December 26, 2024 Advertise | Contact Us | About Us | Search

K.I.S.S.

May 5, 2007

The following evidences the (surface) fact that the US economy is healthy:

For the year to December 2006, the net profit after tax of the thirty Dow Jones Industrial companies ranged from a loss of $2 billion (General Motors) to a profit of $39.5 billion (Exxon Mobil), with an average profit for all 30 companies of $8.3 billion
Excluding GM, the Return on Shareholder Funds (ROSF) ranged from 1.7% (AT&T) to 46.7% (Boeing). Running my eye down the ROSF numbers, the median return seems to have been around 25%.
Excluding GM, the Return on Total Assets (ROTA) ranged from 0.7% (again AT&T) to 18.1% (3M and Microsoft). Median ROTA was around 7.9%.

25% return on shareholders funds after tax is not too shabby. In the face of long term treasury yields of 4.5% before tax, neither is 7.9% ROTA after tax. If there are any problems in the investment world, maybe they revolve around the premiums that investors are prepared to pay to acquire earnings this good.

The following evidences the (surface) fact that US Investors are still behaving rationally:

The P/E ratios of these best performing companies were as follows, as at May 4th 2007.

Exxon: 11.7X
Boeing: 30.63X
3M: 14.7X
Microsoft: 22.1X

It could be argued that this is reasonable. Clearly, the market believes that smokestack industries are less exciting than aerospace and I.T.

From this snapshot summary, the economy seems to barrelling along very nicely, thank you very much. Yellow - the colour of optimism is prevailing over blue - the colour of pessimism.

But:

One problem is that yellow is also associated with another emotion - fear and cowardice. Increasingly, investors are being attracted to the yellow metal.

(Chart courtesy Decisionpoint.com)

From the perspective of a macho Central Banker, investor preoccupation with gold, is a sign of wussiness. Cowards! "Real men" don't worry when the economy is barrelling along and when the country's top companies are earning around 25% return after tax on shareholder funds.

Well, I guess I must be a wuss. I'm worried.

In trying to conjure up a highly simplistic explanation that I might offer to a five year old to explain why I'm worried, the following popped into my head:

"You know that strawberry soda that you love so much that comes in that pretty looking bottle? Well, the bottle might look pretty, but it has some holes in it and all that lovely soda might just leak away. Right now, enough strawberry soda is being poured into the bottle so you don't notice the leak, but the holes are getting bigger because the bottle has become degraded".

"What's degraded, daddy?"

"There will be more holes and the old holes will get bigger"

Let's apply this to reality.

The chronically prevailing level of government debt has weakened the containing walls of the economy. The interest burden on this debt is causing the economic bottle to leak. As time passes, the container wall will continue to degrade ever further as the government borrows ever more to service its inexorably growing debt. As the debt level rises, the leaks will grow to become bigger.

What has the central bankers' response been?

They have simply increased the pressure at which they have been pumping this lovely soda into the bottle. The money taps have been opening wider and wider.

Maybe it will be easier to think in terms of a rusty tin can rather than a plastic bottle with weakening walls.

What's the logical outcome if you try to fill a rusty can with a fire hose? Well, even a five year old can tell you that, inevitably, the can is likely to collapse under the pressure.

"Don't do that daddy! You'll break the can!"

There are some things that even a five year-old can understand but, right now, the innocent children are still focussing on the soda whilst the responsible adults are worrying about the state of the bottle.

So, as a responsible adult, if you saw that the bottle of soda was about to disintegrate, what would you do? It's a simple question.

The answer is equally simple. It's also obvious. It's time to change the container - BEFORE the bottle disintegrates.

What is it that "contains" the world economy? It certainly isn't money.

The answer is "inertia".

If, as a child, you have ever taken a ride on the 'wall of death' at the fun park, you will understand this concept. The wall of death spins around at such a rate that everything sticks to it. When it slows, everything that was sticking to that wall falls to the floor.

And that is where the Central Bankers have made their life threatening error of judgement.

For two hundred and fifty years they have proceeded from the base assumption that the inertia of the economy is governed by "money".

Unfortunately, that was a serious error of judgement. The fact is that the driver of the world economy - the power that gives rise to the inertia is not "money" - it's "energy".

When we finally face this fact then we will come to understand that "fossil fuels" - which have provided the energy input to generate the economic inertia for the past two hundred and fifty years - are now causing a degradation of the economic container.

Too esoteric? Want something that a five year old can understand? Okay.

Your mommy was General Motors. She used to be the strongest business in the world. Last year your mommy died. She had a negative net worth of $5.4 billion as at December 2006. To all intents and purposes she is only breathing because she is on life support. The consumers killed her. She couldn't adapt, and they didn't want her anymore.

Your daddy is Exxon. Last year he was the country's most profitable company, but without mommy, it's only a matter of time before daddy dies. She was his life. Without her, he's nothing.

At face value, it does not add up that one should be dead and the other should be the most profitable in existence. The reason for this dichotomy is that Exxon is living off a historical installed base of internal combustion engine motor cars, whilst the market is saying: "We don't want any more internal combustion engines".

Yes. It's a matter of time

Exxon's response: "Stuff you! I'm da man! From next week, you can all pay $3 a gallon for your gasoline - coz I'm in the business of making money".