All areas of the economy, not just the financial sector, have participated in this orgy

THE SPAWN OF “LAISSEZ FAIRE”

INSTITUTIONAL INCUBI

Our institutions shape our beliefs and are also shaped by them. It is only natural that false beliefs should spawn unhealthy institutions and that those institutions should reinforce our illusions. It should come as no surprise that institutions reflecting the spirit of laissez faire have contributed to our decline.

We neglect the painstaking development of strong foundations in favor of the quick fix. We sacrifice our future to boost immediate satisfaction. Even where we diagnose serious problems, we show an unhealthy attraction to cosmetic repair.

This corresponds to the essence of laissez faire — that individuals working for their own immediate gain produce the greatest economic good for society as a whole. The institutions generated by this philosophy have their own raison d’être — short-term profitability. In suggesting that this is the ultimate standard for all endeavors, they subvert our understanding of value.

We are caught in a vicious circle. We have become increasingly focused on the short term in all aspects of life, reflected in statistics ranging from our debt to our divorce rate to our drug dependence. In turn, our institutions have become dedicated to the short term, eschewing the building of solid foundations in education, industry or personal lives. These institutions, in their turn, fix our attention even more exclusively on the short term. Unfortunately, our indulgences now will impoverish us later. The less we are able to change our priorities, the greater will be our ultimate impoverishment.

Short -Term vs . Long -Term Investment Horizons

It is within the financial markets that we have become most narrowly fixated on the short term. The aphorism often repeated by Robert Farrell, Merrill Lynch’s eminent stock market technician, “Get rich slowly,” contrasts to the expectations mirrored in the proliferation of derivative instruments geared to the short-term speculator. These instruments, which can be destabilizing to the broad market, focus the attention of the financial community on the immediate and away from the long term. The same can be said for the minute-to-minute coverage of networks such as CNBC. This suggests, mistakenly, that markets are driven by short-term news and that the essence of successful investing is rapid

and appropriate reaction to changing news.

As if to underline the pointlessness of the race to be first to capitalize on each piece of news as it breaks, there is an approach to investing that lies at the opposite end of the spectrum. It provides a simple and reliable discipline — ignored by investors — that enables one to consistently outperform the market. The key to this approach is that specific sectors tend to outperform or underperform the broad market for long periods, often more than 10 years at a time. If one gets in a “right” sector early and stays there, one will do well.

The following table contrasts the long-term performance of the Pharmaceutical and Oil Service sectors. It eliminates stock selection as a performance factor by taking all the stocks listed in these sectors by Value Line. It eliminates market timing by calculating the appreciation of each stock from its average 1981 price to its average 1991 price:

Every pharmaceutical manufacturer appreciated. Every oil service stock depreciated. The worst of the pharmaceuticals nearly doubled the best of the oil service. By 1991, a 1981-dollar invested in the average pharmaceutical stock would have been worth 20 times a 1981-dollar invested in the average oil service stock.

Even though the best sectors are often contrarian, at least initially, fundamental and technical analysis and the identification of newly developing economic themes can reveal the ideal investment sectors.

Along these lines, the precious metals producers at the turn of the millennium resemble the pharmaceuticals of the early 1980s. This may seem surprising. It is surely contrarian. Investors see no similarity between the present and the 1970s, which they regard as the perfect investment climate for gold. That decade was characterized by accelerating inflation, which increased demand for gold and led to higher prices. Presently, with low inflation and with the chairman of the Federal Reserve (dutifully echoed by the gurus of Wall Street) assuring investors that inflation will remain subdued for the foreseeable future, there appears to be no reason to buy gold.

This misses the point; it is fighting the last war. It may seem trivial, but gold is a commodity whose price is determined solely by supply and demand. While inflation increases demand for gold, it is not the only factor that can do so. The primary mechanism driving gold demand today is not inflation but increased disposable income, primarily in South and East Asia. As a result of purchases of gold by investors from this region, supply and demand are not close to equilibrium. Unlike the supply-demand equilibrium of the early 1970s, worldwide off-take exceeds supply by more than 40 million ounces per year, more than half of global production.

To date, the supply shortfall has been made up by sales and loans of government gold, enabling banks, bullion banks and hedge funds to acquire a short position in excess of 300 million ounces — four years of mine supply. At some point within the next five years these sales and loans will have to be curtailed, if only because central banks will run out of gold. At that point or earlier, the imbalance will become apparent, market forces will prevail, and the excess demand will be rationed by a sharp increase in the gold price.

Of course, inflation would further increase the demand for and price of gold. But it is not necessary to have any inflation-driven demand to support higher prices. As Frank Veneroso has convincingly shown, the present supplydemand imbalance is sufficient to support a sustainable gold price in excess of $600 per ounce, even without inflation or short covering.

It is typical for financial markets to misdirect attention. Many investors will miss the appreciation in gold because they are waiting for inflation to accelerate.

CREDIT OVERLOAD

In a culture that values the near term and an economy in which credit is profitable for the financial sector, it is to be expected that credit should proliferate. But excessive credit can be a danger, not only to individuals, but to entire economies. Western economic history suggests that long-term economic cycles are coincident with, and perhaps driven by, long-term credit creation/ credit liquidation cycles.

