personal income tax rates, an additional Medicare tax of 2.9% was assessed against earned income. President Clinton followed Bush in 1993 with the largest tax increase in U.S. history. Rates were increased from 31 to 39.6%. The Medicare tax cap was removed. Itemized deductions were reduced through phase-outs. Social Security income subject to taxation was increased from 50 to 85%. At the same time, as shown in the table below, the wage base on which Social Security taxes were assessed went up each year. As personal income increased, the amount of Social Security taxes increased right along with it. Most Americans have felt the squeeze in this last decade. This table dramatically portrays one of the reasons why.
| Social Security & Medicare Tax Table | |||||||||||||||||||||||
| 1990 | 1991 | 1992 | 1993 | 1994 | 1995 | 1996 | 1997 | 1998 | 1999 | 2000 | |||||||||||||
| Base | 51,300 | 53,400 | 55,500 | 57,600 | 60,600 | 61,200 | 62,700 | 65,400 | 68,400 | 72,600 | 76,200 | ||||||||||||
| Employee Rate 7.65% | 3,925 | 4,085 | 4,245 | 4,406 | 4,636 | 4,681 | 4,964 | 5,003 | 5,233 | 5,554 | 5,829 | ||||||||||||
| Self-Employed Rate 15.3% | 7,850 | 8,170 | 8,490 | 8,812 | 9,272 | 9,362 | 9,928 | 10,006 | 10,466 | 11,108 | 11,658 | ||||||||||||
| *Sup. Medicare Tax 1.45 & 2.9% | 125,000 | 130,000 | 135,000 | Unlimited Base --------------------------------------------------> | |||||||||||||||||||
| * Beginning in 1991, there was an additional tax of 1.45% for employers and 2.9% for self-employed above the social security base. After the 1993 Tax Law, Clinton removed Medicare caps. Presently, the Supplemental Tax is assessed on ALL earned income above the social security base. |
| ||||||||||||||||||||||
The end result of Fed money pumping and government taxation was the ravaging of household finances of the average American by taxes and inflation. The government, through an increase in the money supply, created inflation. The monthly budget for necessities for the average American went up each month as the cost of daily living rose across the board. Housing prices went up along with rents. Food prices rose. Medical premiums skyrocketed. The cost of a college education grew each year. Automobiles cost more. Utility bills rose each year. About the only thing that was going down was the cost of technology as we saw with personal computers.
Inflation rates would have been much greater had it not been for imports. The excess demand created through cheap credit was offset in part by imports. Foreign imports helped to keep a lid on domestic prices below what they should have been. Even so, the cost of most goods rose. Inflation statistics hid the true cost of living through statistical manipulation. I would challenge the widespread statement by the financial media that the 90's were a period of moderate inflation. The effects of inflation were everywhere. They were visible in housing prices, food, education, medical, clothing, entertainment, automobiles and finally asset prices. The average household budget – the things people spent money on from Big Macs to movie tickets – went up each year.
Technologically Improved Statistics
Government statisticians massaged these inflation numbers by a "new and improved" accounting method for improvements in technology. The automobile you bought last year may have cost you more money than your last car, but the car was more technologically advanced. It had better safety systems. The car radio sounded better. It may have had a CD player or a GPS system on board. The car cost you more money, but it was technologically a better automobile. Therefore, in the minds of government statisticians, it was a cheaper car because it had been technologically improved. As a result, the price of the car was massaged to account for these improvements adjusting the cost factors lower.
During the 90's as the cost of living was rising for Main Street's average American, on Wall Street financial asset prices were also moving up. Inflation has two outlets. The excess money can either go into the economy, inflating the cost of goods, or it can go into financial assets, inflating their prices. They are essentially one and the same. One of the more remarkable aspects of the 90's is that the outlet for excess money flowed into the financial markets more so than it did the economy. This accounted for the above-average returns of stocks throughout the decade.
The Consumer's Bottom Line
While assets and the price of goods went up, Americans we're taking home less money as a result of taxes. Taxes took a greater bite out of monthly income while the cost of daily living rose. The result was a reduced savings rates. When savings had been exhausted, debt levels increased. I believe the chief reason that the country has a negative savings rate is that household income has been ravaged by the combination of taxes and inflation. As the graphs of household debt and savings illustrate, debt levels are high and savings is negative. These two factors alone make a recovery scenario based on a continuation of consumer spending a precarious one. The consumer-spending bust will soon join the capital-spending bust with devastating consequences for the economy.
The end result is that the boom times of the 90's weren't the result of a new economic paradigm, as many Wall Street and Washington spinmeisters would argue. It was the result of a giant credit boom that fed itself through the financial markets and the economy. The 90's were a result of a return to Keynesian economics: tax, spend and inflate.
II. Four Arguments Against Recovery
There are four special circumstances that would argue against an economic recovery or even an anemic recovery at best. In many ways these circumstances are the result of policy decisions made in Washington and boardrooms of American corporations. They are 1) monetary policy, 2) taxes, 3) energy, and 4) corporate profits.
#1 Monetary Policy Isn't Working
The first issue deals with monetary policy. The recovery scenario propagated on Wall Street is that Fed monetary policy will bail out the U.S. economy. All eyes and hope are on Mr. Greenspan. There is a blind faith that Mr. Greenspan will once again work his monetary magic. By lowering interest rates and flooding the markets with liquidity, it is hoped that the U.S. economy will metamorphose itself into a recovery. The belief in the efficacy of monetary policy has never been higher. Mr. Greenspan contained the collateral damage of the stock market crash in 1987. He single handedly bailed us out of the S&L crisis. He brought us out of the recession of 1990-91. He doused the fires of the Peso, Russian Debt and Long Term Capital Management crisis. Why wouldn't he be able to fix the current economic crisis and restore economic growth in the United States?
There is also widespread belief in the "Greenspan Put," the belief that monetary policy can put a floor underneath stock prices. However, things aren't going according to plan. The economic formula of booming money supply equals booming financial markets which leads to economic recovery isn't working.
After the most aggressive round of Fed easing in decades, the financial markets and the economy aren't responding. In past economic cycles, Fed easing normally produced a recovery in the financial markets first. The rise in stock prices would signal an approaching recovery in the economy. However, signs of recovery are missing as evidenced by the Consumer Confidence Index, Gross Domestic Product, and the NAPM Manufacturing Index.
As these above four graphs indicate, after six rate cuts in 2001 and a seventh expected soon, the economy and the stock market have failed to respond. For the first time in recent memory, the financial markets aren't warming to the Fed's touch. Long-term interest rates have risen since the Fed began cutting short-term rates back in January. That stands in sharp contrast to the last recession when long-term bond yields followed Fed rate cuts by heading lower.
Last Recession
Current Environment
Wall Street is cheering the fact that the economy hasn't dipped into recession. Unfortunately, their myopic belief and optimism is misguided because of blinders created by past experiences. Never before has Fed policy failed to deliver. The result of rate cuts has always been a prolonged stock market expansion and an economic recovery. Why won't it work this time around?
The True Nature of Economic Illness
Proponents of monetary policy argue that there is a lag between changes in interest rates and the time those changes are reflected in the economy. However, this is no ordinary downturn. The economy's ills are structural rather than cyclical. Wall Street still holds the view that the slowdown we are experiencing is nothing more than an inventory correction and therefore the economic malaise is cyclical in nature. The believe that once inventories are reduced, the economy will be back on a growth track. If that were true, the stock market would have signaled its advance. As of this August, all of the major indexes are still in negative territory. The speed of the downturn and its unusual side effects suggest this downturn is structural in nature. A collapse in capital spending, mounting consumer and corporate debt loads, a catastrophic fall in corporate profits, and a sideways and collapsing stock market would suggest the problems are more structural rather than cyclical in nature.
#2 Tax Rebates and Future Cuts Just Won't Cut It
Another specious argument rests on the belief that tax rebates will fill in the gaps left by monetary policy. The only problem with this argument is that very few of the tax benefits occur upfront. Most of the tax benefits are phased in over periods ending as late as 2009 and all of the tax benefits will terminate after 2010. Retroactive to January 1, 2001, a new 10% tax rate will replace the 15% tax rate on the first $12,000 of taxable income for joint filers, $10,000 for heads of household, and $6,000 for singles. Taxpayers won't have to wait for the refunds until next year when they file. The Treasury will mail all refunds to those who pay taxes this year by October. Beginning July 1, 2001, the current 28%, 31%, 36%, and 39.6% income tax rates will be gradually reduced over a six-year period to 25%, 28%, 33%, and 35%. Starting in 2006, the limitation on personal exemptions and itemized deductions for higher-income taxpayers will be phased out.
The problem with this plan is that it will be phased in over a six-year period. All that taxpayers will get this year is the $300, $500, and $600 for single, head of household, and joint filers. What happens after this money is spent? Do economists really think that $300 and $600 rebates will turn this economy around? Do they really believe that it will ameliorate average credit card debt of $8,000, mortgage and installment debt that exceeds disposable income, or a negative savings rate? Even Keynesians acknowledge the need to reduce taxes during times of economic weakness. Tax decreases and government spending are supposed to be used to offset economic weakness. In this regard, the Keynesians running government have been far too stingy. Already there is talk about vanishing surpluses and the possible need to delay the phase-in of tax rate reductions. Dick Gephardt, the Democrat minority leader in the House, has already been speaking about the need to raise taxes. It would become a priority if his party retakes the House in 2002.
The deficit reduction mantra has become an excuse for higher spending and more taxes. Over the last two years of the Clinton Administration, government spending increased at an annual rate of 8%. Both sides shared in the spending orgy. Congress is already talking about delaying next year's tax rate reductions because of possible deficits. It may be news to most congressmen, but recessions produce deficits! Tax revenues are reduced as economic activity slows down. At the same time, government costs rise as a result of transfer payments, which rise with unemployment.
Phasing in the benefits over a six-year period negated a possible policy fix that could have ameliorated the economic downturn. The stimulus that would have been created by lower tax rates is lost as a result of delaying them. Washington is a place of compromise. But in this case, you don't compromise over the number of lifeboats you are going to release when the ship is sinking.
#3 The Future of Energy is A Crisis
A third argument that inhibits economic recovery is the state of America's energy infrastructure. According to the President's energy report, "America in the year 2001 faces the most serious energy shortage since the oil embargoes of the 1970's. A fundamental imbalance between supply and demand defines our nation's energy crisis." 1 As pointed out in previous installments in my Storm Series, we have run out of spare capacity in oil, natural gas, and electricity. Our dependence on foreign oil has never been greater. We now import over 51% of our oil versus 25 to 30% during our last energy crises back in 1973-74 and 1978-79. Low prices and under investment have caused our energy infrastructure to remain neglected and decayed. We are now dependent on OPEC and other foreign powers for much of our oil and natural gas energy needs.
