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Leithner Letter No. 23
26 November 2001

Our industry has now created the largest mess in the history of U.S. financial institutions. ... It is not unfair to liken the situation now facing Congress to cancer and to liken [our industry’s trade association] to a significant carcinogenic agent. And, like cancer, our present troubles will recur if Congress lacks the wisdom and courage to excise elements which helped cause the troubles. ... [Yet the association] responds to the mess as Exxon would have responded to the oil spill from the Valdez if it had insisted thereafter on liberal use of whiskey by tanker captains.

We know that there is a school of thought that trade associations are to be held to no high standard. ... In this view, each industry creates a trade association not to proffer truth or reason or normal human courtesy following egregious fault, but merely to furnish self-serving nonsense and political contributions to counterbalance, in the legislative milieu, the self-serving nonsense and political contributions of other industries’ trade associations. But the evidence now before us is that [this type of conduct] ... has an immense capacity to do harm to the country.

Charles Munger announces the resignations of
Wesco Financial Corp. and Berkshire Hathaway, Inc.
from the U.S. League of Saving Institutions (30 May 1989)

Confidence and Reality

Throughout the latter half of October the financial press fairly brimmed with journalists’ and market professionals’ optimistic prognostications. According to the New York correspondent of The Australian Financial Review (24 October), for example, “a number of prominent [American] strategists are bullish on the outlook for equity markets and have been issuing [positive] reports in recent days.” One strategist stated that the recent sharp fall of interest rates “supports the case for [higher prices of stocks] than during previous cycles ... we believe that the market has almost fully discounted the recession.” According to another, “robust monetary and fiscal policy will take the market higher.”

Perhaps their optimism derives from Dr Greenspan’s sanguinity. On 17 October he told Congress “all in all, I think we are looking at a situation that is nowhere near as bad as many of us thought it would turn out to be.” As if on cue, and to underscore the point, on 21 October The Wall Street Journal Sunday published an article entitled “Making the Case for Buying Stocks Now”; and Barron’s (29 October), in a lead article entitled “Sold On America: Why U.S. Stocks Are Primed To Recover,” noted that “in the face of the attacks’ horrific aftershocks, including America’s military response, 67% of poll respondents described themselves as bullish or very bullish about the stock market’s prospects through next June. And that’s the highest level of investor optimism we’ve seen in years.” Australian market professionals seem to concur. According to The AFR (24 October), many are “willing to look past the current downturn, confident that the US Federal Reserve’s monetary policy easings [will] eventually pull the US economy out of the doldrums.” Not only are professionals buying: according to one Australian bank’s head of margin lending, “sophisticated investors” are continuing to buy with borrowed money. Indeed, perceiving that the dangers associated with gearing are shrinking, significant numbers are planning to increase the size of their margin loans. “People see this as a new buying opportunity [and] right now there’s probably some good buying opportunities around.” More generally, “risk can be well managed [and so it] isn’t something that people should be afraid of. People have genuinely embraced the concept of gearing. It’s an accepted mainstream tool for wealth creation.”

In these matters, as in all significant matters, it is useful to maintain a dispassionate attitude, seek alternate views, ascertain the premises, evidence and logic which underly them, test them and make one’s own decision. A short article by Peter Eavis, dated 27 September and entitled The Route Is Far From Over for Tech Stocks, is quite helpful in this regard. Eavis makes four important sets of points (which also apply, albeit probably to a lesser extent, to Australia) that others have either ignored or derided: Nosebleed Valuations In late September, Nasdaq 100 traded at no less than 73 times 2001 earnings and 42 times expected 2002 earnings. Analysts’ forecasts of earnings are notoriously over-optimistic and, true to form, 2002 estimates presuppose a strong recovery of profitable economic activity. Further, if these already-optimistic expectations are adjusted to reflect companies’ weights in Nasdaq, then the 2001 multiple increases to 103 and the 2002 P/E to 52. Who said that the Nasdaq bubble has been pricked?

Eavis’ reasoning leads to a dour conclusion. “Let’s be insanely generous and assume that the Nasdaq 100 trade deserves to trade at 40 times those weighted 2002 earnings. That would give the Nasdaq 100 a market cap of $1 trillion, and an index value of 915, 23% below [its close on 25 September]. Apply the same drop to the Nasdaq Composite index and you get 1155” (versus its close of 1704 on 23 October).

Profligate Monetary Policies

Like many others, Eavis observes that since 11 September central banks in the U.S. and other countries have accelerated their campaigns, commenced at the beginning of 2001, “to prop up stocks and sustain economic activity. Some of that money is bound to leak into equities over the coming months and create short-lived rallies.”

Unlike others, however, Eavis regards the recent part-recovery of the prices of many financial assets as speculative, liquidity-inspired and therefore unsustainable. This is “because all the easy money in the world can’t create healthy companies and sustainable profits. In fact, the Fed’s largesse will only forestall the deep restructuring U.S. firms need. Arguably, a smart time to buy stocks is when a central bank has been hiking interest rates for a while to slow the economy, not when it’s reducing them in a panic to stop a recession from ever happening.”

