Are we Hearing Voices from the Past?

Part - 3

August 1, 1999


The huge amount of leverage (10 to 1) due to margin debt in the market of 1929 is often pointed to as the reason for the Crash. Today, margin levels are restricted to 50% up front and 30% equity after the initial purchase so many say that such a problem is impossible today, even though margin levels are at their highest levels in history as measured as a percentage of GDP. Per JC Bradford research (see Figure N), margin levels had soared from .5% of GDP in 1991 to a new record of 1.8% by mid 1998. The Fall selloff took margin levels back down to 1.55% of GDP, and the rally since then has seen this percentage rise back to 1.65% as of 12/31/98. No doubt this percentage has moved higher in the month of January to new all-time highs. The previous all-time peak was just before the 1987 crash at .95%.

Even more concerning, is that many fail to recognize other forms of margin that are widely distributed throughout the U.S. economy. For example, home equity loans are invested in the stock market throughout the country. Brokerage houses even sell these instruments as widely accepted products with little risk in the "long run." Additionally, there are the vast amounts of credit card debt. Credit today is easier to get than a rental card at Blockbuster Video. Think about how many credit card applications you receive on a weekly basis that say "you are preapproved for an X-number of thousands of dollars credit line." A study by MasterCard International released on 7/14/98 stated that the growing number of personal bankruptcies will grow to more than 2.2 million by 2001… that's a 75% gain over 1997 levels and assuming the present "wonderful" economic conditions. On 7/13/98, the Acting Comptroller of the Currency, Julie Williams, said that "the deterioration in credit underwriting standards we are seeing in the banking system today is serious [as] it could presage the same kinds of problems that inflicted the industry experienced nearly a decade ago. This is the fourth consecutive year that commercial underwriting standards have slipped." According to a survey of 504 small and mid-sized businesses by Arthur Andersen, 47% of business owners said they used credit cards for business financing, up from 34% in 1997 and 17.3% in 1993. Credit cards are now the leading financing instrument used by these businesses. The number of business who paid off card balances on time fell to 38% from nearly 60% in 1997. Total business debt was rising at a 10.4% annual rate, the fastest since the bull market began in 1991, and stood at $5.13 trillion on September 30, 1998. Businesses, which actually reduced their aggregate debt by $150 billion in calendar year 1991, showed a net borrowing of $522 billion during the past year, a swing of nearly $700 billion annualized. According to a recent study be economists at Goldman Sachs & Co, over the 12 months ended last September, nonfinancial corporations accumulated an additional $359 billion in credit market debt. That was up 72% from the rise in the year ended September 1997 and was a record increase for any four-quarter period. One reason cited by Goldman for all the borrowing was that funds generated by the firms internally from profits and depreciation charges had all but ceased. All the while, the corporations continued massive capital spending programs while pursuing the largest stock buyback efforts in history. After all, most corporate officers get paid through options and other stock incentives. Plus, investors are increasingly in the "what have you done for me lately" mode of thinking. Where is the incentive for management to look ahead and think about what they are spending the company's cash on? The incentive for management currently is to get paid, and it's not their money that they are spending buying up their company's stock at historically bloated prices with company money. In the short term, management reaps the benefits with nice personal capital gains as do investors so everyone is happy. The outrage and calls for government regulation will come later when the cycle turns down, and many of these companies go out of business because of excesses in debt spent on today's high priced paper.

To further illustrate the levels of debt that the American investor and consumer are willing to take on in the current environment is the fact that the U.S. Savings Rate went negative in November of 1998 for the first time since the 1930's as Americans financed continued consumption and stock purchases through debt. On top of this cheery news is the HUGE nightmare awaiting a day of reckoning called the derivatives market. The Comptroller of the Currency reported that the 1998 3rd quarter derivative exposure by U.S. banks stood at $34.6 Trillion. This is an increase of over $6 Trillion in just 3 months from the previous quarter. To put this into perspective, the entire U.S. economy is $6-7 Trillion annually. The report from the OCC laid out some interesting facts: Chase Manhattan Bank currently has $292.6 Billion in assets, yet their derivative exposure is $9.5 Trillion of which $4.2 Trillion will mature within 1 year and the rest in 1 to 5 years. J.P.Morgan has assets of $198 Billion and derivative exposure of $8.5 Trillion. Thus, if Chase were to suffer derivative losses within 1 year of only 7%, or J.P.Morgan losses of 8.6%, they would respectively wipe out their entire asset base.