In the past, recessions have always been associated with higher energy prices. Higher energy prices were contributing factors to the recessions of the seventies, early eighties and the last recession in 1991. Higher energy prices are impacting the current economic downturn. Consumers and corporations are spending more for energy in the form of higher gas prices and higher utility bills. The tax rebates don't come close to covering the higher energy costs hitting consumers. The way we handle this crisis will frame the severity of the approaching economic storm. This time, our energy crisis is not a temporary event caused by consumer hoarding as in the 1970's. For far too long energy needs have been neglected. Americans were led to believe that technology would reduce demands placed on energy. Instead technology has created new demands. There is also widespread belief that oil is plentiful. Oil may be abundant in the Middle East, but not in the West. Industry insiders are alarmed at how fast our oil reserves are dwindling.
President Bush is the first president since Ronald Reagan to address this issue. His plan strikes a balance between the need for more supply and the need for conservation, between drilling for oil and natural gas, and new sources of energy. Yet Congress dithers over the President's energy plan. The fact that we are even debating drilling for oil at ANWR is a complete absurdity. The debate is over 2,000 acres of mosquito-infested, muddy terrain the size of an airport. ANWR contains close to 19 million acres of land. The area of drilling is not a pristine wilderness. It is tundra. The caribou are not endangered – they are thriving.2
The Facts on Energy Consumption
What is often forgotten in this debate are the facts. In 1990, energy consumption in the U.S. was 86 quadrillion BTUs. In a decade, it has grown to 100. That is an increase in energy equivalent of 8 million barrels of oil a day. Over the last two decades almost no new refinery capacity has been added. The ability to deliver imported oil has also diminished. World tanker fleets have declined. Prior to the 90's America increased its power grid capacity by 10% every five years. During the first half of the 90's that capacity had declined to only a 4% increase. In the last half of the decade it declined further to only a 2% increase. At the same time, the demand for electricity grew by 2.5-3% a year and over the last few years, it has accelerated to 4% a year.
During this same time, the supply of energy has declined. Within OPEC, only one country, Saudi Arabia, has excess supply. Decline rates in production in the U.S. in the lower 48 and in Alaska continue to fall. Despite increased investment, output fails to match input. Gas well completions are up in Canada by 41% over the last year, but gas supply grew by only 2%. In the U.S., drilling activity over the past five years has increased three-fold, but output remains flat. New finds are smaller while technology accelerates production decline curves.
Instead of facts, Americans are deluged with irrelevant environmental drivel from the media. The Jimmy Carter Sweater Strategy is proposed as a solution to the crisis. More efficient cars and refrigerators are proffered as answers to our energy needs. According to Matthew Simmons of Simmons International, the savings of increasing gas mileage to 80 miles per gallon in one million new cars would only save us 40,000 barrels of oil each day.3 Imagine how long it would take and what the costs would be if weconverted our entire inventory of existing automobiles to more fuel-efficient cars. It would take over a decade. The idea that conservation will solve our energy crisis is as hollow as it is absurd.
Flaunting The Possible Solutions
Fixing the energy problem is simple. It involves rebuilding our energy infrastructure. It means finding new sources of oil and natural gas. It mandates using new alternate sources of energy such as clean coal technology, geothermal and nuclear power. It will involve building power plants, adding thousands of miles of pipelines, adding refineries, building tankers and adding capacity to our power grid system.
We have a problem in that this crisis hits our economy at a time of weakness and economic vulnerability. Instead of addressing the issue and turning it into an opportunity, rational debate has given way to demagoguery. The needs of plants, insects, fish and animals are placed above humans. Forests are being closed down. Loggers are losing their jobs. Mines are being closed and miners collect unemployment. Ranch lands and grazing rights are being taken away. Access to oil and natural gas on Federal lands is being denied to the energy industry. And now even lives are being threatened. Recently in the Pacific Northwest four firefighters lost their lives because of a fish! 4 Many of these so-called threats to plants, fish and animals are questionable. There is a Pulitzer Prize waiting for the reporter who investigates the fraudulent arguments behind much of the environmental movement. I suspect that the reporter will find that political theory is taken as scientific fact.
The point to be made here is that energy is the lifeblood of our economic system. Without it, our economy shuts down. With it, our economic well-being is enhanced. The current crisis won't go away. It will only get worse. Unless we begin now to address the problem, the prospects for economic recovery will be limited. We will have to rely on the good fortune of weather, which we know is unpredictable. Unusually cool weather has helped California to avoid blackouts this summer, but California is only a few degrees away from its next energy crisis.
The problem of energy has all but disappeared from the front pages. An aberrantly cool summer has led to cutbacks on air-conditioning loads and we've seen the demand for energy dampened by a weak economy. The government has imposed price caps in California. Weather and the economy have been the main factors in reducing our power consumption. The result is that electricity prices have receded. Now there is talk of a power glut. A recent article in Barron's put forth that overbuilding by power producers could imperil the industry.5 I believe this issue of a power glut is short-sided and rests primarily on short-term pricing mechanisms.
Short-Term Thinking on a Long-Term Problem
So much of what happens in the financial markets and in corporate boardrooms is based on short-term thinking. Whether it is the current price of a stock or the current price of a commodity, too much emphasis is placed on short-term pricing mechanisms. Less than three months ago, the country was caught up with energy shortages. Now they are talking about an energy glut. Have the fundamentals changed that dramatically in so short a period that we have gone from shortage to surplus in just three months? A cooler summer and a slower economy doesn't erase the fact that our energy infrastructure continues to deteriorate.
There is no question that an economic slowdown has reduced demand for energy. However, the perception that reducing demand for energy through a weak economy is an answer to the energy crisis is misguided. Power consumption in the Pacific Northwest was reduced when the Bonneville Power Authority asked 10 aluminumsmelters, representing 40 percent of the nation's aluminum production to shut down in order to reduce power. It is estimated that 7,000 workers will lose their jobs as a result.6 The shutdown will conserve energy at the expense of the economy. Surely, putting people out of work, and reducing economic output cannot represent a workable solution to a long-term problem. By this method of thinking, a recession or a depression would be even better since it would further reduce our energy needs. As absurd as this sounds, there are many in the environmental camp that indirectly argue for such an approach.
As far as the weather reducing demand, that can change at any moment. What happens if the weather this winter is also unseasonably cold? The reason prices spiked last winter was that capacity constraints existed within our energy infrastructure. If a refinery breaks down, if weather patterns change, or if demand heats up within the economy, the infrastructure still isn't there to handle it. This is why prices spike when demand increases. Our existing infrastructure is old and badly in need of repair. What happens to this infrastructure when the next economic up cycle begins? A weakening economy may reduce energy demands in the short-term, but it does not solve the energy crisis. It just postpones it.
Supply and Demand Numbers Don't Lie
As these graphs depict, our production of oil and gas has steadily declined over the last three decades. We are no longer energy independent. As our production has declined, our imports have increased. We are now heavily dependent on OPEC for much of our energy needs. If they want to cut back production to maintain prices, we are held hostage to their desire for higher prices. As oil production decline curves accelerate over the next decade, we will have to import even more oil from the Middle East. The price of oil will only go higher over the long term. When you are heavily dependent on outsourcing your energy needs, you are not in a position to dictate the price you pay. Over the next decade the U.S. will be faced with paying higher prices for energy either through market mechanisms because of supply constraints, through government price controls that create shortages, or by higher prices dictated by foreign producers who sit on top of the majority of the world's oil reserves.
One way or another, the price of energy will rise throughout this decade. How much it rises and what we do about it will determine the strength of any economic recovery or the severity of a decline. Cheap and abundant energy has been behind much of the progress that has been made in living standards over the last century. The real danger is that a recession will reduce energy demand short-term, but it will also accelerate the energy crisis and place a limit on any economic recovery. During a recession, we will still be consuming energy. Our production of oil and natural gas will continue to decline. Our aging energy infrastructure will continue to decay. The depletion of our natural resources will continue unabated. The danger of a recession comes from short-term price decreases. Lower prices discourage the necessary investment that is going to be needed to repair and rebuild the whole energy complex. To maintain our standard of living in the United States, we must continuously expand our access to mineral resources and energy. As the U.S. becomes more dependent on importing these resources, our balance of payment problem worsens. The more dependent we become on importing these resources, the greater danger it poses to our standard of living. A nation, which does not control its natural resources, loses control over its economic future.
War – A Very Real & Present Danger
Right now that dependency is on Middle East oil. This is a very unstable region of the world. Placing so much emphasis on imported oil is inherently dangerous to our national security. The consequences of another Middle East War are inconceivable to most economists or analysts. If war breaks out, what would happen to our financial markets, to the price of energy, to our imports of oil from the region, and to our economy? Right now no one is paying attention to this possibility despite the international headlines of conflict. Wall Street glosses over the heightened tensions and the escalation of violence. It does so at its own peril. Analysts ignored these conflicts in the past. Then they were taken by surprise in 1967, again in 1973, again in 1979, and once again in 1990. As I have mentioned in past installments of my Storm Series, our only energy policy at the moment is 25 warships in the Persian Gulf.
Shortsighted and Apathetic Views Inhibit An Effective Energy Policy
The real problem in looking at our energy crisis is that short-term pricing mechanisms have been allowed to dictate our energy policy. For almost two decades, low prices and low returns within the industry took their toll on oil producers and the whole energy complex. The result was industry consolidation that neither added to capacity nor repaired infrastructure. Lower prices fueled strong economic growth at the expense of the energy industry. From exploring for oil and natural gas, building power plants, laying pipelines, to building tankers and our power grid system, the whole system was ignored. Returns were so low that the industry didn't have the capital to modernize or expand and keep the industry healthy.
Another concern is the data on which energy decisions are being made is badly flawed and need of re-evaluation. Price has become everything. Price cannot tell you about the condition of our energy complex, the age of our tanker fleet, OPEC spare capacity, or production decline curves in the West. Price doesn't tell you that capacity constraints exist within the energy complex until severe weather places extra demand on the system. Only when prices rise do we pay attention. And even then, it is only briefly. Any time prices rise, we think they are an aberration or part of a conspiracy by the industry or some insider wanting to make an extra buck. When prices rise, the natural reaction by politicians and the media is to begin pointing fingers and find a villain. Rather than thinking the problem through, politicians only propose band-aids like price controls as a solution. It may mollify voter wrath, but it also gives false signals to consumers to continue their use of energy without regard to conservation and to oil producers who look to their bottom line.
