A Worldwide Economic Boom or Bust?

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There is a  economic boom going on. We see it in London…in Paris…and here in India, too.

“Four years ago, you could have bought as much of this stuff as you wanted for $200 a square foot,” said a friend from Bombay, waving his hand towards a block of old buildings near the Taj hotel. “Now, you’d have to pay two to three times that much.”

Even at $200 a square foot, looking at the dilapidated buildings, we wondered how it could be worth it. But we took his point; things have gone up.

‘This is the best market ever,’ says Jim Cramer, or words to that effect. He is talking about the stock market. He likes it because profits as a percentage of GDP are near a record high. Google is climbing towards $500 a share. Already, it is worth more than the entire Thai stock market. We wonder what investors are thinking? Which would you rather own, dear reader, Google’s profits in five or ten years…or those of all the publicly listed companies in Thailand?

Also up is Goldman – to a new high, based on record high profits. The people who own the stream of profits – stockholders, generally the wealthy – have no complaints. They’ve become much more wealthy in the last few years…even while the average fellow has actually gotten poorer.

Of course, we notice that even at Goldman things can’t be as rosy as they say.

A recent Bloomberg report tells us that Wall Street’s hotshot firm is turning to curious places for its new recruits:

“Goldman Sachs Group Inc., the world’s biggest hedge fund manager, hired 17 traders from Amaranth Advisers LLC to expand the firm’s investments in fixed-income markets, said a person briefed on the matter…

Amaranth collapsed in September after bad energy bets wiped out 70 percent of its $9.5 billion in assets. New York-based Goldman, the world’s largest securities firm by market value, is dedicating more capital to risky strategies after its $10 billion Global Alpha Fund fell 11.6% through November and as returns worsen this year across the hedge fund industry.

Still, capital assets worldwide have been nourished by a flood of liquidity.

“Capitalists are in clover,” says the latest edition of the Economist. “Profits have soared since the dark days of 2001 and companies are so flush with cash that they are buying back their own shares, merging and acquiring each other as if the good times will never end.”

Encouraged by the profit picture, investors have bought stocks. They haven’t made a dime in real terms – measured neither in gold, in euros, nor inflation-adjusted dollars has the Dow really gone up. But investors stopped thinking clearly about 10 years ago…maybe more. Since then, they’ve been listening to people such as Jim Cramer.

We interrupt ourselves to try to understand how the world works. Virtue begets virtue. The businessman who makes an honest profit does so by providing a good service at a good price. He controls his costs and thus finds that he has made a profit – which signals to him that he might be able to provide more services to more people.

But if virtue begets virtue, what does fraud beget?

The profits enjoyed by U.S. firms are real. But they have a strange provenance. In fact, they were begat in a swindle. The liquidity that made the world spin so hotly was not honest savings…it was funny money from central banks and debt.

“Profits are very dependent on whether the economy is expanding or contracting,” the Economist explains. “Businesses have fixed costs and when demand is strong, revenues rise faster than costs; when demand is weak, they fall faster.

“Nick Carn, a strategist at Odey, a hedge-fund group, says it is pretty simple: companies’ revenues are determined by the pace of consumer spending; their costs are largely driven by wages. Profits have grown because Americans have borrowed money to spend more than they have been earning. This cannot continue forever.”

Also in the Economist report is the news that financial services (which contribute over a quarter of all profits) are expected to produce 31% annual growth in profits. Strip them out, and the rest of the market will muster only 2%.

Whence cometh this profit bonanza? It is the misbegotten fruit of a sordid coupling – between savings that didn’t exist and people who had no business borrowing. Combined with low, globalized wage costs, it produced record profits for the lenders and the producers. Businesses could sell more product with little rise in labor expense. Lenders could lend money that no one had saved to hedge funds and homeowners and make a bundle. And it will all work beautifully, as long as nothing goes wrong.

But what could go wrong? What will almost certainly go wrong is that the homeowners will have to cut back. Then, the lenders and hedge funds will be in trouble too. Get this – the last six years have seen the biggest property boom ever. Yet, the average American homeowner actually has less equity in his house than he did in 2000. What he has a lot more of is mortgage debt. And when his house falls in price, that debt is going to chafe his neck like a noose.

The NY TIMES reports that property prices are down a lot more than people think. An auction was held in Naples, where people sought to get rid of their houses fast. Supposedly, housing is up 20% in the city. But when this auction put willing and able buyers together with ready sellers, actual prices were much lower than expected. Sellers took haircuts of 15% – 40% from what they paid for the properties a few years ago. Overall, prices were down about 25% from 2005.

The TIMES quoted an expert from Boston who estimated that prices in that city, too, were off about 20%. And in Northern Virginia, a drop of 10% to 15% has been estimated.

These are not the same as the price information reported in the paper. Sellers are reluctant to accept such losses. Instead, they let properties stay on the market. But these auction prices reflect the truth – when sellers are forced to mark their houses to market, prices are lower than they thought.

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Bill Bonner

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