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Tuesday, July 23, 2002

Buying value, as opposed to, you know, buying into a bubble

George W Bush's latest foray into the world of Wall Street couldn't really have been more ill advised. The kindest that can be said is that this is another example of poor judgement.

The question is, how does he really know whether the market has touched bottom, or whether we're about to go down again. After all no serious economist would venture a judgement here, there is just no way of knowing. Or is the president trying to be a stock analyst like he was once a company executive. I sure hope he doesn't want to be categorized along with those Merrill Lynch analysts who got the profession such a bad name - recommending stocks in public, and trashing them in private (will we one day be able to relish the Bush tapes, the way we were once entertained by the Nixon variant?). Wall Street certainly isn't especially convinced, after all stocks haven't stopped falling since he paid them a visit there.

He should also bear in mind what happened to his treasury secretary Paul O'Neill who last Sept. 19, when markets were falling in the wake of the terrorist attacks, had the vision to say: "My guess is that when we look a year down the road, the people who bought today are going to be the happy people. The people who sold today will be sorry they did it." According to the New York Times he went on to add that he thought the Dow, which was then around 9,500, could be approaching a record high "in another 12 or 18 months."

Paul Krugman's coments in his column today are bang on the mark. What Bush should be doing is thinking about general economic strategy - the dollar, Greenspan and interest rates, and how to reduce preoccupations about the future (rather than the present) of the US government deficit:

The bull market is now well and truly over. In fact, if you adjust for inflation the S.&P. 500 — a much better measure than the overused Dow — is now below its level in late 1996, when Alan Greenspan gave his famous "irrational exuberance" speech.
So what should the responsible officials — Mr. Greenspan, George W. Bush and whatshisname, the Treasury secretary — be doing?
A good first step would be to stop trying to talk up the market by extolling the economy's fundamental strength. For one thing, it reeks of desperation. For another, stocks are still richly valued compared with earnings. Most important, the fundamentals aren't actually all that great. Doubts about corporate governance are growing, not fading away. State and local governments are in a desperate fiscal crisis. And even before the sudden plunge in the markets, the data were pointing not to a boom but to a "jobless recovery," in which the economy grows too slowly to make much if any dent in the unemployment rate.

The Bush administration's economic plans have not changed significantly since the fall of 1999, when they were introduced as a way to ward off a challenge from Steve Forbes. Back when the tax cut that eventually became law was announced, "Dow 36,000" was climbing the best-seller lists. The economic environment has changed completely; the administration's plans haven't changed a bit.
Our economic problems are real, but by no means catastrophic. What scares me is the utter inflexibility of the people who should be solving those problems.
Source: New York Times

Monday, July 22, 2002

The Internet Is A One Way Trip

While the corporate media world is having second, and probably third, thoughts about the advisability of the transition to the internet, the US online world just grows and grows. As many old style media outfits enter denial and relish an imagined return to the good old days, some analysts have been busy cautioning that the Internet's capacity to change the rules ought not to be discounted too quickly. As the New York Times puts it investors may have repudiated the Internet, but consumers have not.

"The Internet may not be doing so great on Wall Street, but it's doing great on Main Street," said Marshall Cohen, senior vice president for research at America Online. "As far as the people who are online, they're using it more and valuing it more." For consumers, that may be a good thing. But for media companies looking to the Internet for profits, it remains a frustrating reality. The "digital revolution" that many traditional media executives were convinced would topple them or make them rich has not materialized.

In part, that is because the Internet has turned out to be more of a souped-up telephone than a delivery vehicle for media and entertainment. E-mail messaging is by far the medium's most popular feature. But with 61 percent of American adults using the Internet, up from 46 percent two years ago, analysts and media executives say the medium is beginning to change consumer expectations of what mainstream culture should offer. Consumers who were once content to sit back and absorb what was beamed at them are demanding more control over how and when they consume movies, television, newspapers and music.

