Storm Watch Update
THE SUM OF MY FEARS
by Jim Puplava
www.financialsense.com
May 31, 2002

Setting The Stage

The Cold War is a forgotten memory. The Gulf War is over. The world is at peace. The threat of Nuclear war is unthinkable. But in the hidden scheme of things, the balance of power in the Middle East and the world is about to change forever. A nuclear-armed Israeli plane is shot down somewhere over Syria and a warhead is missing. A terrorist group finds it, and with the help of a German physicist, is able to fix and improve the damaged bomb. The Vatican and the U.S. are forming a peace plan for the Middle East. Terrorists against peace formulate a plan to setup the superpowers with the objective of starting a war between the United States and Russia. Their plan: smuggle a nuclear bomb into the U.S. and detonate it in Denver, Colorado.

The above scenario was a fiction novel in February 1991. Today, it premiers as a movie. "The Sum of All Fears” was Tom Clancy’s sixth fiction bestseller written at the end of the Cold War and just immediately following the Gulf War. The movie differs from the original book. Because of PC [political correctness] the Middle Eastern terrorists are changed to Neo-Nazi terrorists. The thriller was completed before the attacks of September 11^th, but was held until now. The book and the movie ask us to imagine how our leaders would react if there were a massive terrorist attack on American soil. Although written more than a decade ago, part of the book's storyline came true with the terrorist attacks on the Trade Towers on 9-11. Tragedy struck on American soil. Instead of a bomb, the terrorist used planes. Today there is growing evidence that the book's plot could become a reality. Repeatedly, we have heard from various cabinet members of the Bush Administration that a terrorist attack using a nuclear weapon could become a reality in our near future.

The 'Sage of Omaha' Clearly Sees The Threat

Earlier this month, Warren Buffett addressed this very real issue with shareholders at their annual meeting. Berkshire Hathaway’s main business is insurance. They underwrite risk. Last year Berkshire was caught with a mega-catastrophe when it had only planned for natural catastrophes. The insurance business has three rules: 1] accept only those risks that they can properly evaluate, 2] limit the business they accept so they will suffer no aggregation of losses, and 3] avoid business involving moral risks.¹ As a result of September 11^th, Buffett has had to reevaluate the first two rules of how Berkshire underwrites business. In his letter to shareholders, Buffett states, "Insurers have always found it costly to ignore new exposures. Doing that in the case of terrorism, however, could literally bankrupt the business. No one knows the probability of a nuclear detonation in a major metropolis this year (or even multiple detonations, given a terrorist organization able to construct one bomb might not stop there). Nor can anyone, with assurance, assess the probability in this year, or another, of deadly biological agents being introduced simultaneously… into multiple office buildings and manufacturing plants.”² 

At the same annual shareholder meeting, Buffett told his shareholders that Berkshire will write some coverage for terrorist–related losses, but will not write business that would expose the company to losses beyond Berkshire's ability to comfortably handle. Berkshire, once again, is in the business of insuring risk. Therefore, it is only natural that the company would recognize a new element of risk that goes beyond acts of nature.

Two Years of Warnings

When I wrote Planes, Trains, & Dot Coms on January 2, 2000 and later started my Perfect Financial Storm series on July 18, 2000, I saw two major risks for the U.S.: one, financial and the other, geopolitical. In Planes, Trains & Dot Coms, I warned of the impending risk of the tech boom reflected in over-inflated Nasdaq stocks. In my Perfect Financial Storm articles, I warned of the possibility of the culmination of a series of financial catastrophes that would line up, one upon the other, to form the Perfect Financial Storm. The three risks I wrote about were the dangers of an enormous credit expansion, a U.S. stock market bubble, and a recession in the U.S. In Perspectives, I also warned of future derivative problems and the risk of asymmetric warfare against the U.S. In less than two years, we have seen both transpire. The financial system and the economy have been able to absorb the shockwave of both events -- but at a cost. The Fed did what it always does when faced with a financial or political crisis. They flooded the financial system with money. This money, as shown in the M3 Money Supply graph below, was created out of nothing. To be sure, there is a limit to the quantity of money that can be printed. Sooner or later, the market will enforce discipline on uncontrolled money growth. I believe the markets are doing this now. This forced discipline is reflected in the second graph which is the U. S. Dollar Index. Today, it is in a steep decline against most major currencies.

