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Leithner Letter Nos. 36-37
26 December 2002 - 26 January 2003

There is probably not much more that Dr Greenspan can do about these risks via monetary policy, even if he cuts rates further. If there are grounds for labelling this the Greenspan recession, it is not because of his failure to cut interest rates far enough or fast enough. If he has made a mistake it is his failure to burst the asset price bubble earlier, when he correctly recognised it in December 1996 as irrational exuberance. Instead he became the leading promoter of the new economy.

Alan Wood, The Australian (22 January 2002)

None of us really understands the full implications of the bursting of the equity bubble that occurred in the United States and, in a slightly different form, in Europe. Although each of the 20th century’s major asset price booms and busts unfolded differently, the contractionary influences were usually felt over quite a long time span, with many of the effects only showing up a few years after the initial downturn.

Ian Macfarlane, Governor of the Reserve Bank of Australia,
Monetary Policy in an Uncertain World (13 November 2002)

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 for the upcoming year. Alan Wood (The Australian 22 January) presciently summarised 2002 in these words: “the economists forecasting this recovery are the same ones who failed to see the recession coming and failed to understand the nature and extent of the bubble that preceded it. Stock markets are still overvalued and the impact of the bursting bubble is still working its way through corporate America.”

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 (Letters 24-25). In the second half of 2001 and throughout 2002, the Commonwealth Government and Reserve Bank of Australia moved heaven and earth in an effort to counteract the bust. These efforts, i.e., profligate fiscal and monetary policies, have cost much, achieved little and may create difficulties in the future (Letter 30). To deny and try to attenuate a bust, in short, is to mute and delay a recovery. Leithner & Co.’s plans for 2003 are therefore based upon four unconventionally cautious premises. The first is that the excesses of the late 1990s remain imperfectly recognised and incompletely purged, and therefore that the prices of most assets are prohibitively high. The second is that government intervention in response to the bust has impeded rather than facilitated recovery. The third, a consequence of the first and second, is that Australia’s debt-propelled “recovery” has masked rather than counteracted the bust and is therefore temporary and bogus; and the fourth is that the underlying bust in Australia is likely to continue and may yet be sharp (see also The Hayek Hangover and The Fed’s Prescription for Disaster).

Measuring Dangerously and Reasoning Invalidly

Unlike most market participants, during 2002 Leithner & Co. was in no hurry to sing “Happy Days Are Here Again.” Yet far from crimping our fortunes, this severe and disbelieving stance helped us to achieve good results (in both absolute terms and relative to others). What explains this cautious attitude and these reasonable outcomes? The conviction that if 2001 was the Year of Measuring Dangerously, then 2002 was the Year of Reasoning Invalidly. Six examples of invalid reasoning were repeated fervently, relentlessly and far and wide during the year:

  1. Misconceiving and Misdiagnosing the Bust During 2002 governments and most market participants continued to misconstrue – and in a great many instances prematurely to declare the end of – the bust.

  2. Cancelling the Greenspan Put It appears that the so-called “Greenspan Put,” which was in the money from 1998 to 2001 and upon which many investment decisions have implicitly been based, expired earlier this year.

  3. Misconceiving and Misprescribing Interest Rates Why have governments, central banks and most market participants misconceived, misdiagnosed and prematurely hailed the end of the bust? Perhaps because they misconstrue, regard contemptuously – indeed, in many instances utterly ignore – the natural rate of interest.

  4. Misplaced Faith in Financial and Corporate Regulation During 2002 many belatedly demanded to know what had gone wrong with corporate accounting. They assumed that something had recently gone awry and supposed that stricter laws and more regulation would put things right. More apt, according to Holman Jenkins (The Wall Street Journal 16 January 2002), is the question “what has gone right since we handed accountants the federal gravy train of the mandated annual audit of public companies? Folks, this is not the first time auditors have failed to step forward and blow the whistle on some intransigent management, warning investors to run for their lives.”

  5. Worshipping the False God of Consumption Governments and most market participants have also misconceived, misdiagnosed and prematurely hailed the end of the bust because they have misunderstood, rejected or simply ignored Say’s Law (see Thomas Sowell, Classical Economics Reconsidered, repr. ed., Princeton University Press, 1977, ISBN: 0691003580).

