Leithner Letter Nos. 24-25
26 December 2001 - 26 January 2002

If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more gruelling the depression will be, and the more difficult will be the road to complete recovery.

Murray N. Rothbard, America’s Great Depression (1963)

The end of one calendar year and the beginning of the next is an appropriate time to reflect upon the outgoing year’s events, twists and turns, triumphs, trials and tribulations. It is also a time to place them into a broader context, consider their causes and consequences and set one’s course, cautiously and flexibly, for the incoming year. Stephen Roach, chief economist at Morgan Stanley Dean Whitter, concisely and presciently summarised 2001 in these words (quoted in The New York Times on 28 May): “we went to excess in the late 1990s on many counts – investing in information technology, depleting personal savings, relying on foreign capital and the overarching excess, the stock market bubble. ... At some point, you purge the excesses and revert to the norm, and that is generally triggered by recession.”

In many countries, including Australia, Britain, Canada and (especially) the U.S., the boom of the late 1990s sowed the seeds of bust. Australia’s boom ended in 2000 (see Letters 12-13) and signs of bust gathered pace throughout 2001. Luke Collins (The Australian Financial Review, 16 November), echoing Barton Biggs, Mr Roach’s colleague at MSDW, encapsulates the sentiment: “it was the longest and most powerful economic expansion in history: a decade in which economic bubbles inflated at an unprecedented rate. So why would the inevitable bust be short, shallow and relatively painless?” Leithner & Co.’s plans for 2002 are based on the premise that many of the excesses of the 1990s remain unrecognised and therefore unpurged, and that the bust may be extended and sharp.

2001: A Year of Measuring Dangerously

Perhaps the excesses remain unrecognised and unpurged because the causes of the boom, and hence of the bust, have been widely misdiagnosed. And perhaps for this reason the duration of the bust has already been underestimated. At the beginning of 2001, a plurality of market participants stated confidently that it would be very mild and pass by the middle of the year; during the winter, the end of the bust nowhere in sight, they stated with equal confidence that recovery would occur by the end of the year; and now, in late 2001, their poise is beginning to waver as they (and their brethren in the International Labour Organisation, IMF and OECD) forecast that an improvement will be delayed until mid-2002. Indeed, a few pundits have thrown in the towel until 2003-2004.

Interestingly, despite this series of errors the bulk of mainstream prognosticators continue to plumb for a “V-shaped recovery”; that is, the bust will rapidly reverse course and the “normal” (by the standards of the distinctly-abnormal 1990s) onwards-and-upwards trajectory immediately re-assert itself. In this respect, as in many others, the exuberant mindset of the late 1990s remains so pervasive and deeply embedded that it is hardly noticed.

Market participants’ repeated errors with respect to the unfolding bust’s duration are beginning to be compounded by errors about its severity. One prominent strategist was quoted in Barron’s (26 February) that towards the middle of 2001 economic activity and profit margins would rebound smartly and that the bear market in tech stocks would near its end. Quoth the strategist: “if we’re in for the New Economy’s first recession, blink and you’ll miss it.” By September, however, Morgan Stanley’s team of international economists prophesied that the world faced its worst recession since the Second World War. Their report stated “for a world we judged already to be in synchronous recession before the terrorist attacks on America, the downturn now looks considerably deeper and longer than we ever expected.”

Consumer Spending

These errors point to an important aspect of the bust that has occasioned little or no comment. Mainstream data and methods of measurement seem consistently to predispose market participants towards optimism – and, as the repeated and cumulatively egregious errors of 2001 imply, over-optimism. Consider as an example consumer spending. Central bankers, economists and financial journalists obsess about it (as well as the level of “consumer confidence”). They do so because they believe that consumption comprises roughly two-thirds of economic activity; and during the year they were buoyed that spending by consumers in Anglo-American countries did not fall appreciably.

Yet consumer spending may be far less important than most observers believe; more generally, the premise that demand drives economic activity is, to say the least, questionable. (Another view, as Melbourne journalist Gerald Jackson has emphasised, is that “entrepreneurship drives the economy, savings fuel it and consumer preferences, revealed through spending, steer it.” For details, see Mark Skousen’s article “Chasing the Wrong Numbers” in The Wall Street Journal Europe on 16 July. The U.S. Commerce Department, recognising the need for a broader measure of output, introduced a new national income statistic called Gross Output in 2000. Unlike GDP, GO measures the output of goods and services at all stages of production. As a result GO is almost twice as large as GDP.

