Based on its strong financial performance, Herbalife is a classic “compounder” – a well-managed company that sustains consistent top-line growth, has a leading market position, and steadily increases margins, earnings per share and free cash flow while demonstrating shareholder-friendly behavior. …Led by CEO Michael Johnson, management has also used the company’s ample free cash flow to de-lever its balance sheet and shrink the share count by nearly 25%. This type of steady non-cyclical growth is hard to find and puts Herbalife at the head of the compounders’ class.
With results like these, the case against Herbalife rests on a bold claim that the company is a fraud. The short seller’s lengthy argument against the Company can be boiled down to three principal smoking guns: the first, a claim that Herbalife has been operating an “illegal pyramid scheme” under the nose of the Federal Trade Commission for the past 32 years; the second, that Herbalife’s loyal customer and distributor base has been exploited and harmed despite the low number of consumer complaints and generous company return policies; and the third, a claim that Herbalife’s products are commodities sold at inflated prices not supported by sufficient levels of advertising or R&D.
Taken in reverse order, the third claim misses an essential truth that invalidates the indictment. No one believes Starbucks is a scam because you can buy a cheaper cup of coffee at your local bodega. A key contributor to Herbalife’s growth has been its distributor-led “Nutrition Clubs”, where consumers can purchase single servings of the Company’s signature beverages. The short seller’s assertion ignores the significant value customers place on every consumer brand and its community “experience” – whether at a Herbalife Nutrition Club, a Starbucks, or a corner bar. The markup is merited by community and brand identity, not by the commodity itself.
(Editor: in disclosure, I am long HLF but not as aggressively as Mr. Loeb. Is HLF a franchise because of its brand? But a brand has no meaning unless there is customer captivity. Does HLF have customer captivity?)
The second claim seems similarly dubious. The FTC, by all accounts, receives a very low volume of complaints annually about Herbalife – fewer than forty per year. ….The Company repurchases an average of only 1% of sales volume pursuant to this policy. It is difficult for us to understand why the buyback volume would be so low if there are in fact so many unsatisfied consumers and distributors who presumably would not hesitate to be reunited with their cash.
The pyramid scheme is a serious accusation that we have studied closely with our advisors. We do not believe it has merit. The short thesis rests on the notion that the FTC has been asleep at the switch, missed a massive fraud for over three decades, and will shortly awaken (at the behest of hedge fund short seller) to shut down the Company.
Applying a modest 10-12x earnings multiple suggests Herbalife’s shares are worth $55-$68, offering 40-70% upside from here and making the company a compelling long investment for Third Point.
Herbalife Battle: Great Theater, Terrible Trade By Jeff Macke
In the last 30 days shares of Herbalife (HLF) have gone from the mid-40’s to the 20’s and then back again. It’s a dizzying ride driven by bickering hedge fund managers taking turns in the spotlight to make their cases on the long and short sides. It’s a striking turn for an 11-year-old company with a market cap under $5 billion and, until very recently, almost no mindshare in the investment community.
For those considering getting involved with the stock on either side of the trade, the question is whether or not Herbalife is a “Ponzi Scheme,” as Bill Ackman alleges, or if it’s just another relatively boring company most investors should ignore. Value investor Vitaliy Katsenelson, chief investment officer at Investment Management Associates, says the company is probably best avoided.
“I think you just want to stay away from this fight,” Katsenelson says. He has been to Herbalife’s clubs and came away unimpressed. For one thing, most of the people were there, in his words, “just to sell the product to each other.” For another, the product itself seemed overpriced for what you’re getting. “Most people get into Herbalife not because they want to consume the product but because they want to sell it to their favorite mother-in-law.”
That makes HLF a lousy long, but is it a short? Not really. Katsenelson has done his homework. He’s been to HLF stores and he watched all three hours of Bill Ackman’s argument for shorting the company. After all that legwork Katsenelson just doesn’t see the appeal for either bullish or bearish investors.
Companies don’t just tumble to zero, they need to be pushed. Katsenelson thinks Ackman’s best chance in that regard is to create a self-fulfilling fundamental slide. If Ackman generates enough negative publicity it’s going to be harder for HLF to set up distribution centers. Failing that, the stock could muddle along with the company itself for years before hitting the wall.
“I would just basically stay away,” Katsenelson concludes. That’s probably good advice for the vast majority of individual investors.
Interview with a serial killer
To understand what drives hedge fund managers, I studied this video. Chilling but informative.
The Oslo Housing Bubble Syndrome
Mises Daily: Monday, January 07, 2013 by Mark Thornton (An important market to track in our study of booms and busts.)
The Stockholm syndrome is a psychological phenomenon whereby hostages develop irrational sympathy toward their captors even to the point of defending their captors in subsequent investigations and criminal trials. While this applies to individuals or small groups, the Oslo syndrome applies to whole national populations.
In The Oslo Syndrome: Delusions of a People under Siege (Smith and Kraus Global, 2005), Kenneth Levin describes a “psychological response common among chronically besieged populations, whether minorities subjected to defamation, discrimination and assault or small nations under persistent attack by their neighbors. People living under such stressful conditions often choose to accept at face value the indictments of their accusers in the hope of thereby escaping their predicament.”[1]
Actually, the Oslo syndrome applies to all people living in socialist states. The state tells people what to do, forces people into public schools to be indoctrinated, tells people what we can and cannot consume, uses police power, and punishes people who do not do what they are told, and throws people into prisons if they continue to live the way they choose. The state’s system leads most to just accept things as they are as if it were the only possible way of life. Given that the Oslo syndrome applies to an entire nation, and that Norway is living through what will hopefully be the final housing bubble of this cycle, I thought it appropriate to dub the psychological phenomenon associated with housing bubbles, the “Oslo housing bubble syndrome.” This psychological phenomenon is the “irrational” response of people living in a bubble economy. They ignore or dismiss signs of a bubble and instead attribute their good luck (i.e. higher home prices) to “fundamental factors” that appear to substantiate high prices in real estate or stocks.
