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The Daily Reckoning Friday, January 22, 2010 Markets slip back into the red on China and Obama fears, The Wall Street bonus pool: What would Karl Marx say? Plus, Bill Bonner on that Japanese stocks call and plenty more... Eric Fry, reporting from Laguna Beach, California... Say it ain't so! The Dow Jones Industrial Average has slipped into the red for the day, year, decade and century...all in one day! The Dow tumbled 213 points yesterday, dropping its performance for the New Year (and new decade) into negative territory. This decline also increased the Dow's loss for the century-to-date to about -9%. "Stocks for the long haul" may still be a valid investment strategy, but the haul keeps growing longer. Please don't misunderstand us; we love stocks. But we love them less when they are richly priced or when underlying economic trends are sickly. As it happens, stocks are richly priced AND underlying economic trends are sickly. That's not ideal. Very few companies are reporting profit growth without also reporting expense reductions. In other words, they are "growing" by shrinking. Even Goldman Sachs, America's greatest state-sponsored enterprise, is relying on expense reductions to boost reported profits. Goldman did not merely utilize its government-subsidized financing to book record fourth-quarter profits, it also trimmed its bonus-pool payouts. "In a surprising concession to the public outcry over big Wall Street bonuses," The New York Times explains, "Goldman broke with the long- time industry practice of earmarking roughly half of its annual revenue for compensation. Indeed, the bank did the unthinkable for the final months of 2009: It subtracted about $500 million from its pay pool, rather than add more money to it, even though the bank earned a healthy $4.95 billion for the quarter, above Wall Street expectations." The Times' report is factually correct, but misleading. Goldman's record fourth-quarter profit was the direct result of trimming allocations to the bonus pool. If Goldman had added the "normal" amount to the pool, fourth quarter earnings would have been very disappointing. Furthermore, Goldman's "concession to the public outcry" still delivered a whopping 57% of net earnings to employees. "Normal," as Goldman defines it, would have delivered 70% of the company's net earning's to employees...leaving only 30% for shareholders. Wall Street's very abnormal perception of normal has persisted for a long time. In fact, we highlighted this perverse condition three years ago. In a column entitled "Bonus Envy" we observed, "Karl Marx would be proud...sort of. The laborers of five major Wall Street firms will receive a much greater share of their companies' 2006 profits than the owners of these five firms. Who could have imagined that the ultimate bastion of capitalism would strike a decisive victory for the laborers of the world? "But it is true. Thanks to tens of billions of dollars of year-end bonuses, the laborers of five major Wall Street firms will receive twice the remuneration of the 'capitalists' who own these firms - i.e. the shareholders. In other words, employee compensation at Goldman Sachs, Merrill Lynch, Bear Stearns, Lehman Bros. and Morgan Stanley totaled $60 billion in 2006 - double the year's earnings of the five firms. Almost half of this compensation arrives in the form of year-end bonuses...and the largest bonuses arrive in the bank accounts of a few privileged employees. So let's call this process, 'Marxism with a twist.' "As fans of Das Kapital might recall, Marx argued that 'capitalists' deserve no 'surplus value' from their investments because the capitalists contribute no labor to the production process. Since labor, alone, contributes value to production, Marx asserted, the laborers deserve the profits of the enterprise. Wall Street's major brokerage firms seem to agree. "Wall Street's biggest firms are in the process of doling out more than $24 billion of year-end bonuses to their employees - a figure that would soar above $35 billion if one included stock options and grants, as well as the bonuses of Citigroup, J.P. Morgan and Bank of America. Very few public companies reward their employees so lavishly. "There may not be anything inherently wrong with Wall Street's perverse part-time Marxism. But it just doesn't feel right. These enormous bonuses may be perfectly appropriate and justified and ethical. But it feels quite the opposite. "Perhaps we should not bother to examine the ethical aspects of unbridled capitalism. We are reminded of the expression: 'Don't try to teach ethics to a pig. It wastes your time and annoys the pig.'" Forgive us the lengthy digression, dear reader...Where were we? Oh yeah, we were observing