These cycles have had an average, but highly variable, periodicity of 60 years, the last credit liquidation phase beginning in 1929. The previous one began in the early 1870s, triggered by the overbuilding of railroads and the collapse of Jay Cooke & Co., the country’s largest bank. (It was even more severe in England, and English economists have called the 20 years following 1873 “The Great Depression.”)

Massive credit liquidation phases have been triggered when total debt grew to the point that it overloaded the economy, causing a deflationary implosion in which debt was liquidated by a chain reaction of bankruptcies. The trauma of the resulting depression would restrain credit growth for decades until generations that had not lived through the depression repeated the excesses of their great grandparents.

A number of financial measures suggest we are once again nearing a major credit peak. Before the Great Depression ushered in by the stock market crash of 1929, the ratio of total credit to GNP peaked at a little under 2-to-1. We have now comfortably surpassed that ratio. Non-financial credit, including government debt, reached $18.3 trillion at the end of 2000, with the financial sector adding another $8.2 trillion. Our ratio of debt to GNP is approaching 3-to-1.

All areas of the economy, not just the financial sector, have participated in this orgy. In just the few years since 1995, non-financial corporations increased their debt by two thirds, to $4.5 trillion (The Wall Street Journal, July 5, 2000). Household borrowing increased 60%, to $6.5 trillion. The average household now has 13 credit cards. Margin debt has quadrupled in the past decade. (And there is an additional $100 trillion of financial leverage in derivatives instruments. While this is not strictly debt, it represents extreme financial leverage and can have the same impact.)

Despite the clear parallels with 1929, few economists have expressed concern about our increasing debt and the severity of the liquidity crisis it might cause. It would appear to be simple common sense that we cannot borrow indefinitely to increase our standard of living. At some point it will be necessary to start paying back. But paying back requires less spending and a decline in our standard of living. The only difference between an individual and a country is that a country with a fractional reserve banking system and most of its debt denominated in its own currency can print money and so deflect some of the deflationary impact to an inflationary one.

Because economists and politicians are not historians, they have paid little attention to these problems. Debt and derivatives have worried Congress only when they have threatened to produce immediate dislocations. The free market economist, playing Dr. Pangloss, has assured us this is and will remain the best of all possible economic worlds — at least provided government doesn’t interfere. This does not reflect an awareness of the important similarities between the current cycle and previous ones. If anything, it sounds like Alfred E. Neuman: “What, me worry?”

Laissez faire has rendered a disservice by suggesting there is no need to address such issues, for the invisible hand of the free market will resolve them. These problems have been caused or exacerbated by free market policies. It is hardly likely that the policies that caused them will also resolve them.

Mutual Funds and Corporate Management

It has been widely argued that the rash of corporate takeovers and leveraged buyouts over the past two decades is bad for our economy. Because these acquisitions and buyouts have been financed with debt, they increase our total debt, already dangerously high. Also, because the debt associated with such financial leverage is often classified as “junk” and bears high interest rates, the interest burden on the company can be onerous, pressuring management to eliminate any unnecessary expenses in order to pay down debt. This typically means laying off employees who do not contribute to immediate cash flow. It means cutting R&D, which, after all, negatively impacts the bottom line — in the short term.

The problem lies in the long term. The function of R&D is to insure the long-term prosperity, or even survival, of a company by developing new products, new manufacturing processes, or new markets. Studies note that reducing R&D to preserve cash flow — mortgaging the future to pay for the present — are often early warning signs of impending decline. Perversely, the very structure of our financial community makes it difficult

for managements to maintain a healthy long-term view. Institutions manage most of our financial assets: mutual funds and trust funds for individuals, pension and profit sharing plans for corporations. Consulting firms that specialize in the selection of financial managers choose many of these money managers, especially at the corporate level. Whether or not it is admitted, one of the most important factors in this selection is historical performance. Moreover,

the time frame defining such performance has been shrinking, and in some cases managed accounts are in jeopardy if they underperform benchmark indices for as little as one year.

The narrow focus on the short term is exacerbated by the tendency to link the pay of top management of mutual funds to performance. It doesn’t matter why the stock goes up, whether its appreciation is a product of questionable accounting, massaging earnings to guarantee positive quarter-over-quarter results, or a product of externalizing costs, dumping toxic wastes into the public domain rather than paying the costs of treating them. It is only the bottom line, the appreciation of the portfolio, that counts.

Now suppose a fund manager has purchased a stock and a corporate raider surfaces, offering to purchase the company at a 30% premium to its current price. While the company may have outstanding long-term prospects, the compensation, and even the job, of the financial manager depends on short-term performance. He could enhance that performance by taking the 30% profit in hand and reinvesting the funds in another stock with similar long-term potential.

When it is so easy to improve one’s short-term performance in hand, it is imprudent to bet one’s job on long-term potential in the bush. Moreover, it has been argued that financial managers have a fiduciary responsibility to accept any offer substantially above the market. So it is no surprise that most fund managers sell out in such circumstances.

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Previous Issues

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