Do not get me wrong. The business cycle is not a psychological phenomenon. However, it does impact mass psychology. If a central bank is intent on expanding the money supply with an easy money policy, then some bankers are going to make additional loans and seek out new clients to lend money to. The bankers will be rewarded and their clients will be happy. As the boom plays out, people make big gains and are euphoric and even manic. The boom eventually turns to bust. Many of the same people who were making big gains are now seeing their profits turn into losses, or even foreclosures or bankruptcies. As a result, they become depressed.
The reason that booms turn into busts is that the artificial expansion of credit leads entrepreneurs to embark on many new investment projects that expand the structure of production. The new investment projects eventually cause new constraints to develop. These new developments could not be anticipated by entrepreneurs as a whole.
First, all of these new investment projects place strains on the availability of resources and inputs. Therefore their costs are greater than they anticipated. For example, the price of oil and the wages of specialized labor increase as the bubble proceeds to the peak. Second, as the prices of things like food, energy, and other products with inelastic demand rises, customers have less income available to buy their products. Third, as more of these new investment projects come online and start supplying their products, they are faced with increased competition, again more than they could have anticipated. The result is that their investment projects are now faced with higher costs, fewer customers, and more competitors. This is a recipe for disaster that results in the realization of a cluster of entrepreneurial errors.
If your nation’s economy has not had a bubble in many years it is not surprising that people are shocked when the bubble bursts. However, Norwegians have surely noticed what has happened in the US and PIGS, or even closer to home, in Ireland, the UK, and Iceland. Despite what they have seen there are still those who claim that Norwegian housing prices are genuine. Norwegians have, in a sense, been “psychologically conditioned,” and, as with the Stockholm and Oslo syndromes, are doing precisely the opposite of what they should be doing. A similar phenomenon happened in the US, around 2005, when people were often heard to be saying that “housing prices never go down,” or that “you can’t lose money by investing in real estate.”
There appear to be housing bubbles across Europe with the exception of the PIIIGS (Portugal, Iceland, Ireland, Italy, Greece, and Spain), but the Norwegian bubble seems to be the strongest one. The chart below shows that housing prices in Norway have increased by nearly 300% in the last twenty years.
Sources: Shiller (2005) and Eitrheim and Erlandsen (2004, 2005).
The US has many fundamental flaws in its economy including a large government budget deficit, a large trade deficit, expanding national debt, and exploding, unfunded financial liabilities related to health care and retirees. In contrast, Norway has none of these problems and several factors that suggest that the Norwegian economy is fundamentally sound. It has a large trade surplus and government budget surplus (both have been averaging around 14% of GDP) due to substantial oil revenues that are also building a very large sovereign wealth fund. The fund is approaching $700 billion dollars (Norway’s population is approximately 5 million).
The unemployment rate in Norway has been averaging around 3% which would be considered well below the “natural unemployment rate” in the US (thought to be around 6%). Therefore, Norway has one of the best unemployment rates in its region, in Europe, and even globally. The C.P.I. measure of price inflation in Norway has been around 1%, again one of the best in the world. Real G.D.P. growth has been about 3% and is expected to continue on that path into the future. This growth rate would be consistent with full employment. It is almost too good to be true.
So the fundamental picture does support the impression that housing prices are real. Another factor that supports a “fundamental” view of housing prices is that Oslo, the capital city with almost 1/5th of the nation’s population, has land-use restrictions that keep much land unavailable for construction. This is the same fundamental case that was given for the severe housing bubble in Las Vegas: the government prevented land from being developed. Housing prices in Oslo, however, have not risen much more than the average increase. The largest increases have occurred in areas associated with the oil and oil exploration business.
We cannot know for certain that Norway is experiencing a bubble. However the reasons we suspect a bubble starts with their economy. Norway’s rosy economy is not the result of good policy, but of oil revenues that subsidize their socialist government. Norway ranks 40th on the Freedom Index, below Belgium (38) and Armenia (39), and only above countries like El Salvador (41) and Peru (42). A steep drop in oil prices would be a severe blow to their economy. However, as oil revenues are continuing to pour into the government budget and sovereign wealth fund, it makes the Norwegian economy look like a good bet.
That image is particularly compelling compared to other economies across the globe. All the world’s major economies (i.e., the US, EU, China, and Japan) appear to be tottering on the verge of disaster. Currencies seem to be particularly dangerous given the Bernanke regime of “coordinated” quantitative easing by central banks. The euro is considered most at risk because of a potential uncoordinated currency break up. This threat has resulted in a decreased demand for the euro and an increased demand for alternative currencies from safe countries, such as the Swiss franc and the Norwegian krone.
Instead of allowing the krone to increase in value with this increase in demand, the Norwegian central bank, the Norges Bank, has instead countered with an increase of supply. They have intentionally set interest rates artificial low. The overnight deposit rate has been set at 1.5 percent since last December. They are trying to prevent the krone from appreciating in value, but their efforts have not been completely successful. Preventing this appreciation of the krone is intended to protect exporters, including their national oil company. However, it also helps pump up the housing bubble.
