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Leverage Fuels Stock Market Bubble… Bubble Fuels Leverage

November 30, 1999

Despite what have appeared to be indications of an imminent change to this most difficult environment, the historic stock market dislocation continues. Again this week, the market is dominated by wild moves in stocks and sectors with large short positions. Today, for example, Nextel Communications, with about 24 million shares short, gained 17 ¼ to 115. This stock traded below 40 this summer. The historic Internet speculative run continues, with gains so far this week of 28% for Intuit, 23% for Ebay, 16% for DoubleClick and 12% for Amazon, just to name a few. In the past three sessions, the Interactive Week Internet Index has risen another 5%. The Internet index has a gain of 2%, increasing its year-to-date and 52-week gains to 138% and 204%. So far this week, the NASDAQ 100 has gained 3%, increasing its year-to-date and 52-week gains to 69% and 97%. The Morgan Stanley High Tech index has risen 2%, as its 1999 gain jumped to 83%. Underperforming, the Semiconductors have dropped about 3% this week, while the NASDAQ Telecommunications index is largely unchanged. Outside of the wild speculation and short squeeze, much of the market has been quiet. For the week, the Dow has a gain of 5 points and the S&P500 is flat. The Morgan Stanley Consumer index is also unchanged, while the Morgan Stanley Cyclical index and Transports have dropped 2%. The small cap Russell 2000 has declined about 1%. The interest rate sensitive sectors are now performing poorly. The Utilities, the Bloomberg Wall Street index and the S&P Bank index have each dropped about 3%.

Not surprising to us, today the Commerce Department sharply revised 3rd quarter GDP to 5.5%, up from the previous estimate of 4.8%. And, clearly, there are scants signs that economic activity has tempered so far this quarter. Actually, the latest numbers only confirm that the economy is operating like a runaway train. Today, the number of jobless claims was reported to have dropped last week by 13,000, to the lowest number since mid-September. Also today, the November New York purchasing managers index rose to a very strong 64.1 from October’s 60. The "services" component rose to 63.6 from 60.4 while "manufacturing" surged to 69.1 from 55.6. The index for business activity outlook going out six months rose to 71.2 from 66.1. The index of manufacturing sector prices paid shot to 75 from last month’s 64. Elsewhere, the national index of help-wanted advertising rose another three points last month to 86. And, the University of Michigan index of consumer confidence rose to 107.2 from last month’s 103.2. The index of current economic conditions rose to 116.8 from October’s 112.7.

Importantly, we also see indications of an up tick in the already hot housing markets. Today, the Mortgage Banker’s Association reported that mortgage applications last week increased to the highest levels since the week of July 2nd. The index of mortgage purchase applications rose 5.8% from the previous week, while the index of mortgage refinancings rose almost 9%. The index of mortgage purchases has now increased 24% since the week of October 22nd. Although the bulls have been hoping that a somewhat cooler housing market over the past couple of months was a portent of a moderating economy, this is now looking increasingly like nothing more than wishful thinking.

No doubt about it, the stock market rally, particularly NASDAQ’s moon shot over the past month, will provide a strong boost to housing. Actually, the numbers with regard to increases in perceived stock wealth creation are now so huge that they are virtually incomprehensible. For example, during the past month, the capitalization of Sun Microsystems has increased 50%, or $35 billion. America Online has risen 40%, with an increase of market value of $53 billion. These pale, however, in comparison to the rise in market valuation of Cisco Systems that has gained $88 billion during the past month and is now valued at $314 billion, or more than eight times Boeing and almost seven times General Motors. In what has become inarguably the greatest speculation in history, the NASDAQ100 now has a market value of an astounding $2.82 trillion, having increased more than $500 billion during the past month and $1.1 trillion so far this year. This, importantly, only throws more fuel on a desperately overheated economy.

Actually, recent money and credit data provide clear evidence that of an acceleration of both lending and economic activity. During the past four weeks, bank credit has expanded at an annualized rate of more than 12%, the strongest pace this year. During this period, bank loans have risen almost $63 billion, after growing $19 billion during the third quarter. The breakdown of this lending is most interesting. Of the $63 billion increase, there were an additional $18 billion commercial and industrial loans, $8 billion real estate loans, and $1.4 billion consumer loans. Loans for securities, however, surged almost $27 billion to $129 billion, an unprecedented increase. This data certainly confirms our view of heightened economic activity following the historic stock market run, but also that leverage is playing a major role in feeding the stock market advance. And while October numbers are not yet available, keep in mind that margin debt had already increased $38 billion, or 27%, so far this year.

