In RealMoney tonight Fleck provided a link to a speech he gave in 1999. It's timeless. Here it is:
Editor's Note: This speech was originally delivered at Fraser Management's The Contrary Opinion Forum, which took place Sept, 29 -- Oct. 1, 1999.
What is a bubble? Webster's New World Dictionary defines bubble as:
A film of liquid forming a ball around air or gas.
A transparent dome.
A plausible scheme that proves worthless.
Unfortunately, what has transpired over the last five years in the financial markets has been a bubble. While the entire market obviously won't prove to be worthless, the declines in store for most securities will be tremendous.
I would like to begin today by describing the various factors that collectively have created the financial environment in which we currently find ourselves. I shall then demonstrate that this is a bubble by comparing today to the late 1920s and offer some thoughts as to the potential severity of the aftermath of this bubble. Lastly, I will make a stab at guessing what might pop it.
The seeds of this bubble were sewn way back in 1980, when Congress passed the Depository Institution Deregulation and Monetary Control Act, which called for the phasing out of Regulation Q, which allowed financial institutions to compete with money market funds. A piece of that legislation was financial cancer: Raising the insured deposit maximum to $100,000.00. That seemingly innocuous change (thank you Fernand St. Germain) spawned "brokered deposits," the primary driver of the reckless lending practices of the 1980's.
Money sought out the highest bidder with no regard as to how it might be used. As a result, we witnessed the funding of over-leveraged LBOs and the over-building of real estate long after the 1986 Tax Act made it uneconomical to speculate in property. It is hard to overstate the significance of this legislation in creating the excesses of the 1980s, which set the stage for the even greater excesses of the 1990s.
It is important to realize that the 1990-1991 recession was not precipitated by the Fed. Yes, rates went up but not enough to matter. The economic contraction was instead caused by two factors: One, the collapse of credit as banks and the S&L industry were destroyed by these bad loans and two, the subsequent new-found zeal with which the office of comptroller of the currency began to do its job. Unfortunately, Greenspan didn't understand what was occurring as he made painfully obvious in January 1990 when he stated, "But such imbalances and dislocations as we see in the economy today probably do not suggest anything anymore than a temporary hesitation in the continued expansion of the economy."
However, once he finally understood what was happening, he got busy; ultimately cutting interest rates 24 times in a row, to 3%, which of course drove the public (who was only just beginning to focus on its retirement needs) out of CD's and money markets, and into stocks and bonds. It is ironic that the enormous reckless frenzy of the 1980's, which nearly ruined the banking system, did little apparent damage, and instead spawned a great bull market, and ultimately an even greater bubble.
The collapse of Communism helped precipitate this stunning transformation as it set off a mad dash for capitalism around the globe, creating the first post-cold-war economic boom. The boom eventually forced the Fed to begin raising interest rates, thereby causing the implosion of the carry trade, Orange County, Mexico, etc.
Of course, by then the deregulated banking system had discovered rocket scientists with computers and had begun loading itself up with derivatives. The combination of the Mexican peso collapse and the unwinding carry trade posed a grave threat to Wall Street and the banks so Greenspan and Rubin bailed them out. In doing so, they didn't just spike the punch bowl, they put LSD in it triggering a new round of speculation both domestically and globally that finally began to unwind in the summer of 1997 when the bubbles in southeast Asia burst beginning with Thailand.
Naturally, the central bankers attempted bailouts, once again trying to postpone the ill effects of too many years of speculation. However, with so many countries collapsing at once the Fed (& Co.) could not prevent calamity from hitting those countries. Yet they did succeed in adding more fuel to the stock market frenzy raging here in America.
The default by Russia one year ago caused a chain reaction that culminated with another implosion, that of Long Term Capital, the most recent episode in this long series of Fed bailouts. The real reason for the LTCM bailout appears to have been the stock market not the bond market as was professed. "We were most concerned about the equity book" Jon Corsine, Goldman Sachs CEO told Businessweek. "The whole potential scenario of unwinding their equity portfolio under a forced environment could have had extremely negative consequences on the [overall] market" was how David Komansky, Merrill Lynch's CEO described the situation.
This is why the Fed tried to get ahead of curve in a panicked attempt to change market psychology by, dare we say, market manipulation. Manipulation may be too strong a term, but what else can you call it when rates are cut 25 basis points with only 45 minutes remaining in the trading day in which all index options and options on futures are due to stop trading? In what is surely the biggest move in history, the S&P Futures exploded 4.9% in 4 minutes. The chaos created by this surprise rate cut caused a systems outage at the CBOE forcing them to halt trading and hold a closing rotation for index options for the first time ever.