  6. Misconceiving the Nature of Wealth During the boom and since the bust, governments, central bankers and market participants have thoroughly confused two distinct things: the money prices of goods and the amount of wealth in the economy. Yet the NASDAQ meltdown has not levelled any buildings or rendered any machines inoperable; America, Britain, Australia and other countries are just as full of farms, warehouses, railroads and oil wells as they were at the peak of the mania; nor has the dot-com débâcle sucked the knowledge of Java programming out of anyone’s head.

The Unlearnt Lesson of 2002

Jane Jacobs wrote in Cities and the Wealth of Nations: Principles of Economic Life (Vintage Books, repr. ed., 1985, ISBN: 0394729110) that “macro-economics is the branch of learning entrusted with the theory and practice of understanding and fostering national and international economies. Never has a science, or a supposed science, been so generously indulged. And never have experiments left in their wakes more wreckage, unpleasant surprises, blasted hopes and confusion, to the point that the question seriously arises whether the wreckage is reparable; if it is, certainly not with more of the same. ... Failures can help set us straight if we attend to what they tell us about realities. But observation of realities has never, to put it mildly, been one of the strengths of [macro-economics].”

Economic historian Murray Rothbard agreed. Concluding his analysis of the late 1920s and early 1930s (America’s Great Depression, 1963, 2000, Ludwig von Mises Institute, ISBN: 0945466056), he asked “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” (see also Gene Smiley, Rethinking the Great Depression: A New View of Its Causes and Consequences, Ivan R Dee, Inc., 2002, ISBN: 1566634725). Although his methods, philosophical orientation and area of economic specialisation are diametrically different, John Quiggin’s (The Australian Financial Review 6 June 2002) conclusion is very similar: “fiscal and monetary stimulus is a drug that must be used with care if habituation and addiction are to be avoided. If a temporary recovery is used as a reason for dodging necessary reforms, it may do more harm than good in the long run. Japan provides a cautionary example, [and there] is little sign that the need for reform in the U.S. has been recognised. ... The longer the necessary adjustments ... are delayed, the greater will be the eventual pain.” Pity that nobody in Canberra is listening.

Looking into 2003: Endemic Overconfidence Continues

To disclaim any ability to divine the future with any useful degree of accuracy, and to ignore those who claim to possess useful crystal balls, is not to ignore the future. Quite the contrary: it makes sense to plan for the future by considering scenarios – and to concentrate upon dour scenarios – of what might happen (as opposed to predictions of what will happen) and then to structure one’s investment activities accordingly.

Many and perhaps most others, it seems, are proceeding in a diametrically opposite fashion. Alan Abelson (Barron’s 25 November), for example, notes that “the rejection by its shareholders. ... of the proposal that Cisco pay a cash dividend, and the expressed preference by them for the company to buy in its own stock instead, illustrates one of the things that remains very wrong with this market – there’s still a heap of unpurged bubble mentality. Here’s a company which, if it had provided for the expense of stock options in the third quarter, would have seen its per-share earnings drop from the reported eight cents to a meagre three cents, a shrinkage of over 60%. And whose stock has doubled from its yearly low and is selling – at who knows, really – but, let’s say, 50 times some vague semblance of true earnings. Yet the shareholders turn up their nose at a cash dividend and are hot over the prospect of the company buying in its own stock! Man, that’s right out of the mad-bull playbook of the late Nineties-early 2000. Our point – and why we insist on being such a party-pooper – is that the bubble’s gone but the sentiment it engendered lingers on. So long as it does, we won’t, alas, see the end of the bear market, and rallies like the current one should be viewed for what they are: happy but transient interludes and strictly for the nimble.”

The bubble mentality is widespread, among other reasons, because mainstream data, methods of measurement and interpretations of results consistently distract governments and market participants from hard wheat and towards soft chaff. They thereby predispose them towards optimism – and, as the repeated and cumulatively egregious errors of 2002 have increasingly demonstrated, delusional over-optimism (see also Letter 29 and Letter 32). On 15 July, for example, The AFR published the forecasts of 22 Australian banks and investment institutions. On that date the All Ordinaries Index closed at 3155. They predicted, on average, that in three months the index would be 6.1 per cent higher (i.e., close at 3300) and that in six months that it would rise 10.5 per cent (i.e., close at 3425). What Mr Buffett has called the institutional imperative ruled the roost: none of the 22 predicted that the level of the prices of listed equities would fall during the next three and six months. Alas, on 15 October (i.e., three months later) the index stood at 2946 – a decline of 6 per cent from its level on 15 July and 10.7 per cent shy of the average predicted level. If you make your living as a forecaster, then it is imperative that you predict often and early.

