Economic Denial

John Mauldin | Thoughts from the Frontline
February 15, 2002

Reader response to my prediction that we are in the Muddle Through Economy has been interesting. While most readers seem to agree, a few think I am being too pessimistic and we are poised for a boom and many of you think we are headed for a far worse economic scenario.

Today I am going to address what I believe is the number one threat to that prediction, not to mention the number one threat to the world economy. There is a lot to cover, so we'll dive right in.

The Economy is Not the Stock Market

First, let me respond to a number of letters I have gotten over the last month. I want to make clear that just because I think the economy will muddle through (be basically flat with little growth) this year, does not mean that I necessarily think the stock market will. Looking back at the correlation between the stock market and the economy over the last 40 years yields some very surprising (to many people) facts.

From 1964 to 1981 the Dow Jones Average grew by one-tenth of 1%. From 1981 to1998 the Dow grew 10.5 times or over 1,000%. What made the difference?

Most people would point out how much the economy grew during the latter period as an explanation. The interesting thing is that the US economy grew 373% in the period 1964 to 1981 and only 177% from 1981 to 1998.

In other words, the economy grew at half the rate of the first period and yet the stock market took off like a rocket.

Warren Buffett says the key factors governing stock market returns were interest rates, expected rates of return from stocks and investor psychology.

A period of low interest rates and high investor expectations for stock market returns like we have now is not a prescription for a market crash. Couple that with the continual barrage of cheerleading from investment firms and media, which has clearly (and almost inexplicably) been successful in maintaining investor confidence throughout a bursting stock market bubble, and it should not be surprising that we have not dropped all that much.

That being said, it also appears we are near the limits of investor expectations, at least from a value point of view. Real values seem to have put an upper limit on the stock market, and optimistic expectations have put a floor. Thus we are in a trading range, going sideways. How long can that continue to be the case?

And that is the $64 billion dollar question.

As I have written in past issues, secular bear market cycles do not happen all at once. They happen because investor expectations slowly change over time. Investors become more focused on the near term and less patient with their stocks. Long term investing loses its magic.

For now, investors are told to be patient. We are investing for the long term, say the analysts. In ten years, the markets will be significantly higher because the economy is going to grow. I believe it will grow, although slower than the last decade. But that does not mean the stock market will follow suit.

(I have often wondered why they call Economics the Dismal Science. It seems to be populated almost entirely by happy, contented cheerleaders.)

That is also why I believe that any attempt to raise interest rates this year (or a return to inflation) could have serious consequences for the stock market. The risk is to the downside, as valuations are not going to get much better from earnings growth or on a book value basis this year.

That is one reason why the Enron factor is so important. If investors stop looking at forward pro forma earnings and start using real earnings as the basis for their valuations, it could have very negative consequences for the market. Now, all the investment media and industry will be doing their very best to convince investors to look at optimistic analysts projections of forward earnings.

It is a shell game. Each year, analysts make earning projections for the next year. Remember the studies I cited last year which showed analysts typically over-estimate by about 50%? Each quarter they revise downward their earnings estimates so that by the time you get to the year end, they are pretty close.

But wait, don't look at those old, faded numbers. Look at the new, shiny numbers we now have for earnings 12 months from now. This time we really mean it! Earnings really are going to grow faster this year. These new numbers justify a rising stock price, we are told. What we are not told is that it also keeps the investment banking fees coming in from the companies they rate.

And so the game goes on. In bull markets, everyone overlooks the problem. In long-term secular bear markets, like 1966-1982, investors increasingly start to lower their future expectations and therefore the price they are willing to pay for future returns.

Again, this phenomena does not take place all at once. It is like getting nibbled to death by ducks. That is why I think it is likely the stock market goes sideways, plus or minus 5 or 10 percent all year. The next real leg down will probably come with the next recession. But if interest rates rise, or something happens to change the expectation of investors, the market could fall for a third straight year.

Threat Numero Uno

I have been writing about the serious nature of the Japanese financial problems for almost two years. I continue to think this is the single biggest threat to the world and US economies. New data and analysis, out the last few weeks, confirms my reasons for worrying. Let's go through some numbers and connect the dots. Then I will tell you why the real reasons for concern is rooted in the same causes of the Internet Bubble and Enron Scandal.