How was the Fed able to print money and create credit in unlimited quantities to manufacture this bubble? The absence of CPI inflation! Having learned nothing from the twenties or Tokyo either, the Fed and nearly everyone believes that nothing can be wrong if there is no CPI inflation. Yet, it is only in a period of low inflation that the monetary spigots can stay open long enough to foment a bubble. Once created, the damage has been done and good policy options don't exist. You are then in the bubble-management business. (After 50 shots of Tequila you will feel crummy tomorrow no matter what you do.)
We have created over-capacity and precipitated massive speculation just as we did in the twenties. Inflation has been held in check not by prudent monetary policy but by a unique combination of events. In addition to the post cold war boom and NAFTA, the enormous productivity gains achieved by the massive invasion of powerful microprocessors into our lives conspired to keep CPI inflation in check, just as innovations such as autos, planes, and fractional horsepower electric motors suppressed inflation in the 1920s. Instead of CPI inflation we have created asset inflation in the form of the largest stock market bubble of all time.
I believe these bailouts since Mexico in late 1994 (when we crossed over from bull market to mania) have, in essence, socialized risk and are the principal reasons why the public feels that they cannot lose money in the stock market (over time). We have all seen the same surveys that show people expect compound returns from equities varying between high teens and thirty percent.
In addition to the Fed there are other catalysts that have precipitated the current craze. First, demographics have fostered a "need to believe" on the part of the public, and Wall Street has been happy to supply the rationalization and schemes with which to do so.
Secondly, technology. It is easy to see why technology is such a financial aphrodisiac. Life without television, fax machines, or cellular phones, would be far less enjoyable, and life without Prozac would be a boring life at "book value". Yet nothing heretofore has so seemingly demystified and so dramatically altered the investing landscape the way the PC has. It has simultaneously empowered the masses to believe that they are in complete control and has deluded them into confusing information with knowledge. Most know the price of everything and the value of nothing.
Third, television (and here I mean CNBC primarily -- a/k/a Bubblevision) has helped seduce the public into an over-confident state bordering on arrogance. Folks are now certain that they possess the know-how and have earned the right to be rich.
Lastly, corporate America itself, the object of all this speculation has helped its own cause. Not so much through earnings, but through the creative expression of those earnings. The rascals in charge have enthusiastically and nearly unanimously elevated accounting into pure art via one-time charges, merger related write-offs, forward looking statements about the improvement in business "since the end of the quarter," and of course stock options with their attendant absurd tax treatment. To show how acceptable outright fraud has become, Walter Forbes and "windbag" Al Dunlap are free and very rich men to this day.
Having said all that about corporate America, it is not clear to me whether it actually has had a part in creating the euphoria or whether the euphoria has simply allowed it to occur. Collectively these factors have convinced today's speculators that the only real risk associated with equities is in not owning them.
The total disregard for valuation, precedent, and risk that today's "new era" mentality has engendered should terrify anyone with an understanding of the financial past. The denouement of this tragi-comedy is certain even if the timing is unknown.
Presently, only the GDP of the entire world at $25 trillion overshadows the $14 trillion-$15 trillion capitalization of the U.S. stock market. At 160% of our huge $8.8 trillion GDP, the ratio of market capitalization to GDP is over 60% higher than it was in 1929, the previous all time high. We are light years from the 70-year average of 50% and from the low of 33% seen in 1974 and 1982.
In the last two and a half years, the stock market capitalization has increased over $5 trillion dollars, a gain equal to 60% of America's current GDP. Unfortunately, earnings of the underlying companies have not been responsible for this surge. Since the end of 1996, the S&P 500 has rallied 75%, but S&P earnings have grown only about 6%.
Everyone has his favorite story of extremes these days. For instance, the six biggest tech stocks (Microsoft, Intel, IBM, Cisco, Lucent and Dell) are now valued at $1.65 trillion or 20% of GDP. Microsoft alone is valued at $500 billion making it larger than the entire junk bond market!
My personal favorite anecdote illuminating today's hysteria is Internet Capital Group. It is an internet venture capital fund valued at approximately $12 billion (that has only one public holding worth about $400 million). In a recent interview, a big-time Wall Street analyst justified the current valuation by explaining that recent venture capital returns have been 30 fold and that if all of ICGE investments and the cash received from the IPO were valued at 30 times the stock would be worth about what it was selling for, but that meant you would be getting management for free! Consequently, he liked it. It has rallied over 30% since the interview.
However, it is not the specific examples that are the primary concern. The risk is that the environment which has led to these individual excesses has produced a total market capitalization so out of proportion with the underlying businesses that it has altered the economy of the world.