U.S. Dollar: Boxed In and Hangin' on the Ropes

The world’s currency system, which is based on the dollar, is a system that rests on faith and confidence in paper assets and the governments that issue them. From Argentina to Japan, and now the U.S., that confidence has been shaken. The U.S. has been running perpetual trade and current account deficits that must be financed through foreign savings. There is going to come a point in time, and I think that time is soon, when foreign investors will no longer be willing to accept dollars in exchange for merchandise. As these three graphs of the money supply, the depreciating dollar, and the trade deficit show, the Fed’s room to maneuver may be severely limited in the very near future.

The ability of a central bank to perpetually print money is limited by the mechanisms of the market. Traders, investors, and owners of dollars recognize that they are holding a depreciating asset. As long as there are no other assets of superior quality to compete with, they have few alternatives. Most currencies in the world have been steadily depreciating against one another. If you own paper assets, the main problem has been picking a currency that has the slowest rate of depreciation. However, as Marc Faber writes, "There are two sensitive barometers of major monetary trends. One is the currency market. If the price of the dollar against other currencies begins to plummet, then the market either fears dollar inflation or that the value of the dollar will not hold up in a climate of waning confidence. The other, which is more important, is the gold market."³ It is the recent rise in the price of gold that spells the greatest threat to the dollar and the U.S. financial system. Gold is real money. It can’t be printed out of thin air. It must be produced.

The Threat of Rising Gold Prices
The rise in the price of gold threatens the ability of the Fed to inflate the currency and expand the credit creation mechanisms within the economy. Fiat currencies have a poor track record of stability. Eventually, the public wakes up to the fact that the dollars they hold are depreciating. They notice it when they try to exchange those dollars for other goods. Although the Fed claims to be an inflation fighter, they are in reality the chief source and creator of inflation. This is because inflation, as defined by Webster’s, is "a rise in the general price level, caused by a relative increase in the supply of money and credit." Look again at the M3 Money Supply chart above. The printing presses at the Fed, and within the credit-creation mechanisms of the financial system, have been running nonstop since the early 90’s. The decline in the dollar and the rise in gold are now acting as a check against the dollar debasement policy of the Fed.

Up until this point, all of those dollars-out-of-thin-air have found a home in two areas: first, in financial assets and secondly, in real estate. When excess dollars are created by a central bank, they look for a spot to land. During the initial years of money creation, that spot was in the financial markets. When the financial markets lost their luster, the real estate market became the next object of obsession for those excess dollars. As I wrote in The Next Big Thing, I believe the next landing spot for that money will be natural resources. In his May 21st Gloom, Boom & Doom Report, Marc Faber states, "...commodity prices can increase sharply under any economic scenario provided that there is excessive money and credit creation and that investor confidence in financial assets is shaken.”⁴

Confidence Shakers

It is these confidence shakers that I want to address. I can think of three of them. They are derivatives ( See Rogue Wave/Rogue Trader Part I and  Rogue Waves and Standard Deviations Part 1 & Part 2 ), an asymmetric event ( Rogue Wave/Rogue Trader Part II ) and the disintegration of morals and the loss of integrity in the financial system ( Breakdown: Greed, Complexity and Conflicts of Interest and the Moral Hazard ). Although I‘ve written extensively on all three subjects, it is important to emphasize that a fiat-based monetary system is a confidence game. As long as the public has confidence in the system, central bankers, in the short-run, can get away with slowly inflating the currency. However, there is a limit to that confidence and it is quickly undermined when central bankers over inflate too rapidly as the Fed has done over the last seven years. Another problem surfaces when investors or the public no longer trust the financial system. The more numerous the Enrons, Global Crossings, Arthur Andersens, or other recent Wall Street scandals become, the more the public will begin to distrust the system.

Engineering Our Way to Prosperity
Investors are now finding out that the "new era” of the 90’s wasn’t a new era at all. Most of the earnings numbers that companies reported were financially engineered. This includes the government's own set of books. They were more the product of creative accounting than they were earnings miracles. As Bob Prechter so ably demonstrates in his new book, Conquer the Crash: You Can Survive and Prosper in the Coming Deflationary Depression, the economic and financial numbers of the last decade were, at best, sub par. Every economic statistic from GDP growth, industrial production, capacity utilization, to the unemployment rate was lower in comparison to previous booms. Corporate profits, which peaked in 1997, have been below normal and have been heading down ever since. This is what makes the markets so vulnerable when viewed from a valuation perspective. Every yardstick of financial value is at an extreme, which poses a grave risk for investors. Stock prices would have to drop by at least 50% just to arrive at normal valuations -- much less to become undervalued to encourage investment. Furthermore, Wall Street is still playing with smoke and mirrors. The earnings numbers, and I refer here to the actual bottom line, are going to be so bad that companies and Wall Street have found it necessary to obfuscate them with pro forma numbers.

