Every Generation Has Its Crash
(February 14, 2000) - First E-mail
Please note that since the following article was written on February 14, 2000, some of the information or links contained herein may be outdated.
A Bit of History
From financing the War of 1812 to today's internet and biotechnology companies, Wall Street has played a very significant role in both the American economy and its welfare. In the 19th and early 20th century, the American economy would go through repetitive periods of boom and bust, and on numerous occasions, specific names on Wall Street would be actively involved. Figures such as Cornelius Vanderbilt, Daniel Drew, Jay Gould, J.P. and Jack Morgan in their heydays controlled vast economic fortunes, and with the touch of a hand, could bring Wall Street to its knees.
The gold corner of 1869 was such an example. With the aid of Jim Fisk and Daniel Drew, Jay Gould decided to corner the gold market of the United States. There was only one problem. The U.S. Treasury had approximately $100 million worth of gold secured at Fort Knox, and any attempt to corner the gold market would require the Treasury to stay away. Gould's vast political connections (one of whom was the President, Ulysses Grant) ensured that. By the time they had accumulated all the gold they had intended to (Gould alone bought $7 million), the premium on gold was 160%. This forced the short-sellers to cover, which stabilized the price of gold at about that price. Gould sold all his holdings at the top of the market and made a profit of $10 million. The Treasury did not intervene until several days later, and the fallout was great. Several firms on Wall Street failed, and the stock market collapsed as a result -- which in turn caused numerous brokerage firms to fail.
The panic of 1907 brought out a single savior -- not the Treasury, nor the Federal Reserve (which did not exist then), but J.P. Morgan. The stock market had a very high valuation going into 1907. From March to October, the stock market fell continuously, and in late October, the impending failure of the Knickerbocker Trust Company caused a run on its already depleted funds. The company was left to fail, but Morgan, along with other well-known bankers, provided the funds necessary (>$25 million) to prop up the other major trust institutions. At the same time, the Treasury was propping up the stock market with its own funds. When they ran out, they had to ask Morgan for help. Morgan provided a further $25 million. Without his aid, the NYSE would have to shut down.
Can Wall Street or the Fed Save us?
Today, we have similar figures of powerful businessmen and astute bankers. Warren Buffet, the chairman of Berkshire Hathaway - who made his investors millions over the last 30 years. Peter Lynch, the most successful manager of the Fidelity Magellan Fund, which remains in the top 3 holdings (in terms of assets) of mutual funds in the U.S. today. There is also George Soros, chairman of the Quantum Fund, which speculates in all kinds of financial products and derivatives. More recently, there's Bill Gates, John Chambers of Cisco, and Steve Case of AOL-Time Warner. J.P. Morgan and Goldman Sachs still have incredible influence, although not as much as they used to hold.
So what's the difference, you may ask? The relative power of these people has decreased significantly as the U.S. matured in the 20th century. In 1907, J.P. Morgan virtually single-handedly saved the financial system. 22 years later, in 1929 and 1930, the senior partner of the bank, Thomas Lamont, and the richest businessman at that time, John D. Rockefeller, failed. With the market in freefall, they had pledged funds to support the market by buying "sound common stocks." Roger Babson, the most famous bear at that time, declared in 1930 that the best time to buy stocks was "now." The Federal Reserve also tried to calm the market by slashing the discount rate (from 6% to 5%). From the peak in September to the trough in mid-November in 1929, the Dow lost about 50% of its value. The Dow would not bottom until 1932, when the Bonus Army made its march on Washington (oddly enough, the time to buy stocks would have been then -- when the U.S. was at its most pessimistic, precisely to what is opposite today). From its peak in September of 1929, the Dow had tumbled 89%.
While people from all walks of life "invested," only 2 to 3% of the actual population actually bought stocks or units of investment trusts. The whole nation turned its attention to the stock market in late 1929, while the monetary participation of the general population was definitely not high. Today, this 2 to 3% has increased. More than 40% of the general population is now either directly invested in stocks or indirectly invested in mutual funds. Neither Wall Street nor the Federal Reserve could bail us out in 1929. If anyone thinks Wall Street or the Federal Reserve can bail us out if the market crashes today, then he or she will be fatally wrong.
