Fleck's speech part 2
"The 1929 crash exposed in addition the naivete and ignorance of bankers, businessmen, Wall Street experts and academic economists high and low; it showed they did not understand the system they had been so confidently manipulating. They had tried to substitute their own well-meaning policies for what Adam Smith called 'the invisible hand' of the market, and they had wrought disaster. Far from demonstrating, as Keynes and his school later argued (at the time Keynes failed to predict either the crash or the extent and duration of the Depression) the dangers of a self-regulating economy, the degringolade indicated the opposite: the risks of ill-informed meddling." [This is my basic reason for continually harping about the Fed.]
The "New Era of Investing" chapter of Ben Graham's book Security Analysis written in 1934 describes the late 1920s investment climate. "A new conception was given central importance -- that of trend 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. [Momentum Investing -- an oxymoron if ever there was one.]
"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."
"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. [Sound familiar?] 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." [I'm raising my price target to $300.]
"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?" [How many times have you heard something like this repeated in the last month?]
From the book 1929 by William Klingaman, the following captures the mood of that period:
"The boom had become a full-fledged stampede. Several years later, Otto Kahn looked back toward the early days of September 1929 and concluded that the speculative movement had gained so much momentum by that time that nothing short of a crash could have brought it under control. The American public, Kahn testified, was 'determined to speculate. They were determined that every piece of paper would be worth tomorrow twice what it was today. I do not believe the whole banking community could have prevented it...When it had taken full sway of the people and there was an absolute runaway feeling throughout the country, I doubt whether anyone could have stopped it before calamity overtook us.' [Just like now -- slowly.]
"To liberal journalist Gilbert Seldes, the final days before the crash were the true time of panic. 'I call it panic to be afraid to sell at a profit, lest additional profit be lost,' Seldes wrote. 'The panic which keeps people at roulette tables, the insidious propaganda against quitting a winner, the fear of being taunted by those who held on, all worked together. [Today's motto: Never sell good stocks.] It became not only a point of pride, but a civic duty, not to sell, as if there were ever a buyer without a seller.'
"Although the Wall Street Journal [CNBC] , the chief journalistic promoter of the boom, maintained its traditionally optimistic front, the editors of Business Week [The Economist ] charged unequivocally that 'stock prices are generally out of line with safe earnings expectations, and the market is now almost wholly 'psychological' -- irregular, unsteady and properly apprehensive of the inevitable readjustment that draws near.'
"In fact, only 388 of the nearly 1,200 issues listed on the New York Stock Exchange had advanced between January 2nd and September 3rd [of 1929] , while more than 600 stocks already showed substantial declines from their highest point of the past few years. 'This has been a highly selective market,' observed the Cleveland Trust Company's resident market guru, Colonel Leonard P. Ayres. 'It has made new high records for volume of trading, and most of the stock averages have moved up during considerable periods of time with a rapidity never before equaled. Nevertheless the majority of the issues had been drifting down for a long time...In a real sense there has been under way during most of this year a sort of creeping bear market.' [Exactly, today's market action.]
Roger Babson [the spiritual grandfather of Marc Faber, Jim Grant and me] prophesized the coming debacle (as he often had before) in September 1929 as follows: "Fair weather cannot always continue. The economic cycle is in progress today, as it was in the past. The Federal Reserve System has put the banks in a strong position, but it has not changed human nature. More people are borrowing and speculating today than ever in our history. [These days even student loans are used for speculation.] Sooner or later a crash is coming and it may be terrific.
" 'Things have never been better,' Charlie Mitchell [William McDonough] told reporters on the evening of Friday, September 20? Mitchell cheerfully advised investors to 'be a bull on America'. 'Money is all right' he assured everyone. 'There's nothing to worry about in the financial situation in the United States'." [And everybody knows what happened one month later.]
The best analysis of the economic and monetary policy of the 1920s comes from a book entitled Economics and the Public Welfare 1914-1946 written by Benjamin M. Anderson. From 1920-1937, he 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 being pursued were reckless and would lead to disaster. Since the book was not published until 1948, he had twenty years to reflect on that period.
This is his opinion: " 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 nearly two decades. 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.
Which brings us to the critical question. Should we expect the fallout from this bubble to be more or less severe than the 1930s here and the 1990s in Japan?