*** Consumer prices in Japan are dropping at 4% a year. "We are already in a deflationary spiral," says Takatoshi Ito, professor of economics at Hitotsubashi University. "This makes debtors' balance sheets much more difficult to manage so they join the ranks of non-performing-loan companies. They lay off workers further depressing aggregate demand, thus creating more deflation and so on." (London Financial Times)

*** Moody's said it may downgrade yen-denominated debt by up to two notches to a rating of A2, which would force some foreign funds to sell Japanese government bonds (JGBs) as too risky. This would put Japan below Botswana and in the same category with countries like Cyprus.

There are many bond funds which by their own internal controls are required to only invest in high-grade bonds. This would force them to sell the Japanese government bonds, putting further pressure on the Yen.

*** "Consider the notion that, with perhaps $11 trillion in savings, the Japanese have enough wealth to cope. It sounds as if they do--until you realize that the total on- and off-balance-sheet claims on the household, corporate and government sectors in Japan are about $30 trillion, according to estimates by Goldman Sachs. That sum is six times Japan's $5 trillion GDP. (The total of U.S. public and private debt is $19 trillion, two times GDP.)

"It took only the collapse of a midsize Japanese bank, Hokkaido Takushoku (with assets of $80 billion), to expand Thailand's problems into a regional crisis, says Thomas Byrnes, a sovereign-risk analyst for Moody's. Within three months of the bank's collapse, he says, Japanese financial institutions pulled $118 billion out of the global economy, mostly from Asia and Eastern Europe. South Korea, the world's tenth-largest economy, was effectively bankrupted by the withdrawal of Japanese money, he adds.

"The four biggest of Japan's troubled banks alone have total claimed assets worth $3.7 trillion. It would not be only Korea and other Asian countries that would suffer if these banks' latent troubles erupted. Japan is the world's main source of capital. Much of its $3 trillion in overseas assets is in liquid instruments, such as $333 billion worth of U.S. Treasurys and bank loans to the U.S. and Europe worth $340 billion and $363 billion, respectively. Byrnes sees signs that Japanese banks have already begun to repatriate some of their money."(Forbes)

***"We are very afraid of Japan becoming another Argentina," says Taiichi Sakaiya, who was Japan's economics minister until recently.

***Japan still has a huge surplus, but it is falling. It used to be that exports were the most significant part of the surplus, but not anymore. There has been a recent rise in income, after it has been dropping for an extended period. The rise in income reflects Japanese investors' growing appetite for overseas securities, particularly foreign bonds, which are becoming more attractive because of low domestic interest rates and a depressed stock market. The fall in the yen from last November also boosted the rise in overseas income.

"Japan is living more off income from previous investments than from actively exporting," aid Peter Morgan, economist at HSBC Securities in Tokyo. (Financial Times)

*** Japanese bankruptcies rose 10.6% in January, starting a year that may see a record number of companies go bust, analysts said. The failed companies owed 1.43 trillion yen ($10.8 billion), the credit researcher said. "Bankruptcies are off to a very worrisome start," said Tokyo Shoko's Hirotake Araya. "Company failures will close in on 20,000 cases this year," a level reached only once before, in 1984 when a record 20,841 companies went bust.

***On March 31, the Japanese government guarantee of bank deposits goes away. Already 9% of deposits in small banks have evaporated. That is part of the reason for large Japanese purchases of gold. They have to put their money somewhere. In Japan, gold is in a bull market, up over 50% in the last few years in terms of yen.

***The level of bad debts at Japanese banks is staggering. Many outside analysts believe Japanese banks are essentially bankrupt. Their accounting rules would make Enron executives blush. They do not mark to market the stocks on their books.

***My favorite analyst Greg Weldon found these gems that others seem to be missing. The government-controlled Japanese Institute of Certified Public Accountants has ruled that banks will be exempt from adopting mark to market pricing of interest rate swaps for another year!

Unbelievable! Under the same rules, Enron would be solvent and reporting itself as financially healthy today.

Weldon further notes that Japanese officials publicly state they don't want to prop up banks at this time. Then they quietly announce they will double the size of the "Bank Shareholdings Purchase Corporation" to 4 trillion yen. Basically, starting next Friday, they are going to buy stock from banks which might otherwise be forced to sell into the open market in order to gain liquidity or sell foreign bonds.

