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Fraser Management's
The Contrary Opinion Forum
(Sept. 29-Oct. 1, 1999)
Spinning Financial Illusions - The Story of Bubblenomics
Presented by William A. Fleckenstein
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. This law 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 1980s. 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
percent, which of
course drove the public (who was only just beginning to
focus on its retirement needs) out of CDs and money markets, and into
stocks and
bonds. It is ironic that the enormous reckless frenzy
of the 1980s, 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. It triggered 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 percent in 4 minutes. The chaos
created by this surprise rate cut caused a systems outage at the CBOE,
forcing it 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 '20s 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 '20s. 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.
Starting with Mexico in late 1994 (when we crossed over
from bull market to mania ) I believe these bailouts 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 30 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.
Second, there is 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 overconfident
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 $14-15 trillion capitalization of the U. S. stock
market. At 160
percent of our huge $8.8-trillion GDP, the ratio of
market capitalization to GDP is over 60 percent higher than it was in 1929,
the previous
all-time high. We are light years from the 70-year
average of 50 percent and from the low of 33 percent 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
percent 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 percent, but S&P earnings have grown
only about 6 percent.
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 percent 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. If all of ICGE
investments and the cash received
from the IPO were valued at 30 times, he said, 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 percent since the interview.
However, it is not the specific examples that are the
primary concern. The risk is that the environment that has led to these
individual excesses
has produced a total market capitalization so out of
proportion with the underlying businesses, 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 33
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 that 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."]
"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 20 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 its 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 that
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 percent
of GDP versus 63 percent today. Total debt is nearly
260 percent of GDP versus 200 percent then. It is true that in 1929 broker
loans were
nearly 30 percent of GDP, while today margin debt is
only 2 percent of GDP; however, consumer installment loans plus mortgage
debt stands
at nearly 70 percent of GDP. In addition, the national
value of derivatives held by the banking system is $40 trillion, nearly
five 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 percent 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 160-200 percent (depending on which measure of total
market cap you
use) compared to roughly 100 percent in 1929. In short,
valuations are 60-100 percent higher at the same time debt is 30 percent
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 road maps 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).
uoting 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 21/2 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.
Second, a brief surge in retail PC demand in June and
July precipitated by the introduction of subsidized (so-called "free") PCs.
Last, 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 Jan. 1, 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 percent, its worst in 30 quarters.
This is an especially powerful indictment since they are direct
beneficiaries of all the new
Internet start-ups.
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 percent.
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, and they 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-stock bulls have placed an
over-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.
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