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    Moral Hazard

    The Daily Reckoning

    Paris, France

    Friday, 10 January 2003


    *** Growth target reduced...U.S. has lost "decisive

    *** Reverse mortgages...How to play this new bull
    market...not so fast...

    *** How far are we from the bottom? Homeless people
    freeze...and more!


    The U.N. has revised its world growth estimate for 2003,
    says yesterday's news. It's expecting 2.75% growth.

    Not too bad. It would be better, says the U.N. report but,
    alas, the U.S. economy is "without decisive momentum.'

    The decisive momentum in America has long been supplied by
    consumers. For the last 5 decades, they just kept spending
    their little derrieres off. Consumer spending as a
    percentage of the economy has steadily 70%,
    the highest ever. But lately, consumers can't seem to make
    up their minds. Should they spend...or save? Buy or sell?
    Laugh or cry? Consumer credit fell in November by $2.2
    billion...the first time it has done that in 5 years. And
    then came the "worst holiday shopping season in 30 years".

    What if the American consumer suddenly decides he's bought
    enough...spent enough...borrowed enough...and, generally,
    had enough?

    This is the whole world's worry. "Now is no time for
    restrictive budgets," said France's president Jacques
    Chirac, voicing an opinion that could have come from almost
    any government official of any country in the world. Every
    central bank is inflating...every government is providing
    'fiscal stimulus'. And everyone is counting on the American
    consumer to continue spending.

    "He can't keep it up forever," we point out. As a consumer
    economy takes more and more stimulation to
    produce anything. In 2001, for example, it took $65 worth
    of new debt for every single dollar of extra output.

    Consumers are aging, too. And getting a little desperate.
    The Kansas City Star reports that 'reverse mortgages' are
    catching on among retired people. Instead of giving up
    equity little by little by repeated refinancing, the
    reverse mortgage allows them to get rid of all the
    remaining equity...and get paid out over time.

    The consumer ought to grow cautious...sell a few a little gold...and pay down his debts. Maybe
    this will be the year he does so.

    But let's see what happened on Wall Street. Eric?


    Eric Fry, checking in from the Big Apple...

    - The bulls will not be denied their January rally...and
    who are we to deny them their momentary respite? We would
    sooner deny a condemned man his last cigarette. As the
    "buy" orders poured into the NYSE yesterday, the Dow soared
    181 points to 8,776. The Nasdaq jumped 31 points to 1,076.

    - Meanwhile, bonds tumbled and gold rested. The 10-year
    Treasury note dropped sharply yesterday, driving its yield
    up to 4.16% from 3.98% on Wednesday. Maybe the President's
    $687 billion spending plan isn't such a great thing for
    bondholders after all. Gold slipped 60 cents to $353.70 an

    - It is no secret that the Daily Reckoning teams on both
    sides of the Atlantic believe that gold ought to rise and
    that the dollar ought to fall. One big reason the dollar
    ought to continue weakening is that investing in U.S.
    assets is no longer as pleasant an experience as it used to

    - Throughout the 1990s, the U.S. stock market was a sort of
    financial geisha to foreign capital. The market was so
    hospitable that foreign capital all but refused to leave.
    But these days, the geisha is a gangster. The moment
    foreign capital steps foot on our shores, it is accosted by
    falling asset values denominated in a depreciating
    currency. This inhospitable treatment seems to be
    frightening foreign capital already, as evidenced by the
    dollar's steep decline against the euro over the last 12
    months. We should not be surprised if many more foreign
    investors begin to pack up their valises and head home.

    - "From across the seas," Jim Grant explains, "America is
    perceived as a hegemonic power or, alternatively, as the
    Great Satan. It is also seen as a kind of growth stock.
    What growing enterprises do, in the course of growing, is
    finance themselves, and the world is (or has been) more
    than willing to lend and invest in the 50 states. However,
    there are signs of a change in these perceptions and
    proclivities. More and more, foreign dollars are finding
    their way into government obligations instead of into the
    kind of business investment that contributes to growth."

    - At least SOME money is still flowing our way. That's the
    good news. The bad news is that a T-bond is much easier to
    sell than a factory. So if/as/when foreigners decide to
    head for the exits, they'll be able to do so instantly, by
    selling their vast holdings of bonds and stocks. The
    dollar's fate - more than ever - rests in the hands of
    foreign investors...

    - "After nearly three years of doom and gloom, we as much
    as anyone would like to believe that tech spending will
    improve in earnest this year," writes Mark Veverka of
    Barron's. "But we can't. The evidence simply isn't there to
    support the notion that corporate buyers are ready to load
    up on new hardware, software and services."

