Commentary

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Index

The Cult of Greenspan
November 28, 2000

Misplaced Faith?
Why the Fed can't bail out Wall Street and Main Street again in 2001 as in 1998

As stock markets around the world tumble and the word "recession" makes its way into the headlines of newspapers from Tokyo to New York to London over the past few weeks, anxious investors await the inevitable rate cuts that will get the party started again.  The Fed raised interest rates six times from June 1999 to May 2000 to keep a booming economy from fueling inflation.  Assuming central bankers know more or less how long rate hikes take to bring about the desired economic slowing effect -- 12 to 18 months -- how could they be so cruel as to pull away the punch bowl in time to bring about a collapse during the holidays?   Why not fill it up a bit more to bring some holiday cheer?

Fed interest rate relief is right around the corner.  That's the consensus among the wishful thinkers.  Long time readers of iTulip.com know we're not among them.  The Fed may indeed lower rates, but not as before.
 
 

"We are now on the inevitable down phase of the cycle of Creative Destruction that Joseph Schumpeter described half a century ago. As such, policy makers must take great care not to interfere with the fundamental need to inject greater caution back into the system.  A simple reflation of the bubble in financial assets which existed through the first half of this year would only involve greater dangers for the world economy in the period ahead." Lawrence B. Lindsey at the Imperial Hotel, Tokyo, Japan, November 12, 1998

Oops

The Fed went too far with rate cuts in 1998.  FOMC members perhaps missed Larry's Tokyo speech where he warned that lowering rates too quickly and too deeply was likely to not be in the long term interests of the world economy.  But that's exactly what the committe did in 1998.   In the heat of the Russian bond default crisis, the FOMC voted to drop interest rates between September and November 1998, causing as Lindsay predicted a "reflation of the bubble in financial assets."  And how.

Stock Market Bubble
Chart from InvesTech Research

The NASDAQ bubble takes off late 1998 as excess liquidity pours into the markets...

Saving Rate Collapse
Source: U.S. Department of Commerce, Bureau of Economic Analysis

...personal savings falls through the floor...

...and the current account deficit explodes.

In 1998 the Fed did "interfere with the fundamental need to inject greater caution back into the system" and as a result the "greater dangers for the world economy in the period ahead" that Lindsay warned us of have come to pass.

How is the Fed likely to deal with the developing liquidity crisis in the U.S. in the coming months?  Stock market investors should not hold their breath waiting for immediate relief, even as the U.S. economy heads for a hard landing.  The Fed has to weigh the potential for recession against creating an even more serious economic problem down the road as a result of a new injection of liquidity.  Perhaps the Fed has learned its lesson and this time round will follow Lindsey's advice.
 

"Therefore, the Federal Reserve is likely to pursue a very cautious course of action. We should expect modest interest rate cuts, bringing the Fed funds rate to a roughly neutral position by year end. Further interest rate cuts will be used carefully, in order to minimize the potential for systemic risk that exists in the currently very fragile financial environment. Although Wall Street might hope for much more aggressive interest rate cuts, such reductions are not now in the interest of the U.S. economy and would pose significant policy problems for the Fed. In addition, we might also expect an increased use of the discount window in the period ahead as a way of injecting funds, in a targeted way, into the U.S. financial system." Lawrence B. Lindsey at the Imperial Hotel, Tokyo, Japan, November 12, 1998

If you read all of the text of all the speeches available at Board of Governors of the Federal Reserve System -- sick people that we are, we do -- you will see no mention of the danger to the U.S. economy posed by the collapsing rate of savings and rising household debt in the U.S. over the past eight years.  However, just because the Fed isn't telling us it's worried, does not mean we can relax.  iTulip.com readers have read our warnings since 1998.  Although we have offered no direct advice, we hope readers have decided, after reviewing the information offered here over the past two years, to get ahead of the herd on reducing exposure to the stock market, getting out of debt and increasing savings.

The U.S. has experienced an historically unprecedented, rapid and continuous drop in the personal savings rate since Q4 1998.  For the first time on record, the savings rate data turned negative in Q3 2000.

The average quarterly change in U.S. household saving for the 38 year period of 1960 to 1998 is 7.35%.  The average quarterly change for the two year period of Q3 1998 to Q3 2000 is -52.12%.  There is no comparable two year period in recorded history.  The next most extreme period of quarterly saving decreases was -12.6% in the Q1 1993 to Q1 1995.

From 1960 until 1994 saving grew more or less continuously.  The quarterly change varied within the average range of 7.35% and 50% to -28% in the most extreme cases.  Significant and prolonged fluctuations in saving are associated with the business cycle, with the most extreme variations associated with the biggest booms and busts.

What occurred starting in Q4 1998 is extraordinary.  Saving has fallen quarter to quarter since then until reaching an astounding -112.63% in Q3 2000, the first tripple digit rate change on record.  More alarming, this acceleration of dissaving caps the longest period of dissaving on record.  Saving has fallen every quarter for the past 31 quarters starting in Q1 1993 with the exception of the four quarters Q3 1996 and Q1 - Q3 1998.  Again, there is no comparable period in recorded history.  The longest previous run in dissaving was the Q3 1985 to Q3 1987 period when the savings rate fell for six quarters out of nine.
 

