Where do we go from here?

By Duru

October 6, 2002

"My instincts, refined by 50 years of experience in finance, tell me that we are in but the third act of a five-act Shakespearean drama that portends a bad ending." [LeonLevy] says, "Stock prices may have plummeted from their dizzying heights, but neither consumers nor investors have yet realized the perils of the suffocating pall of debt hanging over the financial world." He also points to intensifying global competition and sees danger to a consumer-oriented economy in the inevitable rebuilding of depleted savings. "Count on it," he said. "When the savings rate rises, my father observed, corporate profits fall." Slimmer profits mean less investment, fewer new jobs, more layoffs, depressed stock prices and perhaps even a reversal in the soaring price of real estate.


Quote by Leon Levy who is releasing his memoir, "The Mind of Wall Street"

Clipped from a larger article, "An Old-School Mind Not Fooled by the New Economy" by Robert D. Hershey, Jr. at



This one paragraph summarizes everything unfortunately. As I mentioned previously, i have squinted, squinted, grimaced, and wrung my hands, TRYING to find some positives out there, and they are very hard to come by. Even as some companies' stock seem incredibly cheap, all indicators tell me they can get cheaper still...


Why are we at this point? And where do we go from here? If you are looking for optimism, you are going to have turn on CNBC, write to the President, sit with Greenspan, or consult your local stock broker. I have tried to find the lights in the caves, but the thicket of bats fluttering around is quite overwhelming.


This missive will be one of those long ones. I am writing this one straight from brain to keyboard because I am feeling it strongly. Excuse me if I am not quite as polished as I should be. But I am writing this urgently because I feel like we are at a crossroads (again!) and a lot of local, regional, and global events are converging very quickly. This convergence will likely provide more stress on our global financial systems than they are capable of taking at this point. All the traditional remedies from increasing government deficits, lowering interest rates, increasing American consumer spending are all reaching towards over-extension. There is little room for error going from here, but because the powers that be choose to be over-optimistic and choose not to alarm the public, very few people are preparing for the worst - this will be the greatest tragedy if some economic calamity does befall us.


Am I just being all gloom and doom? I don't think so. Let's first understand why we are here. The biggest financial bubble in our history, even bigger than that of the 1920s, just popped. This bubble was so large that not even Greenspan knew it was a bubble until after it popped (sorry, I couldn't resist that cheap jab). Anyway, since this bubble was of epic proportions, no one really knows what happens next. No one really knows how this story is "supposed to end." For example, Greenspan himself admitted that the Fed faced economic forces never seen before and was paralyzed as a result. Japan's post-bubble "recovery" is STILL dragging on some 12 or 13 years later. So, why should we expect we can get away with a quick slap on the wrist and continue with prosperity full steam ahead? The answer is, we simply cannot. We instead need to take an honest look at the odds stacked against us and make the judgment whether we think the worst is really behind us or yet to come. I feel like my previous missives have already provided a litany of complaints, whines, and cynicism - so excuse me, if I repeat myself or appear to get mired in negativity. I merely provide these as a counter-balance to the unfounded cheerleading that gets spewed from a lot of the mass media that everyone gets exposed to on a regular basis.


First, most alarming, is that our federal government is at wits end trying to figure out how to get the economy moving again. I suggest that they will not figure it out; as I said, we are in unchartered territory, and the answers will only become clear AFTER THE FACT. What we can say is that the sooner our system is flushed of its excesses - now in the forms of bad debts and unneeded production capacity - the sooner we can begin the painful task of rebuilding. Until then, these bad debts and excess capacity allow the weaker parts of the economy to continue to undercut the potentially stronger parts by waging destructive price competition and putting in peril the balance sheets of a lot of financial institutions. It also fosters a continued lack of discipline amongst consumers who will have almost zero cushion if the worst is to happen. Note, however, that corporations are the ONLY part of the economy trying to rationalize their balance sheets - perhaps because they feel the instinct of fight or die most directly through the free markets of our capitalist system. Consumers and the governments in general have yet to begin this process. The corporations that are trying to get costs in line and reduce debt continue to struggle often times because they also have to fight the weaker players in their industries who still have excess cash and capacity generated during the bubble when these things were flowing free as sunshine.


