The Story of A Bubble – And, Soon, its Aftermath

Background

Four features that can be used to distinguish a bubble, were discussed in Parts 1 and Part 2. These are:

• A severe reduction in the share risk premium. When earnings income on investments become negligible to the extent that these bear no meaningful relationship to income derived from alternative forms of investment, the situation clearly approaches bubble status. Then capital gains appear to have become the 'only' criterion considered by even the traditional investor.
   
• In a sound growing economy, most companies benefit from the increased spending that marks the growth in GDP. In a bubble, the market exhibits signs of a split personality. Market leaders streak ahead to ever higher prices, while most other companies experience a decline in investor demand and in price.
   
• As the average time that a position is held before being closed again shortens, the trend increasingly points to the existence of a bubble.
   
• The greater the degree that investment or rather, speculation, is funded by means of debt, the greater the degree to which the market approaches the concept of a bubble.
   

In Part 3 these characteristics were discussed in some detail to reach the conclusion that Wall Street is in fact in a well established market bubble. We begin with just a few items of news to further illustrate these four characteristics over and above what was said before in this series.

It was reported on the GE Forum that the ratio of income from AAA bonds to dividend income of the S&P500 stands at 7.5. An investor who invests in the S&P500 rather than buy one of these quality bonds, will wait more than seven years at current dividends to obtain the same income that the bond earns in one year. Surely that is a wide divergence between the two markets, with the income derived from the S&P500 way out of line because of its high PE valuation.

Oh, so sorry; You say the game is not about dividends, but about capital gains through a strong performance by the share price? That a new paradigm is in force and this has permanently changed the way the market behaves?

Well, if a ratio between income from quality bonds and stocks approaching 7.5 is an indication that a new paradigm is in force, we have in modern times experienced two occasions of such a new paradigm where the valuation of equities can completely disregard the relative earning power of bonds. And could be expected to continue to do so indefinitely.

Please note on these occasions the ratio of income on quality bonds to dividends just approached this figure of 7.5, not reached it, as has just been the case on Wall Street.

The first was in Japan in 1989. During the 70's and 80's Japan knew all about new paradigms and near two digit growth rates. It was the envy of the world, and its stock market just ran and ran. Dividends? At that time it was often said that the Japanese are different. They have culture that is quite different from that of folks in the west; Japanese care only about capital growth; dividends are very far back in second place. There would be no end of growth in the Japanese economy and PE's of 80 and more could easily be justified on the grounds of what the future held for this people with their culture of hard work and a high savings rate.

Until December 1989 when the Nikkei peaked just short of 40 000 points. The rest is history and nobody really speaks any more of a Japanese culture that has ensured a new economic paradigm.

The new paradigm also says that markets no longer have to march in step. It is quite in order for a majority of stocks to be more than 20% below their highs while market indices set new records. The divergence between the AD-line and the market indices is now more than 22 months old. Compare this with the 13/14 months that the divergence lasted in 1929 before the market finally gave way in the Crash of October 1929. During the run up to this event many academics and commentators spoke of the new economy and the new paradigm that would maintain the stock market at its high levels indefinitely.

Three years later the Dow Jones was down from its high by more than 80%.

Investors buy stocks selectively, based on a study of fundamentals, and expect to hold a position for years at least. Traders buy stocks on expectations of near terms price increases and (used to) keep their trading positions for a few days to a few weeks. Yet we have seen a trend where investors behave like traders and traders have become a completely new breed that keep their positions open for hours at most, often mere minutes only.

Gretchen Morgenson quoted some interesting facts in an article in the NY Times on the Web of 15 January. One item was that 79% of all stocks listed on the NYSE changed hands last year – up from 46% of the total issue that traded in 1990. By comparison, the Nasdaq traded its whole issue more than twice during 1999, up from an 88% turnover in all stocks in 1990.

These figures include all the dogs that hardly trade at all. If the focus is limited to top performers and favourites only, she reports, for example, that the entire issued stock of Doubleclick turned over 21 times during 1999 – a figure that clearly includes stock tightly held by the founders of the corporation. This implies that the available "float" probably traded hands close to 40 times, if not more. Even the massive Amazon saw its total issued stock turn over more than 13 times. For the 50 stocks on Nasdaq with heaviest trading, the average holding period for a position was just 3 weeks on average. One source she quoted likened it to ". .a game of musical chairs, . . ".

