Endemic Distortions to the US Economy

August 11, 1999

The bulls were on a strong offensive today, putting most indices on the positive side for the week. So far this week, the Dow has risen about 1%, while the S&P 500 has a small gain. The Morgan Stanley Cyclical index continues to perform well, gaining 1% this week, and bringing its year-to-date gain to 23%. The Morgan Stanley Consumer index, however, continues to struggle, trading largely unchanged so far this week. The Utilities also continue to trade poorly losing 1%, while the Transports have been hit hard for a 3% decline. The small caps traded strongly this afternoon, erasing the small decline they had coming into the day. It was another one of those near buying panics in some names and groups. The NASDAQ had a huge day with the Composite gaining 3% and the NASDAQ 100 rising 3.6%. For the week, the NASDAQ 100 has increased 1%. Tech stocks have outperformed with the Morgan Stanley High Tech index having risen more than 2%. It now has a year-to-date gain to 30%. The Semiconductor stocks have gained 5% so far this week, and a 1999 gain of about 49%. The financial stocks are also bouncing after some recent difficulty. The S&P Bank index has a gain of about 1 =% this week, while the Bloomberg Wall Street index has risen 1%.

We are, of course, keenly focused on the current precarious position of our financial system. Yesterday it was reported that General American, a $25 billion insurance company, is facing widespread withdrawals and a liquidity crisis. Over the coming months, we are fearful that General Americans problems will not prove an isolated case. After years of unprecedented credit excesses and reckless speculation and financial engineering, many vulnerable institutions now imperil the stability of our entire financial system. Yet few recognize that years of excesses have actually inflicted the greatest long-term damage to the health of our real economy. Today, the soundness of our economy is only increasingly impaired by endemic distortions including massive over-investment in consumer products and services, especially in the technology area, and under-investment in industrial capacity.

A troubling example of this huge imbalance is that while hundreds of billions are being spent on an absolute communications arms race, over the past few weeks tens of millions of Americans have had to deal with brown and black-outs due to the lack of investment in electrical generation capacity. Additionally, the maladjusted US economy is skewed increasingly toward the hyper-indulgent consumer sector. The essential results are a soaring trade deficit and tremendous over-overspending on luxury items and consumption-based structures. In past commentaries we have spoken about the proliferation of credit. A key principal in economics, stressed particularly by the Austrian School, is that credit excesses lead to a problematic misallocation of resources, which we will try to hit on today.

Nowhere is this misallocation of resources more apparent than in the booming sales for imported luxury automobiles. With year-over-year imports rising 17% during the first half, sales increased 9% for Mercedes, 17% for Lexus, 38% for Audi, 22% for BMW, 46% for SAAB, 22% for Jaguar and 36% for Porsche. But it is not just luxury cars as much as it is for luxury goods in general, including big-ticket items such as million dollar yachts and Gulfstream corporate jets. With popularity at an all-time high for luxury vacations, the cruise industry is borrowing aggressively and expanding its fleet. One major company recently took delivery of a new $410 million cruise liner. Over the next four years, this same company will take delivery of four more and has further plans for a $700 million ship. Premium wine prices have skyrocketed, and the number of vineyards continues to escalate in California and elsewhere. The market for fine art is said to be the strongest since the manic Japanese buying binge in 1989. Vacation home sales and construction are very strong nationally, with the hottest markets sporting million dollar price tags in resorts such as Jackson Hole, Aspen, Sun Valley and Vail. Prices are said to have risen sharply for renting this summer in The Hamptons, New York.

As we have written previously, real estate markets are booming throughout the US with sales and new construction for 1999s first half at record levels. In fact, expectations are that 1999 home sales will again be at record levels, a fourth year in a row. This, after 1998 total home sales surpassed the previous record by 13%. The hottest area has been so-called "McMansions", mass-produced homes in "luxury" subdivisions. And in what must be considered a most egregious example of bubble-induced malinvestment, it is now common practice to purchase in exclusive neighborhoods and immediately level the existing structure to make room for a much larger and lavish new home. These are referred to as "scrapers" and this practice is prevalent in booming markets such as Boston, Seattle, Chicago, the San Francisco bay area, Dallas and the suburbs in New York. Silicon Valley executives have been known to throw parties where guests hit golf balls through the picture windows of old mansions before demolition.

It is not, however, just the wealth of Silicon Valley executives that has led to bubble distortions. And with technology stocks more than doubling in price since last fall, truly outrageous property prices throughout the region move even more rapidly toward the stratosphere. A recent Coldwell Banker biannual residential real estate survey of communities in the vicinity of Silicon Valley reported price increases of between 15% and 21% for the first six months of 1999. The median price for a three-bedroom single-family home in Palo Alto increased to $995,000, a 21% increase since year-end. The median four-bedroom price increased 17% to $1.25 million, and the price of a two-bedroom condo rose 16% to $590,000. Luxury home sales are brisk, with median prices above $1.8 million in Los Altos, $1.5 million in Atherton, and $1.25 million in Hillsborough. But it is not just exclusive areas that had stunning appreciation, as Mountainview saw the median price of a three-bedroom home rise 10% in six months to $686,000. In a virtual buyers panic, it is not uncommon for listings to receive as many as 20 offers with the final sales price going considerably above the asking price.

