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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Many serious market students assumed the reaction of investors had been overdoneWhy was Japan hit so hard, and why did deflation begin to engulf that country in 1990? These questions have been debated by economists for a decade, and there is still disagreement. The Triple Waterfall Crash of prices of stocks and real estate was the driving force of the 1990s deflation, but asset deflation cannot in itself explain the long recession that enervated what had once been a vibrant economy. From 1987 to about 1991, the Western world had been transfixed by the blinding rays of the new Rising Sun. After the U.S. Triple Waterfall Crash of technology and growth stocks in 1973-1974, Japanese companies became the global standard in any market they seemed to choose. They began with heavy industriessteel, shipbuilding, machinery, and automobiles. By the early 1980s they were moving so rapidly into electronic technology that President Reagan had to negotiate a slowdown on Japanese chip exports to save the U.S. industry. What Japan was doing on a grand scale was what Sweden did during World War II: winning big from war by neutrality, a stance that permitted trade with both sides. Yes, Japan was not truly neutral; and yes, unlike Sweden, it didnt sell to Nazis. But the Japanese postwar constitution forbade Japanese military aggression (as contrasted with self-defense) outside the islands, while permitting the nation to build up its defenses and its defense industry. The result was that by 1988, Japan had the worlds third-highest defense budget and Japanese manufacturers were huge suppliers to the Pentagonand, to a lesser extent, to the armies of Western Europe. In 1989 the fall of the Berlin Wall signaled the coming end of the Cold War. It also put much of Japan Inc. into a quandary. Where could they replace those lucrative foreign defense markets? A former National Security adviser told me a story just after the end of the Cold War. He had returned from a visit to Japan. While there, he naturally talked to many Japanese leaders. He asked them, With the Cold War over, you now have the worlds third largest defense budget. What are you doing with it? Oh, we are conducting extensive research on our new priorities. Could you give me some examples of important new research? the American asked. Well, we recently completed a full analysis of what we would need if Korea attacked us, and what we would need if we attacked Korea. Can you imagine that? the adviser said to me. Suppose it were revealed that the German government had just completed a survey on what would be needed to invade France? Thats the Western equivalent of the history between Korea and Japan. Perhaps those plans are being reviewed in the light of North Koreas recent intransigence. Most observers considered the deflationary pressures emerging from Japan as good news for the global economy since it helped pull down global inflation rates, giving consumers greater buying power and central banks more breathing room (see Charts 4-1 and 4-2). The sudden, peaceful victory in the Cold War established the United States as sole superpower. Then came the Gulf War, which was pursued by the last of the Cold War leaders, George H.W. Bush, with advanced technology and a display of massive firepower. In light of the current debate on war with Iraq, its worth recalling the strong Democratic opposition then to fighting Iraq. Even though the United Nations had authorized a military response to Saddam Husseins invasion of Kuwait, President Bush needed congressional authorization. Senator Kennedy led the impassioned opposition, which evoked predictions of thousands of body bags. The resolution to repel Iraqs invasion of Kuwait carried by just five votes in the Senate. Less than 300 American soldiers died from all causes in that war. Cold War antiwar emotions die hard. The Gulf War had delayed the onset of the Peace Dividend until after President Bushs electoral defeat. With that rejection, he joined Margaret Thatcher in the roster of Cold War victors who became political losers; Germanys Helmut Kohl, who had been their staunch ally, would join them later. They were in good company: British voters booted out Churchill in the election whose results were announced while he was attending the Potsdam Conference to arrange the settlement of the victory in World War II. War-weary voters want different leadership in peacetime. Theyre tired of being told to sacrifice; they want someone whose attitude is: Let the good times roll! Although few saw it at the time, the wars end meant that there would be a rapidand likely spectacularbuildup in the domestic technology industry. In particular, a system developed over two decades by and for the Pentagonnow called the Internetwould surely be