The Power of a Speculative Mania and Asset Bubble

October 10, 1999

As expected, it was another very unsettled week in the stock market and financial markets generally. Despite higher interest rates, stocks rocketed higher led by the most speculative issues in a move that looked to be exacerbated by derivative trading. For the week, the Dow gained 377 points, or almost 4%. The S&P500 also rose 4%, while the Transports surged 7%. The Morgan Stanley Consumer index increased 5% and the Morgan Stanley Cyclical index 3%. The Utilities suffered with higher interest rates, dropping 1%. The small caps also underperformed, as the Russell 2000 gained 1%. The NASDAQ100 rose 6%, increasing its year-to-date gain to 39%. The Morgan Stanley High Tech index gained 4% and the Semiconductors 2%. In an astonishing speculative run, the NASDAQ Telecommunications index rose 12% and The Internet index surged 13%. Even the financial stocks ignored continuing problems in the credit markets, with the S&P Bank and Bloomberg Wall Street indices rising 6%.

We have nothing but the utmost respect for Tiger Management’s Julian Robertson. His exceptional long-term record speaks for itself. We did, however, take special interest in yesterday’s Wall Street Journal article that described the troubles experienced by his fund company over the past year. Importantly, we see Tiger’s situation as indicative of the problems besieging the leveraged speculating community - losses and fund withdrawals. We see this as having key significance currently for the financial markets and the economy going forward. Indeed, we see this as the piercing of the US Bubble.

Tiger’s assets under management have shrunk to about $8 billion, after peaking at more than $20 billion last summer. Of the $12 billion decline in assets, $6.8 billion was from market losses and $5.2 billion from withdrawals. $2 billion of Tiger’s losses came, apparently, during a single day last fall when the dollar collapsed against the yen. And quoting the Wall Street Journal, "since Oct. 8, 1998, Tiger has liquidated more than $37 billion of equity investments – due to leverage, its investment portfolio is much larger that its capital base." Clearly, Tiger has moved aggressively to reign in leverage and risk, something we suspect many within the leveraged speculating community have yet to accomplish. Deleveraging, such as that done by Tiger and others this past year, has certainly been a major factor behind rising interest rates, widening spreads and faltering credit market liquidity. However, for the system as a whole, dangerous leverage only continues to grow, thus ensuring future crisis.

It is certainly our view that last fall, following the domino collapses of highly leveraged speculations in Russia, Long Term Capital Management and the dollar versus the yen, will prove a momentous inflection point for the US financial system. Up until that point, money literally flooded into Tiger and the entire leveraged speculating community. And with assets growing, these funds would incorporate heavy leverage and expand security holdings exponentially. This, of course, provided incredible demand for securities that fueled much higher stock prices and artificially low bond yields. Booming demand for securities from the leveraged speculating community was largely responsible for creating the perception of unlimited equity and debt capital, as well as the appearance of ever declining interest rates irregardless of borrowing demands. This seemingly limitless demand for securities provided much of the fuel for the unfettered expansion of our financial and economic bubble.

This, however, came to an abrupt halt last fall. Granted, the stock market and economic boom continue this year, but this is largely due to the unprecedented leveraging that has taken place by the "Government-Sponsored Enterprises" (GSE’s), largely Fannie Mae, Freddie Mac and The Federal Home Loan Bank system. These three institutions have grabbed the baton from the leveraged speculators. We have referred to this leveraging by the GSE’s last fall as one big "bail out" of our over-leveraged financial system. Alarmingly, this precarious situation of reckless borrowing and ballooning of balance sheets continues this year, fueling the dangerous asset bubble and overheated economy. During this year’s second quarter, the GSE’s increased their borrowings and financial asset holdings by another $72 billion. This brings their total assets to $1.52 trillion, having grown an astonishing $420 billion, or almost 40%, over the past six quarters. During the second quarter, the Federal Home Loan Bank System expanded assets by $30 billion, or at an annual rate of 40%. The Federal Home Loan Bank system now has total assets of about $330 billion, having doubled since the end of 1996 and more than tripling since the end of 1993. This is completely out of control and only leads to a perpetuation of ever more dangerous distortions throughout our financial system and economy. And in this regard, if the Federal Reserve was truly interested in reigning in the US bubble, it could easily be done with just three phone calls, one to the Federal Home Loan Bank System, one to Fannie Mae, and one to Freddie Mac. To stop the bubble from expanding would only require ending the unprecedented ballooning of their balance sheets. We won’t hold our breath…