Earlier in this series of articles, a figure of $175 billion was used for the margin debt on the NYSE; that was the figure for August 1999 and it was 3.5 times what the margin debt was in 1993. By the end of 1999 this amount has risen to $206 billion – adding another 17% in just 4 months – and apparently that figure has since moved higher to $228 billion. The increase of about $30 billion to the end of 1999 indicates new funds of as much as $60 billion flowing into the stock market, since margin is limited to 50%. Although there are apparently ways of getting around the limit.

If this rate of increase continues through 2000, margin debt will end the year at about 4% of GDP. If margin debt hits a ceiling and ceases to increase, new funds available for investment will decline by $60 billion or more every 4 months, reducing demand for the relatively small number of stocks still in favour with the traders.

All of the above indicate that the 18 year old Great Bull Market on Wall Street has transformed itself into a bubble and that until very recently was still expanding to set new highs on the main indices.

Introduction

Should we therefore assume that, as all previous bubbles have so far done at some stage, this one too will be pricked at some point in time, it now becomes possible to speculate how this event will happen and how matters will unfold in the markets as the rapid deflation of the bubble takes place.

And, of course, what conditions will be like once the dust has settled. Some years later.

The most common factor responsible for the pricking of long-lasting bull markets and, of course, equity bubbles, is interest rates. As rates rise, the increasing disparity between interest income and dividend income places the market under tension.

Holders of equities become very nervous when rates increase; firstly, rising rates imply that bonds offer ever better investment opportunities compared to equities, while rising company earnings, which for a long time justified the high valuations typical of such markets, come under pressure as the cost of capital increases. If earnings growth levels off, PE's can be expected to return to the normal range from say 15-18; for stocks with PE's above 30 this requires at least a 50% drop in prices, and for the stellar performers on Wall Street with PE's way above 50, the re-rating that will take place when earnings are flat calls for price adjustments of 75% or more.

At some point in time, this increasing nervousness in the market reaches a degree where just a small nudge is needed to trigger a substantial sell-off.

Yields in the bond market are a good barometer of expectations for what will happen to interest rates and also of the degree of uncertainty and risk that the more sophisticated players in the bond market perceive in the economy. Including the risk of inflation. We will therefore take a good look at yields on the 30-year Treasury bond and factors that can influence the yield.

Quite a good portion of US debt is held by foreigners. Apart from initial purchases when the US were running a budget deficit, foreign investment in the US – including its debt – continues to increase as a consequence of the rising trade deficit.

Not all the funds earned by foreign imports to the US leave the shores to return to the country where the imported goods came from. Too strong a flow of funds back into the foreign country will cause its own currency to strengthen, which will decrease the competitiveness of manufacturers with respect to all the other sources of imports into the US. Which means many exporters keep a good deal of their foreign earnings in US dollars to be invested in the US. And, since industrialists are seldom venture into stock market speculation with their company earnings, the bulk of these funds finds its way into the bond market.

These funds lie safely in the US for as longs as yields on US bonds do not rise too far, to signal a bear market in US bonds. Sustained weakness in the US bond market may well induce some foreign investors to bring their money home before too much of their capital has evaporated. However, their perception of the health of their investments in the US are seen through the glasses of the exchange rate. If the dollar should begin to slide against their own currency, they will also be tempted to repatriate their money from the US before it is watered down too far. Even if the bond market should remain stable under those circumstances.

Similar reasoning applies to foreign investments on Wall Street. A weaker dollar would tempt foreign holders of stock to lock in their capital profit and to bring the funds thus released home.

Which means we have to keep the strength of the dollar on the table as another factor that could affect the 'health' of the stock market bubble.

The third factor that could contribute tot rising interest rates in the US is of course inflation – that much hated and much feared economic demon that is so difficult to contain again once it has been let loose. Just like the baddies and the uglies that according to the fable lived in Pandora's until they were allowed to escape, and could never thereafter be forced back into captivity. Inflation on the move takes on a life on its own and exerts a tremendous psychological force on the minds of all people who deal with prices – merchants and customers; wholesalers and retailers; importers and manufacturers. When these people have been conditioned to accept the fact of rising prices, and have adjusted to this trend, it is a long an painful process to get inflation under control again.

