How large can a bubble grow before
it bursts? Farther than you think. And there need not be a fatal pinprick
that makes it burst. And when it bursts, the crash that ensues can be deeper
and more discontinuous than you could ever imagine.
In May of 1982, while the bear market in
US stocks was in its deepest throes, and the epic bear market in US bonds
was still completing its base, I was called to advise on the greatest stock
market bubble of all time---the Souk al Manakh in the Persian Gulf. Kuwait
had had an organized stock market for some time. The great wealth created
in Kuwait by the rise in the oil price in the 1970's led to seemingly endless
appreciation in Kuwaiti stocks. In the Arab states in those days, only
sheiks could grant corporate charters, and only corporations could become
publicly traded companies. The royal family of Kuwait did not freely grant
corporate charters for companies that might become vehicles for stock speculation,
so there was a shortage of stocks to trade. This shortage and the new unparalleled
wealth that was looking for vehicles of speculation gave rise to an over
the counter market in Kuwait city where shares in companies domiciled elsewhere
in the Gulf---principally Bahrain and the United Arab Emirates---were traded.
Housed in a converted air-conditioned parking garage, this market was known
as the Souk al Manakh---the camel market.
I was asked at the time by the government
of the United Arab Emirates to advise on the creation of a stock exchange
in the Emirates. Great fortunes were being made in shares of companies
domiciled in the Emirates at the time. Why not bring all this wonderful
new stock market activity home?
For six weeks I worked out of an office
in the UAE central bank in Abu Dhabi. The city was modern, laid out along
a crescent beach at the end of a promontory into the Gulf. The central
bank was a modern glass building behind severe cement columns that met
in graceful Moorish arches. From a great glass window of this modern building,
I could see along a turquoise backwater old tanned fisherman working on
brightly painted ancient fishing dhows that were beached on the blinding
sands. The Sheik of Abu Dhabi was the richest man in the world then. Only
a few decades earlier his brother, the former ruler, was afraid to walk
the streets of what was then a small sandy seaside fishing village for
fear of his creditors.
Being a macro oriented, top-down man, I
set about to see how great a supply of stocks had been made available for
trading on a formal market in the UAE. The results were simply unbelievable.
The market capitalization of the Kuwait exchange and the Souk al Manakh
combined ranked third in the world, behind the US and Japan. It was greater
than that of the UK with all its foreign listed companies. How could this
be? I asked, for both geographically and economically speaking, these few
countries---Kuwait, Bahrain, and the Emirates (the former Trucial States
under British domination)---were only postage stamps of sand on the globe.
Oil had brought wealth to these small countries but their combined economies
were still very small compared to those of the US or Japan or the UK. More
striking was the fact that most of the visible wealth was not reflected
in these companies. The rulers of these sheikdoms owned the oil wealth.
The hugely expensive real estate was privately held, as were the extremely
lucrative import franchises. What assets and income underpinned these multi-billion
dollar market caps?
We did a bottoms up study to find out.
In Bahrain, a financial center, there were banks, seemingly of substance.
There was a raft of companies that made cement and clinker. These companies
were domiciled in five former Trucial states whose names you never heard
of that, alas, had no oil. There was a company or two that imported sheep
and goats for slaughter. And then there was a handful of other companies
whose principal activities were not at all obvious.
The Sheik of Abu Dubai was the richest
man in the world at the time and the Ruler of Dubai was also quite well
to do. The five other sheiks who had no oil were poor cousins. For founders
shares these oil poor sheiks granted charters for corporations that could
be traded on the Souk al Manakh. I can remember driving one day to a small
derelict town that was the capital of one of these oil poor sheikdoms to
analyze a company with a high flying stock on Kuwait's OTC market. For
the life of me, on the balance sheet of this company I could find no assets
of any kind. It dawned on me that, behind most of this third ranking stock
market cap in the world, there were only a few cement and clinker plants,
a slaughter house or two, and quite a few shell games.