The Myths of the "New Era"
Today, you have economists, Wall Street analysts, and financial writers touting that today's economy has entered into a "new era" where there would be perpetual prosperity. The internet and telecommunications would ensure that, right? Wrong!
We have had two major bear markets in the U.S. There were also periods of very meager returns. Combine them together, and we had two periods where the market provided substantial losses or very bad returns. One was from 1929 to 1954, and another from 1969 to 1982. 1929 and 1969, in a way, are both similar to 1999. Read on.
1929 - Calvin Coolidge stated that the 1920's was a "new era of perpetual prosperity."
And in the same year from Bernard Baruch: That disasters couldn't happen because of such things like the "sound centralized banking system," a better "understanding of the laws of economics" and the new "industrial renaissance."
Prior to the crash in 1929, the economy was experiencing approximately the same amount of GDP growth it is today. It was also an era of low inflation, low unemployment, a great sense of optimism, and most notably, technological innovation. The automobile has just been widely accepted as playing an essential role in the economy, and sales of radios were experiencing exponential growth. These two technologies significantly increased the efficiency of the general population. Most probably, the analogous argument could be made to today's internet and telecommunications technologies. If anyone thinks that the fundamentals are different this time around, then they are also wrong.
The 1960's was also a decade of great economic growth. Once again, the U.S. had low inflation, low unemployment, a great sense of optimism, and a space race that captured the entire country. You also had companies like Xerox, Disney, McDonalds, Coca-Cola, Polaroid, etc., which were managed excellently and with very high growth rates. As a result, the trend of what is now called then "Nifty Fifty" emerged. People were buying these companies in droves without any regard to valuations. As I may have mentioned before on a personal level, at its peak in 1969, both McDonalds and Disney had a P/E ratio of over 70. By 1973, their P/E ratios were a mere 6. The former declined from $50 to $3 while the latter from $106 to $16. These two companies rebounded relatively quickly, but companies like Polariod and Xerox never really recovered. And then, you had companies like Control Data and Syntex. Say what?
Look around today, and you will see the words "future" and "internet" uttered so many times on financial journals and articles to justify current valuations that it's sickening. Cisco recently just passed GE as the second most valuable company in the U.S. -- with a market cap of nearly $500 billion. CSCO has a trailing P/E of 180. Yahoo! has a valuation that discounts earnings five to ten years from now. The discount models that people justify its valuation with assumes Yahoo! will continue to growth at the same rate for the next ten years. ie. The company will need to execute flawlessly, the economy would have to stay red hot, and the number of internet users needs to continue to multiply exponentially. Even then, I don't think you can justify a valuation of nearly $100 billion (and a P/E of 1,500). At its peak in the 1929 mania, RCA (Radio) "only" had a P/E ratio of 40. Like I said earlier, Polaroid had a P/E ratio of 90 in the 1969 mania. I don't think you can justify these valuations based on any economic or business fundamentals. (here's a good article that may explain it: http://www.pathfinder.com/fortune/2000/01/24/jun.html).
The Formation of the Advance/Decline Line
The advance/decline line topped out in 1998 and has been on a decline for 22 consecutive months -- beating the old record of 21 months, set in 1969. From reading the article (if you had not kept track of the stock market daily or weekly for the last two years), you could say the bull market had essentially ended in late 1998. The Nasdaq index is a sham. Under the surface, a lot of people has already lost a lot of money. One of their solutions, ironically, includes buying an index fund such as QQQ (the Nasdaq 100) which fuels companies such as CSCO, MSFT, and INTC even more -- therefore, further augmenting already-inflated prices of these companies and ignoring other companies in the Nasdaq.
A quote from the Cleveland Trust Company market guru, Colonel Leonard Ayres in 1929:
"In a real sense there has been under way during most of this year a sort of creeping bear market..."
Pepsi Cola had already declined from 19 to 10, Philip Morris from 41 to 12 and Celanese from 118 to 66 in 1928.
As I have mentioned earlier, the late 1960's was more of the same. Only stocks in the "Nifty Fifty" advanced, while all the other issues traded at new 52-week lows.