    - Veverka cites the findings of a recent Goldman Sachs
    information-technology (IT) spending survey. According to
    the survey, IT spending will be bad in 2003...really,
    really bad. "Contrary to reports of stabilizing IT spending
    and investor optimism heading into 2003," Goldman's report
    observes, "our latest survey (which was conducted prior to
    the holidays in December) shows worsening across the board,
    with some of our indicators hitting new lows and a bias
    toward an expectation of further tightening."

    - Specifically, the survey reveals that IT spending is
    likely to FALL in 2003. That's a first. "Remember," writes
    Veverka, "this is an industry that was used to seeing 14%
    annual hikes in corporate IT spending during the boom...Now
    respondents to the survey say they expect to spend LESS in
    2003 than the year before."

    - More worrisome, key components of the Goldman survey are
    deteriorating rapidly. "For example, the percentage of
    Goldman's respondents in December who expected spending to
    decline swelled to 37%, from 23% in October and 16% in
    August. In fact, the Goldman analysts say they have never
    seen a more dramatic swing in their annual weighted survey
    than the most recent one."

    - Notwithstanding the grim IT-spending outlook anticipated
    by the folks who actually do the spending (or not), Wall
    Street analysts expect a recovery in the sector, as they
    always do.

    - Last week, a couple analysts from Deutsche Bank
    Securities upped their earnings estimates for several
    semiconductor companies. In a classic example of what
    passes for research on Wall Street, the two analysts urged
    their clients to buy stocks like Applied Materials and
    Novellus Systems - not because sales will be improving in
    2003, but only because the analysts expect the valuation
    multiples on the stocks to fatten up a bit. Specifically,
    they predict that Novellus will trade higher from its
    current valuation of two and a half times book value to a
    more opulent valuation of three and a half times book
    value. For the record, NVLS is also selling for a rich 64
    times estimated 2003 earnings.

    - In earlier financial epochs, two and a half times book
    value and 64 times forward earnings did not constitute
    "compelling value." We can think of no reason why the
    current epoch ought to be any different.


    Back in Paris...

    *** Jeremy Siegel, author of Stocks for the Long Run, is on
    the front cover of this month's Worth magazine, promising
    to tell us "How to Play the Next Bull Market."

    We don't know, of course, but Siegel may be getting ahead
    of himself. After stocks crashed in '29, investors thought
    they were pretty safe buying 4 years later. Surely, stocks
    had found the bottom. But, "it took another 8 years,
    several bear markets, and then a war," explains Ray DeVoe,
    "before the stock market really took off."

    After the boom of the '60s, it took a long time again
    before another bull market began...and even longer for
    investors to take an interest in it. "From November '71
    through October '79, investors made net withdrawals from
    equity funds in every month but one," DeVoe points out.
    "Not until November 1981 were there two consecutive months
    of net inflows - even thought the S&P rose five of the six
    years from '75 to through '80."

    *** How far are we from 'the bottom?' Currently, Barron's
    calculates the P/E of the S&P 500 at 34. The dividend yield
    is 1.7% and the S&P sells for 4.2 times book value. Looking
    at 14 cyclical bottoms (not big, bad bear bottoms such as
    the one we're likely to have this time), ISI found that the
    highest P/E of any of them was 16.3 in the fall of 1960.
    The lowest dividend yield was 3.4% in October 1987. And the
    highest price to book was 2.24 times, in October 1990. By
    every measure, today's stocks are nearly twice as high as
    the highest bear market lows ever recorded.

    *** Today's Figaro reports that 4 'homeless' people have
    died in Paris from exposure to cold since temperatures
    dropped on Saturday. It might have said that 4 bums were
    too drunk to come in from the cold...or 4 lunatics were too
    crazy to do so. But this is the Age of Crowds...wherein
    people no longer get what they deserve...but what society
    gives them. More below...

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    The Daily Reckoning PRESENTS: The omnipresence of moral
    hazard...and why man, unlike the fabled Homo Economicus,
    cannot resist it.

    by Bill Bonner

    "We cannot guarantee success, but we can deserve it."

    - George Washington

    In a small town in the Midwest, a man would have to sneak
    around, under the eyes of his neighbors, in order to get up
    to something. Then, word would get around...and soon the
    whole thing would be over.

    But here in Paris, there are moral hazards on every street
    corner, which is what we like about the place. Here, a man
    can get into trouble and stay there for a long time before
    it catches up to him. And if he has no vice when he arrived
    in town, he can pick one up quickly and develop it into a
    life-long companion.