Monetary inflation, as measured by Norway’s M2 measure of the money supply, has lately been running at 8%. During the economic crisis, circa 2007, it ran as high as 20%. From 2008 to the present monetary inflation has averaged about 7.5%.[2]
The result is that Norway is experiencing low price inflation, except in housing and there is still upward pressure on the value of the krone. With central banks around the globe setting interest rates outrageously low it makes it difficult for the Norges Bank to act to raise rates. Higher interest rates would help deflate the housing bubble, but they have failed to implement such a policy.[3] With central bankers embarking on an inflationary death march, the Norges Bank has found itself seemingly trapped into following their policy of ultra low interest rates and monetary inflation.
This is incongruous given that the Norway chose to keep its monetary independence and stay out of the euro zone. It is also unnecessary because the Norges Bank has a policy option.
If the central bank did act and raised interest rates and simply allowed their currency to float, the krone would appreciate and Norwegian savers would get a windfall as the value of their savings increased. This would encourage them to work more, save more, and become wealthy. Every krone would buy more goods from around the world and would buy even more goods tomorrow than today. This appreciation would indeed hurt exporters, such as oil and cheese exporters, but most importantly it would stop and reverse the housing bubble before things get even worse and more distorted.
As usual, with policy decisions it is a matter of making a people wealthier or making a people poorer. In the case of the Oslo housing bubble syndrome, it looks like poorer will win out again.
Today I’m going to explain why gun-control is not only entirely reasonable but also certain to be effective. Only the ignorant can deny this.
First, some orientation. Cement-headed NRA types need to recognize, and state manfully, that the illegalization of guns is in fact perfectly practical. History has shown this repeatedly. When the government outlaws something that huge numbers of people very much want, the outlawed items immediately disappear from society. This has been shown countless times.
When Washington outlawed alcohol, booze vanished overnight and everyone stopped drinking. Can anyone deny this? When Washington banned the use of cannabis, all of those of us made insane by Reefer Madness quit smoking dope, and today there is probably not a town in America in which one might buy a joint. Similarly, Washington made illegal the downloading of copyrighted music – which also stopped immediately. No one now has illegal music. Ask your adolescent daughter.
So with guns. They are small, easily smuggled, of high value to criminals and will be of higher value when only criminals have them, so it is virtually certain that they will vanish when the government says so.
Mexico, where I live, has stringent laws against guns, which have proved at least a partial success. Criminals have AKs, RPGs, and grenades, while nobody else has anything. That’s a partial success, isn’t it?
While I am in favor of illegalizing guns and thus ending crime, I think the principle should be democratically applied. Let us begin by disarming the Pentagon. If this seems unreasonable, ask yourself: who kills more children in a month, Ritalin-addled little boys in America, or the US Air Force in every Moslem country it has heard of? All I ask is an honest body count. I will accept your numbers.
Hempton: Short-seller Went Long Herbalife Fri 04 Jan 13. The following transcript has not been checked for accuracy.
CNBC: Activist Robert Chatman battling Bill Ackman on Herbalife (see next article in this post). Herbalife’s Chairman says Ackman will lose his fight against Herbalife. But he have not the only one who thinks they will lose. Watching this battle, in his own words, says it is like watching hedge fund porn. Herb, thanks for joining us today.
Herb Greenberg: What makes him so interesting in this case is that he is mostly known as a short seller and he is buying the stock even though he agrees with Ackman. He joins us now live in our studios. John Hempton of www.bronte.com, “How are you.”
Hempton: I’m pretty well.
Greenberg: I got to ask a quick question here. yeah. You’re a short seller and you are — you are long this stock. How does that work? Why would you do that? I’m pretty familiar with scum bags. Multilevel marketing schemes are scum bags. There are a million people in their chain and Bill Ackman says Herbalife is ripping them off. Tobacco companies kill twice as many people a year as Herbalife has in its network. Those companies kill 400,000 people in America. Hugely profitable. They are scum bags but return cash to shareholders for decades. If you have shorted them, you’ve been run over.
Herbalife, five years ago, had about 140 million shares, it now has 108 million shares. It buys back stock regularly; pays a fairly hefty dividend. They are a scum bags, but they are a stock market scum bag.
Greenberg: You have to be careful with what you say here. The question is, will the Federal Trade Commission (“FTC”) go after the company? One reason you don’t believe that Ackman will be right is because you don’t believe the FTC will do that.
Hempton: You say something obviously is wrong and you think the government will rescue you. all Herbalife needs to do is find somebody who was fat and is less fat because of Herbalife and somewhere in the 2.5 million distributors there will be a few of those. Wheel them out in front of them (FTC regulators), and you are know, what Bill Ackman’s case now is that the government’s going to go and help the billionaire hedge fund manager.
Greenberg: I know another hedge fund manager here john, and he is very politically connected, very short the stock, and he believes that the heat will get turned up on this industry very quickly here. And he believes that one of the things they will be looking at is the industry itself targeting lower-income people. So what is to say that even though the FTC didn’t do this before, they don’t come back and do it now?
Hempton: I believe the same thing about the tobacco companies 20 years ago. the FTC has known about multilevel marketing schemes for decades. If this (Herbalife’s scam/cash flows) lasts three years, Ackman is wrong. If it lasts a decade, Ackman is so wrong, it’s just silly. Now this thing really has cash flow. A thesis that says, I got to wait for government is a bad thesis. I don’t know how many really dodgy companies I’ve reported to the FTC and what do they do? Sometimes they fine them. The vast bulk of the time they don’t.