that pricey stocks and sluggish economies are not a great mix. Therefore, we'd become a much more confident buyer of stocks if the market were weaker for a while, or if the economy was stronger for a while, or both. But that's not the case. The economy is still wandering around in the wilderness. Workers aren't working; homebuyers aren't buying and consumers aren't consuming. This condition punctuates a decade-long disappointment, as the chart below illustrates. The "lost decade" continues to add days to its lifespan. Until the economy starts to find its way again, trade nimbly and invest selectively. And now over to Bill Bonner, who has today's reckoning from Paris, France... Fear. You can almost smell it. So far, there's just a whiff of it...a faint odor...a little trace in the air...like the smell in a subway car after a bum has left. Yesterday, the Dow fell 213 points. Oil dropped to $76. Gold lost $9. What caused it? What sets off a crash? Yesterday was hardly a crash. But our Crash Alert flag still flies. Because this is a market in danger. It is a market looking for a reason to crash. You never know for sure when or why markets crash. At a certain point, markets become like drunks who want to play a game of Russian roulette. First, they have to find the revolver. Then, they find the trigger. It looked to us as though investors were flexing their trigger fingers yesterday. Some blamed China's recent move towards tighter credit (or what they thought would be a move to tighter credit)...others blamed news from the US: "Jobless claims in US unexpectedly rise," said the Bloomberg report. Here is how the Associated Press described it: "A surprising jump in first-time claims for unemployment aid sent a painful reminder Thursday that jobs remain scarce six months into the economic recovery. "The surge in last week's claims deflated hopes among some analysts that the economy would produce a net gain in jobs in January and help fuel the recovery. "A Labor Department analyst said much of the increase was due to holiday-season-related administrative backlogs at the state agencies that process the claims. Still, economists noted that that would mean claims in previous weeks had been artificially low. Those earlier declines had sparked optimism that layoffs were tapering and that employers would add a modest number of jobs in January. "The January employment report will be issued Feb. 5. But the surveys used to compile that report were done last week, so economists are paying close attention to the jobless claims figures from that week. "'The trend in the data is still discouraging,' Diane Swonk, chief economist for Mesirow Financial, wrote in a note to clients. 'Hopes for a positive employment number in January...are rapidly dimming.'" Anyone who was 'disappointed' by the jobless numbers hasn't been paying attention. Consumer and business credit are falling. That means businesses are not expanding. They're contracting. And that means they need fewer employees. People without jobs can't shop like they used to...and they can't pay their bills. One out of 4 mortgaged houses is underwater. One in 10 is in foreclosure. Many more will probably go into foreclosure as the depression continues and default becomes more socially acceptable. Previous generations regarded default and foreclosure as a disgrace. Lenders priced this aversion into their lending rates. But now, default is just a shrewd financial move. When the financial costs of defaulting are lower than the costs of paying...that's what borrowers will do. Just like Wall Street. As the depression continues, attitudes will change... Voters will probably want real change in Washington; that's what the Massachusetts election may be telling us. But back to our story... This morning, we see another itchy trigger finger. Stocks are falling in Asia. This time it's blamed on Obama's pledge to punish the banks with higher taxes. But the real cause of the wobbles on Wall Street is the economy. Trillions' worth of fiscal and monetary stimulus aren't stimulating at all. They're just shifting control of the economy to the feds...and shifting the debt bubble in their direction, too. Does that make a nation more prosperous? Of course not. The stock market has been ignoring the fundamentals. It's priced dozens of big companies over 50 times last year's earnings. Overall, stock prices are closer to a top than a bottom. And yet, a depression brings a bottom, not a new top. We say this with caution. A few years ago, we might have said it with reckless confidence, but we were smarter back then. Now, we even place our breakfast order with caution. You just never know... No one ever knows exactly what Mr. Market will do. If he wants higher stock prices, he'll get them - no matter what the