Finally, as if that wasn't enough leverage, hedge funds and other financial market players such as the now infamous Long Term Capital Management (LTCM) have employed EXTREME leverage through straight borrowings from US banks (which are insured by the Federal government so in actuality the borrowing is from the American people if things go bad). LTCM was said to be employing 100 to 1 leverage at its height, and threatened to bring down the entire US banking system as it tried to de-leverage according to the Federal Reserve. LTCM's creditors took over operations at LTCM and due to the huge size of their positions have yet to unwind the fund.

Mutual Funds:

Mutual funds, which in many ways have become nothing more than legalized betting pools, are another aspect of the current mania that resemble the 1920's. They were called Investment Trusts in the 1920's. After the 1929 collapse, these trusts were largely blamed for the rank speculation that led to the Crash due to the concentration of money into a few hands and the perverse incentive to speculate better than other trusts in order to compete for funds. Today, there are more mutual funds than there are stocks. Investors throw money at these products not even knowing where the money will go or what they are buying, and then call it investing in "Stocks for the Long Run" (as a current well-known book by Jeremy Siegel is entitled). In most cases, the funds' so-called "managers" have become nothing more than paid gamblers who's objective is to gamble better than the other fund down the street or lose his job to some better horse picker. They continue to bleed down cash reserve levels as competition grows more and more fierce to beat out the indexes or the "next guy's" returns. Today, most mutual fund inflows are invested as soon as funds receive them. Index funds are even worse. At least in a managed fund, there is a professional that in theory thinks about and researches what he is buying with investor's money. In an index fund, the public is simply throwing money indiscriminately at a basket of stocks because the S&P or Dow Jones decided to put them in a group.

Valuation Levels:

The Dow Jones Industrial Average (a basket of 30 stocks known as the DOW—see Figure F) has soared from a level of 4000 in 1995 to a recent high of 9759, a stunning 140% return in 4 years. The NASDAQ Composite and S&P 500 which have a heavy weighting of technology stocks in them have seen even greater gains (see Figures G and H). Nothing is wrong with these fabulous returns, but are they a sustainable reflection of U.S. business conditions or the result of a bubble? A look at various measures of valuation can help.

Valuation levels today are beyond even those of the 1920's and have even surpassed Japan's great bubble. As reported by Barron's July 6, 1998 issue the total U.S. stock market capitalization was 150% of U.S. GDP. This figure is surely larger now as the U.S. stock indexes and internet stocks have since soared to new highs. The previous record was Japan's equity capitalization of 135% of GDP at its top on 12/31/89. 1929's capitalization was only 77% of GDP. The historical average for U.S. capitalization has been around 48%. Dollar Trading Volume (DTV) is another measure of current levels in the U.S. stock market that illustrate with unmistakable clarity the extent of this historic mania. DTV is currently estimated at 160% of GDP per HD BROUS & Co., Inc.'s 1/10/99 edition of CROSSCURRENTS. HD Brous currently estimates that DTV will likely extend to at least 200% of GDP in 1999. This means that for every dollar spent on goods and services each day in this country, $2 will be spent on the trading of stocks! 1929 DTV reached a level of 124% of GDP while 1987 was a mere 55% of GDP. On another note, reminiscent of the boom days of Tokyo when the value of Tokyo real estate was greater than that of the entire continental U.S., the total value of stock market shares held by U.S. residents exceeds the total value of all real estate held by U.S. residents. These measures of valuation strongly suggests that the current mania is at the very least as significant as the one that ended in 1929 and quite possibly one of the largest financial bubbles in history.