The Frog in the Outhouse

I quote the following story from the private HCM Market Letter by Michael Hewitt. I think you will find it interesting.

"In the late 1980s, black limousines used to pull up each afternoon in front of Madame Onoe Nui's house in Osaka, Japan. Men wearing business suits and carrying briefcases would enter her house. They would only emerge hours later, in the middle of the night. While neighbors believed these gentlemen were visiting Madame Nui's popular restaurant (or perhaps that the restaurant had begun serving more than just food), they were in fact coming to pay homage to a figure who was later revealed to be the single most important participant in Japan's stock market bubble: Madame Nui's pet ceramic toad. Toads are considered mysterious and powerful creatures in Japanese and other Eastern cultures. Senior executives from Industrial Bank of Japan (IBJ) would travel from as far as Tokyo to mingle with senior stockbrokers from Yamaichi Securities and other major trading houses at a weekly midnight vigil to honor the toad. Homage to the toad included first patting its head, then reciting prayers in front of a set of Buddhist statues in Madame Nui's garden. The climax of the ceremony would come when Madame Nui seated herself in front of the toad, went into a trance, and delivered her stock market predictions, which were considered oracular and moved the Tokyo markets.

"Madame Nui parlayed her toad and a small set of loans into an enormous financial empire. At its peak, Madame Nui's borrowings reached $22 billion. But, alas, Madame Nui soon came to a now all-too-familiar end. She was arrested for financial fraud in 1991. It turned out that her borrowings were based on fraudulent deposit vouchers forged by friendly bankers. Madame Nui's bankruptcy resulted in losses of more than $2 billion, the resignation of the chairman of IBJ, and the collapse of two banks. Madame Nui vacated her restaurant for cheaper quarters in prison, where she and several of her bank manager cronies spent several years atoning for their sins. I am unable to provide the current whereabouts of the toad."

Hewitt writes a brilliant essay connecting the same impulse in those late night meetings to Enron, Global Crossing and other such firms. If I get permission I will post it on my web site. It is worth the read.

So, how do we tie all this together?

First, can we agree that it seems increasingly obvious that Japan is in trouble? They have avoided reforming their banks and other institutions. They prop up failing companies which sell products at a loss, preventing good companies from being able to charge fair prices. They have run up their national debt to levels approaching banana republic status. They have consistently avoided doing the things which would fix their problems, because the fix would be painful at first, especially to the politically powerful.

If it was just their problem, we could shake our heads and say, "How sad."

But it is a world problem. How they respond to their crisis has huge implications. Do the Japanese banks repatriate their dollar holdings in a desperate need for cash? Do Japanese investors flee the yen into the safety of dollars and euros, creating a bubble in the dollar? We all know where bubbles end. Does the Japanese government bail out the banks by creating huge new pools of cash and increasing the money supply, thus making the yen even weaker and exporting their deflation? Do Japanese banks stop making foreign loans creating a world liquidity crisis?

Does the government continue to fiddle and do nothing as it has done for a decade but talk about reform next year while Tokyo burns? Do they continue to hope that a frog will come to the rescue and give them the answer.

The only way to avoid any of the above problems is for the Japanese to seriously reform their financial system. However, they seem to want to put off the Day of Reckoning as long as possible, in hopes that they can somehow muddle through without having to go through the pain. Let the pain come, but next year.

The Deadly Sin of Denial

The real problem in Japan is that all too human foible of denial. They simply refuse to believe that things won't work out, that somehow they won't lose their power and money if they can just hold on a little longer.

How many companies and management in the US are guilty of the same thing? Enron and the tech bubble were rooted in denial. Everyone at Enron took comfort in somebody else's approval of the accounting system. Every investor in technology in 2000 told themselves this time it is different. For that matter, if I want to find the existence of denial, I only have to look in the mirror.

Denial is one of the most grievous of the Seven Deadly Investment Sins. It allows us to put off the tough decisions we know we should make, or avoid the situations we don't want to deal with.

In the US, the system with all its flaws is set up to help those in denial learn the error of their ways. You are only allowed to lose only so much money before the creditors come and take your assets. Some people and companies are gifted at losing more than others, or at postponing the Day of Reckoning, but in the end they all end up on the courthouse steps if they cannot find a way to pay their creditors.