Anyway, I digress! I was talking about the problems with the government. Our government is nearly paralyzed, yes, paralyzed, when it comes to financial/economic issues at this point. The Fed has almost no bullets left in its interest rate cutting pistol. Further rate cuts will only engender the same temporary boosts of euphoria that the last 11 or so cuts did. Even worse, the comparisons to the ineptitude of Japan will become stronger and clearer. The White House and the Congress are paralyzed by a lack of a plan. Has anyone yet heard ANY sound plan from the Democrats or the Republicans for putting these pieces back together? The Republicans, especially the President, think that once we start dropping bombs on Iraq, a wartime economy can get us in gear. (I find it appalling and sad that so many economy recovery theories are pinned on the shedding of blood. For example, I have heard several commentators lament that all the talk of war gives Wall St. the uncertainty it doesn't like, but once we begin bombing and a victory seems likely, people will be in a mood to buy stocks again). The Democrats cannot afford an economy that does too well because this would give the Republicans a lock on election victories this year and in 2004. Nothing will keep you in office better in America than war victories and money for everybody! Sadly, the Republican plan is likely to backfire. The bombs on Afghanistan gave the stock market speculators more confidence, but the market then peaked just as victory was assured - and you know the rest from there. Even worse, a war against Iraq will expand our already growing deficits. In less than two years we have wiped away all those surpluses generated in the 1990s. This deficit spending was necessary post 9/11, but couple this with all the tax cuts they promised us for the rest of the decade, and you can see that the government has little leeway for fighting a costly war against Iraq. And you can bet we are not getting the billions we got during the last Gulf War from our Allies. In the end, you will have to kiss those tax cuts goodbye, and, if you haven't been tightening the belt, Uncle Sam will *force* you to do it! All-in-all, the Feds will not have much to help us as things steadily deteriorate, and they will be handcuffed by the political wrangling involved with fighting terrorism, Iraq, and each other.


Next stop is the consumer. I have consistently and constantly berated the American consumerist culture of consumption. I have constantly lamented that people in general are piling on debt like the good times are still rolling. Yet, I also understand the irony that if all this excess were to stop, our economy would go into a tailspin. Our economy REQUIRES constant spending by consumers. It requires avarice and a need to buy more and bigger. Why else would the President and the rest of the government rush last year to encourage Americans to keep shopping and visiting the local shopping malls even as we feared that a terrorist was lurking behind every crowd? (Does anyone besides me get uncomfortable with our politicians' implication that normal American lives features lots and lots of shopping?!?!)


But nothing is infinite in this world, even in the land of plenty. As the quote at the beginning of this missive hints, even this profligate spending process will meet a natural end when consumers will be forced to save again as it becomes clearer that the future is not clear. In the end, even American consumers have a sense of self-preservation that requires they save for that college education for their kids, save for that retirement, and most importantly save to meet those mortgage payments next year. Greenspan has supported our shopping addiction as a crutch for the economy until businesses could begin investing again. Greenspan has just about run out of time because almost two years after he first relented and began slashing interest rates, businesses are still awash in debt and excess capacity and are in no mood for hiring more, investing more, or building more. Once again, paralysis stares us starkly in the face.


While I am on the subject of Greenspan, many of you faithful readers have probably noted that my opinion of Greenie and company has notably soured over the past year or so. It has indeed. I have become more and more aware of just how bad a job Greenie has done overall. His first mistake was to let the bubble grow to the size it did and not force us to accept the pain early. Instead, we face the prospect of experiencing a prolonged period of pain with a very uncertain ending. Greenie and company were far too confident that they could guide us to a "soft landing" from the runaway excess of the late 90s, and when that landing turned into a fireball, they were far too confident that they could extinguish the flames without too many more people getting burned. As you know, I was shocked that Greenspan had the gall recently to absolve himself of any blame for this whole disaster. To me, it was the culminating commentary on just how poor the guidance was that we were getting. I will not regurgitate my critique as so many in the press and financial community actually agree with this opinion. I will suffice it to say that it is quite clear to me now that Greenie has been more motivated to save his reputation as a hero and "maestro" than to actually follow policies that are necessary to steer this crazy economy. I am sure his plan was to make the soft landing his final paint brush stroke of genius and to retire amidst a flourish of praise. Instead, he clings on, like so many stock investors, to the hope that the economy can pick up soon before retirement becomes a necessity. Greenspan is facing the real prospect of exiting at best in poor esteem, and, at worst, in disgrace.