First Call reported at the end of the 3rd quarter that profit growth in the U.S. had gone from "slowing" to "negative" for the first time since 1990. With the world economy in the shape it is, this trend is likely to continue. Yet the current PE on the S&P 500 stood at a historic high of 32x as of 1/15/99. It hit a high of 30x in the Summer of 1998. Manic bulls confronted with the reality of negative growth in earnings have now turned to relying on the "future will get better" and low interest rates to prop up the current valuations. Before the speculation ends in euphoria, as history has shown bubbles to end, profits will likely turn positive for one quarter in the future fooling investors into thinking "happy days are here again." At that point there will likely be a top, but until then low interest rates are likely to be the bull prop. Unfortunately, since Alan Greenspan's reckless cutting of short term rates to stem a stock market decline in the Fall of 1998, long term rates have actually risen. The 30-yr Treasury topped in October with a yield of 4.75% and has since been attempting to put in a top by consolidating in the low 5% range (see Figure I). With the continuing decline in the U.S. dollar against the yen and most European currencies that began in late Summer '98, the selling of bonds should only accelerate as foreigners (particularly the Japanese) own the majority of our debt.

Multiples of book value and dividend yields are at such historically silly levels that they aren't even worth discussing and most professionals don't even look at them any more.

The internet stock mania is in a whole other world of silliness when compared to the stock mania in the broader market. As has been well documented by the press recently, this mania takes the cake as far as outright lunacy and stands out as the poster child for the current mania in stocks.

Yahoo! (YHOO) for instance with revenues of $187 million and one year of a $.23 profit had a market capitalization of over $44 billion and traded at almost 2000x earnings at its most recent peak (see Figure J). Even more ludicrous is (AMZN) which sells books, CDs and VCR tapes (all very low margin products) over the internet (see figure K). A business that more and more crowd into daily as there are very few barriers to entry. As of 1/8/99, AMZN's market capitalization was as much as the entire Singapore stock exchange. Again, AMZN has yet to make a profit and even the most optimistic forecasts don't have it earning one penny until well into the new millenium. Obviously, investors have long since thrown rational valuations of these companies out the window. The rampant speculation is not however limited to internet companies. Dell Computer (DELL), the famous Austin-based mail-order assembler of plastic boxes with chips inside, commands a market capitalization of $110 billion and a PE of 95x (see Figure L). Surely a reasonable valuation considering DELL is in a business with no barriers to entry, rapidly falling margins due to the deflation that is engulfing the world, and controls only 9% of a $120 billion market. Is this speculation on the level of the internet silliness? Probably not, but it is close. Another well-known tech stock, Microsoft (MSFT), at its most recent peak on January 20 (see figure M), 1999 had a market capitalization of over $450 billion and added $30 billion in market capitalization that day alone as "investors" tripped over themselves to dive into the shares after a blowout quarter was reported. Never mind that in the conference call, MSFT warned of weaker business conditions in the year ahead. MSFT also has the unique distinction of being the first $400 billion company in history. Granted, MSFT is a great company and appears to have a virtual monopoly in PC operating systems, but similar things were said about RCA in the 1920's. Radio Corporation of America (RCA) was Wall Street's darling high-flyer tech-stock of the 1920s. It made many investors and speculators millionaires. The RCA stock market symbol was known alike by bankers and barbers from New York to San Francisco. It had a virtual monopoly on "wireless" communications for the masses. There was no serious competition in sight. In essence RCA was the leading-edge of the high-technology of the day. Undoubtedly, it enjoyed the same dominance in its field as Microsoft commands today in operating systems and related peripheral software. In the five years prior to the Great Crash of 1929, RCA stock soared from about $11 to its September 1929 high of $114 (adjusted for the 5 for 1 stock split in February of that fatal year). That's an appreciation of 936% in only five years -- equal to an annual compound return of a monumental 60%. Also unbelievingly incredible was the fact it never paid a cash dividend. Investors didn't care, since the stock value increased almost daily. At its 1929 peak RCA boasted an astronomical PE of 72x. Likewise, MSFT has never paid a dividend in its history and boasts a PE of 70x. With around $16 billion in revenues, MSFT is trading at around 25x revenues, and the fact that it can add market capitalization equal to two times its revenues in only one day of trading is truly amazing and indicative of the current speculative environment. This is in the face of management repeatedly warning that profit growth is slowing and that they believe the stock is "too high" per one of their recent conference calls with investors. Despite the fact that Bill Gates and other top management at MSFT have been steady sellers of their stock since July of 1998 per required filings with the SEC, investors continue to bid up MSFT with expectations of higher and higher profits in the future. History suggests that these speculators will be disappointed with their stock purchases.

