Gekko

We're being presented with a pretty stark choice these days by the competing brands of financial forecasters. On one side are the "new paradigm" people, led by techno-optimists such as Wired magazine, some Forbes editors, and the Weekly Standard. Then there are the prophets of doom, including Jim Grant and his Interest Rate Observer crowd, Norman Macrae, the former deputy editor of the Economist, and naturally, the gold-bugs and short-sellers who are still alive. The question is this: Are we in a replay of 1929 or at the beginning of the Age of Aquarius? Does the "technology" revolution mean that the business cycle has been repealed?

No. It doesn't. I put the word technology in quotes because new-paradigm people seem to forget that there have been technological revolutions in the past. For example, the electric motor and the automobile -- which respectively revolutionized the supply and the demand side of American life in the 1920s -- did not change human nature. Manufacturers using decentralized power sources still overbuilt their plants, and newly mobile consumers overborrowed for houses and goods and overbought stocks. The U.S. Government, which at the end of the decade was presided over by one of the best educated, most accomplished social planners of the century, still didn't know what was going on in front of its very eyes.

That sounds kind of crusty and anti-progress, so let me add that the doom-and-gloom crowd I usually hang out with are often wrong in some important ways. The new-paradigm people are right that the relative importance of commodities and physical products has been reduced by the increased effectiveness of computing and telecommunications technology. The fraction of our GDP contributed by commodities has fallen in half, from roughly 20 per cent to 10 per cent, since the commodities price inflation of the early Seventies. So even if Jim Rogers is right, and we're about to pay much more for our copper, nickel, coffee, and soybeans, it doesn't matter as much as it once did. Real value is added to our economy and lives by those biotechnology companies with risky balance sheets. American military potential, and our ability to enforce a semi-peaceful state, is enormously enhanced by our technology and industrial base. The American version of economic reform and corporate governance has become the conventional wisdom throughout the world.

All that means that when trouble comes, it will not be in a the same form as in the past. And again, technological change matters, but not as much as human nature. If markets have more to do with capitalizing the cash flows from technology companies than from resource companies, they still will overshoot on both the upside and the downside. The fantasies of war without casualties are as old as war itself. If we want to remain a world power, let alone a superpower, ground troops will have to eat mud and dust and get killed while they're killing even more of our future enemies. And "the trouble with prosperity," in Jim Grant's phrase, is that it lowers our guard against unforeseen and unforseeable events.

More specifically, while I do not think we are right up against a depression, I do think we are going to get a big drop in the price of equities. The increased diversification of American investment, which means we own a lot more Brazilian, Russian, and Indonesian paper than we once did, won't protect investors as much as they think, because those "uncorrelated" world markets are moving much more in synch with each other than they once did. I don't know what event will trigger the decline, but there are a lot of possibilities, since stock prices now reflect a common perception of the economic future that is not consistent with historical experience.

Look at just one component of the valuation of equities: analysts' expectations of future earnings. Right now, near the peak of the U.S. business cycle, the current profit growth estimates that stock analysts are using are in the 85th percentile of the experience over the last thirty years. In other words, earnings hit or exceeded the market's current assumptions only 15 per cent of the time, which means stock investors, especially those who invest in a broad cross-section of the market, are betting the ranch on an unlikely outcome. The last time U.S. corporations' earnings turned in as good a five-year record as they just have was between 1962, the first year of a profit recovery, and 1967, just as Vietnam - Great Society inflation was kicking in. So we would have to repeat that record to justify these equity prices in terms of future earnings. Maybe. And maybe you'll win Lotto.

It's when you look at the most likely risks that the debate gets hot. Personally, I think that the people who have the illusion they are in charge of the world's economies have all been preparing for the last war. In the States, for example, we are well prepared for another domestic banking crisis. The bankers know that if they lend to crooked, overleveraged real-estate developers in Houston, they are asking for trouble. Regulators, of course, are on the lookout for high-flying leveraged-buyout specialists. Capital ratios for our banks are much more rigorously monitored than they were in the past. When consumer lending got out of hand about a year ago, chargeoffs were forced and standards tightened.