And while the Federal Reserve has made the decision to sit back and watch, the stock market bubble is left to run wild and our financial system marches down a path of self-destruction. In this regard, very interesting data were released this week from the Chicago Board Options Exchange. Wow! The options business has gone from growing rapidly to expanding exponentially. For the month of September, average daily option trading reached a record with volume running almost 20% above year ago levels. Year-to-date volume through September reached almost 174 million contracts, already equaling last year’s record for the entire year. Meanwhile, open interest for stock options exploded, rising more than 40% for the month. Open interest ended September at 30.5 million contracts, compared to the previous record of 21.8 million in August. These numbers are quite disconcerting but, at the same time, illuminating. Actually, this data is unmistakable confirmation of what we have increasingly suspected - the unprecedented proliferation of stock and equity index derivative trading is fueling serious market distortions.

Since the August lows, the Internet index has risen more than 60%. Many of the large Internet stocks have nearly doubled. From August lows, the Morgan Stanley High Tech index has gained more than 20%, while many tech stocks have surged more than 50%. If we were to venture a guess, we would say that the preponderance of derivative activity has been in the Internet and technology sectors. Additionally, we suspect that the widespread writing of call options has, over the past couple of months, likely led to the unprecedented increase in open interest. With the equity market and these highly overvalued stocks looking acutely vulnerable, and with enticing option premiums for the taking, many wrote calls either as part of a "hedging" strategy or, more likely, as pure speculation. But in a year where seemingly reasonable strategies have such a poor "batting average," this move to write call options has been an especially big loser.

But more important than the success or failure of a particular strategy, we see this alarming growth in stock options as an increasingly powerful force propelling the stock market bubble, particularly throughout the Internet and technology areas. In particular, as the number of call options multiply it increases the potential leveraging available to fuel a stock market advance. As stock prices rise, the writers of these call options are forced to purchase the underlying stocks to protect against further losses. These purchases only amplify market strength, which incites greater speculation and more derivative-related purchases. Throw in aggressive short covering and you have all the ingredients for market dislocation. Almost certainly, these are the dynamics responsible for the recent near buyers’ panic in many stocks and groups, and not the underlying fundamentals. Derivatives are the bubble’s best friend.

In this regard, today’s stock market environment is certainly reminiscent of the final wild speculative run in the credit markets back in the summer and fall of 1993. Then, despite an economy accelerating strongly out of recession and a Federal Reserve that would soon be forced to raise interest rates, euphoric bond investors and speculators completely ignored the approaching storm, choosing instead to aggressively play the blow off top. The derivative players were major factors during this period and, importantly, derivative leverage played a powerful role in fueling market dislocations, which at the time passed as a "healthy" advance. But, actually, it was the very unsound proliferation of derivatives used for both speculating and hedging that provided jet fuel for a virtual bond market meltup. Even at the time, this move made little sense fundamentally but that certainly didn’t temper the enthusiasm for playing. It was by far the most popular game in town. Recognizing that the largest market moves often come during the final speculative "blow off," this fact gave great impetus to the mania, especially for the leveraged speculating community. However, as is the way of markets, euphoria and greed soon turned to fear. And when selling began in earnest, the incredible leverage created during the bubble quickly came back to haunt the marketplace in the ensuing painful bond bear market. Clearly, and most pertinent to today’s stock market, the final months of egregious speculation and derivative activity fueled precarious market distortions that placed our financial system in serious jeopardy. But it seems like we are about the only ones that remember how serious the problems were at the time and how they were created.

As we analyze the current environment, we are left pondering how our financial system has, again, so run amuck. The stock market is now no more than a wild and precarious casino dominated by unprecedented leveraged speculation – a true "house of cards." Have we not learned anything from history? It is just shocking that our financial authorities have chosen to sit back and let this bubble run. But that is exactly what they have done and, unfortunately, there is going to be a huge price to pay from their shunning responsibility for protecting the soundness and stability of our financial system. But, for now, we will focus on the work at hand as we expect nothing if not more wild market volatility next week, another options expiration period. We are now living financial history on a daily basis and it is important to keep things in perspective. The environment is at the same time amazing, perplexing, exciting, intensely frustrating, and often utterly unbelievable. But, at the same time, this is a "textbook" mania and, in this respect, it is not confusing. There will be many books written about this period and analysts and historians will pontificate for decades about what the heck happened. After a wild week, we are simply left in awe of the incredible power of a speculative mania and asset bubble. As much as we have read and studied previous manias, there is no way to appreciate them until living through one. With this in mind, we will continue to work diligently to manage risk while positioning for a great unfolding opportunity.

In the Aztec language the name for gold is teocuitlatl which means "excrement of the gods."

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