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Economics: Financial Follies
New York: October 27, 2004
By John R. Stephenson

On the surface, things seem to be pretty good. Perhaps it’s the politicians talking or perhaps it’s the bullish forecasts of government economists. But it is, in fact, the sentiment that many of us hold. We believe that things are good and getting better — and with good reason. Inflation is low, unemployment is low, house prices are high, and for the most part, stocks are hanging in there as well.

We are generally bullish on the economy and the world around us. In survey after survey, people respond that they think next year will be better than the previous year and that the markets will be higher. We know, at least at some level, that things can’t always be great and that they will eventually turn lower. Not one of us is smart enough to predict just when the markets and the economy will go lower and reverse their positive trend, but it is a certainty that, at some point, this too will happen. Just as night follows day, bad markets follow good markets.

It’s when people lose faith in the markets that things start to falter badly. Just what will tip the balance and lead to a change in the general perception of our prospects is hard to say. Once investors start believing that tomorrow is not going to be as bright as today, is when you start to have to worry about falling stock markets. So far, the rising price of oil, sluggish stock market, housing bubble and falling U.S. dollar haven’t made an appreciable dent in most people’s optimism. As long as house prices stay high, jobs plentiful and interest rates low we should be in good shape. With the U.S. consumer representing fifteen percent of global GDP, it is pretty important that he/she keeps spending so the rest of us can keep on shipping our goods and services to the American consumer. But can this situation continue indefinitely?

That’s unlikely. Western are societies increasingly derive their well-being from financial and other service activities rather than basic industries. How many lawyers, bankers, consultants and Ebay entrepreneurs does one society need? If everyone is providing a service to someone else, who is providing a service to a basic industry that has been outsourced to a country with cheaper labor, what is the natural consequence? Hard to say, but at the very least, it is concerning. Just a little while ago, General Motors reported earnings of 78 cents a share during the third quarter of this year. While the earnings news was positive, it is shocking to learn that not one cent of their income came from the manufacturing of cars. In truth, the company lost money on the car-manufacturing portion of the business and made up the losses and a profit on its financing activities — the loaning of money to finance the purchase of cars and homes.

In fact, corporate America is earning money, not through the manufacture of things that people want to buy, but through the financing of products and services. By some estimates, fully 50% of the S&P market capitalization is directly (banks and finance companies) and indirectly (the finance arms of multi-nationals such as GM or General Electric) attributable to finance — the loaning of money to others for a fee. In order to keep growing their earnings quarter after quarter, these “finance” companies have had to have a growing stream of new customers. But who could they be? As Alan Greenspan (the chairman of the U.S. Federal Reserve) once said, “information technology has enabled lenders to reach out to households with previously unrecognized borrowing capacities.” In other words, vendors have been flogging their loans to a larger and larger audience of subprime borrowers — people who could least afford to be borrowing in the first place.

Of course, as more people appear to be succeeding in this “new economy”, the natural result is that an increasing number of us will enter this “profession”. As more and more people scramble to lend money to weaker and weaker credits, the likelihood of a bubble developing in this area of the economy increases. But perhaps we can continue to reflate (a low interest rate policy designed to encourage spending) the economy just long enough for Europe to get going and for businesses to start spending before government and individuals are spent. Perhaps China will float its currency and stop flooding our market with low priced goods.

Maybe. But, in our view, that it is unlikely. It is far more likely that the pressures from an aging demographic, from the huge U.S. government debt and the enormous current account deficit will start to take their toll. The lack of consumer savings and the incessant need to spend, spend, spend will finally run its course. If and when that happens, people will react with alarm and send stocks lower. Your insurance policy? Look for companies that make tangible things or “stuff” such as gold mining stocks or commodity-oriented industries that should benefit from a falling U.S. dollar and a predilection for things that can be touched and felt.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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