The Rude Awakening

Wall Street, New York

Friday, May 27, 2005

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The Rude Awakening PRESENTS: When the Berlin wall came a - tumblin' down in 1989, the entire Western world celebrated the triumph of capitalism over communism. But very few of us imagined that the world's leading capitalists would later veer toward a subtle version of communism...

MISES VRS. MARX Eric J. Fry

"Mr. Gorbachev, open this gate! Mr. Gorbachev, tear down this wall!" -President Ronald Reagan in a speech near the Berlin Wall in 1987

When the Berlin wall came a-tumblin' down in 1989, the entire Western world celebrated the triumph of capitalism over communism. Most of us in the West imagined that the world would become a better place as the "Commies" become capitalists, especially if they also decided to hold an election from time to time. But very few of us imagined that the world's leading capitalists would veer toward a subtle version of communism.

These two opposing trends will likely promote a re-pricing of perceived risk in the global stock and bond markets. Specifically, the valuations of emerging market stocks and bonds should rise relative to stock and bond values here in the "developed world." After all, if the former communists are becoming even more capitalistic than us original capitalists, shouldn't Russian stocks and bonds gradually command higher valuations? And if the world's formerly inept quasi-socialist nations, like Brazil and Argentina, are also becoming exemplary capitalists, shouldn't their stocks and bonds deserve better treatment in the marketplace?

"Less than seventy-five years after it officially began," a New Yorker Magazine article from 1989 proudly declared, "the contest between capitalism and socialism is over: capitalism has won." Surprisingly however, some paragons of capitalism simultaneously surrendered to communism - not entirely, of course, just at the margin.

To illustrate this phenomenon, we turn once again to the official Rude Awakening whipping boy: General Motors. In 1916, General Motors became a U.S. corporation. Within 40 years, it became the first U.S. corporation to earn $1 billion in a single year. In 1917, the Bolsheviks overthrew the Russian Czar, clearing the way for a new communist regime. 40 years later, the "planned" Soviet economy had become much more proficient at filling bunkers with warheads than filling store shelves with bread. The Soviet economy, in short, was a disaster.

But times have changed...to say the least. Today's Russian economy has ambutted $145 billion of foreign exchange reserves - the largest outside of Asia - and has become a net creditor. GM, meanwhile, piles up $1 billon quarterly LOSSES, while becoming a mbuttive debtor. GM's total long- term debts and liabilities are more than DOUBLE Russia's foreign exchange reserves.

The comparison between GM and Russia may not fairly represent America's capitalistic muscle, but it does fairly portray how that muscle is atrophying.

"GM is a car and truck company - for the 74th consecutive year, the world's largest - and has revenues greater than Arizona's gross state product," writes George Will in a recent op-ed piece for the Washington Post. "But GM's stock price is down 45 percent since a year ago; its market capitalization is smaller than Harley Davidson's. This is partly because GM is a welfare state."

"The cost of providing health coverage for 1.1 million GM workers, retirees and dependents is estimated to be $5.6 billion this year," Will relates. "GM says health expenditures - $1,525 per car produced; there is more health care than steel in a GM vehicle's price tag - are one of the main reasons it lost $1.1 billion in the first quarter of 2005...And health care for retirees and their families - there are 2.6 of them for every active worker - is 68 plus 1 percent of GM's health costs."

In short, the modern incarnation of General Motors, for better or worse, fails to operate for the benefit of the capitalists behind it - not for the shareholders, and definitely not for the bondholders.

"It's strange," GM's CEO, Rick Wagoner, muses, "When I joined GM 28 years ago, I did it because I love cars and trucks. I had no idea I'd wind up working as a health-care administrator.''

GM's plight illustrates an important nuance of US-style capitalism in 2005: It is hogtied.

Today's American capitalism finds itself fettered by more restraints than the Lilliputians strapped to Gulliver. It is constrained by high wages, growing health care and pension liabilities, a litigation-friendly judicial system and an onerous regulatory framework.

At the same time, the U.S. economy is attempting to thrive on the thin gruel of debt-financed consumer spending - a gruel concocted from a toxic blend of buttet-inflation and foreign capital. (Thank goodness the communists in China are so eager to lend us capitalists the money we need to maintain our consumption). As we pile up foreign debts, we are also piling up liabilities that must be "socialized" away. We must all, collectively, satisfy the cost of our excesses, either through taxation or currency-debasement or both.