Well, enough of that. I have so much more to tell!


Let's get back to the retail environment. I wrote recently about the imminent disaster facing our retailers as the Christmas season looms with little to get consumers excited, worries over war, a potential retrenchment of consumer spending dollars, and, incredibly, a dockyard strike that leaves produce rotting on the West Coast and is holding up shipments needed to prepare for the Christmas season. Now, you know me, I find any reduction in Christmas spending a GOOD thing for our culture, but I recognize that it is a bad thing for our economy. Regardless, the threat is real that the one last good leg of the economy is about to crumble from all the pressure being applied to it. The stock market's recent slaughter of housing-related and retail stocks is quite a telling sign that we should all heed. The stocks of GM and Ford have been met with nasty bloodletting. It could have been predicted as all this 0% financing cannot go on forever even though consumers have demonstrated that they will no longer buy vehicles without the free money. This is disastrous for these companies. In generations past, the collapse of auto stocks was a sure sign that the economy was headed for trouble. But, now, we are much less dependant on the manufacturing sector, so the signal is only one of many to consider. Still, it is a very bad sign.


I will not even go into the whole debate on whether we are in the middle of a housing bubble. I am far less knowledgeable on real estate (but I plan to improve!). However, based just on the articles I have sent to you all, I am convinced that even if we are not in the midst of a housing bubble, housing and real estate are certainly a part of a credit bubble. 0% financing, no money down, no payments for 12 months, mortgages for minimum wage workers - these are all supported by the historically low levels of interest rates we have. Again, Greenspan was forced to go here to keep the economy crawling along. But it has now moved our stock market bubble to the consumer economy in a dangerous game of musical chairs....and that last chair is close to getting pulled!


Whew! Tired yet! I know I am. But I have more to tell!


The global financial picture provides almost no ray of hope for us either. Latin America continues to struggle. Japan is mired in financial woes. Europe is slumping. SE Asia is a potential bright spot, but they are so dependent on exports (read - American consumption) that any glimmer of hope there will not last as the US dollars stop flying their way. The world typically depends on US spending to lead it out of slumps. And that spending is typically supported by foreign investment in our stock markets and the purchasing of US Treasuries and other debt instruments. This whole "scratch my back and I'll scratch yours" feeding frenzy is at serious risk because foreigners have lost faith in our financial markets (scandals, poor recovery, etc...) and consumers are about to spend less, not more this time. The only reason that foreigners continue to invest in the US at all is that their own home countries are typically doing WORSE than us - or at least offer even less attractive prospects. As a Morgan Stanley analyst (Quinlan) says: "Making good off the misfortunes of others is a precarious way to live...It is unsustainable. Yet that is precisely where the U.S. stands at this juncture in terms of funding its current account deficit." (Sheesh - imagine me quoting an analyst - yikes!) The only possible positive is that when the dollar begins to sink again and forces foreigners to seriously scale back on US investments, our goods will become cheaper to them. But it is often hard to sort out the good from the bad here. Foreigners don't have the money (or the inclination) to spend like Americans do, so even when our goods are cheaper, it is not necessarily true that these increased sales will offset the negatives of higher inflation from imports becoming more expensive and domestic companies having more room to raise prices.


Speaking of raising prices, I mentioned earlier that I have come all the way around from worrying about inflation to worrying about deflation. I mentioned that deflation is a serious malady because it makes servicing debt increasingly hard as your salary declines and your investment declines but the real value of your debt balloons. Deflation can be quite destructive to an economy, just ask Japan. We teeter on the brink of deflation because of the excesses still in our system. I already mentioned this: put excess capacity together with weak economic players that are fighting to survive by cutting prices to the bare bones and below, you get an environment where no one can make money. And when no one makes money, there is no money for investment. Everyone cares only about cost-cutting, not innovating. The whole economy begins to stagnate. If government deficits force interest rates back up, we could actually get stagflation where the economy slows down but inflation picks up. I am not ready to predict this dire scenario, but it is a distinct possibility.


