It is human nature to be greedy. With vision blurred by greed, the financial market participants endeavor to make money out of thin air. Efforts to create wealth without the actual process of production have been successful many times in the history of humankind. The greatest and, possibly, the longest lasting attempt to create wealth out of nothing was "the Tulip mania of the seventeenth century".
During the build-up of the tulip market, the participants were not making money through the actual process of production. Tulips acted as the medium of speculation and its price determined the wealth of participants in the tulip business. It is not clear whether the build-up attracted new investment or new investment fueled the build-up. What is known is that as the build-up continued more and more people were roped in to invest their hard earned earnings. The price of the tulip lost all correlation to its comparative value with other goods or services.
What we now call the "tulip mania" of the seventeenth century was the "sure thing" investment during the period from mid-1500s to 1636. Before its devastating end in 1637, those who bought tulips rarely lost money. People became too confident that this "sure thing" would always make them money and, at its peak, the participants mortgaged their houses and businesses to trade tulips. The craze was so overwhelming that some tulip bulbs of a rare variety sold for a few thousand dollars. Before the inevitable crash any suggestion that the price of tulips was irrational was dismissed by all the participants. Does the tulip market's build-up and its subsequent crash has any relevance for today's times?
A detailed study of the current craze in the some technology and Internet stocks points to an unsustainable build-up. What is a "sure thing" investment today may go down in history as mother of all financial market manias. After the inevitable crash, participants will remember it for centuries and, probably, label it as an "Internet mania of the twenty-first century".
It is difficult to miss the striking resemblance of the tulip mania and the Internet craze. When Yahoo was added to the S&P index its capitalization went up by $30 billion in just 3 trading days. Now $30 billion is still a lot of money. Saudi Arabia, world's largest oil producer, produces oil worth about $72 billion in a full year. Similarly during the tulip mania "one Amsterdamer made 60,000 Guilders in four months, when his annual salary as a burgomaster(mayor) was only 500". In other words the valuations of some of the stocks have broken all links with the real world.
During the build-up, there was a strong belief that the price being paid for a single tulip bulb was reasonable. Similarly the participants in the Internet rally feel that the current prices are reasonable as Internet is an ever-expanding sector. To be a successful analyst, one must justify the actions of market participants. The markets reward only those who are with the trend. During the build-up of the tulip mania anyone justifying the lofty price of tulips was immediately a hero while anyone who issued a warning was a big loser, both personally and professionally.
The build-up of the tulip mania continued for several decades. The collapse was sudden and devastating for many and had its reverberations in most parts of Europe. The build-up in the Internet sector has been only during the last few years. The important question is ---- why the build-up in the Internet sector can not continue for the next few years?
I believe that the Internet mania will come to an end in the next few months if not in the next few weeks. I have the following reasons for my belief:
1. The speed of wealth creation at the peak of the tulip mania was nothing compared to the speed of wealth creation in the today's stock market. The speed is clearly unsustainable. The capitalization of publicly traded Internet stocks is about $ 1trillion with gains in 1999 being more than $ 600 billion. Some of the growth companies outside the Internet sector are also showing similar gains. Appreciation in Yahoo's stock added $30 billion to the wealth of its shareholders in three trading days. Microsoft added more than $ 75 billion to its capitalization in two days. Money hasn't yet lost all its value. Even at near record price of about US$ 25 per barrel, the total Oil consumption of the US is about US$ 180 billion for a full year.
Sooner or later, probably sooner, this new wealth will start chasing goods and services. An equilibrium will then be reached with money losing a lot of its value (hyperinflation) and market capitalization of overvalued stocks taking a beating (wealth, created out of thin air, disappearing into thin air)
2. The number of participants in the Internet mania is already far too many compared to the tulip mania. Nearly all the potential investors are invested in the Internet sector directly or through funds. The only people out of this market are a few value based investors. Leveraging has been the major source of new money for quite some time. For several reasons the FED and most Central banks all over the world have been adding liquidity to the market. This liquidity has been going into the stock market. It is very likely that the FED will withdraw liquidity in the Y2K. Banks will then be forced to evaluate the risks in their exposure to the stock market. Leveraging adds liquidity to a bull market but is also a cause of margin calls in a bear market.
3. The communication systems in the seventeenth century made the build-up of the tulip mania a comparatively slow process. What took a few decades then has only taken a few years now.
4. The participants in the current rally are under the impression that the FED is in full control and the market is too important to be allowed to fail. Whenever the market corrections have threatened to turn into a true bear market, the FED has promptly acted and pumped a lot of liquidity. Easy money could have chased goods and services and caused an unsustainable inflation. Fortunately for policy makers, the new money went straight into the stock market. Very soon, the FED will want to withdraw this extra liquidity by raising interest rates. The money coming out of the stock market will trigger a chain reaction. Participants will want to sell stocks and buy goods that will stoke inflation prompting FED to increase interest rates further.
5. FED appears to be in control because all its actions are considered market friendly. If they increase interest rates then the stock market goes up saying that FED is trying to tame inflation. If they decrease interest rates then also the market goes up saying that FED is prepared to add liquidity to support the stock market. A day is not far when the Fed will appear to have lost all control. If they will raise the interest rates to curb inflation then the stock market will fall and money coming out of the stock market will go into buying goods(inflationary). If they will reduce interest rates then the extra liquidity will result in higher prices of goods (inflationary).
6. Under normal market conditions, unemployment at record low levels would have meant workers demanding higher wages. In the midst of a current stock market mania, the workers are very happy to accept stock options instead of real wages. This latest trend has been extremely bullish for the stock market for two reasons: a) When exercised, the employee is taxed on the basis of the market value of the option (that is the difference between the market price and the exercised price). The company claims the tax deduction based upon the employee's calculated income but does not charge the cost of the options to its earnings. Thus the company is able to declare much higher earnings giving a boost to its share's price. b) When the employee exercises his option he has to pay at the rate of the exercise price. This results in more money coming into the stock market.
7. When the market turns then the employees will demand real wages (thereby reducing the earnings) or sell their stock options. Either action would further push the market lower triggering a chain reaction.
8.The Internet sector comprises only of growth stocks. When the market turns into a bear market, investors in growth stocks will want to exit before everyone else. There will be no bids and collapse will be very sudden much like the tulip mania.
Even if convinced with the above analysis, do not attempt to short sell in this market. This market will certainly not collapse under the weight of short sellers, it will collapse only when too many participants want to take profits.
Sunil Madhok
skmoi@emirates.net.ae
United Arab Emirates
20 December 1999
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