[Fleckenstein] The Story of Bubblenomics

Rohit Khare (rohit@uci.edu)
Sat, 18 Dec 1999 18:23:13 -0800

Fraser Management's The Contrary Opinion Forum (Sept. 29-Oct. 1, 1999)

Spinning Financial Illusions - The Story of Bubblenomics
Presented by William A. Fleckenstein

[I excerpted about 10% of the speech below. Bottom line: he shares
the view that Corporate America has been significantly front-loading
Y2K purchases, with the corresponding dip in sales materializing as
we speak (4Q99). --RK]

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.

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

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.

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.

" 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

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?]

"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.

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.

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).

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.

Much, much more at: