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The Attack on America What Will it Mean for the Markets?

September 18, 2001

In the midst of dominating news coverage, CNBC has managed to ask a host of commentators about their views on how the September 11, 2001 tragedies will alter the markets. Of course we hasten to point out as always these commentators bring with them their usual sell side baggage so one must always consider what they say with a huge grain of salt. But most commentators on CNBC have suggested that the markets may tank when they open Monday morning, but they would likely stabilize and perhaps even begin to rise sharply thereafter. To justify that position, they have looked at several significant incidents in the past.

Some economists are also reminding us that we are likely to have billions of dollars of government spending now to rebuild New York and to wage an anti-terrorism war. Added to the huge amount of money printed by the Fed last week, it is argued that we could once again enter a real boom period just as we had during the late 1990's when money was poured into the economy following disasters.

But Then There is the Kondratieff Winter

I'm afraid this time may be different. We cannot lose sight of the fact that as we have been discussing recently, we are in the early stages of the Kondratieff winter, which is a protracted period of economic depression brought on by excessive debt and mal investment that have built up over the past 60 or 70 years and especially during the autumn period of this long wave cycle.

Lets take a look at some of the situations other analysts have chosen to look at as examples. Richard Russell whom I have the deepest respect for as an analysts suggested the 1906 San Francisco earthquake and fire may be a meaningful comparison. In that instance, the markets rallied sharply in 1906, but then headed into a steep decline in 1907. The problem with that comparison is that this tragedy took place toward the end of the spring-time of the last complete Kondratieff cycle that began in 1896. Accordingly, debt levels were quite low so the economy could be easily stimulated by pushing up the money supply.

What about World War II stimulating us out of the Great Depression? Well the point here is that by the time the U.S. became involved in World War II, the most severe portion of the Kondratieff winter of the last cycle was over. Therefore, unlike the present time, most of the debt repudiation that had to take place in order for a new Kondratieff cycle to begin had already been wiped off the balance sheets of debtors. Also, the stock markets were already flat on their backs with P/E ratios extremely low. Thus there was a real economic justification for buying stocks then, unlike now when stocks remain about as overvalued as any time in our history. At the present time, the earnings an investment dollar buys you if you put it in the S&P 500 is only 3.37% of which only 1.39% is in the form of dividends and 1.98% is in the form of retained earnings. By contrast, you can get a 4.6% cash payment on an investment in 10-year T-Bonds, which are exempt from local taxes.

What about the Kennedy assassination in 1963? The specialists on the NYSE were overwhelmed so the market was closed for one day after prices plunged. When the market reopened, it stabilized and recovered sharply by the end of the year. But 1963 was also toward the end of the spring time in the current Kondratieff cycle, which means there could be non-inflationary growth by way of fiscal and monetary stimulation. To be sure the economy grew strongly as did the stock market until 1966.

What about the 1987 stock market crash? In that event, specialists on the floor of the NYSE also ran out of money. However, the Fed assured the banks that if they went ahead and lent to the specialist firms they would not need to worry about losing money. With those assurances plus a money pumping binge - the first of many to come by Mr. Greenspan, the market recovered sharply. But again, this event took place during a different time in the Kondratieff cycle. Specifically, the 1987 crash occurred in the middle of the autumn in the existing Kondratieff cycle. So, there was still time and room for monetary and fiscal stimulus to work.

The more recent problems related to Mexico, Asia, Long Term Capital Management, Russian, and Y2K, etc. which occurred during the 1994-2000 time frame, were all met with expansive money growth. Being toward the end of the autumn period in the long Kondratieff cycle, it was still possible for an expansive monetary policy to stimulate increased economic activity sufficient to have enabled Mr. Clinton to escape impeachment and to extend the stock market orgy a while longer. But it was a most pernicious stimulation that resulted in mountains of mal investment and mountains of debt. The breaking point was reached in March 2000 which marks the beginning of the current Kondratieff winter.

Why Fiscal and Monetary Policy May not Work This Time

The dreary picture I painted in last week's hotline message, sent out just prior to the September 11, 2001 disaster, has not improved. In fact, news that came out last week showed that consumer confidence had declined to its lowest level for eight years before the Tuesday tragedy. Moreover, this past week a sharp rise in weekly first-time unemployment claims was reported. We also learned last week that U.S. Industrial production dropped in August for an 11th straight month and that this string of declines is the longest since February-March 1960.

The important thing to realize is that the dominant fundamentals that are leading us into the Kondratieff winter, have not changed as a result of the September 11th, tragedy. As such, things that have worked in the past, namely monetary and fiscal policy, are not likely to work now. Those fundamentals are:

1) ENORMOUS INVESTMENT RESOURCES HAVE BEEN MISSALLOCATED TOWARD EXTREMELY FOOLISH ENDEAVORS. Mal-investment in the U.S. starting with the Mexican bail out and gold manipulation took place on a scale never before witnessed in the U.S. and perhaps in the history of the world. The dot come and telecom stock valuations that took place during the second half of the 1990's were made possible by an interventionist Clinton Administration and an accommodative Federal Reserve which under Alan Greenspan did not have the courage to act independently of other forces - most likely the Clinton Administration and the bankers who control (some say own) the Federal Reserve banking system. Whoever is responsible, what we know for sure is that more money, as measured in absolute terms and in percentage terms was created out of thin air like no time in history. That money having been created, fueled the ridiculous equity bubble that has only begun to deflate back to some normal valuation levels.