On 1 October The AFR published the latest forecasts of these 22 major banks and investment institutions. On that date the All Ords closed at 2928. They predicted, on average, that in three months it would rise 5.8 per cent (i.e., close at 3100) and that in six months it would rise 9.3 per cent (i.e., close at 3200). Again, the strong tendency was to look at the world through rose tinted spectacles: only three of the 22 predicted a fall in the level of the prices of listed equities in three months, and just one predicted a fall in six months’ time. Yet the times are slowly changing. The Wall Street Journal (25 November) observes that “Wall Street strategists, once the Lords of the Research realm, are becoming the drones. With investor ire smouldering and regulators mulling sweeping changes about how stock research operates, Wall Street firms have been nixing their top market seers, mostly the recalcitrant bulls. It’s an age-old Street practice: Wrong too long, and you’re gone. What’s different this time is who’s getting tapped to take over. The next-generation strategists aren’t necessarily bearish. Rather, they’re the types likely to prefer hibernation over the spotlight.”

Looking into 2003

We see an emerging tension comprising complaisant expectations of a secure and prosperous future, an unwillingness to save for it, a profound misunderstanding of the process by which capital – and hence wealth – is generated and a susceptibility to sudden shocks that can suddenly, drastically and often permanently decrease one’s standard of living. The incomprehension, disbelief and anguished demands for compensation accompanying this tension may be termed The Distemper of Our Times. Although most politicians, bureaucrats, academics, consumers and taxpayers seem blithely to assume that there is a plight, apparently, of growing numbers of white collar workers in Australia, demonstrating that there is nothing automatic about the maintenance of gilded living standards. The incomprehension about the cause of this plight (i.e., high time preference, poor savings, depleted pool of funding and decadent lifestyle), together with the demand for and the government’s supply of fiscal and monetary demands that are likely over time to worsen that plight, also indicate that an accurate diagnosis of The Distemper of Our Times will be extended and hardly effortless. Three trends that corroborate this melancholy point became evident in 2002 and may become more prominent in 2003.

Item #1: a survey conducted by the National Centre for Social and Economic Modelling and summarised in The Australian Financial Review (12 November) finds that fewer than half of Australian households are saving more than the minimum amount required under this country’s compulsory superannuation arrangements. Further, the people closest to retirement are the worst savers. “The survey, prepared for the Financial Planning Association of Australia, discovered that people approaching retirement still had considerable debt and that superannuation payouts would be used to clear loans rather than provide for old age. The number of people who identify retirement as a primary motive for saving fell steadily during the 1990s, with most now citing holidays and travel as the chief reason for accumulating cash. Less than ten per cent of households reported that they were able to ‘save a lot’ of their disposable income.”

Item#2: on 12 August the Reserve Bank issued a fresh warning about the ballooning level of household debt. It noted that householders are tending more and more to use funds borrowed against their homes in order to finance their purchases of motor cars, holidays and the like. According to Goldman Sachs, during the past two years Australians have “cashed out” their home equity at a record pace. “In an article titled ‘Eating into House and Home’ the firm said that through the 1980s and early 1990s Australians increased the equity in their homes. But ‘the [recent] strength of consumer spending growth and the sharp fall in savings suggests that a substantial part of this equity withdrawal has been going to finance consumption’” (The Australian 15 August).

In the latest edition of its Australian Economic Analyst (summarised in The Australian on 14 November), investment bank Goldman Sachs reported that the debt-to-income ratio in this country is poised to become the highest in the English-speaking world. Household debt is presently 125 per cent of disposable income, and is expected to rise to 130 per cent by the end of the year. Almost 13% of disposable income is presently allocated to the repayment of debt; and unless interest rates fall the debt-service burden will rise. GS says that even a relatively moderate deceleration of the growth of debt may have profound effects: “to stabilise the debt-to-income ratio and debt-servicing costs, household debt growth would have to fall to around 6 per cent from its current 15 per cent rate.” Such a deceleration implies a reduction of new borrowing by households from the $88 billion accumulated over the past year to only $33 billion during the next year. GS concludes “the longer the debt truck steams ahead, the more likely the ride will become bumpy.” In the U.S., according to The Wall Street Journal (6 November), “the home-lending explosion has created more than just record numbers of ‘McMansions’ and remodelled kitchens. There are also record numbers of homeowners now in bankruptcy protection.”

