W
hile Dulles waited, he re- called an old comedy routine from decades ago.A fellow on a 1930s breadline asks his neighbor: “Which do you prefer? Inflation or deflation?” The second man responds:
“Just give me flation. Plain, unvarnished flation.”
Unfortunately, however, the public’s longing for price stability—
neither inflation nor deflation—was not satisfied in most economies of the world throughout history.
In the second half of the twentieth century, inflation was nearly everywhere. There was wage-push inflation, demand-pull infla- tion, and inflation-driven inflation. There was creeping inflation, galloping inflation, runaway inflation, and hyperinflation.
Then, as the century ended and a new one began, for the first time in more than 60 years, an old but powerful force reared its head and began to pound key regions or sectors of the world econ- omy. It was deflation—falling prices, the opposite of inflation. Ironi- cally, however, it was largely ignored. Most people were too deeply engrossed in their daily battles to sense the winds of change.
Commodity deflation had been around for a long time. But consumer price deflation, the kind that average people feel directly
166
Deflation! 167
in their lives, first appeared in a big way overseas—in 2000 and 2001.
In Brazil, a brand new VW Passat, which used to cost $15,000, was going for less than $7,000. Brazil’s VW Santana, another pop- ular sedan, cost even less, with the cheapest model below $5,000.
Luxury condominiums were reduced from $150,000 to under
$80,000.
On the other side of the world, in Japan, the deflation was more widespread and more persistent. For much of 2000, 2001, and 2002, Japanese consumer prices tumbled virtually nonstop. A hamburger fell to half of what it cost a year earlier. Cotton polo shirts were 60 percent cheaper. Real estate was down 50, 60, even 80 percent in key areas.
In North America of 2000 to 2002, however, deflation was more spotty. Some prices, especially housing and health care, were still rising, while prices in other sectors, such as technology, were plunging. The going price for registering an Internet domain name fell from $70 to $7. You could buy almost-new computer servers made by IBM, Compaq, or Sun for 30 cents on the dollar. The price of a 128-megabyte dynamic random-access memory chip (DRAM), used in virtually all personal computers, plunged from
$14 to $2 in just 10 months.
“Deflation!” Tamara repeated to Dulles, as she returned from her phone call. “Yet most people don’t even know what it is. They think it’s the same thing as depression. But you and I know it’s not.
It’s falling prices, which may or may not happen as the same time as a depression. Falling grocery prices. Falling rent. Falling salaries.
Everything falling.”
“That’s frightening,” said Dulles.
“Yes. But are lower prices and cheaper goods such a bad thing in the long run? Not necessarily. Yes, deflation is part and parcel of the short-but-ugly scenario, but that same deflation is the key that makes the subsequent recovery so feasible. Why? Because the pur- chasing power of the currency—the dollar—would be restored.
Because average people who work hard to save a relatively small amount of money would be able to buy a lot more with that money, and would reap the fruits of their labor. The crux of the problem is”
168 Crash Profits: Make Money When Stocks SinkandSoar
“Yes?”
“The crux of the problem is that deflation also happens to be the one thing that nearly everyone in government and industry seems to fear the most. It’s politically unacceptable.”
“Agreed.”
“There’s no doubt that runaway inflation is far, far worse than deflation. And yet, at some point during Scenario B, inflation returns with a vengeance, and it’s a killer. It erodes productivity. It corrodes the fabric of society. It jinxes the chances for recovery.”
Lesser of the Evils
Dulles pondered the dilemma. What Tamara was saying was so true, no economist could possibly disagree. Deflation was clearly the lesser of the evils, and for all those with savings or stable earn- ings, it could even bring significant advantages. Nevertheless, in the highest pinnacles of Washington, Wall Street, and Main Street, deflation also happened to be the most feared of economic forces.
He knew why. The people in power had much more to lose. The average citizen had less to lose and possibly a lot to gain.
“How does deflation play itself out in your short-but-ugly sce- nario?” asked Dulles.