How do you tell your host government that
the stock market they want to bring home is a shell game? I pondered this
diplomatic quandary for weeks as I looked out my office window at those
ancient painted dhows in the desert sun. In the end I mustered the courage
to tell the truth. "It is all a bubble," I told my client-. "And it will
burst." To my relief and amazement, I was greeted, not with displeasure,
but with laughter. "You Westerners have been coming here for five years",
they told me, "and to a man you all have predicted a crash. Don't you understand,
there has never been a place on earth like the Gulf with such unprecedented
wealth? You will never understand that the Gulf market cannot crash."
I had a long time friend in London. His
name was Ali. He was one of several Anglo Arab investment bankers that
flourished in London in those years. When I passed through London on my
way back to the US I stopped to tell him about my trip. Speculation on
the Souk al Manakh was financed with a curious type of informal margin
financing by way of post dated checks. So rapid was the rise in the Gulf
market that post dated checks paid an interest rate of 100% per annum.
Ali was financing speculators in this market. He listened and he smiled.
At the beginning of August I had completed
my report for the government of the UAE. I told them that the market they
wanted to organize was a bubble and that it would crash. Some weeks later
I heard from Ali. He called to thank me for my advice on my recent visit.
He had called in all his post dated checks. "Did you hear what happened
to the Souk?", he asked. "No", I replied. "Well, it topped quietly at mid
summer after you left, with no provocation. One can't quite say it declined
or it crashed; it has just stopped trading."
The Souk al Manakh was the greatest speculative
mania of all time. One could not even speak of valuation. Margin financing
reached unimaginable extremes; one speculator, who had been a customs clerk
two years earlier, had at the peak $14 billion in stocks financed with
$14 billion of margin debt. The people involved believed that the oil rich
Gulf was truly a "New Era". It did not take a trigger to burst this bubble;
it simply crested sometime in the dreadful heat of the Middle East's summer.
Its decline was so discontinuous it cannot be called a crash. There were
simply no bids. ¨
Defiant Speculation
The Fed tightened. That was largely, but
not completely, anticipated. The Fed raised the discount rate. It issued
a warning that the labor force is depleting and the economy continues to
grow unsustainably above trend. These were not expected. The bond market
was supposed to like such stern Fed resolve. Instead it sold off a half
point.
But the stock market proved to be another
thing. The Dow rose 173 points. The Nasdaq, which had been up for 10 out
of 12 days after making a new high, soared another 73 points. Perhaps 20
stocks, most of whom you had not heard of a year ago, rose more than 20
points. One stock rose 1000 % in a day. Its name was China Prosperity.
We understand it is Hong Kong-China maker of toilet paper. It rose from
a dollar to ten dollars because of the news that China will be admitted
into the WTO. Today it rose further to 81. Today, 2.9 million shares traded
by noon. Yesterday 521,000 shares traded. From October 19th
through November 12, daily trading volume averaged 300 shares a day.
People ask us, "Is this the moral hazard
meltup?" We have hypothesized that an unprecedentedly overvalued market
amid rising interest rates, serious fundamental deterioration at its rotten
heart---high tech, and record deterioration in breadth would be subject
to incipient crashes. If government moved to bail out the stock market
at all costs at such a juncture, it would become apparent to all market
participants that the stock market is too big to fail. A seller's strike
would ensue and the market would melt up.
That has sort of, but not quite, happened.
The Dow fell 13% when it broke 10,000 on an intra day basis the Friday
before the anniversary of the Monday October 1987 stock market crash. Over
the prior week the market had entered a crash pattern. Market breadth was
atrocious. The parallels were eerie. Yet, the market mysteriously rebounded
for no apparent reason.
Chairman Greenspan gave a series of speeches
extolling a new high tech era. The guys and gals on CNBC now frequently
mention that the market is too important to fail. Despite the Fed tightening,
more and more commentators point to a record 20% annual rate of expansion
in the monetary base, albeit mostly related to a Y2K provision of currency,
as a true measure of a Fed policy that will not let anything go wrong through
the millenium date.