Double Trouble with Double Numbers
The earnings miracles that Wall Street is predicting for the second quarter and the second half of the year are operating profits, not net income or the bottom line. These pro forma numbers conveniently leave out major restructuring charges and other major writeoffs; while counting gains from asset sales as income. They portray the company in the most favorable light rather than reveal actual conditions. The problem for companies and Wall Street, which is in the business of selling paper assets, is how to hide asset writedowns of the 1990’s merger mania. During the stock market boom of the last decade, companies used the currency of their stock to make acquisitions and drive top line revenue growth and bottom line profits. This was accomplished through takeovers or mergers, which were paid for with company stock. Since most CEO’s received their major source of compensation from stock options, this led to a merger wave in order to drive earnings growth with the goal of driving up share prices. Every method of manipulating profits from mergers and stock buybacks, to creative accounting through revenue recognition or expense deferment, was used to deliver superior earnings performance in the hopes of driving up stock prices. Managers of companies took on debt, issued additional shares of stock that were dilutive and creatively cooked the books to meet growing expectations by analysts and investors.

American Heritage Dictionary defines miracle as "An event that appears inexplicable by the laws of nature and so is held to be supernatural in origin or an act of God: “Miracles are spontaneous, they cannot be summoned, but come of themselves” (Katherine Anne Porter).

It's Time to Pay the Piper
Now those chickens are coming home to roost in the form of large writedowns, which are estimated to be $1 trillion dollars this year. In addition to the writedowns, companies are facing deteriorating business conditions, higher interest expense from all of the debt taken on during the last decade. As this graph shows, the debt to equity ratio for corporations is at record levels. The cost of that debt alone has decimated earnings and will continue to do so especially as credit conditions deteriorate and interest rates continue to rise. This is why there will be no profit miracle this year or even next year. There is too much debt in the system and companies lack pricing power to cover higher labor, raw material, and energy costs. The pricing environment with foreign competition has become too fierce and companies have been forced to absorb most of these costs. The result has been lower profit margins on sales and services.

Therefore, we won't see any profit miracles this year. Instead, we will have the fiction of pro forma earnings. The companies know it. That is why they have been reluctant to provide guidance on future earnings. The analysts know it. That is why they emphasize operating earnings. The media know it. That is why they ignore it. They are owned by corporations who want higher profits. Eventually, investors will know it as stock prices fail to reach new highs.

Debt at the Root - Bubble After Bubble

Debt, which has been a plague on earnings, is also a reason why the housing bubble and the consumer-spending binge will eventually end. There will be no source of pent-up demand to drive this recovery. And that is why it will fail. The only source of demand left will be government. You cannot build a prosperous economy on debt used for consumption. In fact, before any meaningful recovery can take place, all of the excesses of the previous boom must be cleansed from the system. The malinvestments in technology, telecoms, and real estate must be extirpated. The corporate and consumer balance sheets must be repaired. The Fed credit-creating mechanisms must be brought into balance with an honest system of money or the risk of collapse will be that much greater. Today, it looks unlikely. It appears that the Fed is hell bent on avoiding a deflationary collapse in the economy. Therefore, it is on a kamikaze mission that could lead to financial suicide. From the minutes of their January meeting, the Fed is already considering desperate measures from monetizing financial assets, including stocks and real estate, to gold mines.

What is the sum of Alan's Fears?
As Alan Greenspan surveys the financial landscape he has helped to create, he must feel as Tom Clancy’s fictional President does in  “The Sum of All Fears.” His worst nightmares stand before him. The risks of a deflationary depression, or hyperinflation if the dollar collapses, have become his Rubicon. Either fork in the road on which he travels is going to lead to unpleasant results. In many ways, it will become the supreme irony of his life. As a student of Ayn Rand, he knows the dangers of a fiat money system. He once wrote a treatise on gold and the dangers of fiat currencies. Now he finds himself presiding over the largest fiat/credit system ever created by man throughout all of history. The fate of the country and the true character of the man will be judged by the course he chooses to follow.

Who is our Enemy?

As a student of military history, I have learned that a smart enemy attacks you where you feel the safest. The U.S. now stands as the only military superpower on the planet. No enemy would dare attack the U.S. head on. Their attack will be more subtle. The greatest vulnerabilities of the U.S. are its open society and borders and its leveraged economy and financial system. The United States is no longer self sufficient in capital, energy, or in manufacturing. This leaves the nation dependent on outside sources for money, energy, and basic goods. This dependency will limit our country's choice of options to defend itself.