Another by-product of this competitive environment could be the re-emergence of the dominant conglomerates. Imagine, when the weak players finally get squeezed out the system, the only gorillas left standing will be those that amassed so much cash in the past, that they can outlast everyone else. Think Microsoft, Intel, Cisco, and Applied Materials in the tech economy. Eventually, only a few telecoms will be left. Utilities may be forced to further consolidate. The dominance of players like this will be a mixed blessing. On the one hand, they will determine the standards of their industries and innovation will flow through them. But as dominant players, they will have less motivation to innovate, and we will get further slowing of our economy. (Remember, despite the bad rap tech has gotten, technology is the true engine of growth for our economy). On the other hand, we will be so relieved to see some health in the economy, that we will welcome these giants as prophets of stability and secure jobs. The next natural step will be the return of regulation in our economy. We have spent the better part of the last 30 years de-regulating our industries: airlines, utilities, and telecommunications have been the biggest - and they have all been disasters in one form or another (who could have ever imagined that American Airlines' market cap would shrink to the value of just THREE of its 900-plane fleet?!!? Goodness!). I predict that we will eventually get to the point that we will re-question the wisdom of de-regulating so many industries and services that are required to keep the economy strong. If we get comfortable with regulation again, we will certainly get comfortable with giants dominating whole industries - as long as they play within some set of rules dictated by the public sector. I am not sure what the fall-out will be. Certainly, competition is required keep an economy vibrant. But I have not been convinced that competition in industries that are near public necessities like electricity can work over the longer-term. Regardless, regulation/de-regulation will be the next big economic debate of our, or the next, generation.


All in all, it is hard for me to predict whether we will get a double-dip recession, much less a depression (as a few have begun to predict). I know I am not quite qualified to provide definitive answers in this regard (even if I predicted the last recession correctly). Heck, I suspected that we would get a weak recovery in the second half, but even I was not prepared to consider anything more dire! I can say that extreme caution is warranted on everyone's part. Again, we are in unchartered territory and almost no one seems to know what to do now. We are at a loss, paralyzed and left with almost no precedence. If there is a natural medium that the economy must revert to, then we should see an economic fall-out that is at least as large as the economic uprising that we had in the 90s. This reversion makes sense to me. But it means we are far from seeing the worst of things. We are probably indeed only in the "third act of a five-act Shakespearean drama."


Whew! I KNOW you must be tired of reading yet another litany from me, especially since there are some familiar themes here. But if you have made it this far, hang on for one last outburst. I began writing these missives because of the madness in the stock market. So, I must tie all this back to my current readings of our friends on Wall St.


The stock market looks ready to start the next leg down in this bear market. People are finally becoming weary and wary of all the head fakes. The rationales I read for buying stocks are becoming more and more strained. The analysts are getting more and more negative and are slashing earnings and GDP estimates faster than they can say "buy!" or "strong buy!" Typically, the time to buy stocks is when negativity is strong. But not only is it not clear that Wall St. is yet negative enough, but given that we are in unchartered territory, it is hard to even know what "negative enough" means! For example, everyone was betting the second half of the year would feature a vigorous recovery because of the "typical time" it takes for Fed rate cuts to generate economic growth. This expectation has proven quite incorrect. The last time the stock market had three negative years in a row was during the Great Depression, and we have only experienced one other time in our history where the stock market was down four years in a row - again the Great Depression. You can bet that people will start calling for a vigorous recovery in 2003 just because, heck, how could things get worse? I urge you to avoid such logic. You should accept predictions that have some basis in real economic principles, indicators, or activity. Historical comparisons are unlikely to work well here, especially ones that run counter to what your intution tells you. It is hard to tell what will work exactly!