Recent trends in some of my favorite stocks further augmented the usefulness of the advance/decline line. As some of my investors friends may know, one of my favorite stocks has been Knight-Trimark (NITE), the leading Nasdaq market maker. It could be argued that NITE's stock price should be perfectly, positively correlated with the performance of the Nasdaq. As long as performance is good, trading volume should rise. Increase in trading volume (and volatility) should boost the share price of NITE. Lately, the Nasdaq has just been doing that in both departments. Well, NITE reached a high >80 during April of 1999, and declined in value to nearly 22 in October. I bought at about 24, and rode the stock all the way up to 48, the day Greenspan announced a third interest rate hike in mid-November. The stock subsequently fell back, but managed to get over 50 in the next few weeks. With December and January being the Nasdaq's best month, you'd think NITE would be doing pretty good. As of Friday's close, the stock is at 32 7/16. When they announced earnings earlier last month, they beat every estimate out there and subsequently received numerous upgrades. The market rewarded them with a 2% decline. Based on this year's projected earnings, the stock has a P/E of less than 20. If we had the same economic situation which we had in February of last year, this stock should be over 100 by now. The fact that the stocks of Knight-Trimark, the online brokers, and financial stocks aren't doing so well right now points to two possibilities. Either money supply to stocks is dwindling, or the market is discounting a severe correction in the market. Both point to the same thing -- we will have a crash pretty soon.
This divergence cannot last forever, and when it gives, the value of companies such as CSCO, INTC, MSFT, YHOO, QCOM, EMC, ORCL, WMT, HD, and GE would have to give.
Margin and Other Debts
In the same article, read the parts about the increase of margin debts. If you don't believe it, read the following as a backup:
The latest January 2000 numbers has just arrived, and the fact that margin debt increased again in January and did NOTHING for the market is a very bad sign. The increase of margin debt from January 1999 to January 2000 is an astounding 59%. If these numbers don't scare you, then I don't know what will.
Currently, credit is as lax as it could be. If anyone has bought a car or a computer lately, he or she would know. I bought a computer myself back in May, and I did not have to pay the balance on it until four months later. I subsequently "invested" the money that should have gone to paying that balance in the stock market for a quick gain. While not a lot of people are doing this, I believe a significant amount of people out there are speculating on stocks on borrowed money -- either on margin or with money that should have gone to payments of goods such as cars, furniture, or a computer.
The market is in very dangerous territory. Alan Greenspan unknowingly (or unwittedly) fueled the speculation when he slashed the fed funds rate three times in 1998. The end-of-year rise of the Nasdaq from 3000 to over 4000 was partially based on the flooding of the money supply with Y2K money (the justification there was that numerous people would withdraw cash in anticipation of Y2K). Now, to keep inflation in check, Greenspan has to reign in M2 by raising the discount rate. He has already done it once. History has shown that the second time that this is done; the market will be set up for a great fall. Historical arguments aside, however, the arguments in the article are very strong (note: I did not read this article until tonight -- and basically, what I thought was happening is reflected in the article). The narrow market that originated in 1998 was the first indicator of a dangerously low money supply. The savings rate charted into negative territory in 1999, for the first time since the Great Depression. Since then, the market has only gotten narrower and more illiquid. By raising the discount rate three times last year, the fed funds rate stood where it used to before 1998 at the end of 1999 -- at 5.5%. With the latest hike, we're now at 5.75%. Borrowing costs have gotten higher. Pretty soon, it will be much more difficult to borrow money. And when/if Greenspan raises rates again next month to 6% he will essentially choke off the money supply (trivia: when the market crashed in 1929, the fed funds rate was also at 6%). When that happens, the party will be over. People will panic. Instead of "buy and hold," people's favorite phrases will be "sell at market." This decline will fuel margin calls, and with so many people already so heavily extended, a significant number would not be able to make them. Brokers would be forced to liquidate people's holdings, and stock prices will decline further fueling more margin calls.