Higher Government Spending

Eavis also notes that this monetary stimulus is likely to be accompanied by whopping increases of government spending. (As an aside, Australia’s Liberal-National coalition, in terms of its rhetoric a right-of-centre, frugal and conservative government, has in terms of its actions during the past couple of years been among the most profligate in the country’s history.) Many are asserting that such spending during wars, and the inflation that underwrites it, can boost equities’ market prices. Responds Eavis: “well, explain then why the Dow posted only an average annual return of 0.75% in the 1966-72 period, when the Vietnam War was raging and inflationary pressures were high.” Eavis adds the fundamental point, lost upon many market participants, that the higher spending resulting from war, industry bailouts, etc. crowds capital away from productive investments.

Infighting in the Executive BranchMost provocative, given the present climate of opinion, is Eavis’ prophesy about unfolding political developments: “the Bush presidency [will start] to buckle under the stress of fighting an unwinnable war. The tasks of wiping out terrorism and bringing those instrumental in the attacks to justice are almost impossible to achieve. The public is baying for the sort of dramatic results that no president could deliver.”

Another Dour View

Alan Abelson (Barron’s 1 October 2001) also contests the cheerful consensus. He writes that “the bounce-back is apt to prove as short as it is sharp, lasting just long enough to dispel wariness, whet speculative appetites and create the properly heated environment for another thrust down. While no question there has been widespread publicity given to the economy’s sickly condition ... we suspect the true dimensions of the deepening recession have not gained anywhere near the recognition they merit, on either Main Street or Wall Street.”

Abelson reckons that neither the extent nor the impact of recent sackings and future dismissals has been properly appreciated. Nor has the sharply lower level of corporate profits (whether or not they meet even more sharply lowered “expectations”). Abelson adds that the nine (count ’em) reductions of interest rates by the U.S. Federal Reserve during the past twelve months have, thus far at least, done little to encourage profitable economic activity; and with respect to plans to increase government expenditure, he reminds us that throughout the 1990s and up to the present Japan has repeatedly spent billions upon billions upon billions, in the process amassing staggering loads of public debt, and all to no avail. Abelson concludes that “it all boils down to this: We simply don’t think the price of creating, nurturing and flaunting the greatest bubble in stock-market history has been met, with stocks still selling at well over 20 times earnings and the market 130% of GDP.

Despite the destruction of Nasdaq and the major hits to the Dow and the S&P, to put it another way, stocks still aren’t cheap. Until they are, the bear market won’t call it quits.”As another aside, it is noteworthy that several outstanding letters to the editor in recent issues of Barron’s display the explicit premises, hard evidence, valid logic and above all willingness to think independently that, alas, are so frequently lacking among Australian market participants and journalists. Eminently worth reading are letters from Steve Puetz (West Lafayette, Indiana 8 October), John P. Hussman (Ellicott City, Maryland, 8 October), Hollister B. Sykes (Cranford, New Jersey, 8 October), Adam R. Cohen (New York City, 22 October) and Jan Sagett (Bonita Springs, Florida, 22 October 2001).

The Robinson Crusoe Ethic Versus the Distemper of Our Times

How, then, to allocate one’s capital in light of the economic developments throughout 2001 and in the wake of the 11 September attacks on New York and Washington? Leithner & Co. is deeply sceptical that aggressive monetary and fiscal policies in Australia and other countries will achieve their intended beneficial effect – and, like Mr Munger, worries that myopic actions by governments, businesses and associations between them may have myriad unintended and harmful effects. Further, the market prices of most Australian assets, relative to realistic estimates of the streams of earnings they are capable of generating, remain prohibitively expensive. Accordingly, although the securities of a small number of well-established and well-managed enterprises are available at reasonable and in a few cases bargain prices, the case for caution remains strong.

The major financial risk, as always, lies in the disparity between reality and our ability to perceive and interpret it accurately. On that score the bulls may need a fundamental, from-first-principles check-up. Under present conditions there seems to be an incompatibility between the only-partly-real material prosperity of recent years and the false premises, weak evidence, faulty logic and gilded values and policies that have often accompanied it. The maintenance of present standards of living requires much lower time preferences and much higher rates of savings than have been evident in recent years; and the tension between complaisant expectations of a prosperous future and an unwillingness to save for it must resolve itself in either sharply lowered expectations, much greater savings or some combination of the two. Hence the incipient Distemper of Our Times.

The Robinson Crusoe Ethic – a willingness to forego significant current consumption, trim one’s expectations and both accept and undertake entrepreneurial risk (in the proper sense of that phrase) in order to secure one’s prosperity – is one means of redressing this distemper. If they are not mitigated, then the distemper’s embryonic effects may become more apparent; and to the extent that they remain undiagnosed and untreated its insidious effects may become malignant.

Chris Leithner


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