developed for largescale civilian and consumer use. Nobody talked of beating swords into plowshares, but thats just what happenedon a scale greater than even dreamy tech futurist George Gilder predicted. When the Cold War ended, the four largest private sector employers in California were Department of Defense contractors. By 1995, 400,000 defense-related jobs had disappeared in that state alone, with nearly a million more lost in the rest of the nation. At the peak of the Reagan buildup, defense spending accounted for 6.2 percent of GDP. At the nadir of the Clinton climb-down, it accounted for 3.0 percent. When that budget number was announced in the fall of the year 2000, a conservative commentator noted that the nation was now back to the same level of defense spending as at the time of Pearl Harbor. Given the risks out there in an increasingly hostile world, he sourly predicted another Pearl Harbor soon. That Cassandraesque observation was made less than one year before 9/11. A NEW KIND OF WAR The sudden outbreak of the terrorist war blasted the stock market hard, with the Dow Jones Industrials plunging from 9605 to 8920 when the market reopened for trading after 9/11. Many serious market students assumed the reaction of investors had been overdone. That was not my view, and I had the chance to expound those views to a large gathering of hedge funds and pension funds held at a closed-door meeting of the Greenwich Round Table on September 20. Four of us addressed the group. Douglas Cliggott, then of J.P. Morgan, spoke first. He had the best forecasting record on Wall Street. He had been deeply bearish on stocks before 9/11, and he was still bearish. His analysis focused on the economy and corporate profits. The two other speakers, both associated with hedge funds, thought falling interest rates would trigger a good stock market rally (and they were proved rightfor a while). I took a different tack, discussing the effect of war on equity valuations. From the comments of other speakers and attendees, this analysis was novel to them. I argued that the correct p/e for stocks should be reduced by about 20 percent to compensate for the effects of war on the efficiency, flexibility, and profitability of the economy. In that speech and in my writings at the time, I expressed particular concern about protectionism. As I noted, Bill Clinton would probably be taken very seriously as an important president by future historians because hed had the wisdom, vision, and tenacity to stand up to the protectionist and parochial elements in his party. He was the president who gained legislative approval for George H. W. Bushs program of the North American Free Trade Agreement (NAFTA). I expressed fear that, like all past wars, the new War on Terror would lead to protectionism. (Thats the way its worked out. The demands of gaining political support to prosecute the War on Terror have driven George W. Bush into the arms of the protectionists. Free trade may not be the first casualty in war, but it is surely the second. Industry after industry and vested interest after vested interest troop forward to claim that the national interest in wartime demands protection for them. Twas ever thus. This time the focus was steel, lumber, textiles, and agricultureso far. As the dour Dr. Johnson noted, Patriotism is the last refuge of a scoundrel.) Since that Greenwich meeting, market strategists have been constantly debating the right price-earnings ratio for the market. To date, none of the prominent strategists has said that the War on Terror warrants a lower p/e ratio, even those who blame falling consumer optimism numbers on fear of war in Iraq. My fears about a return to protectionism may have been realized. Because protectionism restricts choice for both consumers and businesses, it is a major negative for the stock market. It was no coincidence that President Bushs surprising (to the markets, at least) decision to embrace the steel industrys claims for protection from foreigners started the stock market down in the spring of 2002. The markets slide became vertiginous as Bush added lumber, textiles, and agriculture to the industries coddled from their economic xenophobic insecurities (see Chart 4-3). While staging the greatest sustained assault on Adam Smiths principles of any recent president, Bush made a brief visit to Latin America and Russia, where he told the locals their way to prosperity lay through free trade. It was as if a prominent atheist were to piously announce that although he hadnt changed his personal views, the nations problems could only be solved by deep religious revival. When conservatives rebelled against Bushs protectionism, they were told to keep the faith. The president was so preoccupied with winning the War on Terror that he was apparently letting his political adviser, Karl Rove, call the shots on which