The yield on the US 30 Treasury bond

The recent break upwards from wedge B-F2 and also megaphone F3-F2 is well established. There are technical factors that fall outside the scope of this discussion that imply that the rise in the yield will remain steep at least until market support at about 7% is reached. Over the longer term even that support level seems insecure and rise all the way to line to meet line M again is not as improbable as the thought of a yield of 12% on the US 30-year Treasury bond may sound today.

A key question of course is why yields should continue to rise.

Keep in mind that a rising yield is the same as a declining price for the bond. The bonds bottomed in October 1998 at the time of the 20% fall in the Dow Jones in response to severe problems in Russia. Rumour has it that the Federal Reserve pumped perhaps as much as $800 billion in liquidity into the market in order to prop up Wall Street – a tactic that was very successful, as the Dow Jones proceeded to add another 50% and more from the correction low on 1 October.

On the same day that US equities began a major new bull trend within a 16 year bull market, US bonds ended an 18 year bull market and set off on a bear market that has taken the yield up from 4.8% to 6.7% – the 40% rise in the yield means a major bear market in bond prices is under way.

Coincidence? Perhaps not. The same medicine that stopped the rot on Wall Street was a signal to the bond market that higher liquidity in the money market combined with the inevitable rise in the money supply must sooner or later give rise to higher inflation. It does not really matter whether the link is direct, as when more money chases fewer goods or whether the chain of events goes as follows: more money is borrowed to go into Wall Street, giving rise to higher prices and thus to a greater amount of wealth for American households, who then borrow more money against their new collateral so that they can buy the things they want.

It does not even matter whether the push finally comes from American workers who read about all the new found wealth in America and feel deprived as their wages over the past 5 years have increased by nothing one wants to write home about. At any moment they could decide to obtain a share of that wealth by insisting on decent increases in their wages. That, of course, is the stuff of which Alan Greenspan has nightmares.

Whatever the reason cited when inflation returns, the professionals know that the steep and sustained rise in liquidity and in the money supply that started in September 1998 must sooner or later be reflected in higher inflation. And when that day finally comes, interest rates will rise steeply and bonds will suffer. With this knowledge, the more perspective players in the bond market started to lock in the profits of the 18 year bull market on 3 October 1998 and they haven't stopped yet.

When does it happen?

Observe what happened when the yield moved lower from F2 to F3, reaching market resistance at line B before turning sharply higher. That reversal upwards took place early in 1987 and reached line A by September 1987 – just in time to make investors on Wall Street very nervous and to set the stage for the October 1987 Panic. That move took the yield from 7.37% to 9.76% on the monthly close – an increase in the yield of 32%.

On the monthly chart the most recent increase in the yield is from 4.96% to 6.48% at the end of December and not too far from where the yield is at the time of writing (6.52%). The increase is about 30%, a touch short from what was needed to set off a panic in 1987. The difference is that in October 1987 news of increases in European rates provided the final triggers to convince investors to get out at all costs and not to wait any longer for an improvement in the stock market.

So far there has been no comparable event to give Wall Street a shake. Other factors that could affect the onset of the real bear market are as follows: The yield at 6.5%+ is not as high as it was in 1987, when it was approaching 10%. However, to offset this, the market bubble is now more overblown than ever before and its health is resting on a decreasing number of index stocks. This is likely to make investors more nervous than before.

Further, some degree of profit taking is already taking place. Turnover since December has reached record proportions and this is an indication that worried investors are using the strong demand of late December and January to sell into strength. With increased profit taking two things that are quite important are happening. Firstly, increased selling satisfies available demand that little more quickly, putting an end to the sustained increases in prices. Secondly, the proceeds from real profit taking, as seems to be going on, may not find their way back into the market. If the proceeds are used to settle the debt taken on to open the positions initially, or to disappear into the bond market where risk is lower, then the amount of funds reaming on Wall Street diminishes.

Therefore, in trying to anticipate the start of the real bear market, one should follow two indicators – the rising yield on bonds of all maturities and secondly the turnover pattern on Wall Street and on Nasdaq. If yields keep on rising, the market comes closer to reacting very negatively to any other bad news.

Secondly, if turnover remains at very high levels for as long as demand is quite substantial, it means more and more profit taking is going on. This could become contagious if prices become stagnant and very soon sellers will have to trade continuously at the bid in order to close positions. Then, too, the market will become very susceptible to any shock..

If yields keep on rising and turnover remains high, a situation could arise where even a too strong or too weak economic figure can trigger a serious sell-off to begin the long term slide.

What about a crash?