Energy Will Be A Permanent Problem
This time around, our energy crisis is not temporary. It will become permanent unless we do something about it. Unless we solve it, our future prosperity and that of the world could become imperiled. We have been fortunate in the U.S. in that our excess demand for energy has been supplied by imports from OPEC and other foreign producers. This has come at the expense of a deteriorating trade deficit. However, a day is coming in the not too distant future when our voracious appetite for energy will compete against the demands from emerging world economies. The desire of growing populations in lesser-developed nations to maintain and increase their standard of living intensifies the demand on the world's mineral resources. The United States, with only 5% of the world's population, uses about a third of the globe's annual energy supplies. As we import more of our energy and raw materials (resources in which we were once self-sufficient), we will increasingly lose control over our future economic destiny. Many in the U.S. just don't get it. The era of cheap and abundant energy is gone.
Energy and minerals are the basis of our modern civilization. Without these resources, nations are doomed to remain at poverty levels. If denied access to supplies, countries will either resign themselves to a position of poverty or as in the case of Japan in 1941, go to war. With no new frontiers to explore, nations will continuously face conflicts and jostle for position for access to the earth's raw materials. Future military conflicts like the Gulf War and the current conflict in the Middle East will be over access to the earth's remaining resources of energy, water, fertile soil and other base minerals. It is for these reasons that we must begin now to solve this crisis. The severity of a recession, or the strength of a recovery, will depend on the job that is done.
I've identified three special situations that would argue against an economic recovery or against a recovery of any sufficient strength. I've discussed the ineffectiveness of monetary policy to arrest a market decline or stop the economy from weakening. I've shown that the tax bill lacks the necessary stimulus to ameliorate the downturn because of the phasing in of most of its benefits. I've discussed the danger of the energy crisis and how it has weakened the economy and what it portends for the future unless it is solved. The final situation that does not bode well for the economy or the financial markets is the condition of corporate profits. It is the sorry state of corporate profits that presents the most compelling argument against a return of the bull market of the 90's.
#4 The Truth About Corporate Profits
To fully understand the precarious position of our financial markets requires both an understanding of both macro and micro economic issues. The unparalleled returns in our financial markets during the last decade have been explained as a result of a new paradigm shift within the American economy. Many portray our prosperity as the result of corporate restructuring, management efficiency, our technology edge and the emphasis on shareholder capitalism. This is a myth that is now unraveling with a vengeance. Upon closer inspection of the profit miracle, the rise in profits had more to do with events in Washington than it did on Wall Street. The advancement in profits during the early part of the decade can be attributed to two factors: 1) a lowering of interest rates by the Federal Reserve and 2) a favorable change in the tax laws.
As this graph illustrates, corporate profits peaked by mid-decade. As the U.S. worked itself out of the 1990-91 recession, corporate profits rose at above-average rates. This above-average rise in profits had its genesis in two macro causes outside corporate boardrooms. The contributing factor in the acceleration of profits during the first half of the decade was primarily due to lower interest rates.
As the graph on bond yields indicates, long-term interest rates fell with Fed easing. In an effort to re-liquefy the financial system and bail out the Savings and Loan industry, the Fed brought down interest rates. This made it easy for the banking system to borrow money from the Fed and reinvest the money in long-term treasuries which helped to restore profitability within the banking system. Banks and S&L's could borrow at lower interest rates from the Fed and then turn around and earn higher returns on U.S. Treasury debt. This helped the banks, but it also helped to bring down long-term interest rates in the process.
Lower Rates ... A Finance Department's Dream
At the same time, corporations took advantage of lower long-term rates to refinance their outstanding debt. This accounted for the majority of the surge in corporate profits at the beginning of the decade. As long-term rates came down from the high single digits, companies could refinance expensive debt with lower rates. This lowered their interest expense, which increased earnings. In addition to refinancing debt, Congress changed the tax laws and lengthened depreciation charges on buildings and equipment. As the period for depreciating equipment and buildings was extended, depreciation expense at companies fell. This reduced expenses, which also contributed to higher profits. However, once these two benefits were exhausted, corporate profits began to under perform the economy.
This is illustrated in the graph on the right. In fact, in terms of profitability, profit growth at companies in relation to the economy was sub-par. Throughout the 80's and 90's, profits for companies remained at the lower end of their historical norm. As Warren Buffett pointed out in his November 1999 article in Fortune magazine, you can't have a subset of the aggregate growing at a faster pace than entire aggregate. Eventually it reverts to the mean.7
After-tax Corporate Profits as a % of GDP
The combination of lower interest rates and changing the tax code helped to accelerate profit levels back toward the upper range of 6 percent experienced throughout most of this century. However, these were "one time events" and were unlikely to be sustainable. To keep profits growing at rates that Wall Street and investors were clamoring for took creativity. Over the last half of the 90's profit growth had more to do with "creative accounting" than it did to real, sustainable earnings. Corporate earnings growth has had more to due with an accountant's pen, than it did with the fundamental success of the corporate enterprise.
Corporate CEOs and their accountants began to manage earnings in such a way that pleased both Wall Street and shareholders. The creative ways in which earnings were manipulated are too numerous to cover in this article. Suffice to say they would fill volumes from textbooks to investment best sellers. I'm going to cover just a few.
Convenience Parking
"Parking" allows the company to show increasing sales without actually completing the sales process. Sales are shown on the books of the selling company, but the actual items remain off the books of the customer. In essence, the manufacturer is inventorying items meant for its customers. This may involve the manufacturer keeping the shipped goods in a truck trailer at the customer warehouse or plant until such time as the customer has need for them. The problem occurs when the question is, "To whom do the goods belong?" Do they belong to the manufacturer who sold the goods and booked them as a sale, or do they belong to the customer who has still not moved them into inventory as purchased goods or raw materials?
In the meantime, the buyer has been billed for the goods and the manufacturer has booked a sale and a receivable on its income statement. In reality this has become a deferred sale. It helps to enlarge sales without concurrent increases in costs. This procedure manifests a false profitability.
I remember my first year out of graduate school as an auditor on a job site in the month of December. We were at a plant in preparation for the year-end audit. Beyond the plant a long train loaded with raw materials was parked outside the gates. Throughout the month I noticed that the train remained parked and unloaded. I asked my senior supervisor why this was so and he remarked that if the train unloaded the goods, they would be booked into inventory and increase the cost of goods sold. It now made sense. When I came back from the New Year's holiday, the train was gone and the goods had been unloaded and booked into inventory. Of course it was a new fiscal year for the company.
Events like this happen much more frequently than you imagine. Creative accounting gimmicks like parking contributed to the problems at Sunbeam, Rite Aid, Waste Management and many other companies. The pressure to meet earnings expectations places enormous burden on management to perform to those expectations. This practice has led many companies to restate earnings as accounting irregularities become more frequent.
The Share Buyback Strategy
One way chief executives have been increasing their earnings is through share buybacks. By purchasing their shares in the open market, companies have been retiring stock at unprecedented levels. The idea behind this concept is to enhance shareholder value. By retiring stock, the company divides its profits between fewer shares of stock.
For example, if a company earned $1,000,000 and had 1,000,000 shares of stock, the profit per share would be $1 a share. Let's suppose that the shares were trading in the market at $10 a share and the company used all of its profit of $1,000,000 to buy back its shares. At $10 a share, the company could use the money to buy back 100,000 shares of stock leaving only 900,000 outstanding.
The following year, if the company made the same $1,000,000 profit, it would be divided over 900,000 shares of stock instead of 1,000,000 shares. The result would be that earnings per share would have risen from $1 per share to $1.11 per share. Even though total profits were the same, earnings per share would have risen by 11%. Thus, through the Share Buyback Strategy, the company's earnings per share increased without a fundamental improvement of the business.
Imagine what a company could do if it used debt, along with profits, to buy back shares. The number of shares could be retired at a much faster pace, leaving fewer shares to participate in the profits. This strategy could in turn accelerate earnings per share at an even faster pace. Wall Street and Day Traders reward rising earnings per share by higher stock prices. Rising earnings get analysts attention. Why? Because analysts tend to issue strong buy recommendations on companies whose earnings per share are rising at above-average levels.
Look at the balance sheet and income statements of many of today's big cap growth stocks and you will find this strategy as a contributing factor behind their earnings growth story. Share buybacks make sense when your stock is selling at a low multiple or if you have no business opportunities in which you can expand the enterprise. Buying your shares back when the price is inflated and leveraging your balance sheet to do so is a prescription for trouble down the road. It sacrifices future earnings and impairs the safety of the company.
The Corporate Restructuring Strategy
Another way in which earnings have been enhanced is through corporate restructuring. This technique has become commonplace and a permanent fixture in financial headlines. This practice involves writing off a large amount of expenses in one year or quarter.
Suppose a company is going to downsize its workforce. This could involve closing down plants and result in a large number of employee layoffs. Although this process takes place over a few years, the company books the expense up front in the first year. The write-offs are huge and of course would capture headlines. ABC Company is shutting down 5 plants and laying off 10% of its workforce! The expenses of doing this should be written off over the time period of completing the plant shut down, which could take several years. The beauty of this strategy is that you write off all of your expenses in one year. Wall Street applauds the move because they know that booking all of those expenses in one year makes the next year more profitable.
The write-offs are so big analysts ignore them. Indeed, stock services such as Value Line, exclude the losses from their earnings per share figures. It becomes a footnote listed at the bottom of the page. In the future, if those losses turn out to be less than originally estimated, they become a source of profits by adding them back into earnings. In some ways they become a "profit reserve" that can be called upon when a company needs to make its next quarterly profit objective.
The Acquisition Strategy
Another way to bolster profits is through acquisitions. An acquiring company uses its stock as a currency to buy other companies in an effort to buy another source of sales and profits. The problem here is something accountants call goodwill. Goodwill represents the excess value of a company above its tangible assets such as plants, property and equipment, cash and inventory. If you bought a company for $110 a share but its tangible net worth was $10 a share, the $100 excess value was attributable to goodwill. That goodwill reflected the company's brand franchise or the reputation of its products. It was intangible, but it was part of the company's success. An example of goodwill might include the franchise value of Coca-Cola.
The problem with the merger wave over the last few years is that many companies over paid for the value of their acquisitions. With their stock value flying high during the heydays of the bull market, it didn't matter. Now that overpayment is coming home to roost as more companies take restructuring charges to rid themselves of goodwill, it has to be amortized over a period of years. Recently, JDS Uniphase will adjust its Quarterly Report on Form 10-Q to reduce the carrying value of goodwill by $38.7 billion. In addition to reductions in goodwill, merger related expenses, realized and unrealized losses on equity investments, intangible amortization, and payroll taxes on stock option exercises, will cause the company to report a $50.6 billion loss for the year. That is the largest loss in corporate history. Even tech titan, Microsoft, had to write off $2.5 billion in bad investments. When combined with other charges, the write-off produced a $3.9 billion charge for the recent quarter.