CNBC: “Herb (Greenberg), I’m wondering where we go from here. I know we are looking forward to Herbalife’s rebuttal and Ackman is preparing his rebuttal to that rebuttal. What is the next chapter in the story?
Greenberg: Does this does become the equivalent of the for profit education industry where they go after it and where the industry, people said, they will never go after that industry. The government went after that and in this case you end up with a very hard reset of the business models of these companies.
Hempton: And for profit education industry case the victim is at least in part the government. the government giving stupid loans. a relatively easy way of the government reducing their fiscal drain.
Greenberg: John (Hempton), if in it case the victim is lower-income population, a lot of lower-income population and the Obama Administration could be very interested in that, wouldn’t that potentially have an impact?
Hempton: When did the government care about lower-income people in that way? Lower-income people are largely the victims of tobacco companies too. You look at tobacco, it is completely inversely correlated to wealth and income. Rich people don’t smoke. Poor people smoke. People in most jurisdictions just raise taxes from that.
Greenberg: Okay, we will see who is correct on this one. John, thank you very much for coming along.
Herbalife: Why I Made It a 35% Position after the Bill Ackman Bear Raid
This is a guest post prepared by Robert Chapman. Chapman is the founder of Chapman Capital LLC, which is a Los Angeles based investment company specializing in takeovers and turnarounds. In 2000, Chapman Capital was an activist versus Herbalife following the death of Herbalife’s founder Mark Hughes. This is an amazing article. It’s well-researched and easy to understand. If you’re remotely curious about the future of Herbalife after Ackman’s attack, the mechanics of short selling and the potential value of Herbalife’s stock, this is a MUST read. If you find this article informative, hit the +1 or Like buttons above. Sincerely, +Kevin Thompson
…REGUATORY SUMMARY: FTC has been there, done that.
The Ackman Tell. Many poker games are won and lost upon that infamous turning point when a player properly reads his opponent’s “tell.” To wit, I am confident that during an interview with CNBC’s Andrew Ross Sorkin on “D-Day” (12/20/2012), Bill Ackman slipped his “tell”, confirming my suspicion that he already realized the FTC wasn’t going to make his day by shutting down HLF. I strongly recommend all HLF traders/investors read the transcript of this interview, as Sorkin does a masterful job of fighting the media urge to genuflect before Ackman’s drawn down zipper, otherwise known as “The Whitney Tilson”.
Interview with Michael Mauboussin: Untangling Skill and Luck in Business, Sports, and Investing (From www.simoleonsense.com)
Today we’re going to talk about the role of skill and luck in generating success.
Michael Mauboussin’s Background
Michael Mauboussin, is the Chief Investment Strategist at Legg Mason Capital Management. Michael is also an adjunct at Columbia Business School and Chairman of the Board of Trustees at The Santa Fe Institute.
Book Synopsis
What role, exactly, do skill and luck play in our successes and failures? Some games, like roulette and the lottery, are pure luck. Others, like chess, exist at the other end of the spectrum, relying almost wholly on players’ skill. In his provocative new book, Michael Mauboussin untangles the intricate strands of skill and luck, defines them, and provides useful frameworks for analyzing their relative contributions. He offers concrete suggestions for how to put these insights to work to your advantage in business and other dimensions of life.
CSinvesting Editor: Just remember that those that know, don’t tell; and those that don’t know, have the floor to themselves. Some might call Mr. Mauboussin, “an entertainer.”
…..So Ackman vs. Herbalife has no heroes. Both parties, in their own way, take advantage of the goodwill and trust that underlie capitalism. Herbalife recruits sales people with the knowledge–based on mathematical certainty but undisclosed to its recruits–that the vast majority will lose money. Mr. Ackman, for his part, has gotten rich betting against bad companies. One party is possibly immoral, the other party at best amoral. Who do you cheer for? –Mr. Karlgaard, publisher of Forbes (A Short Seller Takes on a Vitamin Vendor, WSJ Jan 4, 2013)
Yes this battle will be gruesome, bloody and long (perhaps) but our purpose is to understand whether Herbalife which–as of the last filing–sported franchise-like financials of high ROA, ROE and ROIC with growing sales. Copious cash flow. On the surface, the company seems to have a franchise. Why can’t other companies do the same thing. What barriers to entry are there? Product patents, customer captivity, economies of scale and scope, network effects, etc. This battle will allow us to understand what drove Herbalife’s success. Will it be fleeting or lasting. My bet is that Herbalife does NOT have a lasting competitive advantage.
The quote above by Mr. Karlgaard is disappointing because as a publisher of a business magazine, he should understand Mr. Ackman’s purpose. A good investor should invest in companies that will use owner’s capital wisely and should not invest or even warn against investing in companies that mis-allocate capital for the long-term. Short sellers are just as important as having a Warren Buffett in the market. An Ackman does more for future growth than any government program because–like him or not–Mr. Ackman is trying to take capital away from poorly managed, potential frauds, unsustainable businesses while allocating capital to companies that will use his investors’ capital beneficially. He may be proven wrong but that is for the market to decide.