Item #3: data from the Department of Employment and Workplace Relations shows that the job market for white collar professionals is weak and falling. According to The AFR (12 November), “the small overall fall in the [Skilled Vacancies Index] masks a more dramatic trend. Professional vacancies, including accounting, sales and marketing, IT and organisational jobs, have fallen 15 per cent in 12 months.” Blue-collar skilled vacancies, in contrast, have risen. On 22 November The AFR added “demand in the professional occupations plummeted to eight-year lows this month ... the job market remains bleak for professionals compared to trade-related jobs. Labour market analysts say the divergence between white and blue collar workers is startling. ‘It’s quite a stark contrast, and it’s as if you’ve got almost two labour markets.’”

A report released by the U.S. Census Bureau (summarised in The Wall Street Journal on 30 September) found that, contrary to the conventional wisdom, during the bust the incomes of American households have taken a beating. The median household income fell 2.2 per cent in 2001 to US$42,228 – the first year-on-year decline since 1991. Whilst many Wall Street economists focus upon personal income data, “Jared Bernstein at the Economic Policy Institute said the census data pointed to fault lines in the income story. It shows that the income of the wealthiest 10 per cent of households rose in 2001, helping to lift the overall level of income nationwide. But incomes in other classes declined. As a result, the median income – that of a typical middle-class household – declined. ‘From the perspective of working families, the recession looked worse than what you see in the top-line statistics. That’s what we saw in 2001, and what we’re going to see in 2002.’”

According to The Washington Times (30 October), “with more than 8 million people looking for work, long-term joblessness has become a significant problem for many. While unskilled and less-educated labourers often took the brunt of layoffs in past recessions, this time around joblessness is disproportionately hitting workers with skills and education, from recent college graduates and airline pilots to technology workers caught in the dot-com bust, and executives dismissed from disgraced and bankrupt corporations.” Further, “a survey of 125 top business executives found that the majority expect to lay off additional workers next year as their companies grapple with weak profits and revenue. About 60% of the CEOs surveyed expect their companies to reduce staff next year amid continued economic weakness and tight profit margins. Only 11% expected to increase staff, while 28% said their staff would remain the same” (The Wall Street Journal 13 November). As a result, and as noted by Sherry Cooper of the Bank of Montreal Financial Group, the rate of American unemployment masks the true nature of that country’s labour market. “This is a very different kind of joblessness than ever before – it is primarily white collar and highly educated. They are people who have never been unemployed before. They are managers, business consultants, auditors, engineers, technology workers and investment bankers.” When these people eventually find jobs “it is often at salaries that are markedly below what they were making before. Households that are already heavily indebted and savings-poor are finding it necessary to dramatically tighten their belts” (Barron’s 5 November).

Looking Into 2003: Continued Reversion to the Mean?

As in late 2001 so too one year later: few market participants, perhaps especially major institutional “strategists” (see Letter 32), seem to recognise the disparity between their rosy expectations and reasonable expectations. More than a few continue to spout blatant nonsense, parroting things they want to believe or, like Dr Pangloss, expressing the simple hope that all will somehow come good and they will land on their feet. For many, in other words, the distinction between price and value – and the reality that price may for a time exceed value but eventually regresses towards it – remain as unremarked and unappreciated as ever. Accordingly, Alan Sloan’s words (“Get Used to It: The Wall Street Party Is Over,” The Washington Post 4 June) are worth repeating: “sorry to be a party pooper, but the bull market that defined a generation and linked Main Street and Wall Street more intimately than ever is over, and it won’t be back for years and years – maybe not in our lifetimes. ... The 30 percent S&P decline and the 70 percent Nasdaq decline from their peaks in March 2000 are a return to reality, not a passing hangover that will vanish tomorrow night when the party resumes.”