Other Significant Indicators of a Crash
The passing on stocks from the "smart money" to the "dumb money": Notable figures in early 1929 had already sold their stock holdings when the first "break" of the stock market came in March of 1929. There's Bernard Baruch (actually, whether he did sell out before the crash is still up in the air, but he certainly did managed to salvage most of his assets), John Raskob, and of course, Joseph Kennedy. While it was not a "break," you can say we had some pretty heavy selling on the second and third trading sessions of this year -- when stocks fell a great deal on heavy volume. Today, some fund managers are already liquidating their stock positions. GM's pension plan recently liquidated 20 million shares of EDS, which is 4.2% of all the shares outstanding. When the lockup of ICGE expired earlier this month, PaineWebber filed to sell all its stakes in the company "ASAP." One of my friends (she's getting this email too) liquidated her 401(k) mutual funds a couple of weeks ago. When asked why, she replied: "Well, I think the market will crash so I want to have all my $$$ in a money market account." After making some unconvincing comments about how the market would bounce back up even after a severe decline, this "financial advisor" from Paine Webber said something like: "Why? Your fund is already in a 50% cash position." Needless to say, this further convinced her to sell her mutual funds and stocks.
An early indication of a recession: Historically, while a crash does not necessarily result in a recession, a recession would most likely cause a "crash." The severe bear markets of the early 1930's and the 1970's are notable indicators. One of the first indicators of a recession is the number of car sales. If car sales start to decline, then most likely, consumer confidence has declined and therefore, people will be less likely to spend. With consumer spending making up 2/3 of the GDP, that's a very significant factor. While car sales in January have increased year-over-year, don't forget that these sales have been done on very loose credit. Normally, some people who bought would not have even qualified for the financing (or the terms would not have been as good and therefore, would not have bought). Also, GM recently announced that production of a certain Saturn series would decline due to "excess inventory" (read: http://biz.yahoo.com/rf/000210/btu.html). Gateway and Dell had to revise earnings downwards before they could meet them. With the advent of the PC, I believe PC sales is another great indicator. Everything has been blamed on chip shortages from Intel and Y2K, but I think it runs deeper than that (let's face it -- how many people are going to buy the PIII 800?? And Gateway mostly caters to consumers, not businesses -- Y2K doesn't mean jack to consumers, but Christmas does). Moreover, in a recent WSJ article, it was mentioned that Microsoft's and Intel's recent earnings included a significant amount of investment income. If investment income was taken out of the picture, they would not have met earnings estimates. Coupled this with that fact that these two companies are also involved in heavy buying and selling of stocks, and we have another brew for a significant fall (and on a personal level, I believe Windows 2000 would be a disappointment to MSFT's bottom line).
The New York Times recently filed to issue a tracking stock on its own website. Ignore all the commentators on CNBC for now and ask yourself: "Has the market gone crazy?" When a conservative outfit such as the NY Times gets into the mania, I think this is the beginning of the end. Case in point: In early 1929, J.P. Morgan issued its own version of the investment trust.
Legend has it that Joseph Kennedy finally decided to sell out when his shoeshine boy asked him for stock tips. Ask anyone from Hong Kong who remembered what happened in 1973 to 1974, and you'll see what I'm talking about. The Hang Seng Index declined 92% during those two years. Prior to the crash, people from all walks of life were speculating in stocks. If you ask any one of the parents of my friends, they'll say it's time to get out when people such as your grandmother or the janitor (or the cook) starts to speculate in stocks. Today, the trend in the U.S. is essentially the same. Ads from online brokerages fill the airwaves (the Super Bowl, most notably) and the internet. One can open an AmeriTrade account for as little as $500. I won't mention any other details but the breaking point was when my very, very conservative grandfather asked me to open a stock account for him. When people who have lived through a depression, numerous recessions, and crashes start to believe in this "new era" bullshit and get greedy, then I think one should get out.
The Dow declined approximately 600 points during the last three trading days last week, and nobody cared. Moreover, articles on cbsmarketwatch.com, cnnfn.com, and cnbc.com essentially blamed it on "interest rate concerns." Do they really expect us to believe this? If anything, "interest rate concerns" should hamper financial stocks and technology stocks (ie. CSCO, INTC, YHOO, AMZN especially, etc.) the most, not stocks such as the components of the Dow 30 (like MMM, IP, DD, XOM, MRK, etc.). Shares of Berkshire Hathaway also declined significantly in the last three trading days (even after the rumors of the failing health of its Chairman, Warren Buffet was dispelled, it continued to decline), and its now >44% off its record high from June 1998 (when the "real bull market" essentially ended).