The Financial Accounting Standards Board has aided companies in their earnings game. FASB is the private group the SEC relies on to set accounting standards. They have eased the earnings impact of accounting for goodwill from acquisitions. Goodwill, as previously mentioned, is the amount a purchaser pays beyond book value for a company's assets. In the technology boom of the late 90's these sums have been substantial. New rules passed in July allow corporations to assess the value of goodwill on their books periodically and take charges only when it has fallen – hence, the JDS Uniphase hit of $38.7 billion. The FASB backed away from tougher standards that would have forced companies to continue to amortize, or write off, the value of goodwill over 20 years or more.
From a macro perspective, the wave of corporate mergers has done little to improve the prospects of the economy. It is one of the reasons that economic growth and corporate earnings throughout the last decade have been below historical trends. Enduring economic prosperity comes from savings and capital accumulation in the form of real productive assets such a plant and equipment. The wave of corporate mergers, downsizing, and restructuring may boost profits in the short run, but they do nothing to improve long-term economic prospects. When all businesses begin to cut back on plant and equipment, shed assets and employees, they are contracting the economy from a macro perspective. They are reducing revenues and ultimately profits. The result is that corporate capital stock is in decline. In essence, the U.S. is consuming its capital by selling its assets in order to pay for consumption.
Corporate Profits in Decline
This profit deluge is becoming more evident in recent days as the financial markets witness the greatest plunge in corporate profitability in a decade. The downturn in profits at major corporations has been swift and brutal. It has stunned Wall Street analysts and investors alike. The numbers are horrendous from JDS Uniphase fiscal year loss of $50.6 billion to a plunge in the profits of Intel by 94%. The profit squeeze isn't limited to the hard hit technology sector. Profits are down dramatically across most industries outside of energy, utilities and the drug industry. So far second quarter profits fell more than 16% based on the 424 companies reporting in the S&P 500 index.
The precipitous drop in corporate profits, which is only now gaining attention, has been obscured over the last few years by hype and flagrant propaganda. Profits have been falling for years. The decline in profits has been overshadowed by the run up in stock prices. There has also been the game of corporate earnings and how they are reported. The game keeps getting reinvented. Companies, with the help of analysts, are looking for creative ways to bury the earnings story. When a myth like "the new paradigm" or "the profit miracle" is formulated, it becomes difficult to perpetuate it. These days Wall Street diverts the investor's attention from the bottom line to earnings of a different sort. In the old days of principled accounting practices, earnings used to represent after-tax profits from operating the business. These days, when companies talk about profit, they can mean almost anything. In this new paradigm age almost anything goes. Profits can mean cash profits, profits before taxes, profits before write-offs, pro-forma profits, or in the case of technology startups, "potential" profits.
Profit calculations mirror the new math taught in today's public schools where 2+2= 5, 6, 8 or anything you want it to be. The revisionists on Wall Street and the financial analysts turned media personalities are hard at work creating new and improved math with which to understand earnings. In the future, instead of just one bottom line, there may be three. Actually, "whatever works best" seems to be the new motto. A few examples illustrate how this process works.
Examples of "Whatever Works Best"
Example #1 Fudging Cisco's Pro Forma
When Cisco reported its fiscal third quarter profits at the end of the first quarter, analysts and the media concentrated on Cisco's pro forma earnings. According to Cisco's definition, pro forma earnings excluded acquisition-related costs, payroll taxes on exercises of stock options, restructuring costs, investment gains and a $2.25 billion pretax charge for writing down the value of inventory. Media analysts and Wall Street focused only on Cisco's pro forma net income of $230 million. The real number was a loss of $2.69 billion.8
In the latest quarter, Cisco reported its fiscal 2001 and fourth quarter results. Its pro forma net income was $3.09 billion for the year or $0.41 per share for fiscal 2001. That was down from the previous year where the company reported pro forma net income of $3.91 billion or $0.53 per share for fiscal 2000. However, after taking into effect acquisition charges, payroll tax on stock option exercises, restructuring costs, and inventory write downs, the company reported an actual net loss for fiscal 2001 of $1.01 billion or $0.14 per share. This compared to actual net income of $2.67 billion or $0.36 per share for fiscal 2000. For its most recent fourth quarter ending July 28, 2001 pro forma net income was $163 million, or $0.02 share compared to $1.20 billion or $0.16 a share – an actual decrease of 87%. Actual net income was only $7 million or $0.00 per share, compared with actual net income of $796 million or $0.11 per share for the same period last year.
| (in millions) CISCO | 7-28-2001 | 7-29-2000 |
| Operating Income | $28 | $1,515 |
| Interest/Other Income | $199 | $197 |
| Income before taxes | $227 | $1,712 |
| Income Taxes | $64 | $514 |
| Pro Forma Net Income | $163 | $1,198 |
A closer look reveals a situation that has deteriorated far more than was reported. As these numbers indicate, most of the technology giant's earnings for the latest quarter came from interest earned on investments. In other words most of Cisco's profits were coming from earning interest on investments not from the actual operations of the business.
Example #2 SCI's Slippery Numbers
Another example of how earnings reporting distort actual results was the previous quarter's earnings for SCI Systems, an electronics maker acquired recently by Sanmina. The company bragged and the financial press reported that its fiscal fourth-quarter numbers met or beat Wall Street estimates with "cash earnings per share" of $0.27. The actual numbers showed $46.9 million in non-recurring "special charges". These nonrecurring charges reduced the bottom line to an actual loss of $843,000, or $.01 a share. The company disclosed these costs as nonrecurring, even though the company may take a charge ranging between $70-100 million for job cuts and plant closing in the upcoming quarter.9 Personally, I define the word, nonrecurring, as "not occurring again".
Example #3 IBM's Bottom Line Boosters
IBM is another example of how companies play with numbers. The company helped to ignite a rally in the NASDAQ this spring when it reported EPS numbers that grew by 15%, easily beating analysts' estimates. But IBM's earnings are another story. A good amount of IBM's earnings gains over the last few years have nothing to do with the company's underlying business. Stock buy backs and gains in accounting from retirement benefits have given a nice kick to the bottom line. According to a recent analysis of IBM done in Forbes magazine, pension-related gains boosted the company's bottom line by $820 million last year. Those pension gains that flowed to net income represented an improvement of 63% from the previous year. The company has shifted away from the traditional defined benefit plans to cash balance plans, which cost less.10
IBM also boosted additional gains for its bottom line by dipping into its reserve account for doubtful accounts, inventories and reserve restructuring charges. IBM has also been enriching its EPS numbers by share buybacks. Since 1995 IBM has retired 423 million shares. Last year, buybacks added $0.13 to EPS. All is fine and dandy as long as there is plenty of cash to support buybacks. But with the tech sector slowing down, cash flow is falling. IBM's debt has risen to $24.9 billion as of 2000; while free cash flow dropped from $3.7 billion in 1999 to $3.1 billion last year.
IBM's bottom line continues to benefit from share buybacks this year. During the second quarter, the company spent $1.2 billion on buying back its shares. The buybacks reduced outstanding shares from 1.77 billion to 1.74 billion. The company also got a boost to its EPS by reducing its overall tax rate to 29.5% from 30% a year ago. IBM reported that its revenues continue to decline hampered by an 18% decline in personal computer sales. Sales are being hurt by a fall-off in the binge in corporate spending. The company warned analysts that its microelectronics business is likely to see a 15-20% decline because of the glut in inventories of semiconductors. And yet, the EPS numbers continue to look good – thanks to the help of accountants while the underlying business slows down.
Example #4 Others Enter The Earnings Game
In recent years, companies have used everything from pension savings to including investment gains in their earnings reports. Investors need to pay close attention to income statements to sort out how much of earnings actually come from running the business, versus outside activities from interest expense, investment gains, to gains writing options on their own stock. Many companies used gains from writing options on their stock when times were good. Companies ranging from Intel, Microsoft to Dell and others would often include investment gains in their earnings numbers. Analysts would include them until recently, when those gains started turning into losses such as the recent $2.6 billion loss on investments reported by Microsoft in the second quarter. Let me make that last statement plain and simple. When it is to their advantage, numbers are being included. When numbers are a detriment to the bottom line, they are being dropped.
Even companies like Procter & Gamble have resorted to using "special" reporting in how it accounts for its earnings. Traditionally, P&G included sales of its product line as a continuing part of its business. But this June, the company announced it would take $1.2 billion in charges to cut jobs and phase out lines such as Olay and write off food manufacturing charges. Wall Street excluded those charges from their earnings forecast. They have also excluded an additional $2.59 billion in other charges since 1999.
Wizardry in the Finance Department
Even more revealing than these accounting games is the composition of corporate earnings themselves. As shown above with Cisco, a good portion of profits reported these days doesn't come from making widgets or the business of the enterprise. At Intel a sizable portion of the company's depressed earnings now comes from interest income. It seems that an ever-increasing trend in corporate profits comes from their finance departments as financial activities are contributing a greater portion to the corporate bottom line. The business of American companies is rapidly moving from making things to making money on money. Financial service companies are expected to contribute a record 25% of profits for the S&P 500 this year.
Excluding energy, one of the few sectors reporting above-average earnings today is found with finance-related companies like Fannie Mae, Freddie Mac, Capital One and MBNA. It is all part of a by-product of the credit boom. As the Fed and GSEs inflate the money supply, that money is fed into the financial markets and into the economy. It is only natural that companies move into this profitable realm of the incredible American Credit Machine.
| Industrial Companies Benefiting From Finance | |||
| Company | Financial Service Revenues | % Total Sales | Avg 2-10yr Sales Growth |
| GE | $66,177,000,000 | 50% | 16.60% |
| Ford | $29,189,000,000 | 17% | 7.43% |
| GM | $16,502,000,000 | 10% | 10.23% |
| Source: Bloomberg | |||
Many of today's large industrial companies derive an ever-increasing portion of their earnings from financial maneuvers. From industrial giants like GE, Ford, and General Motors to department stores like Sears Roebuck, many generate a sizable portion of their profits from their financial subsidiaries. Actually, some of these companies are beginning to look more like financial companies than they do industrial giants. As this table shows, a greater portion of sales from these companies is coming from their financial subsidiaries.