Bears markets are characterised by a sustained slide in prices broken by intermittent and ever weaker rallies whenever investors begin to think it is now all over and a new bull market is at hand. However, it seems to be almost mandatory for a bear market to have at least one episode of a real panic day, or week, when prices plummet and the media have a field day.

For a panic sell-off to happen, holders of shares must reach a decision to sell at all costs – not to wait after a dip for price to recover, but to hit any bid wherever it sits. This psychological condition is not reached until the main indices are down by say 12-18% from their highs. A 5-10% decline in market indices is worrisome, but not inducive to panic – unless the bad news is catastrophic, of course. With a minor correction in place, investors are still confident that they can get out at a better price soon, if they are just a little patient.

Under those conditions, when the Dow falls 150-200 points, the sellers begin to hold back and give the dipsters opportunity to mop up the relatively small quantity of stock on offer and then to turn prices around again. But if selling gets really serious, any attempt to halt the tide merely means that the dipsters soon become even more urgent sellers when the market keeps on going down. And that is when a panic day such as October 19, 1978 takes place on horrendous turnover without really finding a bottom.

This all means that Wall Street, already down about 6% off its high, still has to lose about 10% or so before the emotional climate will be ripe for the shock that could trigger a panic sell-off. The real question is perhaps not if it will happen, but when. And what happens afterwards?

What will happen then?

If, as seems to become quite likely, there is going to be a major sell-off on Wall Street during the first half of 2000 the sequence of events should pass through the following phases.

1. The market is placed under some pressure by sustained profit taking – such as has been taking place from December through to January, although a recovery now could postpone the event to later in the year.
    
2. Funds released by the profit taking do not return to Wall Street but are used to reduce debt and to buy bonds. This becomes evident in a flattening off of the rise in consumer debt and in some support for the bond market. The increased flow of funds out of the stock market probably means that even fewer stocks participate in keeping market indices on an even keel. Intra-day volatility is also likely to increase as uncertainty becomes more prevalent.
    
3. After the market slips and slides to a loss of about 12-18% from the highs, something out of the blue and very disconcerting news triggers a "sell at all costs" pandemonium among investors. Turnover is extremely high, but the buyers fail to halt the panic. The degree of the fall, which could last over a number of days, will be determined partly by the nature of the news, but also by measures to stop the panic selling. Interrupted trading is one such measure, although if this happens too early it could add to the panic. If a seller had been trying to get out from the opening bell, but then had to sit through an hour of halted trading, he will be even more desperate when trading eventually resumes.
    
4. After the Panic a true bear market should be in full swing. Prices gradually move lower over time on relatively low turnover. Occasionally a piece of news will spark a rally, but this will be seen by disgruntled investors as an opportunity to get out at better than recent prices. The rallies won't last and the subsequent fall will be steep until a new floor is reached.
    

What happens to precious metals?

The decades long campaign to discredit gold in particular has been so effective that very few investors indeed think of gold as anything except a mere commodity. We also have a really strange situation in this market. On the one hand, the hedge fund – central bank coalition must keep POG under a tight rein if they are to avoid a crisis. On the other, many of the people one would suspect of being eager to see a higher POG, namely the producers, are also scared witless that something they never though would occur should just happen to come along – POG rising to $400 and building up speed.

With a steep increase in POG being feared by the speculators and the producers alike, there is a need for a new market force to end the stalemate.

This may well happen if the funds that moved into the bond market from a sinking Wall Street are not sufficient to keep that market buoyant in the face of changing fundamentals and a flight of foreign funds back to where they came from. If the bond market continues to decline quite steeply in value, some of these funds will be moved to the safe haven of last resort – gold and the other precious metals first, and then probably other hard assets as well.

It is said that the mutual fund industry in the US has some $6 trillion under management. 1% of that amount is equal to $60 billion. It is also said that the market capitalisation of all gold mines world wide is about $50 billion, of which say $20 billion is tightly held. This means that the fund managers who wish to escape into gold can not invest even half of one percent unless they buy up every available gold stock.

Should conditions reach the stage where a decision to escape into gold becomes a realistic proposition, even to fund managers who have also succumbed to the rumour that "Gold is dead", then all the efforts by the hedge funds, the central banks and even the hedged producers will not stop the price of gold going through the roof. With silver and platinum in tow and other hard assets not very far behind.

Good news for the gold bulls, but bad news for just about everybody else.