A similar survey in the other major technology hotbed, the greater-Seattle area, also illustrates major bubble-induced housing price distortions. The median price in Seattles King Country is now $300,000. Upper-end properties are seeing prices appreciate as much as 30% from last year. Of 20 counties in the vicinity of Seattle, only six have reported less than double-digit price increases during the past year and this after very strong price increases in 1998. And while it was little more than a decade ago that Seattle had its first million-dollar home sale, they are now commonplace. An article in the Seattle Times began, Worried you wont be able to find a really nice house to buy with your newly exercised stock options? Not to Fret" and then made reference to a website listing 144 homes for sale above $1 million. A multi-year residential building boom continues throughout the region. Stock option millionaires from Microsoft, Amazon and others lead the "biggest mega-house splurge ever." Cranes now tower over Lake Washington as an historic building boom proceeds on $10 million-plus mansions. Estimates have Bill Gates spending as much as $80 million on his 48,000 square-foot home. Gates previous home was purchased for $8 million by the chairman of Delta Air Lines, who immediately tore-down the waterfront mansion to build a new one.

But it is not just a hot residential market that fuels an exuberant local economy. During the past four years, the Seattle area has seen an unprecedented boom in major construction projects. Totaling more than $8 billion, projects include stadiums, a new city hall, libraries, convention centers, concert halls, light rail and airport expansion, and much more spending is in the pipeline. Last September saw the opening of the $118 million Banaroya concert hall. The new Washington Convention and Trade Center expansion is expected to cost $190 million. A new opera house at the Seattle center will run $110 million. The Seattle Aquarium has planned a $150 million expansion, and the Space Needle a $20 million face-lift. Just outside of Seattle, $23 million is to be spent on the new Bellevue Art Museum. Recently, local officials approved a $224 million plan to replace city government buildings. The current city hall was constructed in 1962 at a cost of $7 million. The city is also spending $72 million on a downtown parking garage. A third runway at the Seattle airport has an estimated cost of $773 million. And increasingly frustrated with congested roads, voters recently approved a $3.9 billion initiative for the Local Transportation Authority.

Recently, five new championship golf courses have opened, including a $60 million course developed by a former Microsoft employee who took up golf in 1990. Microsoft founder Paul Allen recently paid almost $500,000 at auction for one of Eric Claptons guitars, which he will now have for his $60 million music museum, being built in honor of his idol, Jimi Hendrix. A construction boom also continues for office buildings, hotels and retail centers with 14 million sq. feet of office space either under construction or in planning. Many "glitzy" new shopping complexes have been constructed and several more are on the way.

Most noteworthy, the new baseball stadium, completed at a cost of $517 million, is the most expensive baseball venue ever built. Originally expected to cost $250 million, it went wildly over-budget with costs that included a $67 million retractable roof. With the team contributing $45 million, the vast majority of funding was borrowed by the city. Soon the Kingdome, only 5 years after a $70 million roof repair, will be demolished to make room for a new football stadium. At an expected cost of $430 million, most will come from public bonds. Interestingly, until completion the Seattle Seahawks will rent the Univ. of Washingtons football stadium at $305,000 per game, which will help to fund the $40 million that will be spent on renovating the colleges basketball venue.

Staggering outlays on sports facilities, however, is a national phenomenon. So far this decade, 33 new professional stadiums have been built. Yet, of the 120 US and Canadian professional sports franchises, 50 are looking to build new facilities. Several markets, like Seattle, are constructing separate venues for baseball and football. San Francisco has a new $300 million baseball park as well as plans for a $500 million stadium for football. Pittsburgh has a new $185 million baseball park; Detroits cost the city $290 million and, in San Diego, $411 million. Denvers new football stadium was constructed for $400 million. Houstons replacement for the Astrodome is costing $310 million. Hoboken is spending $216 million for the hockey team. Here in Dallas, Ross Perot Jr. has plans for a new basketball arena as the centerpiece for a billion dollar office and retail complex. In New Jersey, the basketball arena built in the 80s for $90 million is to be replaced as it "has become outdated by new state-of-the art complexes in cities such as Boston, Chicago, Philadelphia." The New Jersey Sports and Exposition Authority has proposed a $377 million arena and entertainment complex. And in what is certainly in some cases a desperate attempt by local governments to maintain or lure teams to their areas, municipalities are borrowing heavily in what should be considered high-risk projects. Hartford, Connecticut began constructing a $380 stadium after they had lured the New England Patriots to move from Boston. The team, however, recently reneged when a new stadium was approved in Foxboro, Massachusetts. The city of Los Angeles is soon to issue more than $300 million of bonds to build a new stadium hoping to attract a professional team back to LA.