Looking Closer At GE Sales
| Product | 1998 | 1999 | 2000 | Avg 2-Yr Growth |
| Financial Services | 48,694 | 55,749 | 66,177 | 16.60% |
| Power Systems | 8,500 | 10,099 | 14,861 | 32.98% |
| Industrial Prod/Sys | 11,222 | 11,555 | 11,848 | 2.75% |
| Aircraft Engines | 10,294 | 10,730 | 10,779 | 2.35% |
| Technical Products | 5,323 | 6,863 | 7,915 | 22.13% |
| Plastics | 6,633 | 6,941 | 7,776 | 8.34% |
| NBC | 5,269 | 5,790 | 6,797 | 13.64% |
| Appliances | 5,619 | 5,671 | 5,887 | 2.37% |
| Source: Bloomberg | ||||
In the case of GE, close to 50% of its gross revenues are coming from financial services versus the industrial side of the business. GE reported record second quarter earnings, with a good portion of those earnings from its financial unit. Further, GE reported that earnings increased by 15% in the recent quarter to a record $3.897 billion. Of that amount, $1.476 billion came from GE Capital Services. GMAC accounted for 70% of GM's profit in the second quarter.
Ford is expected to report similar earnings percentages from its finance unit. In the case of Ford, it is taking $300 million in profits from securitizing gains.
An Upside Gain Can Be a Downside Potential
The problem with industrial companies turning their business to financial activities is that there are two sides to financing. On the one side are profits that come from the spread in the cost of money and what is charged on lending. The other side of the credit equation is what happens to earnings and the balance sheet when loans go bad. This is a hard lesson that is being learned by companies ranging from technology to banking and finance. American Express reported that second quarter profits fell 76% as the company warned their earnings would take a hit of $1.2 billion in losses in its junk bond portfolio and job cuts. The bulk of those charges would cover losses in junk bonds and the expectation for future defaults. Other companies ranging from Lucent to Microsoft have had to write off bad investments. Many of these giants goosed their sales by lending to customers. Unfortunately, many of those customers have since gone bust. To quote a recent article in Barron's on the subject, "It's fortunate Corporate America is making money on money while it's not making much money making things".11
Corporate Profits ARE in Recession
As the above examples indicate, the long held view of a new profit paradigm in the American economy is more illusionary than it is factual. While the economy isn't technically in a recession, corporate profits have entered into one. Lately, the stock market has been discounting the economic environment, while not improving, it's saying it won't get worse. But on the corporate side, things are getting worse. Profit margins are being squeezed and losses are mounting. What would happen to these dismal profits, if the economy were to go into a recession? Wall Street is only recently coming to grips with this dilemma. The second half profit recovery has been thrown out the window, but the Street has merely postponed their forecasted recovery into next year. Right now earnings estimates are still too high. Rising costs are currently hurting corporate profits the most. Among those costs are rising wages, medical and energy costs. To make matters worse, companies are unable to pass those costs along to consumers.
| Corporate Profits Comparison by Industry | |||
| Industry/Company | 2Q 2000 | 2Q 2001 | Inc/Dec |
| Technology | |||
| Intel | $3,140,000,000 | $196,000,000 | -94% |
| Microsoft | $2,410,000,000 | $66,000,000 | -73% |
| IBM | $1,940,000,000 | $2,050,000,000 | +6% |
| Cisco | $796,000,000 | $7000,000 | -99% |
| Sun Micro Systems | $720,000,000 | <$88,000,000> | –112% |
| EMC | $429,000,000 | $126,400,000 | –71% |
| Qualcomm | $154,700,000 | <$274,700,000> | –278% |
| Communication | |||
| AT&T | $1,600,000,000 | $148,000,000 | –91% |
| Motorola | $204,000,000 | <$759,000,000> | –472% |
| Finance | |||
| American Express | $740,000,000 | $451,000,000 | –76% |
| J. P. Morgan Chase | $1,760,000,000 | $690,000,000 | –61% |
| Merrill Lynch | $921,000,000 | $541,000,000 | –41% |
| Industrial | |||
| GM | $1,750,000,000 | $610,000,000 | –65% |
| DuPont | $949,000,000 | $432,000,000 | –54% |
| Eastman Kodak | $513,000,000 | $325,000,000 | –37% |
| Caterpillar | $315,000,000 | $172,000,000 | –14% |
| GE | $3,380,000,000 | $3,900,000,000 | +15% |
| Media | |||
| AOL Time Warner | <$924,000,000> | <$734,000,000> | –21% |
| Consumer Products | |||
| Proctor & Gamble | $516,000,000 | <$320,000,000> | –162% |
| Energy | |||
| Exxon/Mobile | $4,150,000,000 | $4,380,000,000 | +6% |
| Note: Profits have been rounded Source: Bloomberg | |||
At the same time that rising costs are hitting earnings, rising debt levels are starting to be felt on the bottom line. Corporate balance sheets are in terrible shape. Companies took on enormous amounts of debt to buy back stock or fund acquisitions. Now, higher long-term interest rates and lower stock prices have made the cost of all of that borrowing more expensive. Business investment has plunged – not because of inventory accumulations – but because companies no longer have the cash to fund capital spending.
While Wall Street no longer expects Corporate America to turn the corner this year, there is still hope for a recovery in the first quarter of next year. This may be a bit too optimistic. Historical evidence indicates that when slowdowns begin, they usually end up in a recession. Profits can get even worse if the consumer and the housing market begin to retrench. Mounting debt at the consumer level points to a slowdown in consumer spending ahead of us.
Recently, the government reported that slowdown might be in process. Borrowing by consumers is beginning to fall back as consumers start to pay off debt. Corporations are doing the same and in the process, shedding unneeded workers to help conserve cash. These aren't the kind of things you do if you think a turn-around is eminent. The profit squeeze ravaging the U.S. economy since the third quarter of last year has been unusual in its ferocity. The pullback is taking place across a broad spectrum of sectors.
Wall Street and the media still keep reporting this as nothing more than a simple inventory correction. Even Mr. Greenspan, in his July testimony before Congress, has alluded to an inventory correction. The facts just don't line up. The elements at work here are more structural in nature. The new corporate paradigm myth is evaporating. As the above graphs on profits illustrate, profits this decade peaked back in 1995 and were the product of plunging interest rates. Since then, profits have been sub par.
Essentially, the lack of a clear renaissance in profits was masked by rising stock prices. The illusion of rising profits and rising productivity were more the product of statistical tinkering with hedonic indexing of the tech sector by government and the creativity of corporate accountants. It is for these very reasons that that the coming financial storms will be that more severe.
Summarizing The Arguments Against Recovery
What I have tried to illustrate in this final installment in the Storm Series is that there are too many variables that argue against an immediate recovery. Monetary policy has been ineffective in arresting an economic slowdown or triggering a rebound in the financial markets. The current credit boom is continuing unabated at the risk of peril to our economy and our financial markets. Energy prices are hurting the corporate bottom line and consumer pocketbooks. The energy crisis is real and won't go away. Despite an economic slowdown, the IEA still estimates that global demand for oil this year will increase by 500,000 barrels a day. That demand is coming from Asia and the developing world. The tax cuts could have helped to mitigate some of the weakness of the coming bust by lightening the burden on debt-strapped consumers and corporations. Instead, the tax rate reductions will be phased in over a six-year period. All that consumers will get this year are rebates. Even then the tax rate reductions are in jeopardy with Democrats arguing that they need to be repealed. Dick Gephardt and others are talking about tax increases if deficits reappear. On the corporate front, earnings are already in a recession and are bound to get worse as the economy weakens further.
III. To everything there is a season... (Ecc. 3:1)
I believe we are now in the final year of The Seven Fat Years and that the lean years are ahead of us. How one manages the approaching storms will depend on your perspective and preparation. As I wrote in the beginning of this installment, our seasons of weather are determined by the rotation of the earth's axis around the sun. The angle of the earth relative to the sun's radiation determines whether we are experiencing winter or summer. At exactly the same time it is winter in one part of the world, while it is summer in the opposite side of the globe. It is exactly this perspective one must keep when viewing the investment markets. While the financial markets head towards winter, summer is approaching for hard assets and natural resources. See Century Graph.
Human nature being what it is, there is always a disposition by most investors to think that existing trends go on in perpetuity. When the market has gone up for as long as it has, there is a tendency to believe that this trend is permanent and irreversible. A bull market of rising stocks for 18 years has given way to complacency by investors in thinking that this time it is different. There are special circumstances associated with this boom that make it unlike its predecessors. New paradigm theories propagated by the financial press only reinforce this view. In his classic, The Stock Market Barometer, William Peter Hamilton wrote, "Prosperity will drive men to excess, and repentance for the consequences of those excesses will produce a corresponding depression. The problems of humanity do not change, because human nature is what it has been as far back as human record tells. Cycles are as old as organized humanity."12 Hamilton, a friend and student of Charles Dow, echoed Dow regarding his view that the only permanent fact in the financial markets was change itself.
A Lesson From The Seventies
When I entered the investment business in the late 70's, it was dominated by hard assets. Mutual funds occupied only a small corner of a page in the Wall Street Journal. Taxes, inflation, and high interest rates had decimated the financial markets throughout the late 60's and the 70's. Fortunes were being made in real estate and oil. Gold and silver soared until their apogee in 1980. No one invested in stocks back then. Only a small minority of the investment public saw its potential growth. You couldn't give away financial assets. Financial publications like Business Week declared the death of equities. Stocks sold at seven times earnings. Dividend yields were over 7% and in the case of utilities over 13%. Treasury bond yields had risen to 15% and money market funds were paying investors over 18%. Nobody bought stocks and bonds because they thought bond yields were heading higher and stock prices lower.
Back then the consensus was that gold prices were going to hit $2,000 an ounce and silver was going north of $150. Oil was at $40 a barrel and analysts saw $100 a barrel in the not too distant future. Wall Street and investors paid little attention to the changes being brought about by Paul Volcker, the new chairman of the Fed and the new American president, Ronald Reagan. Volcker was raisinginterest rates and Reagan was lowering taxes and reducing regulations from hamstringing the economy. In a short time, the investment landscape was going to change dramatically. Spring was just around the corner with the greatest bull market of the century about to be launched in the stock market, while hard assets and the rise in metals and energy were heading towards winter. The few who saw it coming were scorned or derided as kooks.
Discerning The Shift
Wall Street hates change and it is slow to react when it comes. The investment public is no different. The public usually jumps on board a trend when it is in its final stage. The only information that is valid for today's investors is the movement of prices. Price reflects the aggregate knowledge of Wall Street and all that it knows about coming events. Even then it may not notice or react when market conditions change. A long trend, if in place long enough, may blind investors to the fact that circumstances and conditions have already changed.
As this graph shows, the stock market has gone nowhere since January 2000. For Dow theorists, the market signals when a change is in place. Charles Dow once wrote, "It is a bull period as long as the average of one high point exceeds that of the previous high point. It is a bear period when the low point becomes lower than the previous low point".13 Hamilton expressed it better when he said, "The thermometer records actual temperature at the moment, just as the stock ticker records actual prices. But it is essentially the business of a barometer to predict".14 The market is not saying what it is today. If it did, it would only be useful as a thermometer. What the market is telling us by its price actions is what conditions will be in the months ahead.