What typically gets the stock market going is a virtuous, self-reinforcing cycle of positive psychological vibes as described here:

"In a normal recovery cost-cutting would be the trigger. 'The market then senses improved earnings, and boosts stock prices, which lifts the confidence of business people, who hire and invest. That worked nicely this year until the summer, when the market was nailed by lack of confidence in corporate leaders. The whole dynamic has been short-circuited." (Mark Zandi, chief economist at Economy.com - this was cut from a Wall Street Journal article). Notice how the stock market zips ahead of a recovery simply because people feel like the recovery will happen. It is nearly an act of faith. Even CEOs and CFOs will dare to make business forecasts on this same faith. The problem is that the market ALWAYS feels like a recovery is around the corner. Thus, we get all the headfakes we have seen to date. It is also why no bear market goes straight down. The health of the stock market depends upon a fundamental well of optimism and faith that in the end, all will be OK and even better. But just as this optimism can run out of control and create bubbles like the one we got, it can cause people to get ahead of the fundamentals in the recovery scenario as well --- causing people to keep losing money as they try to get a jump on the recovery. During these head fakes, you will hear the kind strained reasoning we have heard over the past two years about what "always works" or what is "supposed to happen" when the Fed cuts rates, or when a recession ends, or when the federal government cuts taxes, etc.... Goodness forbid you ever hear anyone say "this time is different"!


I will repeat the following: if a real bull market breaks out, it will last for many years, and you will have time to get in. Don't be fooled into thinking that the only time people make money is by buying at the bottom of the bear, or close to it. Besides, it runs counter to the "buy-and-hold" mantra, right? - where you can just wait out all bad events on your way to riches! (Cynicism intended). Aggressive investors (better yet, traders) can jump right in and then get out at signs of trouble. But conservative investors do well to just wait. If nothing else, look for somewhat stable companies that pay a nice dividend, and keep those CDs rotating.


Regardless, my outlook says that we could be in for a flat decade as far as the stock market goes. The buy-and-hold crowd will struggle to hang on while the traders who hop from one hot industry to the next, or buy the dips and sell on the false rallies (or short the rallies and cover on the dips), will be the ones making money. That is, this will be the decade of the trader and NOT the investor. I have read several commentators who would agree with this assessment. This behavior of the markets will be so frustrating to the average American that by the end of this we will be back to a level of non-participation in the markets similar to the low levels following the last serious bear market of the early 70s. Some of you have already dropped out, but if you don't believe this poor performance is possible consider that the Dow gained all of ONE point from 1964 to 1981. A SEVENTEEN YEAR span during which the Dow went from 863 to 864. There were many ups and downs in this period, of course, but those who decided to just buy and hold their investments during this period likely made no money (and actually experienced negative returns due to high rates of inflation).


To give you another idea of just how far into the stratosphere our bubble got, take a look at this analysis of what kinds of returns we will see in the Nasdaq when it finally gets back to its high of 5000 (starting from Nazz1100 now):

Nazz5000 in x years






Implied rate of return (%)







What this table shows is that IF the Nazz gets back to its highs in 20-25 years from now, we will get a return that is pretty much in line with historical norms. And that is being in-line!!! As I mentioned earlier, we are in a process of bringing the long-term averages BACK to their means, so we should expect that the Nazz, and the other indices, should under-perform for some time to come. Even I am not cynical/skeptical enough yet to start predicting just how much under-performance we should expect, but I am wary.


So, in putting all this together, we have a very precarious situation. One that requires all of you to exercise mucho caution going forward. We can all hope for better days. We can have faith that somehow the markets will work things out and the corporate bad guys will get what they deserve. But, sadly, there is little solid evidence to ground this blind confidence. You will be much better off being cautious: avoiding large debt, scaling back on large financial commitments, saving more, maintaining multiple and alternative career and financial plans, and investing in the safest instruments possible. It is OK to reserve a small amount of funds for more aggressive investments since no one (not even me! =smiles=) can predict the future exactly. But you have to prepared for the very real prospect that any investment in stocks at this point will do poorly for quite some time. Again, mutual funds and index funds will not be great vehicles. 401Ks will languish. Individual stocks will provide the best prospect for profit, but will also be the riskiest unless you are prepared to spend the time doing the analysis and watching for good times to enter and exit these investments. Stock brokers and investment bankers will become even poorer guides for pointing the way to your financial security. I know, it all sounds so dire, and I have now reverted to my 100% bearish stance as I was for most of these past two years, but I feel compelled to lay out the story as you may not see it in the general and mass media.


In future missives, I hope to be able to point to some real positives and some real points of light amidst all this darkness. As they say, the best opportunities can come during times of crisis. If all this bad news paralyzes you as it has our friends in DC, you will not be ready to participate in prosperity until there is little left to trickle down to you.


In the end, be VERY careful out there - and thanks for "bearing" with me!