Clearly, valuation levels put the current stock market beyond almost any measure of valuation ever invented. A reversion to the mean L-T trend of the Dow Industrials would put the DOW at around 4000. (see Figure D) Of course, that's assuming that the trend-line holds. In all likelihood, it will not.


The 1929 mania was accompanied by fraud as all tops in markets tend to. The rampant fraud in accounting and "inside information" resulted in the formation of the Securities and Exchange Commission to prevent such activity in the future.

Today, incidents of fraud appear to be increasing. In the first quarter of 1998, the volume of class-action suits, most of which involve fraud charges, insider trading or both, nearly quadrupled compared with the first quarter of 1996, according to a June 1998 Stanford Law School study. On January 22,1999, the Securities and Exchange Commission announced it is sending letters to more than one hundred companies that reported ``significant'' earnings charges in 1998, telling them the agency might take a closer look at their books for accounting problems. This is likely just the tip of the iceberg. As the party on Wall Street ends, and investors as well as attorneys involved in fraud suits suddenly become concerned again with truth in accounting. For years companies have distorted operating earnings through liberal write-offs (recurring "one-time charges") and other gimmicks. Net earnings have also been distorted through the liberal use of options in place of salary. These vastly understate salary costs, inflating margins and income. With the current multiple of earnings on the S&P being above 30x, one can only imagine what the real multiple of earnings is without such "creative" accounting.

Even more concerning is the following reported by the Street.Com in which it appears that some investment bankers concocted a scheme, that while not fraud, borders on it. The article points out how Yahoo!, the only internet stock to ever turn a profit, Ziff-Davis, Softbank Corporation, E-Trade Group, and Morgan Stanley all contributed to a perhaps coincidental (perhaps not?) set of events to make YHOO create a profit. Ziff, an internet stock, was IPO'd in 1998. As part of the deal, Morgan Stanley loaded down Ziff with more than $1.5 billion in debt and paid the proceeds to Softbank. Softbank turns out to be the largest single shareholder of Yahoo!, owning 30% of the stock. Softbank took $250 million of the Ziff proceeds and bought more Yahoo! shares directly from the company. Next, it took another $400 million and bought $400 million worth of E-Trade Group, an internet stock broker. E-Trade then took this $400 million and signed an extensive marketing and promotional deal with Yahoo!. Yahoo!'s 3rd quarter earnings showed a nice sequential revenue jump in 1998. It turns out that 1/3 of this gain came directly from the Softbank financed E-Trade deal. Due to this unexpected jump in earnings and revenue, Yahoo! leaps from $104 a share to more than $320, or 200%. As the largest shareholder, Softbank walks away with a huge profit. Is this illegal? No. Does it smell? Yes. Once things turn bad, there is no telling what will surface about various schemes that went on during this period.

Clearly this amounts to nothing more than creative legal fraud, but as long as stocks continue to rise and everyone is making money, nobody cares. Nobody wants to rock the boat while the drunken party is still going. The cries of "foul" will only come after the bust when scapegoats are being looked for.

In 1792 the U.S. Congress adopted a bimetallic standard (gold and silver) for the new nation's currency - with gold valued at $19.30 per troy ounce