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Inefficient Markets
14 May 2002
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The crackdowns are well under way. Regulators are all over Wall Street's mess.

Here's the story. Not long after the US government cracked down on Microsoft's business practices, the FBI began its own crackdown of stock promoter rings by late 2000. Hollywood even produced a movie called "Boiler Room." It was a depiction of the street level activities of these rings.

This larcenous industry was the by-product of the biggest bull market ever. Who started it? How much of it was real? That's for us to all find out eventually.

Then the failure of major west coast Utilities resulting from the oil crunch during the fall of 2000 produced the largest corporate bankruptcy on record when energy giant Enron finally came clean. The shockwaves reverberated throughout the continent and culminated in severe emotional outbursts from both sides (government and private sector). As the events unfolded, the failure was found to be more than just the simple case of a company using too much leverage in a recently deregulated market environment.

As the web spread to complex off balance sheet deals whose illegitimacy were widely known by key bankers, members of the government, auditors, and management, it became an increasingly clear case of fraud. So far the case has only barely brushed up against the banking and government elite, but has wiped out one of the world's foremost accounting titans, Arthur Andersen.

That in addition to reports of further accounting abuses resulted in a SEC crackdown on accounting shams, which resulted in a Congressional crackdown on the analyst community that has produced a long list of suspects recently drawn out in front of the firing squad.

The consequence is new SEC regulation for analyst disclosures, and new accounting standards by the nation's auditors as well as its rating agencies.

A break down in relations between the Israeli-US alliance and the Arab world, which became manifestly clear on September 11th, was likely responsible in igniting Bush's passion in the broadening crackdown on terror. The President's charm in matters of foreign policy extended into matters of trade, where industry complaints about the strong dollar policy and unfair competition produced a crackdown on steel importers, which has spread to other industries now, and threatens to include technology also (see Microsoft versus EU).

The Congress is cracking down on energy market manipulation it says is the product of record industry consolidation, thereby excusing anything the government may be doing.

The Fed is cracking down on the way stock options are accounted for by corporations in their public filings. The US department of justice is busy cracking down on private monopolies like Microsoft. God knows I've missed some.

One crackdown after another. But boiler rooms didn't pop up simply because there were too many bad apple baby boomer offspring.

The industry thrived in an environment where valuations were distorted to promote equity investment and enterprise above almost all else. There is a direct connection between the process of inflation and the deterioration of participants' moral codes, or integrity, at least in theory. Inflation has been shown to be an unjust redistribution of wealth long ago. Of course those who manage it are corrupt. Or if not, they are idiots because such a system has been found to be corrupt as well as breed corruption. The aforementioned crackdowns might as well be Exhibit A.

If the growth of the financial services sector, for instance, came about as one of the products of the inflation, it wasn't real, but rather, it was artificial growth. Austrians would call it malinvestment. Some writers refer to the concept as overinvestment or even worse, overproduction.

In other words, if people valued equities above other assets as a consequence of the Fed's activities, the structure of the entire system of production would have to shift to accommodate demand that wasn't sustainable. In the process, the system would (unwittingly maybe) accrue a share in the future liabilities arising from the inevitable correction of market imbalances, which arise from the inability of the Fed to sterilize its policies. If a central bank's activities can shift the risk premium away from equities, why wouldn't we expect the result to be a set of incentives for the promoter classes in the economy?

To the extent that the Fed can be accountable for financing the bull market euphoria, it has indirectly subsidized the promotion business. The plain fact is that "boiler rooms" could not survive in a market that isn't subsidized by a sustainable inflation, at least not on such a large scale. The reason is the market conditions necessary for their existence could never exist for long enough to keep them out of trouble.

Similarly, an oil crisis didn't arrive because the oil industry is ripe with manipulators. What has happened to our collective literacy today? We've known for years that the government's regulatory thrust has created bottlenecks within the energy sectors, as well as the fact that declining production rates in the U.S. over the past thirty years are tied to physical constraints defined by Hubbert long ago.

We could easily blame the Fed for inflation policies that created excess consumption of this commodity as well as the way in which they've affected the value of the dollar in the eyes of major US oil suppliers receiving it in lieu of payment over the years.

How the Fed inflation affects the government price indexes is of no consequence to the way it affects oil. In fact, we've known for years that inflation affects each price in the economy differently and at different times.

Inflation manifests in many ways but it affects (distorts) the valuation process along the way. When the price of something rises relative to another thing it is because the participants in an economic system value that item (good or service) increasingly higher. If that change in valuation is induced by real changes in consumer tastes or preferences the structure of the economy will change in a way as to accommodate the change in tastes. In this way the free market system knows what to produce.

But when it is fooled into thinking it knows what it wants by forces that aren't all that sustainable, the new economic structure turns out to be wrong. If inflation is the source of the moral hazard, its ultimate manifestation is likely to be in the debasement of the currency.

Of course, investors' eyes are way off the ball. Inflation has been accepted over the past 2 decades to mean the rate of growth in certain government price indexes. This way, inflation is only a problem when the government reports that the various price indexes are growing rapidly.