The GO statistic gives a very different picture of the components of economic activity: in the U.S. in 2000, for example, consumption comprised only 38% of activity; business investment (gross fixed investment plus goods-in-process) accounted for 52% and government the remaining 10%. GO, then, ejects consumers and governments from the limelight and restores spending by private businesses to its proper place as the driving force of economic activity. Unlike GDP, and more ominously for future prosperity, GO-style figures show that private spending on capital goods in Australia and the U.S. has declined and in some respects continues to decline sharply. Relatedly, the output of America’s factories, utilities and mines fell by 1.1% in October 2001 after declining 1% in September. The demand for labour in the durable-goods sector is the worst in 25 years, and the outlook for employment in non-durable manufacturing is lower than it was in 1991. Plant utilisation has fallen to 75%, its lowest level since 1983. Industrial production in the U.S. has now decreased for 13 consecutive months – the longest period of decline since a 15-month stretch that ended in July 1932.

Corporate Earnings

Consider another example of overly optimistic measurement. The Wall Street Journal (21 August and 24 August) reported that “few investors know it but the U.S. stock market today is, by one way of looking at it, the most expensive it has ever been.” During the second half of 2001, according to figures from Thomsen Financial/First Call, shares of companies comprising the S&P 500 sold at roughly 25 times earnings. That figure was considerably higher than the long-term historical average of approximately 15 times, but was regarded as reasonable in light of the ever-falling interest rates (and analysts’ ever-ebullient earnings projections for 2002 and beyond) that characterised 2001. In recent years, however, the measurement and reporting of earnings has become increasingly bastardised. Earnings used to refer to earnings compiled under generally accepted accounting principles (GAAP), and the historical average is calculated on that basis. But since the late 1990s earnings “relate to something fuzzier, called ‘operating earnings.’ And that can mean just about whatever a company wants it to mean.”

Arthur Levitt, then-Chairman of the U.S. Securities and Exchange Commission, stated on 18 October 1999 that “a little over a year ago, I voiced concerns over a gradual, but perceptible, erosion in the quality of financial reporting. The motivation to satisfy Wall Street earnings expectations was beginning to override long established precepts of financial reporting and ethical restraint.” Mr Levitt continued: “a culture of gamesmanship over the numbers is not only emerging, but weaving itself into the fabric of accepted conduct. ... A gamesmanship that says it’s OK to bend the rules, tweak the numbers and let small but obviously important discrepancies slide; a gamesmanship that tells managers it’s fine to cut corners and look the other way to boost the stock price; where companies bend to the desires and pressures of Wall Street analysts rather than to the reality of numbers; where auditors are pressured not to rock the boat; and a gamesmanship that focuses exclusively on short-term numbers rather than long-term performance. ...”

Operating earnings, also known as “pro forma” earnings, are typically higher than GAAP earnings. To give an extreme example, JDS Uniphase Corp., a fallen market darling, announced pro forma earnings of $US67.4 million for the financial year ended 30 June; using GAAP, it recorded a loss of $50.6 billion (yes, that’s right, almost $51,000 million). Less egregiously but more generally, during the second half of 2001 the S&P 500’s P/E ratio based upon GAAP was approximately 35-45 – one-third higher than the conventional, oft-quoted but non-GAAP figure. Moreover, that P/E ratio is higher than any ever recorded for this index. (In Australia, which remains relatively unmolested by pro forma shenanigans, the All Ordinaries’ historical average earnings multiple is 12-13 times and in the second half of 2001 traded at ca. 16-19 times.)

It follows that American valuations may presently be twice as dear as their historical norm – and hence that equity markets are much further from sensible prices – than most market participants suppose. Towards the end of 2001 America thus juxtaposes very high asset prices and weak and deteriorating prospects for the earnings those assets might generate. In Alan Abelson’s words (Up & Down Wall Street, Barron’s 5 November), “why in the world is the stock market selling at 25 or 35 times earnings? That’s a valuation more consonant with the tops of bull markets than the bottoms of bear markets and, in fact, is three to four times the multiple at which bear markets have typically bottomed out. Maybe it’s on to something. Or maybe it’s just on something.”

Labour Productivity

A third example, the measurement of worker productivity, is another where “New Era” thinking has exerted and continues to exert much influence upon American (and to a lesser extent Australian) policymakers. In the U.S., the Federal Reserve has referred repeatedly to productivity and its growth as a consequence of an acceleration of the pace of technological development. On 15 June 1999, Dr Greenspan stated that “an economy that 20 years ago seemed to have seen its better days is displaying a remarkable run of economic growth that appears to have its roots in ongoing advances in technology. ... The productivity growth seen in recent years likely represents the benefits of the ongoing diffusion and implementation of a succession of technological advances. ... Likewise, the innovative breakthroughs of today will continue to bear fruit in the future.” Dr Greenspan’s view is steadfast. On 6 March 2000, just hours before Nasdaq’s apex, he delivered an address entitled “The Revolution in Information Technology.” And on 14 November 2001 he stated that “the long-term outlook for productivity growth, as far as I’m concerned, remains substantially undiminished. It’s one of the reasons why, even though we’re going through a very trying period in the last year or so, the outlook in my judgment looks to be extraordinarily good.”