In “The Art of War”, Sun-Tzu advised, “The place we have chosen to give the enemy battle must be kept from him. If he cannot anticipate us, the positions the enemy must prepare to defend will be many. And if the positions he must prepare to defend are many, then any unit we engage in battle will be few in number… The ultimate skill in taking up a strategic position (hsing) is to have no form. If your position is formless, the most carefully concealed spies will not be able to get a look at it. Just as the water avoids high ground and rushes to the lowest point, so on the path to victory avoid the enemy’s strongest points and strike when he is weak.”⁵ 

The Sum of it All

As I began to write the conclusion of this Storm Update, I looked around my study.

• My Bloomberg screen displayed the day’s headlines. It was another down day in the markets. Palm’s shares fell 25% after the company reported it would incur another consecutive loss instead of breaking even. The company sales would come in at $230 million instead of $300 million as estimated in March. Palm said consumers spent less than forecasted as they had little reason to buy.

• Another headline spoke of an impending downgrade of Japan’s sovereign debt. Moody’s warned that it may reduce Japan’s local currency to the lowest of the Group of Seven industrialized nations.

• On another screen, the current CFTC report displayed a record short position in silver that has no possibility of being covered. Like the Enron fiasco, the authorities are blind and asleep at the wheel. Their inattentiveness, or willingness to turn a blind eye, has made another financial debacle possible and even likely over the next twelve months.

• On a stack of papers on my desk lies a copy of the latest OCC Treasury report that shows a similar position in gold by one of our nation's largest banks, J.P. Morgan Chase. Their derivative book looks more like a hedge fund than it does a pillar of financial prudence.

• Next to the stack of papers, lies the manuscript of Bob Prechter’s new book, Conquer the Crash -- a chilling book about a foreseen stock market crash and the depression that follows. It was homework for this week's guest interview for my radio show. Under it lies recent copies of Jane’s Intelligence reports that speak of war and more rumors of war.

• Beside my reading chair is Lady Margaret Thatcher's new book, Statecraft: Strategies for a Changing World. On the jacket, she writes, "I wanted to write one more book -- and I wanted it to be about the future. In this age of spin doctors and sound bites, the ever present danger is that leaders will follow fashion and not their instincts and beliefs."⁶

• On the TV screen on the opposite wall, the evening news began with a lead story about Pakistan shifting its troops from the Afghanistan border to the Indian frontier. India and Pakistan’s military stand on high alert as the President of the United States sends his Secretary of Defense to the region to diffuse a possible nuclear conflagration.

The stack of papers, the books, the intelligence magazines, and the day’s headlines reflect nothing new. They look like so many other days and so many similar headlines over the past year. What makes them different to me today is the fact that these facts are real. They keep me alert and vigilant and far from becoming complacent. Like a battlefield commander, I must glean from them any intelligence they offer in order to formulate a decision whether to attack or defend. From this information, a plan will be formulated: what to buy and what to sell, and when to buy and when to sell.

My gut instincts tell me something big is about to happen this year.

Like any battle, it will be won or lost before it begins. Victory is based on intelligence and preparation. Yet, no matter how well you prepare, there is always that uncertainty. The headlines, newsletters, books, and magazines offer information for all to see. Surely the outcome of the battle will be determined by proper analysis, interpretation, and action. And yet, there is always that twinge of doubt. Do I know all I need to know? Is my intelligence [financial information] good enough? Have I left anything out? Have I covered all the bases? Is this the right battle plan?

Sun-Tzu wrote in The Art of War, "He who knows the enemy and himself will never in a hundred battles be at risk.”⁷ Do we know the real enemy that is before us? Do we really know ourselves? Am I ready for what I know will surely come? That question is the sum of my fears.

Endnotes

1   Buffett, Warren, "Warren Buffett's Letter to Berkshire Shareholders 2001," February 28, 2002.
2   Ibid.
3   Faber, Marc, The Gloom, Boom & Doom Report, May 21, 2002, p. 10.
4   Ibid., p. 8.
5   Sun-Tzu, The Art of Making Warfare, Ballantine Books, 1993. Translated by Roger Ames, p. 126
6   Thatcher, Margaret, Statecraft: Strategies for A Changing World, Harper/Collins, New York, 2002, jacket.
7   Sun-Tzu, The Art of Making Warfare, Ballantine Books, 1993. Translated by Roger Ames, p. 96.

Sum of All Fears (The Movie) l  FSO Buffett Resource Page  l  Buffett's Doomsday Scenario  l  Greenspan's 1966 "Gold and Economic Freedom"

Acknowledgement
Cover graphic by Adam Puplava

© 2002 James J. Puplava
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