Fair use...Technology and history - why this boom must end
By Peter Hartcher
David Hale found himself in a taxi in New York last week. The experience frightened him. Whenever the cab stopped at a red light, the driver busied himself with a small computer. "The guy was trading his stock portfolio," says Hale, the global economist at the Zurich Group.
"It's unbelievable. We have a whole subculture feeding on itself. It's the bell-hop syndrome. That's the scariest thing in the US now." The bell-hop syndrome? "When Joe Kennedy was asked how he managed to sell in time to avoid the Great Crash of 1929, he said the sign was that bell-hops were giving stock tips."
The US is living through the greatest stockmarket surge in history. US shares have gained about $US10 trillion in value in the last decade. That's enough to buy a third of everything produced in the world economy in a year, or the total annual output of the Australian economy 45 times over. Or enough to repay all the debts of all Third World countries 20 times over. And that's just the increase in the value of US shares, not their total value.
This tremendous boom has put an estimated $US2.5 trillion in capital profits into the hands of ordinary individual American investors in the past 10 years. It has fuelled outrageous profligacy among the rich ð the Wall Street Journal carried an ad for a $US14,000 men's business suit with flecks of real gold stitched into it ð that echoes the Tokyo bubble of a decade ago. Remember the shavings of gold atop the sushi?
The rally has also swept up some of the poorest Americans. One New York entrepreneur set up a stock investment fund specially for low-income blacks, and goes door to door scouring ghettos for investors among the janitors and welfare recipients. The market's great boom has proved so strong and so durable that it seems almost invincible. The cab drivers are scrambling.
And the last ones to arrive are the most wildly bullish. A Gallup poll last July found investors who'd been in the market for 20 years or more expected annual stockmarket returns of 13 per cent. People who had arrived in the past five years were counting on gains of 23 per cent.
It is a case of "monkey see, monkey do," according to an expert on financial frenzies and failures, Charles Kindleberger, professor emeritus at the Massachusetts Institute of Technology. "In my talks about financial crisis," he writes in his classic work, Manias, Panics and Crashes, "I have polished one line that always gets a nervous laugh: ?There is nothing so disturbing to one's well-being and judgement as to see a friend get rich.'
"When the number of firms and households indulging in these practices grows large, bringing in segments of the population that are normally aloof from such ventures, speculation for profit leads away from normal, rational behaviour to what has been described as manias or bubbles."
But the sceptics have been on the losing side of the market. Some of the wariest of professional investors have found it irresistible.
The billionaire speculator George Soros spent 1998 and most of 1999 punting that the most overvalued stocks ð those of internet companies ð were headed for a fall. He shorted the market and waited for the inevitable crash to deliver him big profits. It didn't arrive. Last October Soros abandoned his judgement and started buying internet shares. He ended the year with a 40 per cent gain.
The Chinese have an old saying for this: When all around me are going mad, how can I alone remain sane? But perhaps it is not madness. Maybe the mob has it right. After all, this bull market has been running for 17 years now. And the technology stocks have shown fresh vigour ð the main tech index, the Nasdaq, stood at 1,400 points 17 months ago. It's now around 5,000.
Perhaps it vindicates the enthusiasts who preach the boundless possibilities of the information revolution and the new economy. Even David Hale, despite his taxi driver trauma, is turning himself into an internet entrepreneur and plans to bring a dot com company to market.
And surely this is utterly unlike the great episodes of speculative madness of the past? The Dutch tulip craze of the 17th century, the South Sea Bubble of the 18th, and the Tokyo land mania of the 20th were based on a simple scramble for a commodity. The only reason the commodity had value was that it was in short supply. This time, there is a technological revolution which is transforming the world's biggest economy, right?
Not so fast. The promoters of Wall Street's latest frenzy depend on four big stories to sell their wares. All are only partly true, or completely phoney. None will prevent this vast boom, like every one that has ever preceded it, from ending.
Claim number one: There is a new economy which is based on new technologies that have allowed productivity to accelerate in the US economy. This allows the economy to raise its safe speed limit, growing faster without hitting the customary speed bumps of inflation. This, in turn, should keep the economy booming.
It is true that productivity growth has accelerated. After two decades of growth at a sickly annual average of 1.1 per cent, it has quickened since 1995, almost doubling to average 2.1 per cent a year. The magazine Business Week lauded this as a "productivity revolution".
The Federal Reserve's chairman, Alan Greenspan, sounded impressed last May when he said that the acceleration "reflects, at least in part, a more deep-seated, still developing, shift in our economic landscape".
But Robert Gordon, a productivity expert at Northwestern University, had a closer look at the numbers. What he discovered is deeply disturbing for the new economy theorists. Indeed, his is probably the single most subversive piece of research that anyone has produced on the subject. Just two weeks after Greenspan's words, he presented his conclusion to a Federal Reserve conference in Chicago.
All the improvement, he said, was concentrated in just one, small slice of US industry ð the computer hardware industry, which accounts for only 1 per cent of the US economy. "There has been no productivity growth acceleration in the 99 per cent of the economy located outside the sector which manufactures computer hardware," he concluded [his emphasis].
"One of the most surprising results of this paper is that the productivity performance of the manufacturing sector of the US economy since 1995 has been abysmal rather than admirable . . . A final conclusion is that every observer of the economy, from Business Week to Alan Greenspan, has been misled about the economy's performance."
