Food For Thought. Very Long..Fleckenstein THE BEAR..
November 27, 1998
Market Rap with Bill Fleckenstein
If the Fed Buy 'Spoos', Should You?
Grant's Fall Conference - November 12, 1998
I'd like to start today with a quote from a Wall Street Legend. "It's very rare that you can be as unqualifiedly bullish as you can be now." That was Alan Greenspan, not in 1998, but on January 7, 1973, two days after the market peaked on its way to declining 50% over two years as we endured the worst recession since the depression. I'm sure most of you are not aware of this but A.G. actually used to teach a market timing class which is where I met Jim. We both flunked the class - that's why we aren't working on the sell side or at the Fed.
When I last spoke to this group in the Fall of 1996, the topic was "Return of the Cycle". At that time, and until the summer of 1997 when the collapse of the Thai Baht brought down Asia, the existence of a business cycle, credit cycle, any outcome - other than permanent prosperity - was held in contempt by an enormous percentage of the investing public. The editors of Wired magazine, who were also in our timing class, produced this issue (slide) cheer-leading the case for the new era in July 1997, smack dab at the economic top. P.J. O'Rourke captured this mindset best when he wrote, "Maybe the magic of Wall Street can work for everyone in the world. Perhaps the peasants of China can all "go public" and form a billion corporations with assets of "1 water buffalo, 2 conical hats, wok." Each peasant will then make an initial public offering, sell his stock, get rich, and put a lap pool in the rice paddy."
Even more amazing, as recently as this summer, grown men who should know better were still trying to make the case that the new era and permanently rising stocks in the U.S.A. was the likely outcome. The Wall Street Journal Op-ed page was a treasure trove of those ideas. On July 30th, Rudy Dornbush, professor of economics at M.I.T., in an article titled "Growth Forever" stated "this expansion will run forever" because "we have the inventory and fiscal resources to keep the economy going as well as a policy team that won't hesitate to use them for continued expansion." (I guess Central Planning does work - the Russians just didn't have the right "policy team").
Two weeks later in a piece titled "Asia's Crisis Fuels U.S. Boom" David Hale argued that "the consumption effect of America's buoyant asset markets are exactly what the world economy needs now." He added, "the U.S. was better poised to benefit from the Asian crisis than other countries because of the openness of its capital and asset markets." So if the stock market goes high enough we can consume enough to save the world.
On September 16th , Professor Jeremy Siegel weighed in with "Why Stocks Are Still the Investment of Choice" in which he stated "As investors become rightly convinced of the past superiority of stocks as long-term investments, they will bid stock prices even higher...[where] these higher prices will offer investors lower future returns". [but] "even if growth does not accelerate and all the optimistic claims of the new era advocates prove false, stocks at current elevated levels still emerge as the long run asset of choice." Implying that this rear view mirror investing is a win-win situation - either you do great or at worst you do well, but either way you just can't lose. (Unfortunately, life generally issues its margin calls at a time when your investments are doing poorly - a fact that these long run proponents NEVER stop to consider.)
Of course they were just amplifying what Greenspan said on April 3rd: "The surge in U.S. equity prices the last year or two has been driven by expectations that recent gains in
productivity will continue to accelerate." He declined to say whether those expectations were justified, but again acknowledged the possibility that the U. S. economy had indeed entered a new plane of faster sustainable growth as a result of rising productivity in the last two years. He went on to say that he had not fully signed on to the notion of such a new era but said such a view was "not wholly alien" to him. On June 10th, 1998 in a potential repeat of his unfortunate prognostication of January 1973 he ventured that, "The current economic performance, with its combination of strong growth and low inflation, is as impressive as any I have witnessed in my near half-century of daily observation of the American economy."
The meltdown in Thailand, Malaysia, Korea, Indonesia and the ongoing disaster in Japan was not sufficient to convince the investing public that the wishes of the central bank are not automatically a fait accompli in the real world. Investors still believed stocks could/should go up indefinitely if you just avoided those pesky submerging emerging markets, with all of their crony capitalism, overvalued currencies and balance of trade problems (all of which, of course, were ignored while the money was pouring into these markets.)
I believe that the recent Russian default will historically be seen as the point in time when the "new era" idea died as the markets swamped the desires of the central planners/bankers. Not that most people understood it at the time, as Wall Street in the wake of the Ruble devaluation rallied 5% in 48 hours.