UPDATE: MONEY SUPPLY EXPLOSION--We are now officially in double digit territory for non-seasonally adjusted 13 week annualized money supply (M2) growth. Here is the amazing ascent in growth over recent weeks: 5.1%, 5.6%, 6.6%, 7.1%, 7.5%, 7.8%, 8.2%, 8.4%, 8.7%, 9.0%, 9.3%, 9.6%, 9.9%, 10.7%. It is this growth that is going to fuel the U.S. economy, the U.S. stock market and commodities. www.economicpolicyjournal.com
Investing in Banks
I find investing in global banks like Bank of America or Citibank impossible because I have no way to value or understand their businesses. How much “shadow” banking do these entities engage in? I don’t want to find out the hard way. See the article below
Some four years after the 2008 financial crisis, public trust in banks is as low as ever. Sophisticated investors describe big banks as “black boxes” that may still be concealing enormous risks—the sort that could again take down the economy. A close investigation of a supposedly conservative bank’s financial records uncovers the reason for these fears—and points the way toward urgent reforms.
The financial crisis had many causes—too much borrowing, foolish investments, misguided regulation—but at its core, the panic resulted from a lack of transparency. The reason no one wanted to lend to or trade with the banks during the fall of 2008, when Lehman Brothers collapsed, was that no one could understand the banks’ risks. It was impossible to tell, from looking at a particular bank’s disclosures, whether it might suddenly implode. Red the whole article:
The authors of the above article don’t grasp the true cause of the banking panic. Yes, transparency is a problem, but that would ALWAYS be true under our current fractional reserve banking system–it’s inherently a Ponzi scheme that functions on public gullibility and government edict–banks get to violate private property rights.
PS: can anyone fill in the blanks? All panics arise from excess _______ over and above ___________. Correct answer wins this prize:
This was published on January 2, 2013, in Ron Paul’s Monetary Policy Anthology: Materials From the Chairmanship of the Subcommittee on Domestic Monetary Policy and Technology, US House of Representatives, 112th Congress. All the books mentioned in this article are free on the web, go to www.mises.org and do a book search by title.
The scholarly contributions of Murray N. Rothbard span numerous disciplines, and may be found in dozens of books and thousands of articles. But even if we confine ourselves to the topic of money, the subject of this volume, we still find his contributions copious and significant.
As an American monetary historian Rothbard traced the party politics, the pressure groups, and the academic apologists behind the various national banking schemes throughout American history. As a popularizer of monetary theory and history he showed the public what government was really up to as it took greater and greater control over money. As a business cycle expert he wrote scholarly books on the Panic of 1819 and the Great Depression, finding the roots of both in artificial credit expansion. And while the locus classicus of monetary theory in the tradition of the Austrian School is Ludwig von Mises’ 1912 work The Theory of Money and Credit, the most thorough shorter overview of Austrian monetary theory is surely chapter 10 of Rothbard’s treatise Man, Economy and State.
Rothbard placed great emphasis on the central monetary insight of classical economics, namely that the quantity of money is unimportant to economic progress. There is no need for the money supply to be artificially expanded in order to keep pace with population, economic growth, or any other factor. As long as prices are free to fluctuate, changes in the purchasing power of money can accommodate increases in production, increases in money demand, changes in population, or whatever. If production increases, for example, prices simply fall, and the same amount of money can now facilitate an increased number of transactions commensurate with the greater abundance of goods. Any attempt by “monetary policy” to keep prices from falling, to accommodate an increase in the demand for money, or to establish “price stability,” will yield only instability, entrepreneurial confusion, and the boom-bust cycle. There is no way for central bank policy or any form of artificial credit expansion to improve upon the micro-level adjustments that take place at every moment in the market.
With the exception of the Austrian School of economics, to which Rothbard made so many important contributions throughout his career, professional economists have treated money as a good that must be produced by a monopoly – either the government itself or its authorized central bank. Rothbard, on the other hand, teaches that money is a commodity (albeit one with unique attributes) that can be produced without government involvement. Rothbard’s history of money, in fact, is a history of small steps, the importance of which are often appreciated only in hindsight, by which government insinuated its way into the business of money production.
It was Carl Menger who demonstrated how money could emerge on the free market, and Ludwig von Mises who demonstrated that it had to emerge that way. In this as in so many other areas, Mises broke with the reigning orthodoxy, which in this case held that money was a creation of the state and held its value because of the state’s seal of approval. A corollary of the Austrian view was that fiat paper money could not simply be created ex nihilo by the state and imposed on the public. The fiat paper we use today would have to come about in some other way.
It was one of Rothbard’s great contributions to show, in his classic What Has Government Done to Our Money? and elsewhere, the precise steps by which the fiat money in use throughout the world came into existence. First, a commodity money (for convenience, let’s suppose gold) comes into existence on the market, without central direction, simply because people recognize that the use of a highly valued good as a medium of exchange, as opposed to persisting in barter, will make it easier for them to facilitate their transactions. Second, money substitutes began to be issued, and circulate instead of the gold itself. This satisfies the desires of many people for convenience. They would rather carry paper, redeemable into gold, than the gold itself. Finally, government calls in the gold that backs the paper, keeps the gold, and leaves the people with paper money redeemable into nothing. These steps, in turn, were preceded by the seemingly minor – but in retrospect portentous indeed – government interventions of monopolizing the mint, establishing national names for the money in a particular country (dollars, francs, etc.), and imposing legal tender laws.
