Pardon Me

Poor Michael Milken. Not only did he not get the presidential pardon he had hoped for…he must have found it particularly galling that another, shadier financier got the pardon that might have otherwise been his.

Marc Rich, on the lam in Spain for more than a decade, is now free to come back to the United States and get on with his life.

Thanks to the efforts of his ex-wife, and his two law firms, which, coincidentally, were also those of President Clinton and his wife, Mr. Rich may now take a seat of his own at Democratic fundraising events.

The game is not over, of course…both men are still alive. And there is, of course, the Great Unknown of the afterlife too…but so far it does appear that these two men have not gotten justice.

Milken ran afoul of the SEC for crimes that are impossible to describe to a sober man. “What exactly did he do wrong?” will come the reply…to which you will find no ready answer. But, prosecutors leaned on Milken so hard – threatening to destroy his life and that of other family members – that Milken crumpled, copped a plea and served time.

Rich, on the other hand, was charged with two major crimes. He dummied up oil contracts in order to evade taxes…and he violated the “Trading with the Enemy Act” in his commercial dealings with Iraq.

Then, faced with prosecution, Rich did the arguably smart thing: he fled the country and has lived in luxury ever since.

Which man deserved the pardon? I will leave that for you to decide.

What concerns us today is not really Mr. Milken’s battle for justice, but the market of “high-yield” bonds that he helped create. My source for the following report, by the way, is Grant’s Interest Rate Observer, which keeps an eye on such things.

As mentioned here a day or two ago, Mr. Milken’s junk bonds harmed few investors. “By the close of 1991,” explains Grant’s, “high-yield securities (as junk bonds are designated in the up portion of the cycle) had generated a 12-month return of 39%.” Grant’s quotes a high-yield strategist, with this curious elaboration: “1991 was the highest return year on record for high-yield and it was also the highest default year.”

Defaults on junk bonds have been in the news lately. They are what you normally get on the down slope of the credit cycle. Since the upward side of the debt cycle saw an Everest of borrowing…it seems likely that the coming downside will be similarly steep and long – with an avalanche or two of bankruptcies and defaults to bury unsuspecting investors.

That may be reason enough to avoid junk bonds altogether. Or maybe not. Bonds are not equities. They lack the triple- digit dreams of profit. But so, too, do they lack the complete emptiness of a share in an unprofitable business. They come with a coupon, in other words, and investors may be able to earn a good return on their money – even if the company fails…and even if the stock market falls. Then again, they may not.

And here, dear reader, I offer you a bright flash of insight…If you have already thought of it, you can go on about your business, confident that you are not missing anything by not continuing:

When things are out of whack, they tend to get back into whack. Only God knows when…or how.

Junk bonds are out of whack – selling for far less, compared to T-bonds, than usual. If it were to get back into the average whack – say, the spread that prevailed between 1995 and 1997 – it would mean an increase of junk bond prices of 38%.

Is that enough to offset the risk of loss? I don’t know. But the Grant’s team also notes that not all junk bonds are issued by junk companies. Some of them are decent, Old Economy companies that just have taken on too much debt for the down cycle of the junk bond market. One, for example, leads the nation in the production of ice. Another is the dominant firm in a number of industrial equipment niches.

These companies stocks don’t have to soar to make money on their bonds. They just have to be able to pay their bills. And the junk bond market just has to return to at least as good a condition as it was when Michael Milken headed off to jail.

Then again, this credit contraction could turn out to be much worse than it was in the early ’90s.

More to come…I’ve got to run to catch another plane.

Your correspondent,

Bill Bonner Miami, Florida January 26, 2001

*** An alarming realization seems to have struck the market yesterday: the U.S. economy may not be falling off a cliff as expected.

*** Auto sales have been stronger than expected – so strong that DaimlerChrysler announced it would not be closing its Jeep and minivan plants after all.

*** And retail sales – which represent two-thirds of the economy – are rising. Last week, same store sales rose 2.4% over December and 3.4% over the same period a year ago.

*** Home sales are looking good too – with forecasts of 5.14 million units expected to sell this year…up from a forecast in December of only 4.94 million. Housing starts are increasing more than expected too.

*** “U.S. Car Manufacturers Set for Growth,” says a headline in the Financial Times. “Consumers more likely to open their wallets,” notes another in the S.F. Gate. “Consumer confidence may be stronger than data suggest,” adds the Boston Globe.

*** All this good news seemed to weigh on Nasdaq investors yesterday…along with a report that the Fed was considering a measly 25 basis point cut in rates next week, rather than the 50 points investors had expected. Plus, Greenspan testified before the Senate that he now favors a tax cut – further worrying investors that a big rate cut may be moved to the back burner.

*** Thus, the “rate cut rally” may have come to an end yesterday as the Nasdaq fell 104 points. Nasdaq investors have so much simpleminded confidence in rate cuts that anything that seems to stand in their way – even signs of economic growth – must be taken as a sell signal.