In any case, I think it is fairly safe now to make the bold claim that yes, cycles do exist, and that humans are still ruled by greed and fear, as nothing in the water has altered our DNA to change us. What is staggering to contemplate is how much damage has had to occur in so many places throughout the world to sober people up, even a little.
However, the problem is: a.) this isn't a standard business cycle, it's a bubble, so the downside will be dramatically worse than normal, and b.) The Fed thinks it can eliminate the down side and is determined to get its own way. What we need to know is how to reconcile these diametrically opposed forces.
I believe it is imperative to understand how the bubble was built, what has happened in prior bubbles and in their aftermath, in order to have any chance of prospering in the coming investment environment. Bubbles aren't normal cycles. Bubble sounds innocuous, almost humorous. However, once you take time to actually contemplate the ultimate damage inflicted by the bubble in the twenties, or in Japan in the 1980's, the idea of "bubble" will be terrifying. As food for thought, I'd like to share a devastating observation by Benjamin M. Anderson, who from 1920-1937 wrote the Chase Economic Bulletin and was the bank's chief economist. He was a contemporary critic of the monetary authorities as he understood at the time that the policies were reckless and would lead to disaster. In a book entitled Economics and the Public Welfare 1914-1946, published in 1948 he wrote, "Those who see history only from the outside easily convince themselves that impersonal social forces are overwhelming and that individual men in strategic places make little difference. But this is not true. The handling of Federal Reserve policy by Strong and Crissinger in the years 1924-1927 led to ghastly consequences from which we have not yet recovered. Competent and courageous men occupying their positions would have avoided mistakes which these men made." Three years of irresponsible monetary policy set off a chain reaction of trouble that lasted 20 years. Today, Tokyo is still floundering nine years after their bubble burst. Regrettably, future historians are unlikely to describe the current Fed as either competent or courageous. While rare, bubbles are not trivial - they are the financial equivalent of a nuclear holocaust.
How do we prove this is a bubble? Rather than use facts like the stock market is 140 % of GDP versus 80% in 1929, or stocks are the most expensive ever, or stock split beepers are used by people to know when to buy options to prove our case, I propose we examine the attitudes, logic and expectations of our last great bubble to see how they compare to today's environment. We shall compare psychological fingerprints, if you will. I am going to take a few minutes to read to you some excerpts from the "New Era of Investing" chapter of Ben Graham's book Security Analysis written in 1934.
"A new conception was given central importance - that of trend of earnings. If an attempt were to be made to give a mathematical expression to the underlying idea of valuation, it might be said that it was based on the derivative of the earnings, stated in terms of time.
"Along with this idea as to what constituted the basis for common-stock selection, there emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment.
"The combination of these two ideas supplied the "investment theory" upon which the 1927-1929 stock market proceeded. The theory ran as follows:
1. 'The value of a common stock depends on what it can earn in the future.' 2. 'Good common stocks will prove sound and profitable investments.' 3. 'Good common stocks are those which have shown a rising trend of earnings.'
"These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses which could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether it was a desirable purchase. A moment's thought will show that "new-era investment," as practiced by the trusts, was almost identical with speculation as popularly defined in pre-boom days... It would not be inaccurate to state that new-era investment was simply old-style speculation confined to common stocks with a satisfactory trend of earnings. The impressive new concept underlying the greatest stock-market boom in history appears to be no more than a thinly disguised version of the old cynical epigram: 'Investment is successful speculation.'
"The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell.
"An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy "good" stocks, regardless of price, and then to let nature take her upward course...
"An ironical sidelight is thrown on this theory by the practice of the investment trusts. These were formed for the purpose of giving the untrained public the benefit of expert administration of its funds... But most paradoxical was the early abandonment of research and analysis in guiding investment-trust policies. The investment process consisted merely of finding prominent companies with a rising trend of earnings, and then buying their shares regardless of price. Hence the sound policy was to buy only what every one else was buying-a select list of highly popular and exceedingly expensive issues, appropriately known as the "blue chips." Investment trusts actually boasted that their portfolios consisted exclusively of [the most popular and highest priced] common stocks...
"The man in the street, having been urged to entrust his funds to the superior skill of investment experts - for substantial compensation - was soon reassuringly told that the trusts would be careful to buy nothing except what the man in the street was buying himself...
I'm sure it's quite clear to everyone that these quotes could, with minimal changes, have been taken out of today's newspapers. If it looks like a bubble, acts like a bubble, and beeps like a bubble, IT'S A BUBBLE.
How did we build this bubble? It is important to understand how we created this monster so we can put in perspective future attempts at " organized support" ( to steal another term from 1920's) and be able to determine if we think those actions will ultimately be successful.
The engine of the bubble was created way back in 1980 when Congress passed the Depository Institution Deregulation and Monetary Control Act which called for the phase out of Regulation Q allowing financial institutions to compete with money market funds.A piece of that legislation was financial plutonium: raising the insured deposit maximum to $100,000.00. That seemingly innocuous change (thank you Fernand St. Germain) spawned "brokered deposits", an enormous driver of the excesses of the 1980's both in LBO lending and the over-building of real estate long after the 1986 Tax Act made it uneconomical to do so. Money sought out the highest bidder with no regard as to how it might be used. It is hard to overstate the significance of this legislation in creating the excesses of the 1980's, which of course set the stage for the even greater excesses of the 1990's.
It is important to realize that the 1990-1991 recession was not precipitated by the Fed. Yes, rates went up a little but not enough to matter. The economic contraction was instead caused by the collapse of credit as banks and the S&L industry were destroyed by their bad loans and by the new-found religion with which the comptroller of the currency began to do its job. As this was occurring, unfortunately Greenspan didn't understand it as he made painfully obvious in January 1990, "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 figured it out, he got busy; ultimately cutting interest rates 24 times in a row, to 3%, which of course drove the public out of CD's and money markets, and into stocks and bonds. Personally, I struggled a long time to reconcile how the enormous reckless frenzy of the 1980's which nearly ruined the banking system could have resulted in the greatest bull market in history.
The collapse of Communism was the wild card that precipitated 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 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.
They didn't just spike the punch bowl, they put LSD in it (causing me to exit the long side to set up a short fund) triggering a new round of speculation both domestically and globally that finally began to unwind last summer when the bubbles in Thailand and SE Asia burst.
Naturally, they attempted to bail those countries out as well, once again trying to postpone the ill effects of so many years of speculation. However, with them all collapsing at once they couldn't even fake a success, even though Wall Street believed the bailouts would succeed - as did Greenspan. In February 1998, he claimed that Asia's economic crisis should have a limited impact. There is "a small but not negligible probability that the upset in East Asia could have unexpectedly negative impacts on Japan, Latin America, and eastern and central Europe that in turn could have repercussions elsewhere, including the United States." Right idea, dead wrong conclusion!
The default by Russia and the chain reaction that culminated with the implosion of Long Term Capital completed the bubble popping process that Thailand began. It now appears that the real reason for the LTCM bailout was the stock market not the bond market. "We were most concerned about the equity book" Jon Corsine, Goldman Sachs CEO recently 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 creating roughly $500 billion of equity for the world's speculators. The chaos created by this surprise attack caused a systems outage at the CBOE forcing them to halt trading and hold a closing rotation for index options, a first, and currently the subject of an SEC investigation. Were it not for the gravity of the situation, the thought of the SEC investigating the Fed would be hilarious.
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. Good policy options don't exist, the position the Fed is in currently. They are now 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 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 1920's. Instead of CPI inflation we have created asset inflation in the form of the biggest stock market bubble of all time.
Which brings us to the key question of the day. If the Fed buys spoos, should you? A crass way of asking, can the Fed re-inflate the stock market and economy or has "too big to fail" finally become "too large to save"? Fading the Fed has been an unwise proposition at every juncture except 1929-1933. However, looked at historically, post bubbles, fading the Central Bank, Fed or BOJ, is 2 for 2.
In the same perverse way that at market peaks risk appears lowest and at troughs highest, the fact that most do not believe we've seen a bubble increases the odds that we have! Conventional wisdom is that we can't have a recession or a bear market since there is no inflation, and therefore, no Fed tightening to precipitate those two negative outcomes. The recent Fed easings have only increased the confidence of those who worship at the alter of Alan Greenspan. It is a sad irony that at a time when more people than ever believe in the omnipotence & omniscience of the Fed, it will be less effective.
Why am I so certain? As previously stated, the central banks are 0 for 2 this century - post bubble. In addition, there are several large impediments to a return of the bull market. For example, we have witnessed massive destruction of bank capital in a short period of time. It will take some time for the contraction and layoffs to be felt, but it will take far more time for banks to rebuild their capital via conservative carry trades and even more time still for banks to once again lose their collective minds and recreate the lending and derivative environment required to power equities to continued higher highs.
The largest impediment will be the amount of additional capital the world's fixed income markets are going to require, as the most recent refunding amply demonstrated. Massive leverage provided by banks/financial intermediaries and extraordinarily low financing costs available by borrowing in yen allowed far less capital to keep the world's fixed income markets functioning than the future will, especially now that risk levels are being reduced everywhere. It was this excess leverage that created the illusion of excess liquidity and unlimited capital for the world's equity markets. Prospectively, the capital in the world left over to fund our stock market will be reduced accordingly. For example, if a seller of a bond had been leveraged twenty-to-one, and the new buyer is paying cash, you can quickly see the order of magnitude of capital that the bond market will now require. The capital shortage for equities will be alleviated, to some degree, by a weaker real economy (the other big user of capital) but that, of course, is not bullish for stocks either.
Unlike the run from 1991-97, the period that everyone hopes we are about to replicate, the public is up to its eyeballs in stock already. They have increased equities from 0% to 100% of their portfolio. Taft Hartly, Corporate and Municipality employee benefit plans as well as Foundations are maxed out too. Rather than a big tidal wave of wholesale portfolios shifts, the equity market can only look forward to the trickle of incremental cash flow.
The first post cold war economic boom is history, we are entering the first post cold war economic bust. Presently, Europe, America, (and China) are the only places not experiencing recession or depression, but the weakness from the rest of the world will spread to these countries aided and abetted by the destruction of bank capital.
In addition, the cross currents created by the year 2000 transition, insure that the next year will have far more than the usual amount of uncertainty and confusion which won't be beneficial for the economy or stock prices.
Recalling what Ben Graham said, I will not argue that ridiculous valuations are a reason the stock market can't go higher. The lesson of manias is that valuations are meaningless. But it is worth noting that as crazy as they are, valuations are understated because earnings are overstated due to financial engineering; recurring one-time charges, merger related write-offs, employee options in lieu of salary, and stock buy-backs. These games worked while business boomed but they may not prospectively, especially given that a post Cendant and Sunbeam SEC appears determined to crack down on these abuses.
Western central banks, and chiefly our Fed, seem to believe that they understand the future better than Jim Grant knows the past. Their arrogance, the universal deification of the Fed, and greed will cause most investors to lose enormous amounts of money in the next few years.
What should investors do? First, they should lower risk wherever possible, that's common sense. Next, risk should be reduced where it's highest by avoiding leveraged balance sheets and technology. The logic for the former, given all that I have said today, should be self-evident. As for technology (and here I mean hardware), the bottom line is that it is a GDP sensitive, capital intensive business with no barrier to entry and presently in massive oversupply. This over capacity has persisted since late 1995 requiring layoffs at most companies to combat the revenue shortfall. Yet investors still refuse to value technology as a business, preferring to spin a story as to why today's data doesn't matter since the future will be so bright. Technology has been the bubble within the bubble. This lunacy (ex-internet stocks) may be best typified by Dell, a high quality mail-order assembler of other people's components that commands a $90 billion valuation, yet controls a modest 9% of a $120 billion market that has no barrier to entry. It and nine other tech stocks have a combined market capitalization of $1.1 trillion, a sum roughly equal to 110% of the German, half the Japanese, or 10% of the U.S. market.
At some point, these rationalizations will stop. Investors will shun technology stocks as victims of profitless prosperity just as they have at other low points in the last 20 years when we have been bullish on them. At that time, I plan to cover our shorts and return to the long side of the market. I had previously hoped that would occur in the year 2000, but recent government action may well postpone that outcome. Get ready for the ride of a lifetime; it has already started.
Please be sure you've read "What is the Market Rap?" before you send me email. As highlighted in this outline, there are certain questions to which I am unable to respond.
William A. Fleckenstein <fleckenstein@go2net.com>, special to StockSite.
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