“The kinds of price declines you’ve seen sporadically in certain sectors begin to spread. I told you earlier about the vicious circle between bankruptcy and deflation. Well, as a result of that vicious circle, nothing is spared from price declines. It even impacts items that people think will never go down—a doctor’s visit, college tuition, a New York City subway token.”
“That reminds me,” Dulles remarked. “I asked for more evi- dence on the deflation and bankruptcy thing, but you never gave it to me.”
“Sorry. Here’s a clipping from a while back. Let me read this short passage: ‘As the number of bankruptcy filings by public com- panies surges to a record, companies are increasingly being forced to liquidate instead of reorganizing . . . to sell pieces of their busi- ness to the highest bidder.’ ”
“And that was when?
“November 11, 2001. See? Even back then, it was beginning in
Deflation! 169
a few sectors. Rather than using bankruptcy as a way to fix their balance sheets, many companies were simply closing shop and selling off their assets. They were selling inventories, receivables, real estate, equipment, furniture, technology, customer lists—any- thing for almost any price.”
“So?”
“So in Scenario A, that kind of selling produces deflation of the meanest variety—the kind of deflation that spreads with fury. The kind of deflation that takes even the savviest of economists by sur- prise. But it’s over relatively quickly. And once it’s over, the crisis is really over—no hidden land mines that will blow up months or years later.”
Dulles thought back to his accounting days. “So it’s a positive long term. I see that. But can’t also be a positive short term? Let’s say I run a business. Doesn’t that mean I can count on lower labor costs, lower material costs?”
“Short term, negative; long term,positive.”
Dulles closed his eyes briefly. Tamara is right, he thought. For every dollar of cost reduction, the typical business would suffer $2, $3, or
$4 in profit losses due to deflation.
The CPA remembered one computer-server manufacturer that they used to consult with. He wasn’t on the auditing team, but he was familiar with the numbers.
In one year, on one particular line, the manufacturer sold an average of 1,000 units per month for roughly $4,000 each. Total monthly sales: $4 million.
In the following year, it was selling only 700 units per month, a 30 percent drop from the previous year’s rate. That was bad enough, but then came the deflation: The company was battered by a 50 percent decline in the average price of each unit—to about
$2,000 each. Result: Revenues got slaughtered—from $4 million to a meager $1.4 million.
Sure, the cost of components also declined. But marketing and overhead costs barely budged. Before, when it was selling the servers for $4,000, the manufacturer’s total expenses per unit were
$3,500—a profit of $500 each. Now, although the servers were sell- ing for $2,000, the per-unit expenses were still running at about
$3,000—a $1,000 loss on each sale. The more business it did, the more it lost. “We’re losing money, but we’re making it up in
170 Crash Profits: Make Money When Stocks SinkandSoar
volume,” was the common PR line. Losing money but making it up in volume? What a crock of BS that was! Yet, this was typical of what went on in the tech industry of the 1990s.
Now, the short-but-ugly scenario laid out by Tamara Belmont was all about a similar pattern spreading to the entire economy.
For the first time, Dulles was beginning to feel he could get com- pletely behind this scenario. He asked Tamara for three copies of her full report, telling her he would take it to Johnston himself and go through all the points in great detail. She seemed very pleased and went back to her office.
Dulles swiveled his chair around and stared out the window to 14th Street. What was the best way to approach Johnston? It clearly had to be the technology price deflation.That had been John- ston’s home turf. He knew all about it, and they had talked about it frequently in the past. Even before Johnston resigned from UCBS, technology price deflation had clearly begun to slice through all of the various divisions—and was probably stillwreaking havoc in the company under the new management.
Yet most people outside of the industry—even many inside the industry—didn’t realize how serious the technology price decline would be for the companies. They didn’t realize that it had been an important factor behind the worst collapse in corporate profits since the Great Depression (every penny of the totalprofits earned by 4,200-plus Nasdaq companies after mid-1994 wiped out), the largest single losses in the history of the world ( JDS Uniphase and AOL), and the greatest and fastest destruction of investor wealth ($5 trillion lost in the Nasdaq in just 11 months).