And whether it turns a profit or not, media companies are being forced to respond. Some of the Internet's effects on media, like the growing number of multitaskers, are subtle — although not so subtle for advertisers, who might be interested to know whether the eyeballs they are buying are simultaneously trained on two screens. Others, like the online file-swapping that the recording industry holds responsible for a chunk of the 10 percent decline in CD sales in America last year, are more extreme. But perhaps the most far-reaching impact lies in the rhythms and habits formed by daily use of the Web's interactive features. "We see young people who are flowing between TV and the Web almost seamlessly, finding new ways of getting what they want, going to what they want when they want it," said Betsy Frank, executive vice president for research and planning at MTV Networks. "That's what the Web has taught them — you don't have to sit around for something you're not interested in."
Source: New York Times

So while AOL TIme Warner have been busy pressuring Robert W. Pittman, their chief operating officer and the most visible remnant of America Online's culture, to resign (and at the same time elevating a Time Warner executive to oversee the online division thus signaling that the Internet is no longer the focus of its plans), more and more Americans are incorporating internet as a key feature in their daily lives. The Pew Internet Project found that 66 million people use the Internet on a typical day. Eleven million Americans said the Internet played an important role in choosing a school or college, 8 million said their use of the Internet helped them through a job transition and 8 million said the Internet played a role in finding a place to live. These numbers may still seem small. The point is they are growing. And if Time Warner & company cannot see how to make the internet work for them, then the failure is not with the internet, nor is it with the Americans who use it. As I said at the begining, the internet is a one way ticket, there is no going back.
How Big Is The Profits Gap?

It's now an open secret that US companies were not as profitable as they were imagined to be during the boom years. The big question is just how big was the difference, it is this problem more than any other that is currently besetting the equity markets. Morgan Stanley's chief US equity strategist Steve Galbraith has been doing his sums and has calculated that the S&P 500 companies had operating earnings of 4.1% of GDP on average between 1996-2001. The normalized valuation of the S&P companies could be around 17 times earnings, which would put the index's market capitalization at 70% of GDP and the index's value, at 800. But as Andy Xie points out:

Recent information, however, casts serious doubt on the reliability of corporate earnings in the late 1990s. The reported operating earnings of S&P 500 companies were only 2.6% of GDP between 1990-95. The rising share of foreign earnings explained only 0.8% of the increase in the earnings-to-GDP ratio. Was the earnings rise as a share of GDP in late 1990s mainly an accounting phenomenon? Should the earnings picture of the early 1990s be the standard?

The answer to this question may determine how low S&P 500 can go. If sustainable corporate earnings are 3.2% rather than 4.1% of GDP, the S&P 500 index could fall to 625 at 17 times earnings. If bear market sentiment depresses valuation to 14 times earnings -- not uncommon in previous bear markets -- the S&P 500 could fall to 515, or 39% below last Friday's close. That would put the index's market capitalization at 45% of GDP, similar to the level of the early 1990s.
Source: Morgan Stanley Global Economic Forum

Or put another way there is still plenty of room to go down some. Not only this. If it is true that corporate earnings were nearer say 3.2% of GDP, then a big balance sheet adjustment is underway, and this itself is likely to have its own consequences on equity values and capital expenditure. Which all means that we may be nearer a double dip than most like to admit, not to mention the inevitable knock-on effects on the productivity numbers from all this downward adjusting.

Now It's The Banks Turn To Feel The Heat

Most people are aware the the financial scandals in corporate America - like Enron, and now WorldCom - have hit investor confidence badly in the stock markets, but few are probably aware of the creeping knock-on impact of the financial losses and subsequent decline in share values on the insurance and banking sector. The European markets were full of tremors in the insurance sector toda, as, for example, Aegon, the Dutch insurance group, warned that its earnings in 2002 would be 30-35 per cent lower than expected. Aegon blamed the profits warning on further deterioration in the US credit markets and continuing defaults in its corporate bond portfolio which has E150m exposure to collapsed telecoms giant WorldCom. Even the most respected and most diversified groups have not been immune: France's AXA AND German rival Allianz are both down around 40 percent.

"This is a real crisis for insurers," said Carsten Zielke, head of insurance at WestLB Panmure. "I think there could be more insolvencies and a lot of mergers, if stock markets keep going down." The key problem is that falling equity markets have eroded the investment gains that European insurers have used in the past to smooth earnings and support policyholder pay-outs.