fundamentals tell us. But we have to stick with the fundamentals anyway. That's all we've got. And they tell us to watch out. In a 'normal' recession, businesses would be re-hiring by this time in the cycle. They're not doing so. Why? Because it's not a 'normal' recession. It's something quite different. Something we haven't seen in the last 50 years. Something we never wanted to see again. But here it is - a depression. That's what those higher unemployment figures tell us. People who own and run businesses aren't hiring. They know the jig is up. The insiders who own businesses are selling 24 shares for every one they buy. Unemployment is over 10%...and it seems likely to stay there for a long time. Consumer and business credit are declining - for the first time in half a century. And those trends too seem likely to continue. There are still beaucoup mistakes to correct and a long way down to go. So relax. Buckle your seat belts. Sell your stocks. And enjoy the show. And more thoughts... "I spent some time driving around over the weekend," began an Irish colleague. "The Irish property market is a disaster. Over in Cork is the highest residential building in Ireland, the Elysium Tower. It was begun a couple of years ago. They have something like 300 units. But they've only sold 7. And now the owner is trying to buy back those 7 properties. It costs him so much to keep the lights on and to maintain the building, he figures he would be better off buying back the 7 units he sold and shutting the whole property down. "If you wanted to buy something in Ireland now, you could get a very good deal..." Uh oh. Both good and bad news on our new Trade of the Decade. Japanese shares were rising, last time we looked...because the falling yen makes Japanese exports more attractive. But to whom are they going to sell? US consumers look like bad prospects. Their real, disposable incomes have gone nowhere in nearly 40 years. In the last two years, household net worth and incomes have been falling. Credit is falling too. The young have no jobs - even the ones with college degrees. One out of 5 defaults on his college debt. And the old have no money. Seniors are holding onto jobs as long as they can...trying to make up for years of failing to save. China is another big customer. And the Chinese economy is about ready to blow up. Some luxury properties in Shanghai rose 100% last year. And now the authorities are tightening up on credit. What happens to an export economy when its major customers go broke? We're going to find out... Japan's business leaders sense trouble. Business borrowing is collapsing. It's at its lowest point in 5 years. This Trade of the Decade could be in for a rocky start. More below in today's essay... --------------------------------------------------------------- The Daily Reckoning PRESENTS: Why would anyone on earth possibly want to buy something that has been beaten down for two straight decades? Well, why not? It takes the "foresight" of someone like Gorgeous Gordon Brown to sell at the bottom of a market. That's exactly what you don't want to do (unless you want to become the United Kingdom's PM). In today's column, Bill Bonner makes the case for unloved Japanese stocks twenty years after their all-time high... The Last Shall Be First By Bill Bonner Paris, France The yen is falling. It's down 5% against the dollar since November. Investors are finally noticing. With a deficit of 50% of GDP, the Japanese government walks where angels fear to tread. Americans aren't far behind. To make a long story short, our money is on the angels. Only an economist would dare to look 10 years ahead. Only a fool would put money on it. Today, we do both. But our new "Trade of the Decade," is not so much a look into the future as it is a look at the past. Ten years ago, your humble correspondent offered his first 'Trade of the Decade.' He should have stopped there, for the trade was a big success. It was a simpleton's trade: Sell US stocks/buy gold. That was in the year 2000. At that time, US stocks had been going up for the previous 18 years, multiplying investors' money 11 times. By then, stocks had been going up for so long that the memory of man ranneth not to the contrary. Investors' imaginations saw no alternative. Stocks for the Long Run was the title of a popular book. It was also an investment formula that seemed unbeatable. Alas, the formula proved beatable. It was time for stocks to go the other way. The first decade of the 21st century proved to be the worst time to hold stocks since the '30s. Net returns were negative - especially when adjusted for inflation. Adjusted to the CPI, the Dow ended the decade down 40%. The other side of the trade - the buy side - was just as simpleminded. Gold hit a high over $800 