Among vast effusions of warm and woolly nonsense and cheery hopes are nuggets of hard data and wisdom. In the words of Barrie Dunstan (The Weekend Australian Financial Review, 4-5 May), “what is happening is probably a drawn-out phase during which overpriced stocks of all types are coming back to earth. ... Forget about projections of economic growth in the United States or elsewhere. Stock markets at the moment aren’t about business prospects; they’re about the excessive valuations investors have been placing on shares. These valuations went far too high. ... Now they are in the process of adjusting in what the experts call ‘reversion to the mean.’” According to Robert Fuller, cited by Dunstan, “you won’t hear much about reversion to the mean from investment managers – one never does when they are on the wrong side of it – but the process is one of the most logical and predictable long-term cyclical developments in markets.”

Several other nuggets are worth emphasing. Barron’s (15 July), for example, asked its readers to “suppose we had a recovery in S&P earnings of 50%, 1982-84’s Reaganesque size. By 2004, without one dime’s increase in S&P stock prices, we would still have a P/E for the S&P of about 27 – or close to double the average P/E of the post-war era. That is, even with a stupendous growth in earnings, coming from who knows where, stocks are likely to be not at all cheap year after next unless the market falls further.” Similarly, Barrie Dunstan (AFR 2-3 November) cited a funds manger who told his clients that the bear market “is not a consequence of 11/9, corporate malfeasance, war with Iraq, skirt lengths or any of the many other serious and silly reasons advanced. The crash is occurring purely and simply because markets became outrageously overvalued at the end of the 1990s.”

The AFR (17 October) added that “on average [in the U.S.], at major market lows stocks sold below book value, at 14 times dividends and at eight times earnings. The current readings of 3.5 times book, 52 times dividends and 27 times earnings do not look cheap even if we acknowledge that inflation and interest rates are low.”David Fuller, paraphrased by Barrie Dunstan (AFR 29-39 June), notes “investors aren’t so much spooked by terrorism as the brutal effect of the unwinding of a super-cycle bull market. His answer to the question whether an 18-year bull market can be unwound in two or three years, after which markets will return to the good old days, is ‘of course not, according to every shred of logic and centuries of history.’ But it won’t be an uninterrupted fall and the stock market will see many medium-term rallies. ... So what is the 2002-2003 message? Hold your nerve during any downswings; be a cautious stock picker; and don’t be in too much of a hurry to pick the bottom.”

Three Cautious Conclusions for 2003

Stephen Roach, chief economist at Morgan Stanley, best expresses our first cautious conclusion. “In the end, as painful as they are, recessions are about purging excess. We have not [fully] done that” (The Wall Street Journal 2 March; see also the Alan Kohler’s interview with Mr Roach). The Economist (12 August) adds “most U.S. economists weigh up America’s prospects as if there were only two options: a double-dip recession or a sustained recovery. A third and possibly more likely option is a protracted period [of sluggishness] until the U.S. has shed its excesses.”

Secondly, invalid reasoning and distracted over-optimism are encouraging many market participants to pay excessive prices for stocks, bonds and titles to real estate. If so, then it is possible that these prices may become less excessive in 2003. Distracted over-optimism and faulty thinking have also generated, among many debt laden white collar employees who consume for the moment and disregard tomorrow, a dangerous confusion of fantasy and reality; and it is possible that during 2003 the former will yield somewhat to the latter. Finally, plus ça change, plus c’est la même chose.

According to James Medbery, quoted in Barron’s (18 November), “the annals of ... finance are not particularly exhilarating. The exhibition of fraud in high places, and of effrontery on the part of responsible managers bordering on the sublime, which has characterised the past few years, is not calculated to inspire overconfidence in the future.” Medbery’s book Men and Mysteries of Wall Street, in which his quote appears, was published in 1870. For these three reasons, caution and scepticism, which have served Leithner & Co. well since the onset of the bust in 2000, will remain strong in 2003.

According to H.L. Mencken, “men become civilised, not in proportion to their willingness to believe but in proportion to their readiness to doubt.” So do investors and businesspeople. Hence value investors, as custodians of capital, strive at all times and on the basis of cautious assessments 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; and because the Company is a net saver and therefore a net purchaser, my preference for 2003 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. In Mr Buffett’s words: “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 2002 has been a good year, and a year’s time will tell whether the same will apply to 2003.

Leithner & Co., like many of the inhabitants of Terra Australis, takes a break during the latter half of December and the first fortnight of January. Best wishes for a pleasant summer and Christmas holiday, happy New Year, easygoing Australia Day and prosperous 2003.

Chris Leithner


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