Beyond stadiums, there has also been a boom in auto racetracks. Joliet, Illinois is building a $100 million track, Kansas City is constructing a $250 million auto-racing venue and Donald Trump has plans for a $250 million track in the New York Metro area. Meanwhile, cities across the country have and continue to build major convention centers, including San Diegos planned $185 million expansion. Municipalities have also moved aggressively to construct prodigal public transportation projects with little concern about economics. The ongoing $5 billion Los Angeles subway project has been recognized as a "white elephant" for some time.

Nowhere, however, is "while elephant" more appropriate than for the staggering construction melee that continues to this day in Las Vegas. One can simply not imagine a better illustration of malinvestment fostered by easy access to the capital markets, with consumer demand spurred by bubble-induced wealth effects. Las Vegas now has almost 110,000 hotel rooms and another 16,000 are on the way. Over the past several years, monstrous projects have been constructed including the MGM Grand, Luxor, The Orleans, and the Stratosphere. Last October, Mirage Resorts opened the Bellagio, complete with a $285 million art collection, at a total cost of $1.6 billion. The Venetian, 32 stories with 3,000 full suites, a $300 million shopping mall and 15 restaurants, was constructed for $1.5 billion. Mandalay Bay opened in March. At a cost of almost $1 billion, this hotel/casino has 3,700 rooms, an 11-acre aquatic park complete with six-foot surfing waves, a 12,000-seat events center and a $40 million museum of rare coins. At $280 million, the Resort at Summerlin ten miles from the strip had only 50 rooms booked for its recent opening. Coming soon, the Aladdin with 3,600 rooms and a 7,000-seat theater at an estimated cost of $1.3 billion. And the Paris hotel/casino, with a 50-story one-half size replica of the Eiffel Tower, will run almost $800 million. By next year, Las Vegas will have 6 million square feet of convention space, an increase of 44% in just three years. To ease traffic congestion, $300 million is being spent to widen local freeways.

Quite simply, we see such outlays as the greatest proliferation of malinvestment ever. Come the eventual bursting of the American bubble there will be the painful recognition that unprecedented credit excesses have been spent most imprudently. With the bursting of the bubble the great damage inflicted onto the US economy will become clear. Not only has too much leverage allowed the creation of too much paper, but too much of this credit has financed consumption and spending on things that will have very little economic value down the road - when ebullient consumers no longer have the great benefit of stock market and real estate wealth-effects and both consumers and businesses lose easy access to cheap borrowings. Unfortunately, as the entire country appears fixated on the hourly gyrations in the stock market, the critically important story of the continued damage to our economy goes largely unnoticed.

David Tice

www.prudentbear.com

-- Andy (2000EOD@prodigy.net), August 12, 1999

Answers

A truly thought-provoking article. Thanks for posting it Andy.

(Gee, that didn't hurt a bit!)

-- Bingo1 (howe9@pop.shentel.net), August 12, 1999.

You're welcome. Mind-boggling isn't it?

Later,

-- Andy (2000EOD@prodigy.net), August 12, 1999.

Andy: Thanks for the thread and thank you for keeping us informed.

-- bardou (bardou@baloney.com), August 12, 1999.

Did today's rich forgot about that wonderful virtue that only the rich may exercise... magnificence!?

-- Stan Faryna (info@giglobal.com), August 12, 1999.

Andy-thanks for the flabbergasting info-it puts things into sad perspective. Those who will be truly "rich" in the future are those who have been slowly building supplies for their loved ones. Time for me to continue by going out to buy some more luxury beans and t.p.-

-- churchorganist (swedemusic@webtv.net), August 12, 1999.

For years I have watched government and business with a complete misunderstanding. I would think ..even with as large a tax base as we have,the country can't possibly withstand the enormous spending and waste. But I've been wrong, it just seems to keep rolling on its own tremendous inertia.I keep saying ...when the public catches on,look out!

-- citizen (lost@sea.com), August 12, 1999.

Good example of not paying attention to what can/or may happen in the future. Economies can and do go up and down. What is going to happen when the current economy slows down? Jobs lost, empty office space, etc. I watch these things because I own a company. I'm the guy "they" love to tax, I'm in the top bracket, I'm the evil corporate boogie man. Well guess what? I don't spend money on jets, cars, trips, big houses. I spend money on PEOPLE! Yep that's right, people. They are my secret weapon. I count on them and they count on me. We spend money on training, benefits, equipment, etc. We don't need to put a dot com after our name and sell something that you just have to have!! We sell service and support for computers and networks and we do it well.