in 1980. Then, it slipped for the next 20 years. It didn't come to rest until September 1999 at $260. That was the famous "Brown Bottom" in the yellow metal...when the then chancellor of the exchequer, Gordon Brown, sold Britain's gold at the lowest price in two decades. (To bring readers up to date, now Mr. Brown applies his vision and energy to Britain's economic recovery efforts.) Gold is real money. But in the years when gold was being beaten down, other forms of money were running wild. Financial assets mushroomed all over the globe. A whole new 'shadow banking' system emerged...with new financial instruments, representing trillions...no, hundreds of trillions...of dollars. Prices on everything were soaring - equity, debt, real property. It did not take a genius to see that gold would have to catch up, sooner or later. As it turned out, no major asset class did better. Gold finished every single year higher than the year before. It doubled. Then, it doubled again. What made the trade a success was neither clairvoyance nor omniscience; it was merely an observation known as 'regression to the mean.' The word 'normal' has been in the dictionary for a long time. It must be there for a reason. What it describes is where things tend to go when they've gotten out of whack. Regression to the mean is so powerful, no one escapes it. For every decade of walking around time, a person spends a million years dead. Over a century, practically every human regresses to the grave. So, what is so abnormal now that regression to the mean is as certain as death? Almost all investments are expensive by most historical measures. But if all go down, what will they go down against? Money! That's why real money - gold - is likely to go up again in the next 10 years. But gold is not cheap. It rose nearly 400% over the last 10 years and now is fairly priced. Gold in the treasure trove found in England last year is worth today about the same thing it was when it was buried 12 centuries ago. It cannot regress to the mean; it is already there. On the buy side, we are looking for an investment that is despised...not one that is admired. And so, back to Japan, where equities peaked out in 1990 and have been going down ever since. While the Japanese government wanders among the stars, the private sector has dropped back to the ground. Or beneath it. Tokyo-listed stocks have lost 75% of their value, wiping out an entire generation worth of growth. Many Japanese companies sell for less than the value of their current net assets. And now, after twenty years, Japan's private businesses are finally benefiting from the stimulus programs. The government will go broke, but by destroying its own credit, Japan cuts the value of the yen and boosts profits for its exporters. Toyota's local labor costs - in dollar terms - fell 5% in the last three months. And by the time the catastrophe is complete, Japan's businesses could be the most competitive in the world. One way or another, 10 years from now, we'll wager that Japanese stocks will be higher...if only relative to the rest of the world's equities. But of all the whack that investments might be out of, US Treasury debt stands above them all. For the last 27 years, the US government's cost of borrowing has gone down. But while bond yields declined, the quantity of US debt exploded. Official, on-the-books debt trebled. Include off the books, unfunded financial obligations and the total reaches $118 trillion - 8 times GDP. And now the explosions come every month. As the depression continues, US deficit-financing needs could rise to $150 billion every 30 days. So far, the bond market has absorbed the shocks with good grace. But sometime in the next 10 years, the angels are bound to be proven right. Sell US Treasury bonds. Buy Japanese stocks. Regards, Bill Bonner, for The Daily Reckoning Joel's Note: Readers are reminded to save the dates - July 20-23 - for this year's Agora Financial Investment Symposium in Vancouver. Along with Bill, Eric and a roll call of Agora's finest, we've also locked in a top-notch program of contrarian financial commentators, market analysts and industry insiders. All in all, it promises to be a grand ol' affair. The date might seem like a while off yet, but January is just about done and tickets are already selling fast. Plus, if you reserve your spot now, the crew at Opportunity Travel can hook you up with a sizable discount. So get in while the gettin's good. --------------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com The Daily Reckoning - Special Reports: Gold: The Truth About Gold Fiat Currency: Using the Past to See into the Future "THE GREAT AMERICAN RECOVERY RP-OFF" Brace yourself for what's about to go down as the BIGGEST FINANCIAL SWINDLE in world history.