Rothbard also brought the Austrian theory of the business cycle to a popular audience. Joseph Salerno, who has been called the best monetary economist working in the Austrian tradition today, was first drawn to the Austrian School by Rothbard’s essay “Economic Depressions: Their Cause and Cure.” There Rothbard laid out the problems that business cycle theory needed to solve. In particular, any theory of the cycle needed to account, first, for why entrepreneurs should make similar errors in a cluster, when these entrepreneurs have been chosen by the market for their skill at forecasting consumer demand. If these are the entrepreneurs who have done the best job of anticipating consumer demand in the past, why should they suddenly do such a poor job, and all at once? And why should these errors be especially clustered in the capital-goods sectors of the economy?
According to Rothbard, competing theories could not answer either of these questions satisfactorily. Certainly any theory that tried to blame the bust on a sudden fall in consumer spending could not explain why consumer-goods industries, as an empirical fact, tended to perform relatively better than capital-goods industries.
Only the Austrian theory of the business cycle adequately accounted for the phenomena we observe during the boom and bust. The cause of the entrepreneurial confusion, according to the Austrians, is the white noise the Federal Reserve introduces into the system by its manipulation of interest rates, which it accomplishes by injecting newly created money into the banking system. The artificially low rates mislead entrepreneurs into a different pattern of production than would have occurred otherwise. This structure of production is not what the free market and its price system would have led entrepreneurs to erect, and it would be sustainable only if the public were willing to defer consumption and provide investment capital to a greater degree than they actually are. With the passage of time this mismatch between consumer wants and the existing structure of production becomes evident, massive losses are suffered, and the process of reallocating resources into a sustainable pattern in the service of consumer demand commences. This latter process is the bust, which is actually the beginning of the economy’s restoration to health.
The concentration of losses in the capital-goods sector can be explained by the same factor: the artificially low-interest rates brought about by the Fed’s intervention into the economy. What Austrians call the higher-order stages of production, the stages farthest removed from finished consumer goods, are more interest-rate sensitive, and will therefore be given disproportionate stimulus by the Fed’s policy of lowering interest rates.
Equipped with this theory, Rothbard wrote America’s Great Depression(1963). There Rothbard did two things. First, he showed that the Great Depression had not been the fault of “unregulated capitalism.” After explaining the Austrian theory of the business cycle and showing why it was superior to rival accounts, Rothbard went on to apply it to the most devastating event in U.S. economic history. In the first part of his exposition, Rothbard focused on showing the extent of the inflation during the 1920s, pointing out that the relatively flat consumer price level was misleading: given the explosion in productivity during the roaring ’20s, prices should have been falling. He also pointed out how bloated the capital-goods sector became vis-a-vis consumer goods production. In other words, the ingredients and characteristics of the Austrian business cycle theory were very much present in the years leading up to the Depression.
Second, Rothbard showed that the persistence of the Depression was attributable to government policy. Herbert Hoover, far from a supporter of laissez-faire, had sought to prop up wages during a business depression, spent huge sums on public works, bailed out banks and railroads, increased the government’s role in agriculture, impaired the international division of labor via the Smoot-Hawley Tariff, attacked short sellers, and raised taxes, to mention just a portion of the Hoover program.
Rothbard had been interested in business cycles since his days as a graduate student. He had intended to work on a history of American business cycles for his Ph.D. dissertation under Joseph Dorfman at Columbia University, but he found out that the first major cycle in American history, the Panic of 1819, provided ample material for study in itself. That dissertation eventually appeared as a book, via Columbia University Press, called The Panic of 1819: Reactions and Policies (1962). In that book, which the scholarly journals have declared to be the definitive study, Rothbard found that a great many contemporaries identified the Bank of the United States – which was supposed to be a source of stability – as the primary culprit in that period of boom and bust. American statesmen who had once favored such banks, and who thought paper money inflation could be a source of economic progress, converted to hard money on the spot, and proposals for 100-percent specie banking proliferated.
In A History of Money and Banking: The Colonial Era to World War II, a collection of Rothbard’s historical writings published after the author’s death, Rothbard traced the history of money in the United States and came up with some unconventional findings. The most stable period of the nineteenth century from a monetary standpoint turns out to be the period of the Independent Treasury, the time when the banking system was burdened with the least government involvement. What’s more, the various economic cycles of the nineteenth century were consistently tied to artificial credit expansion, either participated in or connived at by government and its privileged banks. Rothbard further showed that the traditional tale of the 1870s, when the United States was supposed to have been in the middle of the “Long Depression,” was all wrong. This was actually a period of great prosperity, Rothbard said. Years later, economic historians have since concluded that Rothbard’s position had been the correct one.
Rothbard’s treatment of the Federal Reserve System itself, which he dealt with in numerous other works, involved the same kind of analysis that historians like Gabriel Kolko and Robert Wiebe applied to other fruits of the Progressive Era. The conventional wisdom, as conveyed in the textbooks, is that the Progressives were enlightened intellectuals who sought to employ the federal regulatory apparatus in the service of the public good. The wicked, grasping private sector was to be brought to heel at last by these advocates of social justice.
New Left revisionists demonstrated that this version of the Progressive Era was nothing but a caricature. The dominant theme in Progressive thought was expert control over various aspects of society and the economy. The Progressives were not populists. They placed their confidence in a technocratic elite administering federal agencies removed from regular public oversight. What’s more, the resulting regulatory apparatus tended to favor the dominant firms in the market, which is why the forces of big business were in sympathy with, rather than irreconcilably opposed to, the Progressive program. “With such powerful interests as the Morgans, the Rockefellers, and Kuhn, Loeb in basic agreement on a new central bank,” Rothbard wrote, “who could prevail against it?”