I have been accused of not being "with it" as far as jumping into the Internet craze. Hell I helped develop networks for the Big Boys. I know full well what will work and what's smoke and mirrors. People are selling dreams and dreams can end badly. I want my folks to have good jobs, good pay and good opportunities. The extravagences that are outlined in the article make me very nervous. When, and not if, the slowdown does appear it is going to be tough for many people.

I don't have a problem with success, more power to those that make it. But I do worry that we as a country and we as business people are not investing in the areas we should be. We are not maintaining our infrastructures, our basic community services, etc. We are not telling, demanding, that our elected officials maintain these fundamental areas. I don't object to paying taxs if they are spent wisely which in many cases they are not. I do object to the idea that my labors, my employees labors are wasted on schemes and projects that benefit a few.

When things do get tough I hope we all have the grace or wisdom to "think" our way to a beneficial solution and not "feel" our way into a bigger mess in the name of fairness.

just my .02 worth.... :)

-- Freelancer (mercenary2000@yahoo.com), August 12, 1999.

The breathless description of Seattle's boom is mostly true, though the downtown library's architecture has yet to be limned, the new runway has yet to be built, the wildly impractical and overbudgeted rail system is only in the planning stages (a small band of visionaries would expand the Monorail instead---go Elevated!), and the city hall has yet to be finalized. Still, the construction boom is truly staggering. On a side note, a friend who made a fortune here by building a brand name believes the regional boom is already fizzling, and predicts empty condos and office suites in the near future. One cannot help hoping he is right if only to gain some surcease from the ubiquitous jackhammers and detours.

And only five short years ago Seattle was still a sleepy backwater town for losers!

-- Former Headbanger (emer@ldcity.com), August 12, 1999.

It's the clearest possible case of historical patterns repeating. It's also probably inevitable. Long-cycle economics is hard to argue against, except in the smaller details and (for the speculator) the uncertain timing. My belief is that the latter reflects a chaotic oscillator (like el Nino) rather than a truly periodic one (like a pendulum).

Real-estate speculation, boom and bust: Florida, 1927.

Massively over-hyped technology and stock: Radio (RCA), 1929. (Radio, the technology, did indeed live up to its promise, it's just the stock that didn't).

"The roaring twenties". Some similar epithet will be coined for the nineties, I'm quite sure.

Methinks that Y2K's greatest effect won't be the immediate disruption, but as a trigger for the next turn of this cycle.

What's coming may be ugly. History also teaches that there will ultimately be a silver lining. The new infrastructures and technologies, that will doubtless cause much misery when boom turns to bust, will still be there decades into the next century, and will indeed prove useful.

I get worried when someone starts talking about "misapplication of capital". It suggests that some committee or dictator could apply it better. That's what the soviets tried. It's what most dictators try, to a greater or lesser extent. It simply doesn't work. All it does is to stifle innovation. (And other nasty things of course: I'm restricting my view here to economics)

Depressions, however uncomfortable, seem to serve the same purpose in economics that winter does in nature. They kill off old weak enterprises that resist innovation, and set the scene for a new cycle of growth and development.

And another interesting statistic to ponder: at the end of the 1930s, the majority of USA households owned a refrigerator, three times as many as in 1930. Refrigerators weren't ever over-hyped, it's hard to hype a white box that makes things cool. It's just so useful that refrigeration was a growth area even during the great depression. (Wish I knew what today's "sleeper" technology is!)

Some here will doubtless call me an optimist. So be it.

-- Nigel Arnot (nra@maxwell.ph.kcl.ac.uk), August 12, 1999.

Can you say 'kickbacks?' Sure. And Stan the man: did you mean munifence? Magnanimous? The Internet poobahs should visit L.I.s Gold Coast, and behold the spectacle of all those rotting husks built by the Astors, Vanderbilts, et al. Sic transit gloria mundi.

-- Spidey (in@jam.commie), August 12, 1999.

It seems such a waste to knock down a perfectly good house, often craftsman with solid old-growth timber, just to build a newer bigger flashier one.

-- many wish they had a house (prices@too.high), August 12, 1999.

Ladies and Gentlemen,

THIS is Babylon The Great!

JJ

-- Jeremiah Jetson (laterthan@uthink.com), August 12, 1999.

Gee - and no one as yet has mentioned that the new most expensive baseball park in the counrty - Safeco Field - was vote DOWN by the voters, but the state legislature in all their infinite wisdom, decided that the "people" didn't really know what they wanted when they voted no on the stadium ref. so decided we should pay pay pay and build it anyway. GRRRR...

And don't even get me started on what the increases in property values have done to the property taxes in the area....We can't even retire here in our beautiful little home on 5 acres because it would take more than 15% (based on this years taxes) of our retirement income just to pay the taxes. So much for planning (and we have a better than average retirement plan).

-- Valkyrie (anon@please.net), August 12, 1999.