What we know is that valuations in the
high tech sector are unprecedented. So is the degree of speculation, despite
serious underlying deterioration in the sector's fundamentals. Nothing
in the history of the G-10 stock markets can compare---not even Japan.
Nothing except the greatest bubble of them all---the Souk al Manakh.
High Tech---the Hardware Sector
We turned bearish on the hardware high
tech sector years ago. Our decision seems laughable now. Why did we do
so? The answer is simple. For three decades global revenues from computers
and their components and peripherals grew at perhaps a 20% rate with an
annual growth rate of 40% at cyclical peaks, roughly a zero growth rate
at troughs, and a four-year average periodicity. The prices of the stocks
in this group moved with this cycle. In the mid 1990's peak 40% annual
revenue growth lasted two to three years versus one year in prior cycles.
Excesses developed. A downturn comparable to past down cycles could be
foreseen. History indicated that the stocks would follow suit.
What in fact transpired was worse than
we ever expected. Global semiconductor revenues peaked in 1995. They fell
for three years. Even with a good bounce this year, they will be below
1995's level. Yet, the Sox index peaked at 300 back then and is approaching
700 today.
Two and half years ago global PC revenues
peaked. The stodgier mainframe sector has continued to grow, but at a single
digit rate. Such a slowdown has no precedent. Worse yet, revenues were
bolstered late in this period by a surge in purchases needed to meet Y2K
compliance. Some computer purchases scheduled for the year 2000 and beyond
were made in advance in 1999 and 1998. Now that tomorrow's computer needs
have been met, all the consulting firms predict a nuclear winter with declining
industry revenues next year. Forrester Research predicts no growth for
several years. Disappointing reports are now coming out of IBM, Hewlett
Packard, Unisys, and even Dell, as well as all the PC distributors, suggesting
nuclear winter in fact began in the third quarter. There is very considerable
evidence that this whole industry on a global basis may exhibit no revenue
growth for a half decade from early 1997 to 2001 or 2002. Yet, the stocks
of the most seriously affected companies, now at record valuations, only
go sideways. The least affected companies soar.
The disappointments are everywhere. Oracle,
once a 40% grower, reports year-over-year revenue growth of only 13%. Yet
the stock soars. Cisco's guidance calls for only a 3% sequential rise in
revenue in the fourth quarter and a decline in earnings. The stock rises.
Intel has disappointed once again. It has been disappointing for years.
In Q1 1997 it earned $.55 a share. In Q3 1999 it disappointed, reporting
$.55 a share two and a half years later. AMD is shipping 750-megahertz
chips. Intel can not meet shipments of test quantities of 700 and 733 meg
chips. The big PC vendors must have the top of the line chips, since that
is where the big profit margins lie. Via, with Formosa Plastics and the
Taiwanese government behind it, has licensed low-end chip designs from
Cyrix and IDTI, and plans big inroads next year into the low end of the
microprocessor market. Add to this nuclear winter. Yet Intel's stock holds.
Even Microsoft suffers. According to Goldman's Rick Sherlund, Microsoft
took "unearned revenues" down in Q3 1999 for the first time, inflating
year-over-year revenue growth which was, in reality, 19%, not 28%, as reported.
The US judge ruled against them in the monopoly trial. CNBC commentators
argued that they would win in an appeal, but the expert legal commentary
in the newspapers indicated such rulings are seldom overturned. Suits from
allegedly damaged companies wait in the wings. Before the judge's ruling,
Microsoft management said its stock was absurdly overvalued. Yet, the stock
remains unfazed.
The Manic Fringe
Such disappointments do not matter, argue
the high tech bulls. This is the old high tech. The growth is in the new
high tech. Of course, the top six tech stocks ranked by market cap which
account for well in excess of 10% of the entire market cap are all driven
primarily by old tech, not new tech.
More than two years ago when the PC slowdown
started, Wall Street bulls focused on networking and servers as the new
source of unending rapid growth. Yet, now, as the fundamental disappointments
surface, they are to be found in networking and servers as well as in straight
PCs and mainframes. Maturation, saturation, competition, and Y2K appear
to be affecting virtually almost all hardware businesses. Apparently software
is also affected---witness the slowdown in real revenue growth at Oracle
and Microsoft. Even the service business has been hit with disappointments
at Unisys and IBM.
