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Investor Psychology: Caught in the Bubble Again the Economics of the Internet and How it Works

June 2, 1999

"We're dying from a thousand knives" beefed an Internet trader after this past week's Net stock bash that buried investors for losses in stocks like, already down 50% from its all-time high,, down 36%, and AOL, down a similar percentage. Although it is fairly common knowledge that, sooner or later, all bubbles burst, recent statistics show that investors have nonetheless fallen for the Internet stock bubble hook, line, and sinker, with many loading up on margin just before that bubble began to burst.

Looking to cash in on the big returns provided by the stock market's historic bull run, sophisticated investors and inexperienced traders alike have flocked to the market in droves this year, throwing caution to the wind at such a pace as to drive the U.S. savings rate into negative territory for the first time since 1933 when the world was in the grips of a severe deflationary depression. In order to maintain their trading accounts, investors have also decided that it's all right to maintain high credit card balances and to borrow money to buy stock. The U.S. savings rate again was reported to be negative in numbers released by the U.S. government on Friday. Americans withdrew from savings accounts at a rate of -0.7% in April.

U.S. consumer credit card debt is at record levels. Both a low savings rate and a high rate of consumer spending suggest that consumers are, in fact, feeling the Wealth Effect typical of raging bull markets. The reasoning is that if your stock account statements look good, then that's enough savings in itself to justify refraining from sending money to conventional bank savings accounts.

And that's not all. Investors have been borrowing on margin to buy stock at a rapidly accelerating pace this year, a situation that is also fairly common knowledge during raging bull markets. According to recent New York Stock Exchange reports, April 1999 saw a record one-month increase in total margin debt outstanding. Margin debt increased by $25.5 billion to $181.94 billion from the prior record high of $156.44 billion. This represents an astounding increase of 39.8% in just the past six months, one of the fastest--if not the fastest--rates of growth in history.

According to some research firms, margin debt is now an astounding 2% of U.S. Gross Domestic Product, a figure that is all the more worrisome when one realizes that total U.S. stock market capitalization now stands at a record 151% of GDP, and when one accounts for the fact that a record 44% of all U.S. households now own stock or mutual funds. In 1968, the last major speculative venture involving much of the public, total participation from U.S. households never exceeded 35% and stock market capitalization was not even 100% of GDP. In fact, not even in 1929 did these kind of numbers roll across the desks of research firms. America, then, now values its businesses that produce the goods and services that go into the Gross Domestic Product number more than those goods and services themselves. Historically, this has been a red-flag signal that the stock market is overvalued and investors are in for a route as valuations are quickly adjusted downward.

To make matters worse, investor psychology typical of the ending phases of a bull market has also taken hold recently. Although investors have, on balance, reportedly made good money during the stock market rally of 1999, this past week featured a poll reflecting investor attitudes about the recent Internet stock bash. When asked what they're doing with their Internet stock investments, 51% of respondents indicated they're "riding it out," 23% said they're "doubling down" on positions, 15% said they're short-selling them, and only 10% had "had enough." This suggests an attitude that most investors are not only riding out the market decline with no strategy to speak of, but that many had bought near recent all-time highs and on margin at record levels to boot. Thus, despite making good money on the rise, investors are displaying typical symptoms of overstaying their welcome.

To put the market capitalization problem further in prospective, we can observe James Grant's ( Grant's Interest Rate Observer ) recent comments echoing what many investors are now discovering the hard way. Grant observed that "the capitalization of an AOL is as much as a company like Merck, but Merck has $27 million in revenues and AOL has one tenth of that in revenues. Therefore, investors are paying high prices for a company that is in the business of making itself obsolete."

As we observed in our May issue of The Global Market Strategist, which contains a detailed article describing what the Internet really is from an economic perspective ( a new industry that is an efficient and revolutionary price distribution mechanism, but that is nearing the second stage of new industry development ) and why we have expected Internet stocks to plunge. The Internet is a fantastic resource for consumers and a great way for global businesses to deliver their products efficiently to those consumers. But that very efficiency eventually ruins the average, overly bullish investor loaded up in stocks in that new industry because as companies that enter the new industry due to seductive profit margins become subject to intense competition. That competition eventually becomes fierce enough to drive profit margins to zero as the first phase of new industry development nears its end.

Then, the dreaded company shake-out occurs, with many businesses that initially emerged onto the marketplace shaken out by profit margins too low to remain in business. Investors must be cautious of which companies in which they invest, what price they're paying, and how solid an infrastructure the company has as the second phase of new industry development takes hold.

As example, IBM, has surged in price recently after their Internet sales of computers and computer products soared. But IBM produces a product--brand name computers and software--and the Internet is helping them distribute that product in a way that supplements their already-established sales in an efficient manner., however, sells books. Yet, many companies sell books, and the Internet to a company like an Amazon or a Barnes and Noble is a price distribution system that is driving the price of books down enough to adversely affect profit margins.'s losses are forecast by analysts to exceed revenue growth in the months ahead, a symptom of the kind of competition that takes hold at this stage of industry development.

Since the purchase of stock is, in effect, the purchase of a company's earnings, one must be very conscious of the price one is paying for the right to participate in those earnings. The average investor, we contend, did not borrow money to buy the Amazon's and the AOL's this year to participate in earnings or as a result of carefully researching the situation, but for the reasons that typically dominate investor psychology in each raging bull market that history has offered: the desire for action--to trade--and because of greed, not as an evil personality trait, so to speak, but as the opposite end of the fear/greed spectrum from that had that dominated market collapses such as 1929, 1962, 1973, 1987, 1990, and even last year in 1998. A similar collapse occurred in the Asian markets in 1997, in Latin American markets in 1995, in Japanese stocks after the bubble of the late 1980s burst, in gold in 1980, and so on. Each time, despite history, investors have flocked to the marketplace in droves just at the wrong time, and the U.S. stock market in 1999 appears no different from the bubbles of times past.

According to the Talmud you should keep one-third of your assets each in land, business interests, and gold.
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