The rules in Japan are not so harsh. You can go on for years losing money and sowing seeds of instability and rot into the system. Banks have simply not exercised the same level of prudence as US banks, nor do they reveal to their investors the level of their exposure. It is a corrupt system, and one in which denial is especially rampant.

In the best selling book, "Against the Gods ," Peter Bernstein tells us how psychologist Amos Tversky created something called Prospect Theory. It attempts to explain why people invest the way they do.

It seems the major driving force for investors is LOSS aversion. It is not so much that people hate uncertainty, --- but, rather, they hate losing.

In a later study, he notes the irony: It would follow that cutting your losses is also a good idea, but investors hate to take losses, because a loss taken is an acknowledgement of error. Loss-aversion combined with ego leads investors to gamble by clinging to their mistakes in the fond hope that some day the market will vindicate their judgment and make them whole.

What is the one common cliche that is told about the Japanese? They hate to lose face. Avoiding embarrassment, or creating embarrassment for others, is part of the national character.

This can have many endearing charms, and is not entirely without merit. But in a capitalistic system, it can be a huge problem. It leads to denial. It keeps people from admitting mistakes and cleaning house, until it is too late.

The process has started. How it will end is hard to say. Just as the story of the toad above illustrates, you can pull off a fraud for only so long. And the Japanese financial system is currently based upon the fraud that they are solvent.

Will world leaders basically (and quietly so as to save face) force Japan to reform, fearful of Japan pulling the world into deeper recession? Will Japanese leaders have the courage to nationalize their failing banks, allowing companies to die? This will put a huge burden on the poor Japanese tax-payer who will have to shoulder the cost of the bailout. Will Japanese voters finally rebel as their problems mount and "throw the bums out" who have allowed the problems to fester for so long?

I do not think Japan muddles through. They are in for a very rough ride. The real question is whether they drag the world along with them. It is not altogether clear that they will. The world economy is huge and resilient. It can take quite a licking and keep on ticking.

But this is a problem that may be of a magnitude that our generation has not seen. This is the one "systemic risk" that I truly worry about.

It will not be a fast thing. You won't wake up overnight and find the rug pulled out from under your feet. It will be slow and painful, like a Robert Altman movie. It won't send us into a depression, like the doomsayers write.

It will simply put the US into a prolonged period of the Muddle Through Economy, bouncing between recession and slow growth. It will be a huge anchor, until Japan can get their act together, or until they shrink to the insignificance of Argentina.

Why? There is the real potential they will continue to export their deflation to the world with increasing effectiveness. They will do this because they hope that it will allow them to avoid dealing with their own problems. They will do this out of denial of the real problems. Our corporations which are involved in the world economy will have little or no pricing power in such an environment, which puts a severe cramp on profit growth. That puts limits on capital spending growth, which hurts employment, which hurts consumer spending, etc. World without end, amen.

It doesn't have to happen. It can be avoided. But somebody needs to talk to the Japanese leadership about the cost of denial.

Working the Night Away

For those of you who get my monthly Accredited Investor letter, let me say that this month's is done, but for reasons which will become obvious when you get it, I am having to delay sending it out. Sorry.

This has been a tough week. On top of my usual writing and business workload, I have been working with a friend who is having problems with a company whose management is in serious denial. That may be why the topic is on my mind.

This weekend, I have the privilege of getting in a car with my wife and driving to Austin. Being alone with her with no interruptions will seem like a luxury.

In the next week or two, I hope to put the first draft of a few chapters from my book in progress, Absolute Returns, on the web for comments. These chapters will deal with the long term economic cycles and what we can expect over the next decades from various types of investments. I will let you know when I post them.

I do read and appreciate your comments, good or bad. Thanks for letting me come into your world. And remember that even though this week's letter does not sound all that positive, that "I have never seen the righteous forsaken, or his children begging bread." The good news is that we do not depend upon the Japanese or any government for our livelihoods. If we deal with the cards as they are dealt, and avoid denial ourselves, we will do just fine. There are lots of ways to take care of yourself and your family, but getting depressed or fearful or into denial is not one of them. Smart, hard working investors will do just fine.

Your glad to be hitting the send button analyst,

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