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Economic and Market Commentary

Half Brainer


here was a pretty good Steve Martin movie in the early 90s entitled The Man with Two Brains. I’ve always remembered the title because at the time, I thought that his character probably had four times as much gray matter as I did. Now as you’ve probably already computed, 4 x 1 normal brain = 4 brains not 2, so the correct mathematics must imply I have half a brain which, as it turns out dear reader, is the frightening truth. Not to imply that I’m a nitwit or anything because I am actively involved in managing your financial nest egg, but brains, as I’ve learned, are divided into left and right hemispheres. A recent MRI scan, though, verified that I have absolutely no right side to my apparently otherwise normal brain. After viewing the initial image my startled nurse appeared on the verge of calling 911 or using one of those secret paging codes like “ Dr. Death to the X-ray room stat.” I quickly told her, however, that this was what I had suspected all along – that in fact I have no right side to my brain: can’t draw, can’t paint a picture, coloring within the lines is an excursion in total futility. This I know is hard to fathom, but as further proof, my self portraits have never really progressed beyond the level of stick figures, and to this day, I still have to be reminded to give them fingers and toes. 

Imagine, then, the jealously and envy I harbor for all of you with two complete halves to your brains. And imagine the feeling of right-sided impotence I have when meandering through an art gallery or leafing through one of those giant-sized art books lying on my family room coffee table that are really meant to impress visitors instead of frustrate me. Well, you need feel sorrow and empathy for me no longer, because while it’s true that even advanced genetic biology will never be able to grow a half brain for me on the outside of a mouse or a dog or whatever, I have at least discovered a kindred spirit – a half brained twin who can’t draw or paint either. And the most remarkable thing about my discovery is that this twin is (was) an artist – and a famous one to boot. 

Yves Klein is the name of my half empty-headed friend and (1928-1962) follows his title on two spectacular pieces listed in a recent Christie’s twentieth century art sales catalogue. The “1962” points out I guess, that he’s dead which is too bad, because it makes it harder to compare notes, but wow, I mean wow, this guy painted like I draw self portraits, and he got paid for it too! I present to you the first of his two images for your perusal and careful discrimination.

This tour de farce was titled “IKB” and consisted of “pigment and synthetic resin laid down on panel” as Christie’s described it. 8 1/2  x 7 inches, too, which is important in the art world, but which in this case might be otherwise described as a tad “puny.” Nevertheless, it sold for $35,000 because, I assume, Mr. Klein’s blues were the bluest of all possible blues. No elephant dung here, Mayor Giuliani! Just step back, your honor, and drool at the creativity of this canvas.

As further proof of the artistic ability of my half brained twin, I present for you another of Mr. Klein’s creations, the better known (17 x 14) piece entitled “IKB 121,” priced at $150,000 no less.

Well now, if that’s not the clincher. This guy was truly a painter extraordinaire. Mr. Klein, as it turns out, called himself “Yves le monochrome” and I can surely see why. When you’ve got a niche, exploit it, Yves must have figured. I can’t pronounce French very well so when I try to reach my half spirit in séance-like dreams, I just address him as Mr. Blue. “Mr. Blue,” I ask, “where, oh where, in the art world is my niche?” The following was his suggestion that I now lay before you for critical acclaim:

What I should have expected, I suppose. But as his ghostly voice faded into the distance for perhaps the last time, I heard him say – “I got a monopoly on the blue, kid. Why don’t you try red? And next time, don’t forget the fingers.” Half brain. Some kindred spirit, he was.

Oh, what should a nitwit write about this month, as he applies the functional left side of his brain to the current state of the investment markets? So many topics, so little time as the saying goes. Being a bond guy, I am prone to see those topics as drinking glasses that are half empty instead of half full and to expect Goldilocks to wake up any time now from her temporary nap, instead of sleeping through the night, filled with sugarplum dreams of productivity miracles and escalating NASDAQ capital gains. That expectation, in addition to my empty right-sided brain, I suppose, is my professional handicap – so you should take that into consideration as you analyze the following. But it seems to me folks, that this state of nirvana can only keep going for so long. For despite the positive impact of technology on our economy and financial markets, almost all of you with commonsensical left-sided brains must know that we have a bit of a Ponzi-scheme going here: at least some of our prosperity is based upon prosperity itself. A very FDR-ish thought, don’t you think, but perhaps just as relevant today during years of plenty, as was Roosevelt’s during times of despair. It’s another way of saying that the market “tail” is now wagging the economy “dog” instead of vice versa. We must have double-digit gains in stock prices in order to support existing levels of consumer and investment spending. We must have more and more Cisco’s in order to maintain foreign sponsorship of a grossly overvalued dollar. We must have red hot IPOs aplenty in order to divert serious analysis of a current account deficit that now exceeds 4% of GDP and which would be viewed as an emerging market Achilles heel were it not for the fact that our stock market makes such concerns disappear. Poof! If Christie’s could convince someone that “Yves le monochrome” was a distinguished artist, then I suppose a throbbing stock market can be enough to convince most of the world that all of this can continue indefinitely. It can’t. When the music stops, nobody knows, but it will stop, and for legitimately left-brained reasons. 