Faced with these problems, the high tech
bulls have turned to the Internet sector. More than a year ago we argued
that, though the internet was a significant technological revolution, most
stand-alone internet companies would never make a profit (There Are
No Ricardian Rents In Cyberspace, 10/14/98). Our argument was simple.
Technological innovations provide the innovators with transitory monopoly
positions and therefore transitory monopoly rents. Therefore, technology
companies at the frontier should earn large profits early on. But, almost
all internet companies were in fact losing money. Why? Because there was
too much ease of entry and subsequent competition to allow lucrative franchises
to be established on the Net. The flood of IPO money aggravated such competitive
pressure. It also corrupted business discipline, which could only lead
to greater losses.
A case in point was Amazon.com. This early
pioneer in Internet marketing had as good a chance as any to earn a profit.
It was there first and early. Barnes and Noble and Bertelsman and Borders
were slow to compete. It was perhaps the best know brand name on the Net.
Yet, losses grew more rapidly than revenues. In order to earn a profit,
they entered more and more new businesses. Losses continued to explode.
The company soon appeared to be "out of control".
From all we can tell, our analysis of the
internet industry has been right on target. Take Amazon. Sequential quarter-to-quarter
revenue growth fell to roughly 10% on average in Q2 and Q3, despite entry
into numerous new businesses. Apparently, their book sales have plateaued,
as saturation and competition in a low growth business have materialized.
Now, if ever, they should be making a profit. Instead, their loss in Q3
was more than half their sales. Year-over-year revenues rose 1.3 fold .
But their loss rose 4.4 fold. They must be burning cash at a $300 million
rate. They raised $1.5 billion early this year before underwriter's fees.
That is not much greater than their current annual burn rate. In their
Q3 report, gross margins fell and they forecast yet another decline in
gross margins. The state of this alleged Internet blue chip is simply horrendous.
With $1.5 billion in convertible debt, if the stock falls, whatever its
assets, those assets will belong to the debt holders and there will be
nothing for the shareholders. This stock could readily go to ZERO, yet
the overall Internet craze buoys the stock.
Amazon is no exception. Fred Hickey looked
at 130 interent companies that reported in October. Of these 130, ten reported
a profit. Two---AOL and Yahoo---reported a material profit. One must wonder
how real are the profits at AOL and Yahoo. AOL capitalized marketing expense
for five years and showed a profit. It then wrote off its capitalized marketing
expense; the write off exceeded its cumulative reported prior five-year
profit by fivefold. Employee compensation via options is never expensed.
Yahoo's current P&L benefits from past write-offs of future advertising
expense. There are growing reports of ever more liberal accounting practices
at internet companies which AOL and Yahoo must share.
More importantly, of the eight remaining
internet companies with reported profits, profits are only marginal. In
many cases, profits were buoyed by interest expense earned on cash from
IPO's, not from their basic business. Of the 110 companies that reported
losses, revenue growth was very rapid, averaging 100% over the last year.
But, of the greatest importance, on average losses for these companies
grew by 200%.
The number of companies where losses are
simply soaring relative to revenues is astonishing. For the internet analysts,
this does not matter. Loss growth is good, because it shows the company
is "executing". The list of spectacular such "growers" is endless.
The Street.com, a pioneer internet investment
rag with great early exposure on CNBC and a booming high tech stock market,
should be making a profit if anyone in this market is. Yet, while sales
rose from $1.1 million to $3.9 million, loses rose from $3.2 million to
$7.2 million. The company fired its CEO and the new CEO faces rapidly burning
cash.
For I Village, sales rose from $4.0 million
to $10.7 million quarter to quarter and losses rose from $12.0 million
to $28.4 million. Other issues exhibit yet more stellar growth in losses.