First let us acknowledge that every time is different and that much of the damage to occur post bubbles is a result of bad decisions made during the aftermath. Also complicating any assessment of the facts is the "unknown" factor. By that I mean dangerous practices that are occurring now during the bubble that will only come to light later.
Those who say the fallout should be manageable believe our situation is not comparable to Japan. In hindsight, they say that Japan was a corrupt, over-leveraged command economy that had forgotten about rates of return and obsessed instead with market share. In addition, the Japanese bubble was primarily a real estate bubble which the bureaucrats there have proved particularly inept at solving.
They will argue that the 1920s are a poor analogy because our economy is now far less cyclical than it was then, that we have huge financial shock absorbers in place and most importantly an enlightened, nay omniscient Fed, all of which make an economic debacle unlikely.
There is a fair amount of truth in all of these claims (along with some revisionist history) but the zeal with which that view is believed has caused us to dramatically push the envelope from a "balance sheet" perspective.
Let's compare a few data points, recognizing that the old data may not be as accurate as today's. In 1929 government debt stood at 17% of GDP versus 63% today. Total debt is nearly 260% of GDP now versus 200% then. It is true that in 1929 broker loans were nearly 30% of GDP, while today margin debt is only 2% of GDP, however, consumer installment loans plus mortgage debt stands at nearly 70% of GDP. In addition, the national value of derivatives held by the banking system is $40 trillion, nearly 5 times GDP and we have absolutely no idea how they might behave if the financial world were to function differently prospectively than it has in the last decade.
Further complicating matters we currently run a trade deficit that is about 3% of GDP versus a unilateral surplus 70 years ago and we have a negative savings rate, both of which place our currency at a far greater risk than it ever was then, potentially complicating the Fed's future rescue efforts.
Lastly, on top of this leverage, the value of equities to GDP now stands 160% to 200% (depending on which measure of total market cap you use) compared to roughly 100% in 1929. In short, valuations are 60%-100% higher at the same time debt is 30% higher while we are being financed thanks to the kindness of strangers (foreigners).
You can easily see that those who believe that previous periods of trouble have no relevance have acted accordingly thereby "raising the bar" for the "shock absorbers" and the Fed. Unfortunately there are no roadmaps for the future, but we can be guided by precedent. The fallout from this bubble may be ameliorated for the reasons the new era apostles cite. The economic dislocations will probably not be as gruesome as the 1930s and might not even be as difficult as the Japan of the 1990s. However, given the facts I think it is safe to conclude that it will be plenty bad enough and will be far worse than most have imagined.
So, what could end this bubble? Everyone knows the obvious choices and I won't elaborate on them. Likewise, I obviously can't elaborate on an unknowable shock. However, I believe that the bubble could burst if people lose confidence or faith in the technology stocks that have carried the bull market. I don't think the market can go down for real unless, and until the bull market in technology stocks ends.
What could derail technology stocks and bring them back to reality? In short, corporate America and the year 2000 dubbed "nuclear winter" by my good friend Fred Hickey, the world's best tech analyst. (For those of you who haven't heard the term used in this context, it refers to the fact that corporate America has purchased all the hardware and software it needs to be ready for the year 2000. Consequently order rates are in the process of collapsing and will stay that way for quite some time).
Quoting Fred, "Tech stocks have been on a gigantic tear based upon the perception that end-user demand for computer technology products is strong. They believe that surging PC demand is behind the pickup in semiconductor sales. While they do not know it yet, they are wrong! In fact, the second-half "nuclear winter" slowdown in computer sales anticipated by market researchers for two years is hitting with full force. Unfortunately, Wall Street is too blinded by greed to notice it. Just as it has never noticed a shift in spending in the past."
Here, some recent history will explain the previous statement. In 1995, almost all analysts and investors believed that widespread semiconductor shortages and surging prices were a sign of huge Windows 95-related pent-up demand for computer products and peripherals. Unfortunately, Windows 95 was a disappointment relative to expectations leading to a sizeable tech stock decline that lasted until the middle of 1996. In fact, 1995's worldwide semiconductor sales of $150 billion is a peak that has yet to be surpassed.
More illuminating still is the fact that there's been no revenue growth worldwide in the PC industry in the last 2 and a half years. Amazingly despite the favorable impact of the Y2K upgrade cycle, unit growth has not been strong enough to offset ASP declines. Yet hope springs eternal as every year for four years running Wall Street has believed that the year's first-half PC debacle has had no relation to the one the year before. The analysts have been incapable of connecting the dots each time as they appear unable to grasp that the problem is horsepower saturation and excess capacity.
Last fall there was another channel stuff, primarily by Compaq. Weaker than expected PC demand in the first half of 1999 finally exposed this long running charade and led to the ouster from the company of Eckhard Pfeiffer and Earl (the pearl) Mason, two of the industry's biggest fibbers.
The weight of the industry's problems caused market-darling Intel to miss revenue estimates in both the first and second quarters by $400 million. AMD corroborated this weakness as they couldn't find a home for almost 2.3 million processors. Yet shortly after Intel reported its results in mid-July, for no apparent reason DRAM prices began rising substantially. Strange happenings were occurring in the disk drive market too. All of a sudden, there were shortages in the popular 4 and 6 gig drives, and prices firmed. Semiconductor and PC related stocks celebrated these events by embarking on the (recently ended) enormous rally which saw Intel, for example, spring from 50 to 90.
What happened to create all this euphoria? Three things. First, the perennial belief in a strong second half for PC sales that I have described. Secondly, a brief surge in retail PC demand in June and July precipitated by the introduction of subsidized (so-called "free") PCs. Lastly, the fear of potential Y2K production disruptions outside of the United States lead to a fear-driven Y2K inventory build complete with double and triple ordering.
Human nature is such that the fear of shortages always leads to over-ordering and hoarding as we've seen many times in the past in the semi-conductor (and other) industries. In the perfectly perverse fashion of markets, just as the free-for-all in component buying and stock ramping was reaching a speculative frenzy, nuclear winter sneaked in like the proverbial thief in the night.
While Wall Street focused on the fact that vendors at the back of the food chain were ordering parts and building hardware like there was no tomorrow, the folks on the front line, trying to sell products to corporate America, were hitting a wall.
The top three computer distributors with combined revenues of $50 billion (in a world that buys $150 billion of PCs annually) led by Ingram Micro, the largest with $24 billion in revenues, divulged that results were disappointing. Privately, certain companies are advising that computer spending lock-downs are in place. This should come as no surprise, after all it takes time to stabilize and integrate software and hardware. If you expect it all to be tested and running smoothly by January 1st, 2000, you can't wait until the fourth quarter to install it -- that's too late.
Systems integration and sub assembly companies have also disclosed a fall-off in business while Oracle just reported year-over-year revenue growth of just 12%, its worst in 30 quarters. This is an especially powerful indictment since they are direct beneficiaries of all the new internet startups.
Recent body-English by IBM, Hewlett Packard and Intel tend to corroborate the view that business is worsening by the week, a trend that will only accelerate. Soon reports of additional problems should be flying fast and furious. There is little chance that Dell, Intel and IBM, to name three of the five biggest tech stocks, can make their fourth quarter estimates, and that is just the tip of the iceberg.
At some point, the cumulative damage should be sufficient to crack the misplaced confidence that investors have in these dramatically overpriced businesses which, by the way, have lower barriers to entry and are more commodity-like than most care to admit. When that light bulb goes off and the stampede for the exit ensues, it will be a debacle in which many stocks will fall over 50%.
Mainly, tech stocks are priced as they are not because investors have studied the businesses and judiciously bought them, but because people have piled into them due to momentum and blind faith. Everyone wants to own what is going up, not what is priced attractively. Consequently, we have created a dramatic disconnect between both expectations and valuations versus reality that can only be rectified by a huge downward adjustment in the price of these stocks. To quote Steve Ballmer, "there's such an overvaluation of tech stocks, it's absurd."
I should mention that it is not just PC related and semiconductor stocks that are at risk. Networking companies have benefited from Y2K remediation efforts as well, they too could be susceptible to a falloff in demand. Ultimately the stock market itself via its ability to float Internet companies has helped create demand for networking and telecommunications products. If the companies that currently have problems indirectly shut the IPO window, more companies will experience weakness prospectively.
In summary, technology stocks bulls have placed over a trillion dollar bet that demand will stay strong when it is more likely that we will encounter not just our now-typical weaker than expected second half, but a true collapse in orders. Never since the mania leg of this bull market began in 1995 have so many factors been aligned so perfectly to pull the rug from under the feet of technology investors. Nuclear winter may just be the catalyst to end the mania. |