Ponzi’s scheme, you’ll remember, collapsed at a critical point when the inflows he was using to pay for the outflows were just not enough. Word spread that a few investors were missing their monthly interest payments, which led to withdrawals, further cash flow squeezes and ultimate collapse. Now, the U.S. economy and its stock market is not a Ponzi-scheme. People are working hard and working smart and we are in the midst of a technology boom. But there are Ponzi-like elements in the current environment which could stop the music quite abruptly, the major one being the stock market itself. When it stops going up at the rate investors have grown accustomed to, then the process reverses and the headaches begin. Note that the prior sentence didn’t even talk about the stock market going down. All that is needed to set off that initial spark is for the market to disappoint expectations.  

Take a look at the following chart for an explanation why.

Private Net Savings as % of GDP
Figure 1 is a line graph showing U.S. private net savings as a percentage of gross domestic product, from 1960 to 1999. The metric shows a steep decline in recent years, falling to about negative 4.5% in 1998, down from around positive 5% in 1990. From 1960 to 1990, private net savings fluctuated between 0% and 6%. The metric breaks out of that range to the downside around 1996, falling below 0%.
Figure 1
Source: Bureau of Economic Analysis

This graph displays private net saving as a % of GDP and at first blush may seem to have little to do with stocks themselves, but the two, it turns out, are linked at the hip, and have as high a correlation as Klein’s “IKB” and “IKB 121.” When private net savings falls abruptly into the minus column, as it recently has for the first time in over 50 years, it means that spending is exceeding income. In 1999, U.S. consumers are spending nearly 5% more than they earn via wages, dividends, and interest on their investments, the difference being provided by increased debt and realized capital gains which are not considered to be part of net savings. Now here’s the critical rub. Some will claim that capital gains are as sure a thing as the sun rising in the East, and that has surely been true. If so, then maybe we should mentally adjust savings, and therefore spending assumptions to reflect a more modern, realistic attitude. Well, maybe. But even so, unless stocks keep going up at the same rate as they have in the past – unless capital gains keep accumulating at the same double digit rate they have in recent years, then the growth rate of consumer spending will fall, the growth rate of profits will decline, and the growth rate of the economy itself will slow down. An economy that feeds on capital gains must cool off if those capital gains do the same. Our prosperity, to return to the same phrase, depends on prosperity itself, and at least some of our prosperity depends upon a booming stock market.

History shows that the current state of affairs cannot continue indefinitely. Other countries such as Britain and Japan in the late 80s, have experienced the same negative net savings trends as seen in Figure 1, which were really glorified spending binges based upon asset bubbles. When the bubbles stopped expanding and eventually popped, the savings rate returned to the plus column, slowing their economies and eventually producing serious recessions. Recession need not be the eventual outcome here in the U.S. as we approach the new millennium. We could back off gently as is Greenspan’s hope and intent as he tries to slow the stock market down. But much of the ultimate conclusion rests not just in his finely skilled hands or acutely tuned left-sided brain. Because we are spending so much, foreign investors in dollar denominated stocks and bonds have a big vote in deciding the verdict - they hold more and more of the IOUs. If they decide to cash them in rather abruptly, as opposed to accumulating them at a pace reflective of our spending habits, then the dollar will decline, inflation will rise, Greenspan will raise rates, the economy will slow. Why would they ever cash them in? Lots of reasons, but as this Outlook suggests, a faltering stock market leads the list. Without a prosperous stock market, it all can come undone rather quickly.  

So here’s to stocks, and here’s to the good life based upon escalating capital gains. As long as they continue to go up at 20% annual rates, Uncle Ponzi will have enough cash to keep the good times rolling. If they don’t, well, as P.T. Barnum, Ponzi, and Yves Klein knew, there’s a sucker born every minute and someone willing to take his money as well. PIMCO’s money continues to be directed into high quality areas with an eventual expectation that yields will or have peaked in the 6 1/2% area for long U.S. Treasury bonds. Those expectations, while uncertain on timing, are conditioned upon the ultimate exposure of our Ponzi-like prosperity for what it is: Part real, part illusionary, but certainly not monochromatic or even monolithically destined to continue at the same pace forever. “Yves le monochrome” would surely be disappointed. Until next month, so long – 

William H. Gross
Managing Director


No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.
This article contains the current opinions of the author but not necessarily Pacific Investment Management Company, and does not represent a recommendation of any particular security, strategy or investment product. 
The author's opinions are subject to change without notice. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
This article is distributed for educational purposes and should not be considered as investment advice or an offer of any security for sale. Past performance is not indicative of future results and no representation is made that the stated results will be replicated. Copyright ©1999-2003 Pacific Investment Management Company LLC. All rights reserved.

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