The Globe.com, the greatest performing new issue ever, reported quarter
to quarter revenue growth from $1.6 million to $4.7 million and a growth
in losses from $4.0 million to $14.0 million. Better yet is Mortgage.com
with revenue growth from $2.0 million to $5.0 million and loss growth from
$1.3 million to $22.6 million.
Investors are kiting these stocks light
years from their grim realities. Investor behavior regarding individual
issues defies all logic. Take Peapod, the internet grocer. Year-over- year
the stock's revenues barely grew from $15 million to $16 million. By contrast,
their loss exploded from $4 million to $10 million. A competitor, Webvan,
had an IPO. The market ran Peapod's stock up 40% in a day in sympathy with
an IPO from a competitor. Peapod then announced that they were burning
cash so fast they would run out of money in several quarters.
Herding Dynamics
Stock market breadth has been eroding for
over a year and a half. Even though the Dow and S&P are roughly at
their highs and the Nasdaq is in all time new high ground, the A/D ratio
remains just off its lows. Even the big cap high tech favorites cannot
buck their adverse fundamentals; more often than not they are still in
rounding top formations. All the money in the market is funneling into
one narrow group of stock whose fundamentals are virtually non-existent.
Part of this is due to sheer speculation
by uninformed household investors who extrapolate a once in a lifetime
bubble in stock prices forward forever. This is reinforced by a new era
hype fostered by Wall Street, the media, and that ever-loquacious new era
apostle, Alan Greenspan. But much of it is due to cynical relative performance
money managers who feel compelled to go where the action is for, if they
do not, they will lose performance and their jobs. We have seen in other
markets how such herding behavior ends. We quote from a piece we wrote
last fall (The Apogee of the Pendulum, Nov. 1, 1998).
Now, above all, money managers are in the
business of maximizing fees, and fee income is a function of the quantity
of money under management. If households have adaptive expectations behavior
regarding returns earned by investment managers, short-term performance
results will determine assets under management and fee income. It is a
fact that the best long-term investments are often anything but the best
performing issues in the short run. This is especially true in speculative
markets when extrapolative or adaptive expectations behavior regarding
future returns become predominant and drive asset prices ever further from
long run equilibrium. Then speculative dynamics with their short-term self-fulfilling
positive feedback loops begin to flourish. Under such conditions, managers
who focus on long term fundamentals lose clients when short run speculative
dynamics diverge from long run fundamental trends. Under such conditions,
momentum oriented managers with skills as trend following traders attract
funds. Gradually, in a process of Darwinian selection, investment managers
mirror the adaptive extrapolative behavior (laced with a good bit of greed)
of the uninformed households who entrust them with their money. The incentive
structure of money management turns fiduciaries into bandwagon speculators.
Bandwagon money managers generally care
little for long term fundamentals. Tulip bulbs are as good a trade as any,
as long as everyone else wants to buy them. George Soros, the most celebrated
investment manager of our time, has stated clearly again and again the
rationale behind bandwagon management. According to Soros, markets are
always in error; they are always in disequilibrium. The path to riches
is to recognize these market errors early, jump on board to enjoy the meat
of the move, and then jump off before they come a cropper.
Bandwagon management is for a time self-fulfilling.
When everyone wishes to jump aboard a bandwagon, the object of the speculation
continues to move further and further from its equilibrium. During a period
dominated by bandwagon speculation, all other approaches to investing become
discredited. Investors who look to long term fundamentals to buy assets
cheap suffer losses as they become absurdly cheap. Timing becomes everything
and the investor rooted in time tested parameters of fundamental value
is always too early, often disastrously so.
Bandwagon management drives prices in markets
ever further from their long run equilibria. In the end, however, relative
prices matter. Prices in deep disequilibria set into motion economic processes
that act to drive prices back to their long run equilibria. The self-fulfilling
success of bandwagon speculation drives the maximum number of market participants
into markets at their extreme, and at that point they are positioned against
an array of fundamental forces now acting against them. In the recent apogee
of high performance hedge fund investing, the bandwagon managers attracted
so much money and employed so much leverage that their positions became
too large for their markets. When they wanted to sell, not only were fundamental
market forces arrayed against them---they could not arrange to execute
their sale. There was no liquidity. And when they were forced to sell,
the markets moved in a discontinuous manner against them. Hedge funds and
proprietary traders owned most of Russia's securities. Unwinding carry
trades in the yen, a hugely liquid market, led to the largest two day discontinuous
price move of any major floating G7 currency.