Are Australian workers becoming more productive? The answer to this question has momentous consequences. Leithner & Co. takes an agnostic (and, in today’s chastened but still very confident climate, contrarian) view. Important as it is, and much as we would like to know it, we do we not know and in principle cannot know the answer to this question. Reasoning from first principles we find a disconcerting conclusion: notwithstanding their pretensions to scientific rigour and accuracy, the methods used to measure productivity are at best questionable and at worst invalid. These methods also have an unintended and largely unremarked consequence: in recent years they have implicitly encouraged the aggressive growth of credit not backed by savings. The inference is that interest rates have been forced far too low for far too long. From this sin, it seems to me, flow a multitude of unpalatable and still largely unrecognised consequences.

Cumulative Measurement Error and Incipient Investor Error

On 3 September Barron’s published a chart, compiled by Sanford C. Bernstein & Co., of operating margins for the S&P 400 (that’s not a typo) from 1976 to 2000. The chart depicts both reported and adjusted (for non-recurring items, stock options, pension plans, etc) margins. It shows that once those adjustments are made “the exceptional performance” of reported margins during the second half of the decade “disappears entirely.” Using these adjustments, Bernstein concludes (in Alan Abelson’s words) “that there was no growth of earnings per share during 1995-2000. ... In other words, shorn of gimmicks, the vaunted growth of both profit margins and earnings in the boom years goes up in smoke.” More generally, “Wall Street’s main talking points in the lift-off stage of the late, great bull market – exploding earnings, expanding profit margins and surging productivity – were pretty much hot air. The monster investment those myths fostered, however, has by no means been fully washed out of this market. What that says to us, simply, is that until it is, any rally will prove merely an interruption to the market’s melancholy downward trek.”

Hence a fundamental lesson which was taught a century ago but has yet to be learnt by the bulk of today’s policy makers and market participants. In the words of Ludwig von Mises (Human Action, 1949), “it cannot be denied that all investigations concerning the relation of prices and costs presuppose both the use of money and the market process. But the mathematical economists shut their eyes to this obvious fact. They formulate equations and draw curves which are supposed to describe reality. In fact they describe only a hypothetical and unrealisable state of affairs, in no way similar to the problems in question. They substitute algebraic symbols for the determinate terms of money as used in economic calculation and believe that this procedure renders their reasoning more scientific. They strongly impress the gullible layman. In fact they only confuse and muddle things. ...” (For details, see Economic Insights Vol. 6, No. 4, published by the Federal Reserve Bank of Dallas.)

Looking into 2002

A Deeper Bust?

Leithner & Co. obviously does not know whether a longer and deeper bust is in prospect (James Grant’s excellent article Blind Seers in the 26 November issue of Forbes should be required and repeated reading for investors). Yet it can and will conduct its operations in 2002 on the dour assumption that such a thing may occur.

A bust, it seems to me, is not two consecutive quarters of shrinking real GDP. It is not triggered by exogenous shocks (such as the attacks on the Twin Towers and Pentagon); nor is it manifested by decrements of business and consumer confidence. Rather, a bust is a regenerative process whereby “clusters of entrepreneurial error” created largely by profligate government policies are recognised and liquidated. Busts, despite the pain that undoubtedly accompanies them, are salutary: it is only by this process that a structure of production conforming to consumers’ demands can be re-established. This adjustment may or may not entail a negative rate of growth of GDP, and its severity depends upon individuals’ pool of funding. A growing pool renders the process of purging entrepreneurial error less painful. Conversely, a stagnant or a declining pool makes the liquidation of “malinvestments” lengthier and more painful. In this respect K.C. Swanson’s article, Roaring ’90s Didn’t Leave Middle Class With Much Cushion, makes sobering reading.

A Fitful and Artificial Recovery?If the causes of the 90s boom and subsequent bust have been widely misdiagnosed, then the remedies ubiquitously, repeatedly and massively prescribed to combat the bust – the creation of credit and rises of government expenditure – are likely to do no good and possibly much harm. Policymakers and market participants in Anglo-American countries are a devoutly religious lot, and a foundation of their faith is the conviction that governments (via aggressive monetary and fiscal policies) can engineer economic security and prosperity. According to this view, not only will a given turn of the policy lever produce the anticipated (good) result: there will be no unintended (bad) consequences.