The stock market of today is saying is that a long-term trend in place for so many years is about to be reversed. Its volatility, the gyration of prices, and the sudden swoon in the indexes are signaling a coming storm. Nobody seems to want to listen to this message of the markets. To quote Hamilton again, "Is the American public so ungrateful to its Micaiahs and Cassandras as this? Yes, indeed, and more so. It does not like unpleasant truths; the prophet of calamity will make himself hated in any case, and hated all the more if his predictions come true."15 Investors still want to believe in the past. Everyone is waiting for the tech sector to rebound and return to its glory days of double-digit returns. Those days are past and only blind faith keeps it alive. As the above chart on the technology sector shows, new orders are in a free fall. A new trend is in its formative stage.
One Man's Winter is Another Man's Summer
As these three graphs indicate, we have been experiencing a bull market in financial assets and a bear market in hard assets. It is inconceivable by many that these trends would reverse. However, a graph of the financial markets over the last century may be helpful to remind us of these reversing trends.
20th Century Stock Market Chart
Click to view full image
When reviewing the 20th Century, two points are obvious. # 1 Bull markets are not a permanent condition. # 2 There are periods when financial assets do well and there are periods when hard assets lead the market. When financial assets are in a bear market, hard assets are usually in an up-trend. Going back to my weather analogy, one man's winter is another man's summer.
Why Do Trends Die Off?
There are many reasons why these trends reverse. It can be explained by basic economics. Low prices leads to low returns for an industry. Therefore, they discourage new investment. When low prices remain in place for a long enough period, it leads to consolidation within an industry. In an effort to cut costs, companies either merge or shed assets in an effort to remain competitive. The weaker players fold or are absorbed by the strong. This is what happened to the energy sector during the 80's and 90's. Decades of low prices caused the industry to consolidate. It became more profitable for companies to buy other companies than it did to explore for new oil. The result has been an energy complex that is frayed and worn out and is short of excess capacity. Low prices kept the industry from expanding and rebuilding its infrastructure. Meanwhile demand continued to increase as a result of expanding economies and growing populations. New demands were placed on energy with the technology boom. We are now at that point where supply is no longer capable of keeping up with demand, so prices are on the rise.
For precious metals it is exactly the same. Low prices have caused the industry to contract. There are fewer players today than a decade ago. Like energy, demand for precious metals has continued to grow while supply has been unable to keep up with demand. So we are running supply deficits, which have been met by central bank sales and leasing. For silver above-ground stocks of inventory have been used to make up the shortfall created by the lack of new mine production.
These conditions can only go on for so long. There isn't an infinite supply of precious metals or energy. It will take higher prices to create the investment incentives to explore for new oil and natural gas. In the case of precious metals, central bank stocks of gold aren't infinite. Eventually sales and leasing by central bankers may come to an end. The Washington Accord in September of 1999 has signaled that the gold leasing game is nearing its end.
Phase Two Of A Bear Market
Referring to the chart of the financial markets over the last century, it clearly illustrates the winter and summer seasons in the financial markets. We have had bears markets in the past and we will have them again in the future. In my opinion, we are already in phase two of this one. The first stage of the bear market began last year and took the froth out of the stock market. The second phase is what we are experiencing now. It is a long, drawn out process where stocks began to react negatively to each news event. Instead of going up when interest rates are lowered they rise momentarily only to recede even lower. During this phase of the bear market, bear-o-metric pressure increases and the storms forces begin to build until they reach maximum power. At that point, we will enter the third and final phase of the bear market where the damage will be greatest. During this phase we will transition towards a new trend, which will become the genesis of the next big favorite in the financial markets. I believe it will be a bull market for natural resources.
The Darlings of The Decades
| S & P 500 Ten Biggest Stocks by Decade (Index Weight) | |||||||
| 1970's | 1980's | 1990's | 2000 | ||||
| IBM | 4.3% | IBM | 3.0% | Microsoft | 3.9% | GE | 5.043% |
| AT&T | 3.8% | Exxon | 2.9% | GE | 3.3% | Microsoft | 2.752% |
| Exxon | 3.8% | GE | 2.3% | Intel | 2.4% | Exxon/Mobile | 2.589% |
| Std Oil IN | 2.5% | Philip Morris | 2.2% | IBM | 2.1% | Pfizer | 2.495% |
| Schlumberger | 2.4% | Royal Dutch | 1.9% | Wal-Mart | 1.9% | Citigroup | 2.210% |
| Shell Oil | 1.9% | Bristol-Myers | 1.6% | Cisco | 1.9% | Wal-Mart | 1.954% |
| Mobil | 1.9% | Merck | 1.6% | Lucent | 1.8% | Intel | 1.826% |
| Std Oil CA | 1.8% | Wal-Mart | 1.6% | Exxon | 1.8% | AIG | 1.725% |
| Arco | 1.6% | AT&T | 1.5% | Citigroup | 1.5% | Merck | 1.660% |
| GE | 1.5% | Coca Cola | 1.4% | AT&T | 1.4% | AOL | 1.657% |
| Source: Wall Street Journal, 8/27/99 and Bloomberg | |||||||
Each decade has been dominated by a different trend. During the 1970's, 7 out of the top 10 stocks in the S&P 500 were related to energy. In the 1980's, drug, retail, and consumer product companies dominated the S&P. By the end of the 1990's, technology dominated the list. Today's dominance is more dispersed with a mixture of finance, technology, drug and industrial. The heady days of technology have receded. Microsoft, Cisco, and Intel no longer have market caps exceeding half a trillion. Today only GE approaches that level. As I've written in "Trains, Plains and Dot Coms" technological innovation is nothing new. It has been a hallmark of American Industry. There have been four distinct technology cycles beginning at the turn of the century, the 1920's, the 1960's, and more recently the 1990's.
There will be another cycle in technology, but I believe it will not dominate this current decade. I believe companies in natural resources and industrial development and construction will become the market leaders at the dawn of this new century. America's infrastructure has been allowed to decay. From roads, bridges, airports, water systems, and energy, to new plants and equipment – all will have to be rebuilt. Unless we do so, we will lose our industrial lead. In addition, our energy complex will have to be repaired and rebuilt and new sources of alternative energy will have to be explored. We are living in the sunset of the petroleum age. We are now at a point at which prices will slowly begin to rise. By 2010 we will arrive at a point where energy shortages in oil and natural gas will be a common experience.
IV. Market Shift
Naturally, It's Natural Resources
The coming boom in natural resources will be driven by population growth, economic expansion, and the spread of industrialization. As wealth expands through industrialization in the developing world, it is accompanied by an appetite for material goods. Demand will increase for energy, autos, building materials, appliances, and resource-intensive commodities. This escalating worldwide demand for resources and commodities of all types will lead to scarcities and disputes over the ownership to these mineral rights. Necessity will collide with the fact that world supplies of many of these resources are limited with oil and water leading them. The combination of increasing world demand, resource shortages, and disputes over their ownership will become the source of conflict in this new decade.
Conflicts Will Arise
Throughout human history, natural resources have been the cause behind most wars. Nations wanted them and took them or tried to take them by going to war. There are no new frontiers to explore on this planet. Therefore nations will find themselves in opposition over access to the earth's remaining resources. The last century was a prelude of things to come. Oil has been behind the conflict in three major wars of the last century. The most recent conflict over oil was the Gulf War of 1991. The side that prevails in war will be the side that can maintain a robust economy and control over resources vital to its economy. Lack of access to oil defeated Germany and Japan. Oil was at the center of the stage in the last two World Wars of the 20th Century. It is likely to provoke conflict in this century as well. No industrialized nation or developing nation can survive without access to oil.
I've already covered demand for oil and water in Part 8 of this Storm Series. Without belaboring the subject, all I wish to add are some thoughts on the geo-political aspects. Right now America has three major problems with natural resources. We once had plentiful supplies of oil and natural gas. Today, our oil reserve base is down to about 30 billion barrels. A second problem is the rise in power of the environmental movement. The Green's are shutting down the development of our remaining resources. This limitation has led to a third problem which is our dependence on foreign powers for supply to meet our resource deficits.
These three issues are setting the stage for the coming conflicts of the new century as nations jostle over access to oil and water. In the case of oil, the nexus will be the Middle East, the Caspian Sea basin, and South China Sea. Once again the Middle East, the cradle of civilization, will occupy the front pages as it always has. Throughout recorded history there have been more wars fought in this region than in any other place on the globe. From ancient Mesopotamia, to the Babylonian and Assyrian empires, to the Greek and Roman Empires, to the British and the Americans in the 20th Century, empire after empire have sought control over this sacred ground. It is the genesis of the world's three largest religions and the source of one of the earth's most precious resources.
The Politics of Oil in The Middle East
The Middle East contains approximately 65% of the world's remaining sources of oil. The Caspian Sea is estimated to contain another 10%. Therefore, in one region of the globe we have 75% of what the world wants and values as its most precious resource. There simply is no other pool of oil large enough to sustain the world's voracious appetite. Five Arab nations control this oil. All of them are Muslim. Some are friendly but suspicious of the West, while the others are hostile. But it is these nations and not the West which control the oil. We find a similar situation In the Caspian Sea basin. Russia and Iran, along with several former Soviet Republics, border this land-locked sea of vast energy resources. The Caspian contains the second or third largest source of energy reserves of oil and natural gas in the world.
Shifting Military Strategy
The next source of global conflict will be centered in these regions. America is already shifting its military assets and building up its presence in the region. The U.S. spends approximately $75 billion, or 25% of its military budget each year defending its interest in the Middle East. Russia is also building up its military assets around the Caspian Basin. In a major foreign policy speech President George W. Bush has signaled a change in America's military strategy. It will shift away from Europe to the Middle East and the Pacific where the main oil regions of the world are found. America's military strategy is transitioning to be able to strike with lighting speed and project its presence over longer distances. American leaders see a strategic interest in developing the Caspian energy supplies as a necessity to the continuing risk in the Persian Gulf.
Washington has two specific interests in the Caspian basin. The first is an alternative source of oil to the Persian Gulf and the second is to ensure control over the transportation of that oil to markets controlled by the West. Washington wants to bypass Russia and Iran. To accomplish this the United States wants to build a pipeline from Kazakhstan and Turkmenistan to Georgia and Turkey. The Cold War may be over, but a new Cold War and possible confrontation is building between the two powers in the Caspian. Both sides are reinforcing and strengthening their military positions. As a Caspian state, Russia is in a better position to build on its existing infrastructure. Tensions throughout the Caspian basin will surely mount as the U.S. and Russia stretch their military muscles.