In January, IP announced earnings and its earnings estimates were subsequently raised. The stock was trading at $58 before the raise and today, IP can be bought for 42 11/16. Similarly, MMM was upgraded on January 27 when it was trading at 96 7/8. MMM closed last Friday at 82 15/16. Despite record sales and modest growth, GM's P/E ratio is a mere 8.68 (according to the finance pages of Yahoo!). Dupont (DD) is experiencing outstanding income growth, and its share price is hovering near a 52-week low. If anything, this further indicates the decline of the advance/decline line. However, this is a very notable one. When the Dow and the Nasdaq starts to experience such a divergence, I think it really indicates how the crazy the market is going and how much the money supply is dwindling.
I firmly believe a crash will happen within six to nine months on its own accord. If we get a disaster way out of a left field (similar to the failure of a hedge fund, Long Term Capital Management in 1998), then the fall will be instantaneous. Investors will lose faith in the American financial system, and with stocks being so overpriced in such a narrow market, people will panic and sell. Only this time, the supply of money has already declined so much that the number of sellers would significantly overwhelm dip buyers. We will get a few days of really big declines and volatility. Stocks such as CSCO, QCOM, and ORCL, SCMR could fall 30% in a day. Of course, there will be some dip buying. The president would go on TV and make the usual "everything is sound, the fundamentals haven't changed" statement (but then, these past few years of gains haven't really been based on fundamentals at all). Managers of notable funds would do the same thing -- and reassure investors by telling them they are, at the moment, buying "sound quality common stocks." The market would settle and we could even rally. If I had not gone back to the New York Times archives and read the financial news of every edition from the period 10/21/1929 to 11/10/1929, I would probably have been convinced to buy back in too (the statements from notable figures were very reassuring). But this time, we really have outdone ourselves. Note that I have compared the 1990's to the 1920's and 1960's. The 1990's mania is more similar to the 1920s mania -- only bigger. The ramifications will be high, and with the recent amount of GDP growth mostly done on borrowed money, I firmly believe we will have a recession.
The term "recession" may sound unfamiliar to some people, myself included. After all, I have not lived through any significant recession, and if I did, I probably wouldn't have remembered it. But I believe we will. People would lose confidence in Wall Street. Funds would turn back to bonds instead of stocks. All the indices would close lower every year for the next three or four years. The Dow could end up losing 75% (and I'm being conservative) by the time the trough comes around. The Nasdaq has much more room to fall. I wouldn't be surprised if the Nasdaq declines >85% from its peak. If inflation does show up, gold would be back in vogue. Heck, with 10,000 tons of the metal shorted, gold has ample room to move up.
So what to do?
Normally, I don't like to make recommendations -- especially on whether to buy or sell a certain stock. But these latest events have much cause for alarm. I never lost any sleep when I was 100% margined on an internet stock back in 1998, and I never did either when I was 100% short (on margin) in two internet stocks back in the same year. After more than ten weeks of historical research and looking at all the economic and social indicators, I believe we are at the tail end of the bull market. And needless to say, this has caused me a significant amount of sleep lately. If any of you are actually listening to me right now, I'd recommend selling all your stock holdings. If you're on margin and you're long, reverse the situation right now. If most of your assets are in stocks, sell enough so as to lessen the exposure of your risk. If you're planning to retire ten year to fifteen years from now and have a significant amount of assets in "aggressive growth" mutual funds, sell them immediately. Hold cash, or if you're the relatively adventurous type, put the money in a bear fund or a gold fund. Right now, 25% of my mom's portfolio is in a bear fund (BEARX) and another 25% is in a gold fund (FGLDX). The remaining 50% is in a money market account.
Anyway, this about just all sums it up. Sorry for being so verbose. Hope you found this not too boring and not too radical. If you have made it this far, then congratulations!
Until next time,