Could this be true? The board of governors of the Federal Reserve put one of its own economists, Karl Whelan, onto the job. In a paper published last month, Whelan decided that Gordon was right: "We did not find any evidence that [productivity] growth has picked up" outside the computer hardware industry, he wrote. "Indeed, given historical patterns, it seems unlikely that the recent pace of computer-related technological advance can be sustained . . . a slowdown in aggregate productivity growth would be the most likely outcome."
So much for the productivity revolution and the new economy it was supposed to sustain. Claim number two: Technology companies can turn in stellar performances, even if the overall economy does not.
This can be quite true, but it is not the whole story. When you buy a share in a company, you are buying into two separate phenomena. One is the company. You also buying into a pattern of stockmarket behaviour. However, even if the company and its technology turn out to be brilliantly successful, its price is set by the financial markets, and the financial markets move with their own rhythm.
What does this say about the future of US tech stocks, which account for a third of the total value of the US stockmarket?
Jeremy Siegel, Professor of the Wharton School at the University of Pennsylvania, is famous in the US as a strong and consistent advocate of the stockmarket as a good long-term investment. His 1994 book, Stocks for the Long Run, became the Bible of the professional stock promoter and salesman.
Last week he issued a warning. Right now, he says, Wall Street "has been driven to an extreme not justified by any history". His evidence? "History has shown that whenever companies, no matter how great, get priced above 50 to 60 times earnings, buyer beware." That is, beware if a share is trading at a price 50 to 60 times the earnings that it generates, otherwise known as its price to earnings ratio or P/E.
How do today's stock prices compare with this benchmark? The 100 biggest companies listed on the Nasdaq were trading during the week at an average P/E ratio of about 100 times. Many darlings of today's Wall Street fashions are trading with P/Es of several hundred. Last year, America Online traded at a P/E of more than 700.
Siegel pointed out in The Wall Street Journal that in the history of the US market, whenever a stock has traded at anything like this ratio, it has subsequently underperformed the overall market for a quarter of a century or more.
He cites two examples of world-class companies from the late 1960s ð Polaroid, which boasted a P/E of 95, and IBM, with a ratio of 50. These companies were dominant and extremely profitable. But Polaroid rewarded investors with a negative return over the next 30 years; and despite its recent recovery, IBM made less than half the market average in the years since that peak.
Claim number three: Buying into a technology stock means you might be buying the next Microsoft, joining a stunning technological revolution that promises super returns.
Again, this could be true. But it is unlikely. One of the century's most successful investors, Warren Buffett, personal wealth $US31 billion, refuses to join the game. He admits it is a seductive idea: "Just pick the obvious winners, your broker will tell you, and ride the wave."
But he says that this is based on optimism, not analysis. "The Tinkerbell approach ð clap if you believe ð just won't cut it."
So what is the Buffett approach? "I thought it would be instructive to go back and look at a couple of industries that transformed this country much earlier in the century: automobiles and aviation. "If you had foreseen in the early days of cars how this industry would develop, you would have said, ?Here is the road to riches.'"
He discovered that in its early phase, the US car industry boasted 2,000 makes: "After corporate carnage that never let up, we came down to three US car companies ð themselves no lollapaloozas for investors."
As for the aeroplane manufacturing industry, Buffett counted about 300 in the years 1919-39 "of which only a handful are still breathing today." What about airlines? "As of 1992," says Buffett, "the money that had been made since the dawn of aviation by all of this country's airline companies was zero. Absolutely zero.
"I'd like to think that if I'd been at Kitty Hawk in 1903 when Orville Wright took off, I would have been farsighted enough, and public spirited enough ð I owed this to future capitalists ð to shoot him down." Buffett says it would have been smarter to short the market for horses than to invest in cars. The founder of one-time stockmarket darling Amazon.com, Jeff Bezos, was amazed to hear Buffett's analysis: "I noticed that decades ago, it was de rigueur to use ?motors' in the name, just as everybody uses ?dot com' today. I thought, wow, the parallel is interesting. We still have the opportunity to be a footnote in the e-commerce industry."'
Claim number four: Even if interest rates continue to go up, it won't hurt technology stocks. The basis for this claim? Traditional companies hold debt. They suffer when the interest rate on that debt rises. But new technology companies have mainly equity, which is unaffected by rate rises. "Anyone who says that doesn't know their economics," says Jim Walker, chief economist at Credit Lyonnais Securities Asia, and twice voted the best economist in Asia. "The technology company might not borrow, but the people who do borrow are their customers. And so the rising rates will hurt their customers. That means the technology company will start missing its sales forecasts and the whole thing starts to unravel."
So if these claims in support of an unending stock boom are unreliable, what has been pushing share prices so high for so long? Kindleberger points out that a mania almost always begins in a time of low interest rates and easy money.
And indeed it has been the gusher of liquidity that has created the boom. This year's stratospheric technology stock prices have been borne aloft by an unprecedented jet of liquidity. US mutual funds have put a record average of $US7.4 billion into new economy stocks every week so far this year. "This is three-and-a-half times the pace seen in the fourth quarter of 1999, and that was a record," according to JP Morgan.
Kindleberger points out that rising interest rates, a tightening of the liquidity tap, are usually the death knell for such booms.
The chief economist at Deutsche Banc Alex Brown in New York, Ed Yardini, wrote last month: "In numerous conversations with numerous portfolio managers last year, we agreed that the stockmarket was experiencing a classic speculative bubble. The conclusion of all these conversations was always the same ð ?This will end badly.'"
But exactly how and when the boom will end is impossible to pick. Every boom is unique, and so are the circumstances of its death. Mark Twain probably had it when he remarked that history may not repeat, but it rhymes. The cabbie had better stick with his day job.
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