A Booming Financing Sector and a Bubble Economy

April 12, 1999

It was quite an euphoric week for the bulls as they took full advantage of the window of opportunity before the onset of 1st quarter earnings announcements. For the week, the Dow gained 340 points, or more than 3%, and the S&P 500 rose 4%. The transports gained 2%, the Morgan Stanley Cyclical index 3% and the Morgan Stanley Consumer index 2%. Even the small caps came to life at weeks-end, rising 2% for the week, while the Utilities continue to struggle, closing unchanged. The technology rally continued, with the NASDAQ 100 rising 4%, and the semiconductors and Morgan Stanley High Tech index gaining 6%. The Internet speculative frenzy ran unabated, with the Street.com Internet index surging 11%, bringing its year-to-date gain to 80%. Come Monday, with reaction to this afternoon's warning from Compaq, many may regret not having been more cautious with the tech stocks. All the same, this week online stocks led the financial sector to one of its strongest performances in some time. The S&P Bank index gained 6% and the Bloomberg Wall Street index spiked 10% higher, bringing its year-to-date gain to 40%. Investors have certainly come to believe that there is no better way to play the US bubble than to go right to the source.

Financial bubbles are just so seductive. They create an environment where the economy grows rapidly, financial markets boom and the populace enjoys the feeling rapidly expanding wealth and prosperity. Incomes rise, asset prices rise, and the perception is that money and wealth are in great abundance. And bull markets, almost by definition, give the perception of endless liquidity. The critical mistake, however, is extrapolating the bull market forever. But bull markets just look and feel so good, everything just seems to fit together very well - it really "feels" like prosperity is truly supported by strong fundamentals and, of course, everyone so wants to believe it is permanent. And, importantly, bubbles and speculative manias are possible only with a truly "great story," one able to captivate investors, bankers, businessmen and central bankers, alike.

Admittedly, today in the US many perceive incredible wealth as the vast majority has accepted the bullish analysis of our country's profound financial and economic health. And it is certainly human nature to extrapolate prosperity for years into the future. Looking at recent Federal Reserve data, the household sector at the end of 1998 had total assets of a staggering $43 trillion, of which 70% or, $30 trillion, were financial assets - stocks, fund holdings and credit market instruments. Since the beginning of 1995, household tangible assets increased $2.6 trillion to $12.9 trillion. Financial assets, on the other hand, grew a staggering $11 trillion, or 57%.

And while it is here apparent as to how consumers have the wherewithal to spend, investors the assets to invest, and day-traders and speculators the resources to play the market, the key point is that one's financial assets is another's financial liability. And this gets us to the heart of the insurmountable problem with financial bubbles: Over time too many financial claims are created that can not be supported by the real economy; too much perceived wealth is created in inflated asset prices that are not supported by the cash flow of the underlying businesses; and too much damage and distortion is done to the real economy as the major focus of major portions within an economy shifts away from saving and investing to create real economic wealth to simply working to profit from and consuming the rewards of the expanding bubble. With this in mind, today the bulls can stick with whatever "new era" theories they can concoct in support of the booming stock market, but the facts speak for themselves. This historic bubble has had extraordinary effects on our financial system and economy.

Let's look at the stock market. The Wilshire 5000 index is comprised of US traded equities, excluding preferred stocks, foreign stocks and ADR's. "5000" is actually a misnomer, as today this index includes 7,394 companies with a market value of more than $12 trillion. Out of the near 7,400 stocks, 376 produce "capital goods", 285 "consumer durables", 170 are involved in "transportation", 283 in "energy" and 289 in "utilities". And illustrating the transformation of economy to services and technology, "Materials and Services" comprises 1,547 stocks and "technology" 1314. The unprecedented role of financial services is certainly apparent as 1,489 publicly traded companies are in "finance".

Indeed, the degree to which financial services has come to dominate our stock market and economy is truly astonishing. The New York Stock Exchange Financials index of 968 companies now has a market value of $2.15 trillion. Looking closer at industry groups, the AMEX Securities Broker/Dealer index of 12 companies now has a market value of $755 billion. The Standard & Poor's Bank index of 32 major banks has a market value of $770 billion. The Standard & Poor's Insurance Composite of 20 companies has a market capitalization of $340 billion. Fannie Mae and Freddie Mac combine for a market value of $110 billion. And with NASDAQ, the 100 largest financial companies have a market value of $201 billion.

But it is not just so-called "finance" companies that are working diligently to profit from the financial bubble. Just look at General Electric, with the largest revenues of any company in America. With a market value of almost $370 billion, it has become a top Wall Street favorite for its ability to consistently grow revenues over many years. GE is also widely viewed as a patent example of America's industrial renaissance and global dominance. Well, at the end of 1998, GE had total assets of $356 billion, of which about 10% were "Property, plant and equipment". GE's aggressive move into financial services is most notable, as GE Capital Services now has total assets of $303 billion, or 85% of total GE assets. In 1998 alone, GE Capital increased assets by $48 billion, or more than 90% of total asset growth for consolidated GE. And looking at recently released first quarter results, GE's reliance on finance only grows more extreme. With year-over-year revenues actually declining for 3 of 8 business segments, it was only aggressive growth in financial services that allowed total revenues to grow 8%, the weakest revenue growth in years. In fact, with revenues growing 11%, GE Capital was responsible for 80% of total GE revenue growth.

Clearly, GE is finding it much easier to create profits by providing financial services than it is in building products. And in this regard, GE much exemplifies the entire US economy. As massive global overcapacity for producing most goods works to crush profits for manufacturer and, at the same time, is a major factor behind the Fed's monetary accommodation, more and more companies are choose the financial sphere to satisfy Wall Street. And as GE and other industrial companies aggressively grow their financial arms, this only adds additional aggressive players to an already overcompetitive and extended US financial system. In this way, ironically, the global financial crisis and deflationary forces have thus far greatly fueled the US bubble. And as companies and investors alike shift away from production based businesses to companies profiting from the financial bubble, investors, speculators and US corporate management are rewarded for such activities as aggressive lending, investment banking, stock trading and the like. The great proliferation of such activities has and continues to fuel this historic financial and economic boom and, in the process, inflates profits from such activities. Meanwhile, such bubble-related profits work like a magnet for our limited resources, leading to major distortions that will surface with the inevitable bust.

Today the bullish analysis is replete with captivating phrases such as "creative destruction" that supposedly describe our so-called "new" economy. We just don't see it this way. There is simply nothing creative about the destruction of profits for so many companies with real businesses and products. Today after the close, Compaq announced that it would report disappointing profits. Citing competitive pricing pressures and demand below-expectations, the company announced it sees profits of 15 cents, less than half of analysts' estimates. Interestingly, this is less than the company made during the first quarter of 1994, when the stock traded about one-quarter of where it does today. Obviously, last year's huge write-offs that led to a net loss of $2.7 billion was not the end of Compaq's problems. Clearly, Compaq's disappointment is just further evidence of an unfolding profits collapse, one that is underway for much of the technology industry and, really, throughout much of the manufacturing sector. Admittedly, investors may very well come in Monday and see even more reason to buy companies such as Internet stocks, online brokerages and investment banks, companies that don't have Compaq's burden of trying to make money selling real products. Nonetheless, it is hard not to believe that this most amazing bubble is increasingly living on borrowed time.

Monday we will see how the market reacts to Compaq's disappointment. Come Friday, we have options expiration. A most interesting week is seemingly assured.

In 1934 President Franklin Delano Roosevelt devalued the dollar by raising the price of gold to $35 per ounce.