Dependence Necessitates Strategy
The American economy and its industry have become too dependent on imported supplies of critical raw materials. This necessitates a military strategy that protects this growing source of supply to the U.S. economy. Economic security is driving foreign policy and military strategy. Increasingly America's voracious appetite for natural resources will come into conflict with the emerging demands of a developing world. With only 5% of the world's population, we consume a third of the world's energy.
The future war over oil is becoming more obvious by the growing buildup of military forces in the region. The Arab states are arming. Russia is shifting more of its forces into the North Caucasus and the Caspian Sea basin. It currently has over 80,000 ground troops throughout the region. The United States is providing arms and advice to several of the former Soviet Republics. At the same time, as a result of the Gulf War, the U.S. has left in place substantial military assets in the region. The Pentagon has positioned vast supplies of heavy equipment at depots in pro-Western nations. It has also moved in ships and aircraft capable of assembling a substantial combat force. Those military assets are there for only one reason – to protect oil and the system that transports it.
The U.S. may have abandoned its two-front war strategy, but in the Persian Gulf we are building forces large enough to handle a three-war scenario. These three scenarios are to repel Iraqi forces and the ambitions of Saddam Hussein, to keep Iran from closing the Strait of Hormuz, and to protect Saudi Arabia from internal revolt. The U.S. doesn't want to repeat the mistakes of the Carter Administration when it let its valuable ally, the Shah, fall from power. The result was Shah Mohammad Reza Pahlavi was replaced by a militant religious regime led by the Ayatollah Ruholla Khomeini.
The protection of critical raw materials and their transit routes has been central to American security for over the last half century. From Roosevelt and Truman to Carter and Bush, American presidents have let it be known that we will go to war to protect access to resources and their transit routes. The task of implementing that strategy is at the heart of CENTCOM (U.S. Central Command). "The ability to project overwhelming force and decisive military power is the key to CENTCOM's theater strategy as well as shape the battlefield,"16 General Zinni told Congress in 1999. This commitment to unilateral intervention to protect U.S. interests and a war doctrine of dominating the battlefield has become the cornerstone of U.S. foreign policy in the region.
Now U.S. forces are being expanded to cover the Caspian Sea basin. Unlike Russia, the U.S. has no military bases in the Caspian. America is expanding its influence through surrogates, diplomatic efforts and military exercises and military aid to former Soviet States. The underlying message is clear. Americans consider the Caspian to be a vital U.S. interest. The combination of the buildup of Russian and American military capabilities in the Caspian region will only heighten political tensions and hostility and make war that much more probable. Unlike the Persian Gulf, the conflicts will be over border disputes. There is no commonly accepted legal framework covering the ownership of the Caspian's underwater energy resources. As noted, the Caspian is a landlocked sea. Pipelines deliver the transportation of the regions resources of oil and natural gas. Those pipelines traverse terrain north and south, east and west bordered by conflict in either direction. As oil flows through these pipelines, they will take on strategic importance in the countries through which they pass. This could involve not only regional conflict within the area, but if not resolved at the local level, it could lead to the involvement of Washington and Moscow.
As of this writing there is a tense standoff between Iran and Azerbaijan over territorial disputes over the Caspian Sea. Iran is consulting closely with its ally, Russia, over the matter. Iran has already used its military power to block a British Petroleum research project. The dispute is still unsettled and unless a workable treaty is reached between the two states tensions could escalate even more.17
The Politics of Oil in The Far East
Energy politics also pervade the Pacific Rim around the South China Sea. Like the Middle East, five states border the region. It contains the third largest source of oil reserves in the world. From the great powers of China, Japan, and the United States to smaller nations like the Philippines, Taiwan and Vietnam – all have a strategic interest there because of oil. Like the Middle East and the Caspian, the local powers are building up their military assets. China, the U.S. and Japan are also repositioning military assets in the region. The Pacific and the Middle East are replacing Europe in strategic importance in U.S. foreign policy and military strategy. At the heart of that strategy is energy. Many of the same conflicts and rivalries that exist in the Middle East exist throughout this region as well. Until recently, most conflict in the region was between China and Vietnam. Since 1995 the conflict has spread to other nations as seen in the Philippines and Malaysia.
South China Sea's Spratly Islands Increasing in Importance
In 1995, the Philippines discovered that China had constructed a small military depot on Mischief Reef, an islet claimed by Manila. This provoked a series of military clashes that has since altered the strategic balance of power in the South China Sea. The conflict in the South China Sea is over a dispute over the Spratly Islands. This collection of islets, cays, and reefs are spread throughout 80 thousand miles bordering six states: China, Brunei, Malaysia, Vietnam, Taiwan and the Philippines. China now lays claim to the entire Spratly chain. To support its claims, China has embarked on a costly campaign to build a blue water navy. An aggressive expansion of China's navy has triggered a naval arms race in the South China Sea. Local states, fearing China's policy of aggrandizement since the late 1980's, have spent costly sums to build up their navies. In the next decade various naval acquisition programs now under way in the region will bring the number of war ships to over one hundred. This naval buildup is unmatched in any other part of the globe. Instead of patrol boats, we now have warships. The U.S. has moved considerable naval assets into the region with a new naval base in Singapore. The coming conflicts in the South China Sea, like the Persian Gulf and the Caspian, will center on vital energy interests and the trade routes that transport it.
The Politics of Water in The World
Like oil, water is a scarce resource. The same needs that exist for oil exist for water. The vast majority of the earth's surface consists of large bodies of water, yet only 3% of the globe's total water supply is fresh water. The great majority of that supply is located in the polar ice caps. The risk of conflict that exists in energy is also present in water because many of the more important bodies of fresh water are shared by two or more nations. In Global Trends 2015, the Central Intelligence Agency states that half of the world's population will live in countries that will experience severe shortages of water. Water-stressed areas around the globe will be found in dense population centers located in Africa, the Middle East, South Asia, and in northern China. In the developing world, 80% of water is used for agriculture, a trend that will not be sustainable. Conservation and efficiency measures will not be ameliorate the coming water shortages. The CIA estimates that by 2015 limits on available water within those regions will lead to increased conflict.18
There are currently three strategic locations where the potential for conflict exists. They are located along the Nile River Basin and the Jordan River, the Tigris and the Euphrates, and the Indus Basin. Just as with oil, population growth and economic expansion are boosting world demand for water. Disorder can arise over the allocation of water resources as a particular supply of water traverses several international boundaries. For example, the Nile River passes through nine countries. The Euphrates travels through four.
In the Middle East, the Tigris-Euphrates, the Jordan, and the Nile have played key roles in the development and agriculture of the region. These rivers have been a source of war between competing kingdoms and empires that go as far back as the fighting over Jacob's wells. Approximately half a billion people live and feed off these rivers. They depend on them for the bulk of their food and their drinking water. Water, as much as oil, is behind much of the region's tensions. The next Middle East War could just as easily begin over water as politics or oil.
From the time of the Old Testament to the present age great wars have been fought along the banks of these rivers. Water is a major source of conflict right now in the Middle East. If you want to understand the current conflict between Israel and the Palestinians, you need to look at the issue of water. The West Bank sits on top of a large water aquifer. By gaining the Golan Heights from Syria during Six-Day War, Israel gained control over the Baniyas River. It also gained the West Bank, which gives Israel access to the lower Jordan River and all of the aquifers north of Jerusalem.
Each one of these three river basins poses significant risk for conflict. Population growth and hence the demand for water is growing faster than supply. As supply shortages of this valuable resource increase, so does the potential risk for war. Turkey is building new dams and irrigation projects on the Tigris and Euphrates Rivers, which will affect water flows to Syria and Iraq. Egypt is diverting Nile water that will direct flows away from Ethiopia and the Sudan. Action by one state that borders another state near a water region can precipitate action by another. Damming a river, controlling an aquifer and using more of its supply can force leaders to respond to what they consider an infringement upon national resources. Government is expected to provide for the needs of its people. This ability to provide for the basic well being of its constituents gives government its mandate to rule. When it fails to provide for those basic necessities, it must either attempt to stifle internal dissent (risking civil war) or it must blame others, which leads to conflicts between states.
Low Intensity Conflicts (LIC) Increasing
Since the end of the Cold War, political analysts have predicted a world of peace. Instead we have seen conflict. There are over 36 regional wars or LICs (Low Intensity Conflicts) around the globe today. Experts have tried hard to define the shape of the Post Cold War world. Samuel Huntington in his book, The Clash of Civilizations, has defined conflict along religious and tribal lines. Robert Kaplan defines it in his book, The Coming Anarchy: Shattering the Dreams of the Post Cold War, by a world of anarchy triggered by population excess. Friedman argues in The Lexus and the Olive Tree that the world will be shaped along economic interest triggered by globalization. Others, ranging from Youngquist to more recently Klare, believe it will be shaped more by the escalating demand for the earth's resources. Their arguments all contribute to our understanding of a world that is changing rapidly around us. I believe the growing demand for resources will in the end become the dominant factor, especially as we approach the sunset of the petroleum era.
V. Storm Watch
Throughout this Storm Series, I have identified potential storm fronts that will soon engulf the financial markets. The front edge of the storm has already arrived. It can be seen in the collapse of the technology bubble, the rapid slowdown of the economy, the acceleration of job layoffs, the deterioration in corporate profits and the currency upheaval in Turkey, in Argentina, and now the dollar. The politicians, the analysts and the news anchors are telling us this is just a brief mid-summer squall. I believe it to be otherwise. No one is infallible in his or her predictions. I certainly make no such claims. Nevertheless, there is a storm brewing. The direction, the path and the severity of this approaching storm have yet to be determined. Time will give us that answer.
Follow The Wind
When I'm out sailing, I constantly watch the tell-tails along the edges of my sails. If I am in perfect trim, these strips flow parallel to the water with the direction of the wind. I use them to determine if I am sailing true to my course. The wind never flows steadily in one direction for very long. If I don't pay attention, and keep my sails in perfect trim, the tell-tails begin to droop. This tells me I am moving off-course and I need to make an adjustment. If I don't, the boat will eventually lose speed and become less balanced. If I want to keep the boat optimally powered, those tell-tails must flow in the same direction as the wind. The wind can decrease or increase in force as well as change its direction. Sailors call these changes "puffs", which are short gusts of wind. These short gusts are either headers or lifts. A lift is a short burst of wind, which helps to accelerate the boat in the direction that is desired. A header does just the opposite. Headers shift the boat away from the desired direction that the boat is headed. A good sailor will always fine-tune his sails to maximize the speed of the boat by anticipating and responding to headers and lifts.