*** So, they took their money out of the techs and moved it over to the Dow, which rose 82 points. There were 1,589 advancing issues on the NYSE exchange yesterday; 1,232 declining ones. Breadth was positive for 12 of the last 13 days.

*** The euro slipped a little bit more…to 92.25 cents.

*** Not much action in the gold market.

*** What happened to the bear market and the coming recession? All in good time, gentle reader, all in good time. “The great Dow theorist Robert Rhea,” writes Richard Russell in yesterday’s message, “said that the ‘single surest action in the market is the automatic recovery, often 50%, following a crash.'”

*** But the longer-term prospects for neither the stock market nor the economy look good. Russell: “When the S&P sells for over 22 times earnings, the median appreciation in stocks over the coming 10 years is 5%.” Against that, he notes, is the yield on 10-year T-notes of 5.27% – guaranteed.

*** And the economy still has to wash out trillions’ worth of bad investments, hose down millions of greedy investors and debt-caked consumers, and mop up resulting mess. “The financial condition of the consumer,” notes a report from Hoisington Investment Management of Austin, Texas, “is the worst in modern times due to 8 years of heavy spending relative to income.” The same might be said for businesses.

*** “It still boggles my imagination,” Barron’s quoted Barton Biggs recently, “that everybody thinks we can come through the biggest bubble in the history of the world and certainly the longest boom that the U.S. has ever had and get out of it with a very, very mild recession. Is that the way it works?” No…I don’t think it is.

*** And yet, even the junk bond market has revived: The L.A. Times reports that over $10 billion of high-yield bonds were issued already this month, more than twice the $4.16 billion issued in all of the last quarter. Another $2.4 billion is in the pipeline. More below…

*** Christopher Byron notes that a Salt Lake City company, InvestAmerica, got a boost in its share price the day BEFORE it announced it was planning “to buy ‘$675 million of optical networking equipment’ from Nortel Network. “How will InvestAmerica pay for such a purchase?” asks Byron. “So what that InvestAmerica has exactly $70,533 of cash on hand, has no tangible net worth, and only $1.3 million in revenue and $4.8 million in losses last year. On the trading day prior to the announcement, the stock soared as high as $1.47 a share from 70 cents (funny how things seem to work that way on Wall Street, isn’t it), then collapsed the next trading day as the early birds sold out, driving the price down to close at 74 cents.”

*** “Sanitizing and defanging are alive and well on CNBC,” says Legg Mason’s Ray Devoe, “as if the 54.6% decline in the NASDAQ from the March 10, 2000 high to the recent lows never took place. One recent feature presentation was based on the theme ‘There’s Money To Be Made In This Market’ and featured some of the alternative power stocks that could benefit from California’s electricity crisis. Plug Power was the apparent winner – the announcer stated that it ‘was up 178% in about three weeks.’ I have followed this controversial company as it rose from its IPO in 1999 at $15 to $156 a share on January 12, 2000. The stock crashed to $9 on December 21, 2000-a 94.2% loss in less than a year. Even after what could be a ‘dead cat bounce’ at $25 the stock is still down 84.0% from where it was a year ago.”

*** “The TMT (Technology, Media, Telecom) bubble is eerily similar to the 1845-1846 mania,” writes The Fleet Street Letter’s Robert Miller. “There was a massive explosion of companies seeking to exploit every conceivable niche of newly opened markets, however bizarre. At the height of the boom in 1845, the capitalisation of railway shares was around 30% of British GDP compared to 50% for IT stocks as a percentage of US GDP in March last year.

“But the true lesson of the 1845 railway mania is that the decline in TMT stocks is far from over. Some 1,500 miles of line that were authorised in the boom years were abandoned and numerous bubble railway companies collapsed. But equally, apparently well-established companies, with lines between important cities, saw their earnings and their share prices collapse. Likewise, the 1845 bubble…was followed by a major recession which savaged the earnings of even established companies…”

*** Yesterday began badly when a strike by train workers stopped the regular service out to the airport. But the line of people waiting for a cab was so long – I realized that I could never make my flight to Miami. Fortunately, I heard an announcement explaining that I might get a train from another station…so I rushed to the other station and finally got to CDG. At the airport, without a minute to spare, I was taken in hand by a bold and beautiful clerk who rushed me through security…so I finally arrived on board on time and in style.

*** “Strikes!” she said as we dashed through passport control. “It wouldn’t be France without strikes.”

*** Once on board, I discovered that my travel agent had managed to get me into first class. Normally, I use frequent-flier miles to upgrade to business class. But they have discovered an even better trick – which I will reveal in due course.

*** All the denizens of the first class compartment were middle-aged men (except for one woman in her 30s who looked middle aged) wearing blue jeans. The suit-and-tie merchants in Paris made nothing on these gentlemen. Once airborne, they all got out their DVD players and watched movies – which activity entertained them throughout the 10- hour flight. On one screen to my left, Nicholas Cage was getting a rather serious looking face-lift. On the screen to my right Nicholas Cage was driving an ambulance, in desperate need of a shave, sleep and a career change. I felt like a party pooper when I pulled out my laptop computer and began answering my mail.