Consequently, we can no longer blame the government for the affects of inflation on anything but prices because we don't measure inflation any other way. So long as prices are "under control" we can't pin the blame for widespread corruption, financial sector volatility, malinvestment, over regulation, accumulating economic imbalances, rising unemployment rates, failing global relations, worsening national default rates, or even select price distortions on inflation; for price distortions only exist in the first place when the prices that the government reports all rise at the same time.

We can't even properly allocate the blame for the government's deteriorating budget if our eye is on the wrong ball.

Certainly, the government's expenditure outlays anticipate the success of inflation in ultimately increasing its tax revenues. But if in our minds we've redefined the term inflation to apply only to specific price indexes, we'll see the government's expected outlays as confidence in a revival of the economy.

There is a difference between anticipating the revival of an economic expansion and the revival of an inflation cycle in far-reaching implications.

Not surprisingly, investors seem to be confused about where to pin the blame today.

The sideshows and witch-hunts have been drawing fanfare. They were predictable. In fact, so much so that they're largely boring and old news to us. For instance, the proper accounting for stock options is important in the right context, but otherwise irrelevant in determining appropriate valuations today. Perhaps "redundant" would be the better word.

The question is why doesn't any of this ever happen on the way up? Could we point to these belated trends (backlashes) as proof of the extent of the malinvestment and equity overvaluation? If yes, the blame can be easily identified by asking the simple question, which has more influence on valuation in the stock market, the accounting for options or the inflation policies of the Fed?

Why is it that while stock prices are appreciating we can look at the poor practices of Wall Street firms, and know nothing will be done about them until we're on our way down? The answer is simple. Delusion. But nobody admits to being part of it even well after the factů in many cases not even to themselves.

It's a matter of mass psychology. In a bull market, investors treat news like we are seeing today with skepticism, doubt, and contempt, if they don't ignore it altogether. Is somebody going to try and tell us that the issue of the proper accounting for stock options wasn't discussed during the bull market years of the late nineties?

In fact, I remember discussing the impact on employment costs and wage prices that would arise under both conditions - a bull & bear market - as a consequence of the growing use of this form of remuneration with my own clients way back when.

For those whom these crackdowns are news, the stock market is probably not seen as overvalued in the first place. But then we know that a bear market can't endure if everyone has already discounted the bad news like the lead bears have. The bears need to eat something.

I'd like to invoke an analogy that was written once by one of the stock market's legends (either Ben Graham or Gerald Loeb) where he likened the market to a still pond. As a stone, representing the information I presume, was thrown into the water, the impact from the stone would cause waves, or circles, which grew from the center outward. Each one of these circles represents information being passed to the next group, and the next, resulting in larger circles, or waves. This is a bull market.

Academia, mostly, argues that this can't really be since market values presume that all information is already discounted. Many technical analysts concur.

I don't. Not at all is the market efficient in my own experience, for whatever that bit of anecdotal evidence is worth. The controversy over stock options and other overly ambitious accounting tactics has been in the public domain for years. If the market is only discounting it now, how can it be efficient?

Another example of the market's general inefficiency could be the leverage the Fed enjoyed while gold prices fell. The declining price of gold could very well be the chief motivator helping many investors to delude themselves into seeing inflation as under control. I know that sounds arrogant, but it's not really.

Ask any layperson what inflation is? The answer will be straight out of the Fed's own handbook on how to perceive the world their way; that is, if the person questioned even knows the answer in the first place.

And while few journalists have the gall to accuse the government's banking cartels of gold price suppression, many professional traders in private know very well what the motives would be, even if they stay in the closet on those views.

Back in 1999 analysts were well aware of how the gold industry's hedging programs would ultimately reverse because they were broadly overdone. Today's unwinding of many hedge books is news to many, but only a milestone to us.

As the bull market in gold grows, investors could become more confident about what they already know, and closet gold bulls should feel safer coming out of the closet. What investors believe and take for granted today they might not believe tomorrow, and vice versa.

If they believe the government's definition of inflation, and gold prices rise such that the bullion banks lose money and investors get it in their pocket books the credibility of the Fed will decline, and the circles in the golden pond will simultaneously grow ever larger.

One day far off into the future, when this discussion is no longer seen as contrarian, the public will crackdown on the FRB, one way or another. When that day arrives the majority of people will treat the event as news. The primary bull market in gold will be in full swing and questioned only by perma-contrarians looking to call a top. We cannot tell how many circles will be left to grow in the bull market at that point. But we can predict the market to be discounting what we already know today.

What do we know today? We know that US asset market valuations are distorted, largely as the consequence of runaway and unsustainable (money & credit) inflation, which is in the process of breaking down now. We think we know the dollar is losing its position as the premier global common medium of exchange, and that its position was also the result of unsustainable forces. We know that inflation is not under "control," and we are confident that runaway price spirals and commodity shortages are inevitable in the not so distant future.

We know that it is only a matter of time before the public cracks down on the enemy from within. We are confident that the major banks will see more scrutiny for their gold hedging as well as other derivative activities, and that more extraordinary write downs will occur as these markets move against their off balance sheet positions.

I know - who are we to know anything? We don't really. But we've been right so far without knowing much about anything. I think that if you came back to this page in 2 years time, you'd find that the market is still discounting the 2 paragraphs before this one. After all, it is a big rock that's landed in this pond.

Ed Bugos

The Goldenbar Report: is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you to confirm the facts on your own before making important investment commitments.