Seemingly alien to most policymakers and market participants is the notion that money is no more and no less than a medium of exchange. Money facilitates the transfer of property, but neither existing money nor the printing of new money per se can produce wealth. Equally alien is the notion that capital derives from the fruits of past labour and that credit is based upon the promise of future labour. Yet recent (to say nothing of more extended) history indicates that promises made on the basis of rosy projections and without regard to past savings often derange the balance between consumers’ and entrepreneurs’ time preferences and thus set the stage for clusters of error. Not just alien but also subversive is the notion that to consume is necessarily to destroy value, and to destroy value is to hinder the replacement and augmentation of the pool of productive resources that enables consumption. Heretical, then, is the notion that the “extra” consumption seemingly enabled by governments’ spendthrift fiscal and monetary policies leads not only to the premature destruction of capital which could otherwise have been created: it also hastens the destruction of existing capital derived from past saving. Such policies unintentionally encourage Australians, like Crusoe III, to consume their own seed corn.

Alas, during 2001 the Reserve Bank of Australia continued to create large amounts of credit not backed by savings, and (by the standards of its American counterpart) reduced interest rates at a moderate pace. And the 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 12-18 months been among the most profligate in the country’s history. This intervention is likely to set in train a renewed misallocation of resources which may manifest itself in 2002 through a “recovery.” Whatever the euphoria it incites in financial markets, such a recovery neither causes economic growth nor creates wealth. Rather, it misdirects Australia’s small and eroding pool of funding and thereby weakens the potential for longer term and sustainable prosperity. During 2002, then, Leithner & Co. will be in no hurry to sing “Happy Days Are Here Again.”

The End of Central Bank “Puts”?

The possibility needs to be raised that the so-called “Greenspan Put”, which was in the money during much of 2001, may expire in 2002. This phrase entered the lexicon after the collapse of Long-Term Capital Management in 1998. The idea is that reserve banks, particularly the U.S. Federal Reserve, have in recent years attempted to create a floor under the prices of financial assets. Investors, like Pavlov’s dogs, have been conditioned by Y2K, LTCM, Russian bond and Mexican peso fiascos – and throughout 2001 – to expect that banks will inject large amounts of credit into financial markets whenever anything is the matter. The effect of these injections has been to support asset prices (or, at least, to mitigate declines of prices). This perceived put option on markets has convinced many participants that they will be able to sell assets in the future at some fixed price. Hence the Greenspan Put – and, not incidentally, the veneration of fractional-reserve banking by most market participants.

Clearly, reserve banks can indirectly support asset prices only as long as they can force interest rates lower. Equally clearly, they cannot create unlimited amounts of credit indefinitely. Accordingly, at some stage the put option they create must expire. At that point things become interesting. On the one hand, The Australian Financial Review (21 November) reported that 44 per cent of respondents to a survey expect returns of 10-15% per annum indefinitely into the future. Reasoning from first principles we come to a very different conclusion: to the extent that it involves buying and selling the scrip of Australia’s largest listed companies, the achievement of such returns must henceforth rely upon emotional and speculative and not cognitive and investment operations. More generally, very few seem to recognise the disparity between their expectations and reasonable expectations.

More than a few continue to spout nonsense, parroting things they want to believe or, like Dr Pangloss, expressing the simple hope that all will come good and they will land on their feet. For many, in other words, the major lesson of 2000 and 2001 – i.e., that price and value are distinct phenomena, that price may for a time exceed value but that it must eventually regress to it – remains unappreciated and therefore unlearnt. Most continue to obsess about prices and their near-term fluctuations but are resolutely oblivious about companies’ actual operations and enduring value. For these reasons disbelief, which served us well in 2000 and 2001, will remain strong in 2002. Value investors, as custodians of capital, seek at all times to buy quality assets at reasonable or bargain prices. Leithner & Co. therefore likes gloom, doom, pessimism and despondency – not for their own sake but because they help to make good businesses available at good prices. Precisely because the Company is a net saver and therefore a net purchaser, my preference for 2002 is that the quality of the businesses we own (or seek to own) improves but that the prices at which we are able to buy them falls. Mr Buffett gets the last word: “only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.” On that basis 2001 was a good year, and time will tell whether 2002 is a good year.

The Leithner Letter, like many of the inhabitants of Terra Australis, takes a break during December and January. Best wishes for a pleasant summer and Christmas holiday, happy New Year, easygoing Australia Day and prosperous 2002.

Chris Leithner


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