In short, the U.S. economy is attempting the impossible. America is still capable of great things, but not impossible things.

Meanwhile, the one-time Bolsheviks are becoming more likely to quote Ludwig von Mises than Karl Marx. "With varying degrees of enthusiasm," Hernando de Soto declared in The Mystery of Capital, "Third World and former communist nations have balanced their budgets, cut subsidies, welcomed foreign investment, and dropped their tariff barriers."

As a result, the terms "emerging market" and "developed market" are becoming anachronistic, if not utterly deceptive. We think it is reasonable to ask, therefore, if "blue chip" emerging market stocks are still much more risky than "blue chip" developed market stocks? Or if emerging market government bonds are still much more risky that US high-yield bonds?

The global bond market has already answered the second question for us...and the answer is "No." The bond market might change its mind, of course. But for the moment, the yield of emerging market "sovereigns," as they are called, have "traded through" US junk yields. In other words, bond investors now consider emerging market government bonds to be less risky than US junk bonds.

Emerging market stock values are also climbing relative to their developed world counterparts. The chart below portrays emerging market PE ratios relative to the S&P 500's. For most of the last two years, the ratio has been climbing. Recently, however, the spread between the two widened out again, such that the S&P's PE ratio of 20 is nearly double the 11 PE of the Morgan Stanley Emerging Market Index. Net-net, emerging market valuations have improved somewhat, but they continue to carry a very steep discount relative to the S&P 500.

We sense a buying opportunity...relatively speaking.

Last month, Indian Prime Minister Manmohan Singh declared that his country and China "could together reshape the world order." The re-shaping has already begun. The two countries have singed dozens of bilateral agreements to enhance their mutual cooperation economically and militarily.

"Burgeoning economic ties are driving much of the goodwill," the Wall Street Journal reports. "Two-way trade reached $13.6 billion last year. Up from $3 billion in 2000. Russian, Brazil, South Korea and numerous other nations have been busily establishing bi-lateral and multi- lateral economic agreements of various types. The one conspicuous feature of almost every trade agreement is the absence of an American signature. A new world order seems to be unfolding all around us. The simple, bi-polar world we used to know - pitched between powerful Western economies and feeble developing world economies - no longer exists.

Sooner or later, the global securities markets will begin to reflect these changing realities.

America is still the most prosperous nation in the world, but our securities markets already reflect that reality. The emerging prosperity of the world's "emerging" economies does not carry such a rich price tag in the global securities markets.

Maybe, therefore, we should begin investing in the new world order, rather than its predecessor.

Did You Notice...? By Eric J. Fry

A corporate culture of well-mannered avarice also restrains the mighty American economy. Many public companies labor under a Soviet-style central planning - the sort of planning that arranges things very nicely for the planners themselves, but much less well for the proletariat.

Many American boardrooms promote a type of short-term, "shareholder-friendly" strategic planning that tends to enrich corporate officers at the expense of the voiceless minority capitalists who own the company's stocks or bonds.

"In 2003, the ratio between CEO pay and worker pay reached 301 to 1, up from 282 to 1 in 2002," according to a report from United for a Fair Economy. "If the minimum wage had increased as quickly as CEO pay has since 1990, it would today be $15.76 per hour, rather than the current $5.15 per hour."

"By any standard, many of today's executive compensation packages are excessive," BusinessWeek butterts. "Too often, directors have awarded compensation packages that go well beyond what is required to attract and retain executives and have rewarded even poorly performing CEOs...The problem is that excessive CEO pay takes dollars out of families. Moreover, a poorly designed executive compensation package can reward decisions that are not in the long-term interests of a company, its shareholders and employees."

Corporate avarice, as enshrined in America corporate culture, is no less counterproductive for being legal. If America wishes to improve its "productivity," it could begin the process by firing every CEO who draws a paycheck over $10,000,000 a year. And if we really want to get serious about improving our productivity, we could also fire every CEO who draws a paycheck over $5,000,000.

India's highest paid CEO, Vivek Paul, earns $1,100,000 per year to oversee Wipro, India's largest information technology company. The average American CEO earns more than $8 million per year...Maybe its time to begin outsourcing CEOs to India.