The end of the unwinding of bandwagon trades
has not yet arrived. There are still bandwagons waiting to come unwound.
Most notable is the US stock market with its huge public participation
and its vast supportive industry of "herding" money managers.
Beware
We have argued, there are no Ricardian
rents in cyberspace. The experience of the entire interent group over the
last two years provides endless evidence we are correct. There is no sign
that, with corporate maturity, comes profit. Let us put it bluntly: the
US stock market is the greatest stock market bubble in G-10 history. The
high tech subsector is the most absurd stock market bubble except for the
greatest bubble of them all---the Middle East's Souk al Manakh. The peak
of every such bubble is marked by stock fraud. The internet stock craze
is perhaps the greatest stock fraud in history. Most of these companies
have been hatched simply as objects of stock market speculation with the
intention of bilking the public through IPO's .
Never have so many instant billionaires
been created, let alone on companies that have perhaps no hope for a profit.
One company, Sycamore Networks, has sales of $11 billion through October,
losses of $21 billion, and one customer---and it just went public with
an immediate market cap of $25 billion. Such stories are endless. You can
be assured that the greatest criminal minds in the nation are pursuing
this mass stock scam. Not only will many, if not most, of these fledgling
high tech companies never show a profit; many of them will turn out to
be outright deliberate frauds. We can expect in the future that internet
moguls, faced with the inevitable demise of their non-viable businesses,
will seize the company kitty and head for asylum abroad, Vesco-style.
Many, if not most, of the institutional
money managers that are kiting these high tech marginals light years from
reality know there is no defensible investment case for their holdings.
They know they are involved in a stock scam. Britain's largest pension
manager, Mercury Asset Management, has just been sued for 100 million pounds
by the Unilever Corporation in a suit alleging negligence in the management
of its money because of underperformance. The Surrey Council Pension Fund
and the Saintsbury Pension Fund in Britain are considering whether they
should follow Unilever on the grounds that their trustees are under a fiduciary
duty to explore similar actions should the Unilever legal action succeed.
One of these days one or several of the current ubiquitous internet stock
scams will come definitively to light. Then, fund managers, realizing they
have no justification as fiduciaries for owning such stocks, will fear
suit and will try to sell. Others, realizing their trustees and shareholders
are beholden to explore similar actions, will try to sell as well. Under
such conditions, there may be no bids. Hear it from someone who witnessed
it first hand: that is the way the Souk ended---with no bids.
Conclusion
There are elements that may make for a
full-fledged moral hazard meltup in today's market, but a conviction that
the market is too big to fail is not yet widespread enough. That may come
later, after another and more shattering stock swoon. We do not buy the
hypothesis that stocks are rising because the Fed is pouring fuel on the
fire. The explosion in the monetary base reflects a special provision of
currency and reserves through the millenium date. The monetary aggregates
and credit, not the monetary base, drive portfolios, and these, though
rapidly growing, have not accelerated. What we are seeing is unbridled
speculation of an old fashioned variety taken to a new extreme by a Wall
Street gone Madison Avenue, a media that finds the stock market plays better
than the Super Bowl, and a Fed Chairman whose behavior has departed from
that of prior central bank governors at any time and anywhere to cheerlead
on a new era market mania. The case of China Prosperity---the Chinese toilet
tissue company---tells us a lot about the type of dynamics that are driving
the unprecedented speculation in the high tech sector. Now that the Fed
has tightened, all market participants feel free to speculate without fear
through the millenium date. Maybe we will keep melting up, but, with everyone
on one side of the boat, we could just as easily fail again. The real moral
hazard meltup, if it ever happens, is probably an iteration or two away.