It is with these insights in mind that Rothbard scrutinized the Federal Reserve. He would have none of the idea that the Fed was the creation of far-seeing public officials who sought to subject the banking system to wise regulation for the sake of the people’s well-being. The Fed was created not to punish the banking system, but to make its fractional-reserve lending operate more smoothly. In The Case Against the Fed, What Has Government Done to Our Money?, and The Mystery of Banking, Rothbard took the reader through the step-by-step process by which the banks engaged in credit expansion, earning a return by lending money created out of thin air. Without a central bank to coordinate this process, Rothbard showed, the banks’ position was precarious. If one bank inflated more than others, those others would seek to redeem those notes for specie and the issuing bank would be unable to honor all the redemption claims coming in.
The primary purpose of the central bank, therefore, in addition to propping up the banks through its various liquidity injections and its position as the lender of last resort, is to coordinate the inflationary process. When faced with the creation of new money by the Fed, the banks will inflate on top of this new money at the same rate (as determined by the Fed’s reserve requirement for banks). Therefore, the various redemptions will tend, on net, to cancel each other out. This is what Rothbard meant when he said the central bank made it possible to “inflate the currency in a smooth, controlled, and uniform manner throughout the nation.”
Although Rothbard distinguished himself as a monetary theorist and as a monetary historian, he did not confine himself to theory or history. He devoted plenty of attention to the here and now – to critiques of Federal Reserve policy, for example, or to criticisms of government responses to the various fiascoes, the Savings and Loan bailout among them, to which our financial system is especially prone. He likewise looked beyond the present system to a regime of sound money, and in The Case for a 100 Percent Gold Dollar and The Mystery of Banking laid out a practical, step-by-step plan to get there from here.
In his work on monetary theory and history, as in his work in so many other areas, Rothbard showed from both an economic and a moral point of view why a system of liberty was preferable to a system of government control. At a time when the political class and the banking establishment are being subjected to more scrutiny than ever, the message of Rothbard takes on a special urgency.
For that reason we should all be grateful that his monetary work, and that of the other great Austrian economists, is being carried on by Murray Rothbard’s friend and colleague Ron Paul. By my reckoning, no one in history has brought true monetary theory and history to a larger audience.
Only a sudden, improbable drop in society’s rate of time preference (read: real interest rate) would allow stock-market indexes, in the absence of credit expansion, to jump to a new, consolidated level, from which point, at most, slow gradual stock-market growth could take place. Thus continuously prolonged stock-market booms and euphoria are invariably artificial and fed by credit expansion. Moreover such episodes of euphoria encourage the public to postpone consumption for the short-term and invest cash balances in the stock market. Therefore while expectations of stock-market booms fed by credit expansion last, the crisis and recession can be temporarily postponed. This is what happened at the end of the 1990s, before the severe stock-market adjustment of 2000-2001…..Therefore–and this is the most important conclusion–uninterrupted stock market growth NEVER indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion, un-backed by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis. Source: The Stock Market, Credit and Capital Formation by Machlup
Reader’s Question on Adjusted PEs
I would like your opinion on an original (?) issue I have with the Shiller PE10 index. I wrote a blog post on that subject (and I merely did it to get feedback):
I had seen too many Shiller PE10 indices, and investment decisions which depend on it (last one being the GMO Capital “13th Labour of Hercules” White Paper). Found here: JM_13thLabourofHercules_11122 (1)
In a nutshell: P/E10 is used where the denominator is inflated by official CPI-U, which has changed definition over time, with a wide convergence compared to the inflation indicated by a historic (1980, 1990) CPI-U index definition.
If you recalculate the Shiller PE10 with earnings inflated with “real inflation” (which I did in my post), you get 17 instead of 22 for today (roughly).
John Chew’s reply: I applaud your efforts to correct a distortion but any government aggregate is flawed. See article on the CPI below. Your adjustment may be less flawed but still you may not have a worthwhile tool/indicator. I mostly focus on individual companies and disregard discussions on market P/E. First the P is distorted by the FED and the Earnings are distorted by GAAP accounting. I would rather spend time on understanding the quotation (under the cartoon) on the stock market.
One thing that has achieved Holy Writ with economists and politicians is the Consumer Price Index, or the CPI. Each month, people from Alan Greenspan to traders at the New York Stock Exchange to the economist in the Economics 101 prison await the latest announcement from the US Department of Labor that tells us the change in “consumer prices” from the previous month.
Many folks make very important decisions after hearing this number, since it supposedly measures the “rate of inflation.” If the change in the price index is “too high,” then the Federal Reserve Board of Governors might vote to increase the Fed’s discount rate. Likewise, high numbers will also trigger a giant sale of stocks on Wall Street, as traders anticipate higher interest rates, which both eat into profits and provide safer avenues of investment through interest-bearing securities.
Economists depend upon the CPI when taking time-series measurements of financial instruments, since such measurements can only sense if they are expressed in “constant” money terms. For example, the 11,000-point Dow Jones Industrial Average of today is not 11 times the value of the 1,000-point Dow of 1969 because the relative value of the US dollar has declined by about fourfold in the past three decades, according to the CPI.
Given that the US government has made war on money for most of the past century, one cannot blame those who make a living from financial instruments to want a consistent measure of value over time. Like most products coming from the bowels of government offices, however, the CPI should be tagged with warning labels. Furthermore, one should remember that economists and politicians often use the CPI dishonestly.
The first thing to keep in mind is that the CPI is not an economic variable. It is a statistic that at best gives an inaccurate picture of an economic phenomenon: inflation. To calculate the monthly CPI, the USDepartment of Labor takes a weighted average of prices of various things that consumers purchase, and then its statisticians try to figure out the various proportions of different items in a “mythical” household budget. For example, the statisticians may hold that housing costs are 30 percent of household expenditures, food costs 20 percent, gasoline another 15 percent, and so on.
Armed with the proportional spending of the “average” household, the statisticians then assign that percentage to price changes of each item. Obviously, the higher the percentage of a household budget for a certain item, the more “influential” that item may be. For example, if gasoline prices rise sharply, then those particular price increases are seen as “fueling inflation” (no pun intended).
It is easy for the observer to see that the CPI can perpetuate the myth of “cost-push” inflation, in which the cause of rising prices is, well, rising prices. Indeed, many evening news broadcasts on the new CPI figures will begin with something like, “Increases in gasoline prices have helped ignite a new round of inflation, the Labor Department reported today.”
Furthermore, the portrayal of the “official” version of inflation as an average causes other mischief as well, the most noticeable being the classification of the prices of some goods and services as “rising faster than the rate of inflation.” The implication of such a statement is that if the price of something increases at a faster rate than the increase in the CPI, then something illegitimate must be occurring. Soon afterward, politicians begin to call for price controls, and then the real damage to the economy begins.
As economists and others of the Austrian School understand, inflation occurs when the value of money declines relative to the goods and services it can purchase. In other words, inflation is a monetary phenomenon, not a price phenomenon. Prices go up because inflation is happening, not the other way around.
During a period of inflation, prices of some things increase more rapidly than prices of others. For example, during the last decade, money prices of gasoline and food have increased, while personal computer prices have fallen. That does not mean computers are impervious to inflation, but rather that inflation affects different items in different ways. Furthermore, without inflation, computer prices would have fallen even further.
What, then, is the real rate of inflation if the CPI is inaccurate? The truth is that there is no good way to gain a true measure of inflation, especially in this era when the Federal Reserve System is flooding the economy with new dollars. All we can say for certain is that inflation, with all its evils and distortions, has become what seems to be a permanent part of our economy.
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William L. Anderson, adjunct scholar of the Mises Institute, teaches economics at Frostburg State University (anderwl@ prodigy.net).
The author of this blog when he lived with cannibals in Irian Jaya (Western Papua New Guinea). How this picture came to be is a long, long story told over several beers. I urge readers to think of these skulls as representing investors who did NOT read the proxies and financial footnotes of the companies they bought. Be careful and always think for yourself. Please! A moment of silence for the many who did not survive. More on cannibals here: http://www.smithsonianmag.com/travel/cannibals.html.
Bernanke’s money printing is certainly having his intended effect in the stock market today. The joys and inevitable sorrows of manipulation. Eventually, the Fed will have to stop having its foot on the monetary gas pedal. This blog has been updating you on the 8% to 9% money growth and you are all aware of the current negative real interest rates ( a war on savers).
Irrational Behavior
Don’t forget to improve by signing up for A Beginner’s Guide to Irrational Behavior (Dan Ariely). “In this course we will learn about some of the many ways in which people behave in less than rational ways, and how we might overcome these problems.” https://www.coursera.org/course/behavioralecon
A Special Situation
A Leveraged Stub Stock Remember to do your own work and if you invest, size your position accordingly in a company that could either pay down debt and turnaround or be crushed by debt. The author of the blog below addresses many of the issues that need to be thought about. One key is to look carefully at maintenance capital expenditures (“MCX”) because if management skimps on MCX to pay down debt, then the company really is in liquidation and the asset values may not be there to support the turnaround. You can learn as much about investing/companies that you analyze and pass on as the ones you invest in. You just need to keep track of your omissions and see if your thought process was correct. I bet you 10 to 1 that not 1 in 100 professional money managers do that on a systematic basis. What a chance to learn, but you have to be diligent.
Debate about the efficacy of the Austrian Business Cycle
This debate is somewhat similar to the debate of efficient market theory. How can entrepreneurs be fooled time and time again by the Fed’s market manipulations that consistently lead to booms and busts. What about rationality?
OK, I don’t like right or left wing extremists either, but many people in foreign lands like Afghanistan and Pakistan view us in this way. Listen to what you don’t like to hear. The media’s portrayal of the tragedy in Sandy Hook
should be contrasted with the silence on U.S. sanctioned drone killings of women and children (“collateral damage”). The actual video starts at 4:26.
Here is the Perhsing Square website on Herbalife. Sign up and learn:
Pershing has their HLF deck up on the website: http://factsaboutherbalife.com/
Verdict: This will get ugly but my money would be on Ackman since there is no competitive advantage, so I would place the value no more than tangible book value at best with no more than a 90 second look at the financials.
The purpose of this post is also to study a Ponzi scheme. The response of the company to Ackman’s research leads me to say this company’s days are numbered.
BOOM and BUST
Could Austrian Business Cycle Theory Dotcom Boom and Bust have helped you as an investor? Buffett’s presentation on the Dotcom Bubble in early 1999 (See page 64) A Study of Market History through Graham Babson Buffett and Others. Note how the market went into a speculative frenzy, rising more than 50% AFTER Buffett’s speech. Human action can’t be predicted like a physics experiment.
An excellent book that predicted the bust was the The Internet Bubble: Inside the overvalue World of High Tech Stocks–and What you Need to Know To Avoid The Coming Shakeout by Anthony Perkins and Michael Perkins (1999 and 2001 editions).