He looked again at Tamara’s chart showing the total wipeout of corporate profits among the Nasdaq companies. Certainly, one reason was the accounting manipulations. The profits weren’t there to begin with. So when the big accounting revelations came to light, the mirage dissolved with the sunshine. But deflation was the other big factor, the factor that few people were talking about.
Deflation was the nightmare of the tech industry. Now, in the short-but-ugly scenario, it would become the nightmare for other industries as well—autos, appliances, housing, even services. It would come as a total shock, for no one would be expecting it. Yet, in the long run, it would be one of the crash benefits.
Deflation! 171
Tamara had linked it to bankruptcies, and Dulles sensed intu- itively that she was right on target. Indeed, thinking back, he remembered that most of the failing companies he had known as a consultant got hit by deflation in one form or another. They had big debts coming due every day. But they were living from hand to mouth. So they were counting on ever-higher prices and ever- larger revenues to acquire the cash they needed to repay those debts. Then it happened, like two colliding freight trains: debts and deflation. And the company was history.
His thoughts went back to some of his own research—loose ends that had mystified him but were now beginning to make more sense.
No wonder so many investment grade bond issuers (triple-B or better) were being downgraded to junk status (double-B or lower)—
American Greetings, Providian Financial, Lucent Technologies, Royal Caribbean Cruises, AMR, Delta, plus dozens of other listed companies!
No wonder so many junk bond issuers were defaulting in record numbers! Bethlehem Steel had defaulted on $179 million in bonds, gutting the portfolios of thousands of investors. Swiss Air had defaulted on 1.5 billion, destroying the wealth of thousands more.
Banana producer Chiquita had defaulted on $700 million in debt.
Wireless data provider Metricom—$300 million in high-yielding 13 percent bonds that were due in 2010. Apparently 13 percent had sounded great to thousands of investors. But what good had it done them? They never got paid!
Financing Dries Up
Dulles then thought about the financing problems many of his for- mer clients were now facing. Even if they were in relatively good shape, they would now be having trouble raising money.
Where and when did that start? he asked himself. He quickly remembered: In venture capital. Everyone knew someone who had had lost fortunes on IPOs for companies that no longer existed. What people didn’t know was how many supposedly
“smart” venture capitalists fared even worse.
172 Crash Profits: Make Money When Stocks SinkandSoar
Indeed, in 2001 and 2002, venture capital firms had experi- enced their worst years in history.New investment capital put up by venture capitalists plunged by an incredible 62 percent in 2001, and by an additional92 percent in 2002.
He remembered back to 1999. That’s when Chase Manhattan broke into venture capital by buying up the small cap investment banking firm Hambrecht & Quist. Later, even after the Chase merger with Morgan, the company was still suffering the conse- quences of the H&Q disaster.
He recalled the case of Safeguard Scientifics, one of the few publicly traded venture capital firms. This was a firm that had a stellar and colorful 50-year history. But none of that made a bit of difference when the Internet bubble popped, driving Safeguard from $99 a share to $1.03 in October 2002.
Nor was this just a “dot-bomb” phenomenon. The same pattern of disappearing financing that struck down dot-coms was now beginning to hit almost every industry in America. In both worst- case scenarios, bond investors would withdraw from any company that did not have stellar ratings. Big banks would recoil in horror from the new, heightened risk of making additional loans to com- panies that were already overloaded with debt.
Dulles wondered whether it was, in fact, already beginning.
Wasn’t it Wachovia Bank that had publicly announced it would be stricter with loans to airlines, aircraft parts suppliers, hotels, and food suppliers to restaurants on the East Coast? Hadn’t Bank of America shut down a crucial credit window on commercial con- tractors?
If this was already happening, what would happen in one of Tamara’s scenarios? He could easily see nearly all banks limiting the size of offered credit lines, increasing fees, and requiring more collateral. He could see credit windows closing everywhere and the lights going out at companies that relied on that credit the way addicts rely on drugs.
Just as in the tech companies and the telecoms, nothing could sink a credit-addicted company more quickly than cold turkey—the sudden withdrawal of that credit. So far, though, the credit squeeze was primarily felt by small- and medium-sized companies. Big blue chips still had access to new credit.