More importantly, they have stripped balance sheets of the hidden reserves insurers have used to maintain adequate levels of capital and meet solvency ratios. As a result, solvency margins - set by regulators to ensure companies can honour liabilities and write new business - are under pressure. If the market continues to fall, the fear is that some insurers may have to sell more equities to maintain solvency levels.
Source: Financial Times

Meanwhile the problems are now mounting in the banking sector. WorldCom's fallout has been global for the banks, with U.S. banks like J.P. Morgan topping the list of creditors with $17.2 billion in exposure, including assets held by the bank for its clients, according to information contained in the bankruptcy filing.

Shares in Europe's biggest listed WorldCom creditor Deutsche Bank have dropped around five percent to its lowest level in eight months on fears the bank may lose part of $1 billion in WorldCom exposure, while shares in Dutch bank ABN AMRO -- whose total exposure to WorldCom is put at $753.1 million -- were worse hit, falling some seven percent to their lowest level in almost four years. This situation has sharpened fears that the banking sector could be approaching a crisis that would force some into mergers or prompt others to make urgent calls on shareholders for more cash.

Analysts now say risks to banks' financial health posed by equity losses and WorldCom style corporate blowups have eclipsed many of investors' other concerns and now dominate the debate about banks' strategic direction. Investors used to believe that only the biggest "bulge bracket" investment banks would survive an industry shakeout. Now, banks who have shown themselves better protected from equity market losses are proving their worth. "The state of the balance sheet is much more pressing at this stage than the whole issue surrounding critical mass and economies of scale," said Richard Thomas at ABN AMRO. "In the investment banking world we are at a sort of crossroads where the big players are going to have to think long and hard about where they want to go and what they want to do because the models are not sustainable," he said.
Source: Reuters Yahoo News


The jury is still out on this topic - a topic which is not to be confused with that of whether, even after taking account of the winners and losers, we are collectivy better of thanks to globalisation (see below). Xavier Sala i Martin has just come out with a new set of arguments explaining what those of us who had been watching India and China recently already suspected: taken across the world popluation as a whole inequality is declining (at least on some measures). This is because, although within country inequality seems to be growing (though not everywhere and not all the time), and though between country inequality is growing if we count each individual country as one unit, if we take account of population size in fact per capita inequality is reducing since some very populous countries (namely China and India) are closing the gap with the richest group, and quickly. So the real problem is to discover why the countries who are not closing the gap down are failing to do so, a lot of human suffering could be avoided if more attention was paid to this topic and less to the sterile ideological debate about globalisation, which is, after all a reality - if it wasn't, you wouldn't be reading this in a frontierless, decentralised internet.

Mr Sala-i-Martin explains. Imagine that five-sixths of the world's population live in poor and stagnant economies, and one-sixth in rich fast-growing ones. In across-country terms, this gives you “divergence, big time”. Now imagine that one poor but very populous economy starts to grow very quickly. At the same time, inequality within this country worsens somewhat.Despite its size, this country is only one data-point in the across-country comparisons: its rapid growth is not enough to make any difference to divergence. So you have rising within-country inequality and rising across-country inequality. Yet one-sixth of the world's population, by assumption, is seeing its incomes rise rapidly towards those of the rich. Inequality measured across all the people of the world, therefore, may very well be falling.

For those more interested in relieving poverty than in narrowing the gaps between rich and poor, the results from the estimated distribution are equally pleasing: the proportion of people living on less than a dollar a day fell from 20% in 1970 to 5% in 1998; the proportion living on less than two dollars a day fell from 44% to 8%. The headcount of poverty worldwide has fallen by some 400m.The only bad news is that, after the respite provided recently by surging globalisation, inequality may well resume its long-term historical trend and start rising again in due course. The reason is that China and India will no longer be poor—and if the world's poorest countries, mainly in Africa, continue to stagnate, the global dispersion of incomes will widen. Whether the main problem here is African poverty or global inequality (caused by China and India leaving poverty behind) is one for the UN's economists to think about.
Source: The Economist LINK

So back to the begining. Are we better off as a result of globalisation? It depends whether your criteria is collective wellbeing, or reducing inequality: remember we could all be poor and equal, but would that be better?

You can download a version of the Sala i Martin paper in PDF format HERE