small-scale domestic economic trade-offs with the Democrats were needed to keep control of the House and gain control of the Senate in November. Some market historians darkly noted that it was the passage of the Smoot-Hawley Tariff that turned the correction at the end of the 1920s into the Crash of 1929 and the Great Depression. Bush had become the second Republican president to go protectionist when the real protectionist goal was protecting his own partys position in Congress. He continued his emulation of Herbert Hoover by making remarks in July (the worst month for the S&P since the Depression) that the stock market collapse was unreasonable, because the economy is sound. (Yes, its just a coincidence, but the three worst bear markets in the S&P 500 came with Republicans in the White HouseHoover, Nixon, and Bush.) The War on Terror, in combination with the recession of 2001, turned the nations fiscal situation from surplus to deficit. As we are told repeatedly, this is a new kind of war. Will the war introduce sufficient inflationary pressures into the economy to offset the deflation still being pumped from Japan, and, more importantly, from China? (See Chinas Impact on the Global Economy and Corporate Profitability, in Chapter 8.) Readers who take a trip to Wal-Mart or Target store these days will see the large-scale penetration of products made in China, East Asia, and Japan. Not since the colonial era have such large segments of the U.S. economy been captured by distant suppliers whose main competitive advantage is price. The United States is fast becoming a postindustrial society. That means bargains for consumers, but it also means the loss of millions of wellpaid manufacturing jobs. No wonder North American unions are so bitterly opposed to free trade. Will the war have sufficient impact on the economy and on corporate profitability to justify a stock market p/e retreat to Cold War levels? During the late 1990s the New Economy Shills & Mountebanks justified record p/e levels on the S&P (and astronomic p/e levels on Nasdaq) by talking of endless economic growth and rising profits generated by the economys growing use of new technologies. Those forecasts have been 100 percent wrong. One thing that will hold back business enthusiasm is the huge increase in insurance costs arising from the War on Terror. That building owners can face punitive damages (in which lawyers will collect 33 to 40 percent of the payouts) because terrorists fly gasoline-laden planes into their properties means insurers must charge huge premiums even for insurance on office buildings, let alone on planes. That leap in insurance costs comes at a time of crisis in the corporate insurance coverage for companies, their directors and officers, and for the costs arising from lawsuits based on malfeasance (see Asbestos and the Growing Burden of Insurance Costs in Chapter 8). No, Enronitis and its associated diseases have nothing to do with war, but the combination of premium increasesor outright denial of coverage arising from the war with premium increasesor, again, outright denial of coveragearising from malfeasance is a big burden on business, and a big burden on the stock market as well. By the way, this is a global problem. European stock markets fell as hard as U.S. stocks in 2002; a big factor in those plunges was the forced liquidation of billions of dollars worth of stocks held by European insurers and reinsurers who were on the hook for 9/11 and corporate malfeasance damages. On the Continent, this became a mutually reinforcing fall in equity valuesinsurers sold because of balance sheet problems, which drove stock prices lower, which forced more insurer selling, and so onas European indices fell to multiyear lows. As of August 2002, the nine-year total return on the leading Morgan Stanley international stock index, EAFE (Europe, Australia, Far East), was zero. The fat returns from one of historys greatest bull markets had been completely erased. There is never a good time for a war, but this one came at a time when America was reeling from the immense economic, financial, and human disasters inflicted from another new kind of wara war on the ethical (and, in a few cases, the legal) principles of capitalism by a new group of financial brigandsarmies of sleazebags, book cookers, unaccountable accountants, and uncountable Shills & Mountebanks who enriched themselves to the tune of hundreds of billions of dollars. Their biggest bases of assault on American wealth and on Americans belief in their system were Silicon Valley, Houston, and Wall Street. That latter war, which has claimed so many victims and is being waged on so many fronts, is six years old. The War on Terror, which has claimed so many victims and is being waged on so many fronts, is not yet two years old. |
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