Former Fed Chairman Paul Volcker recently summed up the situation quite succinctly when he said, "The fate of the world economy is now totally dependent on the stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings." I urge you to think about that statement. It is the reason why any responsible person should be aware of these facts.
The numbers are so gargantuan and so completely beyond our range of experience that they have lost their ability to produce a visceral impact. For instance, we all know that light travels at 186,000 miles per second, yet how many can grasp how fast that is? We know that computers can add numbers in a fraction of a nanosecond (one billionth of a second, which is how long it takes light to travel one foot), but who can appreciate that? However, if we observe that the relationship between one nanosecond and one second is the same as one second and thirty-three years, we can begin to appreciate how magically fast light moves and computers work. We are able to do this because we have experience dealing with seconds and years.
In that same vein, I believe the best way to put the current mania in its proper perspective, is not to compare facts and figures but to examine qualitative descriptions from our mania of the late 1920s. New era believers today roll their eyes at the mere suggestion of this analogy, yet most have no knowledge of what actually took place in those days. (Steve Forbes, for example, says there was no bubble. Fed tightening caused all the problems.)
What follows are excerpts from several books which illustrate how nearly identical the behavior of today's stock market participants is to that of 70 years ago. I will be editorializing some of these passages to make the obvious even more so.
In short, the late 20s bubble was caused by poor policy decisions, resulting in excess credit creation, which led to a bubble. "Modern Times" best describes in brief why policies were pursued, what resulted, and the consequences:
"The aim was to avoid trouble and escape the need to resolve painful political dilemmas. [The Fed policies since Mexico's implosion in 1994.] The policy appeared to be succeeding. In the second half of the decade, the cheap credit the Strong-Norman policy pumped into the world economy perked up trade. ... So the notion of deliberate controlled growth within a framework of price stability had been turned into reality. This was genuine economic management at last! The American experiment [Greenspan experiment] in stabilization from 1922 to 1928 showed that early treatment could check a tendency either to inflation or to depression. ... The American experiment was a great advance upon the practice of the nineteenth century.
"Yet in fact the inflation was there, and growing, all the time [same as now] . What no one seems to have appreciated is the significance of the phenomenal growth of productivity in the U.S. between 1919 and 1929: output per worker in manufacturing industry rising by 43 percent. This was made possible by a staggering increase in capital investment, which rose by an average annual rate of 6.4 percent a year. The productivity increase should have been reflected in lower prices. The extent to which it was not reflected the degree of inflation produced by economic management with the object of stabilization.
"It is true that if prices had not been managed, wages would have fallen too. But the drop in prices must have been steeper; and therefore real wages -- purchasing power -- would have increased steadily, pari passu with productivity. The workers would have been able to enjoy more of the goods their improved performance was turning out of the factories. As it was, working-class families found it a struggle to keep up with the new prosperity. They could afford cars -- just. But it was an effort to renew them. The Twenties boom was based essentially on the car. [PCs anyone?]
"As the boom continued, and prices failed to fall, it became harder for the consumer to keep the boom going. Strong's last push, in fact, did little to help the 'real' economy. It fed speculation. Very little of the new credit went through to the mass-consumer. Strong's coup de whiskey benefited almost solely the non-wage earners: the last phase of the boom was largely speculative. [Three rate cuts in the fall of '98.] Until 1928 stock-exchange prices had merely kept pace with actual industry performance. From the beginning of 1928 the element of unreality, of fantasy indeed, began to grow. As Bagehot put it, 'All people are most credulous when they are most happy.'
"Two new and sinister elements emerged: a vast increase in margin trading [online/day trading] and a rash of hastily cobbled-together investment trusts [Internet stocks] . By 1929 some stocks were selling at fifty times earnings. [How about well in excess of 50 times revenues today?] As one expert put it, the market was 'discounting not merely the future but the hereafter.' A market boom based on capital gains is merely a form of pyramid selling.
"The new investment trusts, which by the end of 1928 were emerging at the rate of one a day [several internet IPOs per day now] , were archetypal inverted pyramids. They were supposed to enable the 'little man' to 'get a piece of the action.' [Again, online trading.] In fact, they merely provided an additional superstructure of almost pure speculation, and the 'high leverage' worked in reverse once the market broke. [Futures, options and OTC derivatives today]
"It is astonishing that, once margin trading and investment trusting took over, the Federal bankers failed to raise interest rates and persisted in cheap money. But many of the bankers had lost their sense of reality by the beginning of 1929. [William McDonough, president of the New York Fed recently embraced the new era stating "It's likely the American productivity boom will continue. I'm very confident about the future trend of the American economy. The forces that have allowed us to do so well are likely to continue."]
Part 2 continued in the next post |