The key source of stock market leverage, however, is not likely margin borrowing. Sure, on-line trading volumes have of late risen sharply and there are increased reports of buying Internet and technology mutual funds on margin. Yet, we believe the more powerful source of stock market leverage arises from derivatives. As such, we see more evidence of an historic proliferation of derivative trading. Monday the Chicago Board Options Exchange announced that last Friday was the busiest day of stock options trading ever. A total of 1.62 million contracts traded, equivalent to 165 million shares of stock. This beat the previous record set on October 15th by more than 5%. For the month of October, volume of 25.7 million contracts broke September’s record by 16%. Average daily volume for the month of October ran 38% above a year ago. Stock option open interest also set a new record, increasing another 8% from September. Total stock option open interest now totals 33.9 million contracts, having increased 61% since July and 86% from year ago levels. And these are just the numbers from one exchange and exclude the massive over-the-counter derivatives market.

As we have stated previously, it is our view that record option activity has been a powerful source of rocket fuel for the stock market. It is certainly our belief that widespread speculation in call options has played a particularly key role. Many speculators have been writing calls to pocket the hefty premiums, only to have been caught short during this momentous market meltup. Others aggressively purchased call options, choosing to take highly leveraged speculative bets that have been huge winners. Importantly, as the stocks with large option activity moved higher, particularly in the big NASDAQ and technology names, the writers of these call options were forced to aggressively purchase the underlying stocks to hedge market exposure. This has undoubtedly led to huge borrowings that have helped power the meltup. In fact, we would not be at all surprised if this type of borrowing has been a major factor responsible for the financial sector’s massive commercial paper issuance since September. This may also explain the surge in money market fund assets that have increased $74 billion, or at an annualized rate of about 40%, during the past six weeks. Keep in mind also that M3 money supply over the past six weeks has increased $113.4 billion, or at an annualized rate of almost 16%. It is simply not a coincidence that over the past few months we have had unprecedented derivative trading, an historic meltup in exactly those stocks with the largest derivative positions and, at the same time, a wild expansion in bank security credit, money market assets and money supply. As we said, no coincidence.

Interestingly, many argue that recent money supply growth is not related to the stock market advance. Others argue that the increase in money supply is mainly the result of Federal Reserve operations ahead of Y2K. In response, Y2K operations are certainly factors behind the big move in the very narrow definition of money. We, however, believe that a focus on aggregates such as bank reserves and the monetary base have lost most of their value, that only broad measures of money are of much relevance today. Sure, back when banks were about the only lending game in town, bank reserves did serve as a key indication of potential lending, and the term "high powered money" was very meaningful. Today, however, the credit game has changed completely. Credit can now be created in excess by a myriad of institutions outside of the banking system. So last fall when there was a meltup in the government bond market, Fannie Mae and Freddie Mac borrowed massively in the money and capital markets to balloon their balance sheets with refinanced mortgages, flooding the financial system and economy with liquidity. Now, with a meltup in the stock market, others within the financial sector borrow aggressively in the money markets to lend to their clients to buy stocks, again throwing more liquidity onto an already dangerously overheated system. One could simply not dream of a better example of a financial and asset bubble.

And in response to the notion that current money growth is not exceptional, all we can say is that the numbers speak for themselves. Money supply is expanding dangerously and it should be clear that not only is the stock market advance being fueled by this liquidity, the stock market meltup, itself, is a powerful force inciting money and credit excesses. Indeed, we are now in the midst of a dangerous self-feeding meltup, a credit and asset bubble in the crescendo of excess. We will not predict when this will end, but we have absolutely no doubt how it will end. In fact, the outcome is clearer now than ever before. Unfortunately, a dangerous bubble that should have been pierced long ago has been left to grow to unprecedented extremes. And, as is typical of credit and speculative bubbles, the greatest and most dangerous excesses occur at the end of the cycle. This has inarguably been the case over the past 18 months.

The current environment could not be more dangerous. And with the stock market, the credit system and the economy in "meltup mode," we would expect that the bond market would be the first to crack. Again this week, there were increasing signs of stress in credit markets here and abroad, particularly in Europe. There is no doubt that considerable leverage had developed in the European credit markets, as it had here at home. It is exactly within these highly leveraged credit systems that we look for an accident that will puncture the historic speculative stock market bubbles that now circle much of the globe. No bubble, however, compares to what we have here at home, especially in the NASDAQ, technology and Internet areas. And no financial system and economy is in greater danger today than ours is.

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