2) MOUNTAINS OF DEBT CANNOT BE SERVICED FROM CASH FLOWS.In a fractional reserve systems such as the U.S. and virtually all nations have adopted, money is created by making loans. When a loan is made, it magically becomes money for the borrower. He then deposits the loan proceeds in his or another bank account and "bingo," another loan of say 90% to 95% (depending on reserve requirements) magically becomes still more "money" when the next loan is made. To provide more liquidity to the banks to encourage even more loans and the creation of more money, the Fed buys bonds, which pumps reserves into the banks. What the Austrian school economists understand, but which is not understood by Keynesian or Monetarist economists is a very simple but logical fact that you do not create wealth by "printing" money. Yet, people having "money" in their accounts feel rich and indeed they are because the mystical creation of paper money gives them claims against the wealth created by American workers. The old saying, "easy come-easy go" fits here because it helps explain human behavior when money is so easily obtained. When money comes easily to people, they tend to do such incredibly stupid things with it. I will never forget the discussion I had with a petroleum engineer I used to sit next to while I was still working at ING Barings. Back in 1996 and 1997 my friend Alan always made the point that stocks would continue to rise "because there is no other place to put your money." Indeed that was true of my banking colleagues most of whom were in the six to seven figure income range. Why do bankers make so much? Because they are the "closest people to the printing presses! I know because I used to be one of them.

The failure to recognize this very fundamental truth is at the center of the disease Wall Street faced even before September 11, 2001. Now, since this fractional reserve banking system has been pumping in "phony" money for so many decades, we have - before September 11th, reached the "threshold of lethality" as far as the Kondratieff wave is concerned. That threshold was reached in March 2000 when the stock market peaked and some $4 to $7 trillion of equity valuation was lost from the beginning stages of the bear market in equities.

But economists and CNBC talking heads insist that the market will come back with monetary stimulus from Greenspan and $40 billion in Federal spending from Congress to rebuild New York plus additional sums to arm ourselves against the terrorists.

Why won't this work? Because 1) mal investment has led to declining earnings and 2) because so much money was borrowed that the debt servicing requirements on our economy are beyond levels which can be serviced. As Ian Gordon points out, the threshold of lethality has been crossed in our financial system because mountains of mal investment cannot provide sufficient income to repay debts. As a result, I am fearful that wave after wave of defaults lies in our future.

It is not always applicable to project micro-economic conditions on to the macro-economy, but a simple example of how a single company's finances are relevant to a nation's financial condition can be illustrated as follows: Let's say a company borrowed $50 million to build a dot com business that investors (foolishly) thought would "some day" provide a 30% annual return. Instead, it turns out that the company returns an annual cash flow of only 1% on the $50 million borrowed, leaving it with an after tax return or $500,000 per year. (Not all dot com companies are even this lucky as many of them are having trouble making any money) If the loan is to be repaid over say 10 years, the entire income of $500,000 per year falls far short of generating the $5 million per year payment of principal, never mind interest payments. Multiply this kind of situation or worse by thousands of times in the U.S. economy and you start to get the picture of why we are in trouble. And consumers are, on the whole even more overextend that corporations.

The Keynesians argue "yes but a government can print money and the company above cannot do so." But this is a circular argument that is false because as just pointed out, printing more money requires still more debt which in turn sucks the economy downward like quicksand! During the Kondratieff winter, this is a false remedy which I'm afraid makes things worse rather than better because the combination of declining earnings (which results from mal investment) and debt defaults are pathological to the economy.

Moreover, this condition is certainly not conducive to building confidence in an economy, which is another reason the U.S. dollar is in such big trouble. Having over sold the value of the dollar in large part by rigging the gold price, and then concocting a falsehood about American productivity, foreigners have kept pumping money into our economy. When reality sets in with respect to what the American economy really is, foreign money is likely to pull out of the U.S. and flow into gold or the Euro, which enjoys a far greater gold backing that does the post Clinton dollar.

So, whatever happens when the markets when they reopen on Monday, in the near future it is hard for this writer to concoct a scenario that is bullish for the dollar or U.S. equities. It is also difficult to figure how the realization that the U.S. is not so special after all as a political safe haven will serve to bolster confidence in the U.S. and its financial markets, no matter what kind of patriotic slogans Wall Street tries to sell to the public or what kind of resources the Fed scrounges up on Monday to stabilize the markets.

More than ever, gold as money makes the most sense because its value is not dependent on the ability of others to pay their debts as is the case with fiat currencies like the dollar and virtually all others since 1971.


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