In order to anticipate these puffs, you must follow the wind. Wind cannot be seen. But its effect can be seen on the water by dark patches or ripples in the waves. A trained eye can spot them with ease. For investors, it is the same. Like the tell-tails on a sail, the economy and the financial markets are constantly giving us feedback. They tell us about the force and the direction that both are headed. In the case of the current storm, the financial tell-tails are drooping, signaling a course change, and an adjustment at the wheel.
Financial Tell-Tails
The Economy
The fist tell-tail to keep your eye on is the economy. Right now the economy is slowing down, but it is still not in recession. Real estate and consumer spending are holding it up. Watch these two indicators for a sudden shift. Be on the lookout for a drop in consumer spending and a pullback in borrowing. We are already seeing the early signs of slowing. The government has reported that borrowing by consumers has already begun to slowdown. Watch the composition of the retail sales numbers. Right now they are flat, but already a sudden shift is taking place. The sales of department stores have fallen dramatically. Discounters like Costco and Wal-Mart are still doing well, but the shift of sales to discounters is telling me that consumers are becoming more cautious. However, even Wal-Mart has warned analysts that the next two quarters may be on the low end of their estimates. When Wal-Mart and Costco sales start falling, the retrenchment will be in full swing. Inventories and the production of cardboard will also be another sign. When inventories continue to build and the production of cardboard drops it will signal the retrenchment in consumer spending is gathering strength. Even today, August 16th, this trend continues. Gap and Nordstrom reported 2nd quarter profits. Gap's earnings fell 51% and Nordstrom's net income was down 15%. Even so, Kohl's which attracted shoppers with low prices on clothing and housewares, reported net income jumped 35%.
Real Estate
Housing will be another sector to keep your eyes on. At the moment it is still running strong because of low mortgage rates. However, the upper-end on housing is already starting to soften. When the wealthy stop buying, the little guy will follow. Watch for a drop in permits, housing starts, and a fall off in existing home sales. You should also begin to see housing prices start to soften. Watch the paper for adds on price reductions. Following Home Depot sales will provide further confirmation on whether the housing market is softening. When Home Depot sales figures start to drop, they should confirm the drop in permits, housing starts and new home sales. The consumer and housing markets are the last two sectors to remain standing. When they go, we will be in a true recession.
Corporate Profits
The other indicator to keep an eye on is corporate profits. Wall Street is counting on a pick up in capital spending to take over from the consumer. However, profits drive capital spending by business. When profits disappear or when losses appear, companies will start to conserve their cash. Without an increase in profits, there will be no money to fund capital expenditures. We will see Corporate America begin to hunker down and conserve cash to help weather the downturn. This strategy accounts for the massive amount of layoffs. Financial analysts are counting on capital spending to be the first sign that a recovery is taking place. Watch profits first. They'll give you the answer on whether a capital spending recovery now widely forecasted will end up being fact or fiction.
On the day I published this installment, Dell and Hewlett-Packard reported their latest quarterly earnings. Dell lost $101 million versus a profit of $462 million during the same period last year. HP reported that its earnings fell 89%, while sales dropped 14%. Dell reported that its profit margins declined from 21.3% to 17.5%. Furthermore, the PC industry reported its first sales decline in the second quarter for the first time in 15 years as consumers and businesses spent less. The industry is in the midst of a vicious price war. These are additional signs that a deflationary storm front is hitting the U. S. economy. From techs to retailing, prices are dropping.
Estimating the Storm's Intensity
Once you have a handle on the direction of the economy and the approaching recession, you will need to discern the severity of the storm. Will it be a nor'easter, a hurricane, or just a passing squall? The main direction this storm is likely to take is either a low-pressure cold front, which could be deflationary, or a high-pressure hurricane, which would be inflationary. The key will be the dollar and whether it holds. If the dollar falls and doesn't recoup, then we're headed for very rough weather. There is too much hot money in our financial markets right now. Our record trade deficits have put an enormous amount of money into the hands of foreigners. Right now, they are selling us goods and investing the dollars we pay them in exchange, back into our financial markets in bonds, stocks, cash, and real estate. As long as there is confidence in the dollar, the economic and financial storms will be less severe. I have listed several indicators in Storm Tactics, which identify whether the storm will end up being inflationary or deflationary. Just remember, the dollar will be the key. Faith in the dollar is based on faith in the strength of America's economy and the strength of America's military. A loss in either would deal a mortal wound to our currency.
Preparing For The Storm
Reduce Personal Debt
If I've emphasized anything at all over this last year, it's get out of debt. If you have credit cards, pay them off. If you are contributing to a 401(k) plan, and you have large amounts of credit card debt or installment debt, stop contributing. Instead direct the money towards riding yourself of your debt burdens. It is doubtful that your mutual funds are going to give you the same return when compared to the interest banks are charging you on your Visa or MasterCard.
Mortgage Debt
If your mortgage payments are too high, consider refinancing. Interest rates are still low. If your house payment keeps you up at night, it is too high. Think of downsizing now while the housing market is still strong. Ask yourself how secure is your job or that of your spouse? What would happen if one spouse lost his or her job? Could you still afford the payment? I'm not suggesting that everyone should get out of real estate. If your payment is comfortable and your job is secure, you have no need to worry. It is those who are heavily mortgaged or those whose jobs are in jeopardy that I'm concerned about.
Cash Reserves
Finally, if you don't have debt problems, build up your cash reserves. This will allow you to take advantage of investment bargains or provide a safety cushion if your employment situation changes. Having cash reserves is important. It is like having a life preserver on board ship. Economic downturns can either be feared or they can provide opportunity. It all depends on your perspective. Having cash when prices drop puts you in a better position to take advantage when an opportunity presents itself.
Personal Investments
As far as investments are concerned, don't be invested in anything you don't understand. If you're not sure about what it is you own, you better find out now. If you don't understand it, don't own it. If you don't want to do this alone, then find someone you can trust that holds similar convictions. The other alternative is to keep your money in cash. I would recommend T-bills if you have more than $10,000 or if less, a government money market fund. If you have sufficient investment knowledge, keep your eye on natural resources. I believe they will provide the best opportunity to make money in this storm.
Remember my analogy about weather. When it is winter in one part of the globe, it is summer in the other part of the world. It all boils down to keeping a clear head and watching the tell-tails. I strongly believe the natural resource boom is the next "Big Thing". Very few people see it, yet all of the signs are there. Study the Century Chart. I think it speaks volumes about the trend ahead.
Finally, no matter the outcome of the financial storms heading towards the U. S. economy, I wish you fair winds, clear skies, and safe passage. May God speed you in these uncharted waters of The Perfect Financial Storm.
VI. Acknowledgements
I would like to acknowledge and give thanks to many who have helped to shape and contribute to my understanding of The Perfect Financial Storm. First, I would like to thank the good Lord for giving me the wisdom to challenge assumptions and ask questions. A special thanks to Sebastian Junger for writing the book and Wolfgang Petersen for making the movie which provided me with the inspiration for my work.
Thanks are also in order to Bill Murphy and GATA for helping me understand today what I didn't know about gold back in 1994. Many thanks are due to Dave Morgan for his help and insights on silver and the futures market. I would also like to thank Doug Noland for his Credit Bubble Bulletin. I have learned much by reading his articles and I've especially enjoyed our interviews on Financial Sense Newshour. He is blazing new trails in explaining credit and its impact on our economy.
A grateful thank you is due to all of those web sites and chat rooms where the truth is told and shared for promoting this series: Le Metropole Cafe, Prudent Bear, Fallstreet, Gold Eagle, Bear Forum, Silver-Investor, Fiendbear, Sharelynx, Kitcomm, NewsMax, WorldNetDaily, Yahoo Finance Boards, The Raging Bull, and USAGold. A special thanks to Nick Laird for his late Saturday night help with graphs.
Last and not least, thank you to my wife, Mary, who bears the brunt of my late-night thinking, who edits my writing and makes it more intelligible, and for her efforts as webmaster and the time creating the graphs, which tell so much of this story.
Endnotes
| 1 | The White House Report of the National Energy Policy Development Group, Overview, p.1. |
| 2 | The White House Report of the National Energy Policy Development Group, Chapter 5, p. 9. |
| 3 | Simmons, Matthew, Investing in Energy: An Exercise Not for the Faint Hearted, Simmons International, p. 18. |
| 4 | Alden, Diane, "When The Eagles Return," NewsMax.com |
| 5 | "Too Much Power", Barron's, August 6, 2001. |
| 6 | Hebert, J. Joseph, "Power Crunch Idles Aluminum Plant," Yahoo News, Top Stories - AP |
| 7 | Buffett, Warren, Fortune, November 1999. |
| 8 | "Cisco Fiscal 4th Qtr. Earnings Insight", Bloomberg, August 7, 2001. |
| 9 | "U. S. Earnings Reports May Not Shed Light On Profits," Bloomberg, August 3, 2001. |
| 10 | "Recurring Gains?," Forbes, May 14, 2001, p. 86. |
| 11 | "Money From Nothing," Barron's, July 23, 2001. |
| 12 | Hamilton, William Peter, The Stock Market Barometer, p. 13, 19. |
| 13 | Ibid. p. 32. |
| 14 | Ibid. p. 49. |
| 15 | Ibid. p. 33. |
| 16 | General Zinni, Senate Armed Services Committee, April 13, 1999. |
| 17 | Jane's Foreign Report, August 9, 2001, No. 2652. |
| 18 | Global Trends 2015: A Dialogue About the Future With Non Government Experts, NIC 2000-02, December 2000 - National Intelligence Council. |
Reading Recommendations
|
The Clash of Civilizations and the Remaking of World Order by Samuel P. Huntington |
The Coming Anarchy: Shattering the Dreams of the Post Cold War by Robert D. Kaplan |
The Lexus and The Olive Tree by Thomas L. Friedman |  GeoDestinies by Walter Youngquist |  Resource Wars by Michael T. Klare |
CAUTION: This article is for information purposes only. It is general in nature and does not take into consideration any reader's personal circumstances and/or investment objectives or needs. Therefore, it has limitations and you should be aware of this. You should always seek competent, experienced professional advice before acting on anything you are unsure about. Few forecasts or strategies are ever one hundred percent correct. Most every consideration, action or strategy involves a particular or unique type of risk. Seldom is anything really a sure thing. No specific individual advice is implied or offered to any reader. This article and others on this web site deal with possibilities and unfortunately, not certainties.
Perspectives Part 10: RIDERS ON THE STORM is the tenth and final installment of a series on "The Perfect Financial Storm? Financial Storms Heading Towards the U.S. Economy". You might be interested in reading the other stories in this series. Please visit the COVER PAGE.
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