    After work, your editor could sit down at the Paradis, have
    a few drinks and a cigarette, and then wander over to the
    rue St. Denis and enjoy himself with Brigitte or Fran?oise
    for a modest outlay.

    If he were more ambitious about his vices, he could take up
    gambling...stock market speculating...or even theft. He
    might begin picking pockets on the metro and work his way
    up...first to robbing his partners or defrauding
    investors...and then, on to the big time, he could go into

    There is a certain rhythm to moral hazards. Whether petty
    or great, all are exhilarating at the beginning...and
    heartbreaking at the end. For there is always a price to

    "All the universe is moral," wrote Emerson early in the
    19th century. Now, no one believes it...except us.

    And yet, the cycle is same for market booms, empires, and
    even an individual life. What tickles the fancy so much at
    the d,but, saddens it at the finale.

    "Whatever your weakness," says Richard Russell, "the market
    will find it."

    Greedy investors wait too long to sell - and lose their
    money. Fear keeps others from ever buying in the first
    place. Laziness gets others - who fail to do their homework
    and get carried along by mob sentiments into buying the
    most popular stocks at their most absurd prices.

    "I ought to have sold at the top," says the one. "I ought
    to have bought at the bottom," says the other. "I ought to
    have looked at the balance sheet," says the third. "I ought
    not to have drunk that last bottle," says the fifth.

    But modern economists act as if the story had no
    if there were no 'oughts.' Everything happens according to
    cause and effect, they believe.

    There is no such thing as a stock that is too expensive or
    too cheap, they say...because the stock market is perfect.
    It finds the exactly ideal price every minute of every day.

    There is no such thing as moral failing either. A man
    cannot be faulted for buying a stock at its perfect price.

    And prices would be perfect, if the man were the man that
    economists think he is. In their minds, man is a rational,
    profit-optimizing machine. That is, he is unlike any man
    anyone ever met...he is Homo Economicus...the mythical
    creature of economists' imaginations...always making the
    right decision after carefully weighing the available

    Real men rarely weigh anything carefully - except perhaps
    sirloin steaks when they buy them by the pound. Many never
    met a moral hazard that they didn't like.

    And when they participate in collective undertakings - such
    as politics, war, football games or stock market booms -
    they immediately become even bigger boobs, making fools of
    themselves as regularly as faucet drips.

    Economists then imagine that the economy functions as a
    sort of machine, too - with Homo Economicus popping up and
    down like valve lifters. No moral hazards present
    themselves...for a machine is as inert to larceny as it is
    to a short skirt.

    You can put a pack of cards or a fifth of whiskey in front
    of a machine, come back an hour later, and the machine
    still won't have touched them. Not so a human being. All he
    needs is an opportunity, and he's on his way to Hell!

    The term 'moral hazard' has a special meaning as well as a
    general one.

    "The idea is simple," explains Jeffrey Tucker in an article
    published by the Mises Institute in December of 1998, "If
    you are continually willing to protect people from the
    consequences of their own errors, your benevolence will be
    factored into the future decisions of the persons rescued.
    In the long run, they will make even more errors. The
    principle exists at all levels. The teacher who changes
    grades when students plead hardship isn't helping in the
    long run. The teacher is rewarding and thereby encouraging
    poor study habits. He is creating moral hazard."

    The new, collectivized world of the late 20th century was
    full of accommodating teachers and forgiving wives.
    Investors paid too much for stocks. Businesses and
    consumers borrowed too much. And the whole world seemed to
    believe what couldn't be true - that the dollar was more
    valuable than gold. For nearly 20 years, gold went down
    while the dollar went up.

    Gold ought to have gone up. Since the beginning of Alan
    Greenspan's term, the Monetary Base has almost tripled. In
    the most recent few years of Mr. Greenspan's term, short-
    term interest rates have been driven down to barely a fifth
    of what they were two years ago.

    "[L]owering rates or providing ample liquidity when
    problems materialize, but not raising them as imbalances
    build up, can be rather insidious in the longer run,"
    concedes a working paper from the Bank of International
    Settlements. "They promote a form of moral hazard that can
    sow the seeds of instability and of costly fluctuations in
    the real economy."

    By the beginning of 2003, there were an estimated $9
    trillion of U.S. dollar assets in foreign hands...and three
    times as many in circulation as there had been in 1987. The
    hazards had never been greater...nor ever so hard to see...

    More Monday...

    Bill Bonner


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