TE AM FL Y
Team-Fly®
Deflation! 173
Art, Antiques, and Collectibles
Dulles also thought about his own favorite assets. He wasn’t wealthy. But he was a collector of some art and antiques. He remembered reading that, back in the 1930s, when wealthy fami- lies ran into a cash pinch, they’d auction off rare art and antiques for pennies on the dollar. Similarly, after the Crash of ’87, art and antiques at major auctions fell as much as 30, even 50 percent. The plunge didn’t last very long. But it illustrated how susceptible those items were to deflation.
If Tamara’s deflation scenario came true, what would happen to the price of a Tiffany Favrile floor lamp? A 1918 U.S. airmail Cur- tis Jenny stamp? An autographed Jackie Robinson baseball card?
A Ming Dynasty vase? They were all vulnerable to steep plunges, much like the stock market.
Would price declines be sporadic or across the board? Would the wealthy buyers in America, Japan, Hong Kong, and the Middle East be affected? When deflation struck their businesses and other assets, would it force them to sell too? It was certainly possible.
He began to envision deflation as a snowball, feeding on itself as it rolled down a mountain. It would be no different than the selling frenzies he had already seen in the stock market: Prices would fall because people were selling . . . and people would sell more because prices were falling. They would sell for all kinds of reasons—perhaps because they were driven by their inner psyche or pushed by exter- nal pressure, or simply because everyone else was doing it.
Dulles prayed neither worst-case scenario would come to pass, but if he had to choose between one or the other, he would clearly choose Scenario A, short but ugly. “Get it over with! Don’t drag it out! Let’s move on to better times!” he whispered to no one in par- ticular.
The Danger of Higher Yields
One reason Linda Dedini was so interested in the discussion in Dulles’s office was that she had a key concern regarding money markets, bonds, CDs, and so forth. When she realized that none of
174 Crash Profits: Make Money When Stocks SinkandSoar
these was a primary topic, she left. Besides, she had a 1 P.M. with her adviser, and traffic on the parkway to Baltimore was always uncertain.
While driving, she refocused her mind on the strategy she was seeking to develop—a strategy that would give her the higher yields she needed withoutthe higher risk.
“These Treasury bills are killing me,” she said to the adviser via her cell phone, after alerting him that she was running a bit late.
“No, I’m not complaining. Thank God I’m not losing money any more. But look at these low interest rates! They’re a rip-off! Plus, I have to pay income taxes on the interest, right? Then, I have to cover inflation. What’s inflation running now?”
“Maybe 2 percent. Maybe less.”
“That doesn’t sound right to me. But OK, we can talk about it some more when I get there.”
She parked the car in his driveway, walked to the door, and rang the bell. As they walked back to his home office, she picked up exactly where they had left off. “I don’t believe those low infla- tion numbers that the government keeps putting out. My insurance bills are going up by a helluva lot more than that. They just jacked up the kids’ school tuition again this year. It’s nonstop.”
“What about deflation?” asked the adviser. “Have you ever thought of that prospect? With deflation, even if you make zeroper- cent, the value of your cash is growing, perhaps by leaps and bounds. You’ve already seen it in the stock market. For the same dollar, you can now buy four times the number of UCBS shares you could buy before. You’ve already seen it with PCs. You can buy 10 times the computer power for one-fourth the price of just a few years ago. How much deflation is that? Something like 97 per- cent deflation? Someday, you could see it spread to your grocery bills and even your electric bill.”
Linda was not at all convinced. In practice, she simply did not see it. “That’s conjecture,” she said. “Right now, I absolutely have to do better than these Treasury bills. So here’s my idea. I find cor- porate bonds rated, say, triple-B. That’s still pretty secure, right?”
“Yes, that’s the lowest grade of bonds that are still considered nonspeculative—‘investment grade.’ Anything below that, like dou- ble-B or worse, is considered speculative or ‘junk.’ ”
“Good. Then I get the triple-B. If they’re downgraded below