"The paper credit which, with such encomiums to themselves they boast to have set up, what effects has it produced, but only to lull the nation asleep, while the ready money that should even carry on our common business, has been exported?  Can this imaginary wealth stand the shock of a sudden calamity?"  - Charles Davenant (1656-1714)

The extraordinary rate of dissaving in the U.S. since 1994 has been made possible by the willingness of foreigners to purchase U.S. capital goods.  This effect is especially evident in foreign purchases of U.S. public debt.   If foreigners decide to stop saving on behalf of U.S. households, because returns fall relative to domestic or alternative foreign capital goods, either U.S. households will have to increase savings to make up the difference or the amount of capital available will fall.  In the latter case, the U.S. will experience a slowing economy coupled with rising inflation.

As saving has fallen, U.S. households have taken on ever increasing debt, increasing liabilities more than 30% in proportion to income since 1980.   There is no doubt that the U.S. economy is two thirds driven by consumption, but what is less often discussed is that in the U.S. consumption is largely driven by dissaving combined with increasing levels of household debt.  When Greenspan thanks rising productivity for the miracle of extended economic growth without inflation, curiously he never mentions a more obvious source, dissaving and debt.  References to the factors of dissaving and debt is conspicuously absent from all the Fed employee speeches and testimony available at Board of Governors of the Federal Reserve System..

Only one similar previous period in history provides us a view into what the future holds.  In Business Cycles, written in 1939, Joseph A. Schumpeter analyzes the causes of the 1930s depression.  Poor monetary policy following the 1929 crash is the orthodox theory of the cause of The Great Depression.  Yet Schumpeter shows that loose monetary policy, low household savings rates, high household indebtedness, a frothy stock market, uneven distribution of wealth and inauspicious loans by banks to individuals and corporations -- for stock purchases on margin in the 1920s and for real estate and stock buy-backs in the 1990s -- create conditions for economic collapse that leave monetary authorities more or less helpless once the collapse commences.
 

Consumers' borrowing is one of the most conspicuous danger points in the secondary phenomena of prosperity, and consumers' debts are among the most conspicuous weak spots in recession and depression.  In other words, we shall readily understand why the load of debt thus light heartedly incurred by people who foresaw nothing but booms should become a serious matter whenever incomes fell, and that construction would then contribute, directly and through the effects on the credit structure of impaired values of real estate, as much to a depression as it had contributed to the preceding booms. Nothing is so likely to produce cumulative depressive processes as such commitments of a vast number of households to an overhead financed to a great extent by commercial banks. Joseph A. Schumpeter -- Business Cycles, 1939

What does this mean for the U.S.?  When the U.S. economy inevitably heads into the bust part of the current business cycle, saving will increase more or less in proportion to the previous rates of saving declines during the boom, that is, the lower the rate of saving heading into a recession, the higher the rate of saving during the recession.  During the recession of 1984, for eample, the last severe recession in the U.S., the quarterly saving change hit the highest rate of increase on record, up 50% in Q3.  A 100% or higher quarterly increase in saving is possible at some point during the next recession.  The prolonged period of dissaving that preceeds this recession will tend to extend and deepen it.  When?  The recession has likely already begun.

Data Source: Economagic.com

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Questioning Fashionable Financial Advice - Part I

Popular financial advice reflects both popular culture and the natural tendency of everyone, including economists and financial advisors, to extrapolate the present.  In boom times the best case future is often assumed in the financial planning process.  Pick a time frame from history and you can make any case that suits your purposes to "prove" the best and worst ways to invest your money.  If the US population has accepted any popular financial wisdom over the past ten years it is that holding a large portion of assets in stocks and holding them for the long term is the best policy.

What if the next ten years are less like the ideal 1990 to 2000 period for stocks and more like the inflationary 1970 to 1980 period in the US, the deflationary 1930 to 1940 period in the US or the deflationary recession in Japan that started in 1990 following the collapse of the real estate and stock market bubble and continues to this day?

The Nikkei peaked at close to 40,000 in January 1990, is currently 16,547 more than 10 years later

Owning stocks during all these periods was a disaster, holding cash in one case was a boon and in another a disaster, holding fixed income instruments in one case a boon and in another a disaster, and owning gold was a boon in the inflationary case, and worked well in the deflationary case in the U.S., at least until 1934 when the U.S. government confiscated private gold and passed laws making private gold ownership illegal (the laws were repealed 40 years later, in 1973).  Understandably, no one likes to contemplate the unlikely worst case scenario -- doesn't make for a very cheerful brochure at your neighborhood financial services firm.  But allocating a portion of assets for a very rainy day makes sense, even if that day never comes.  The questions are, what kinds of insurance are likely to be effective under various extreme conditions and how much should one's assets ought to be allocated to insurance?

Today we start to tackle the sticky subject of economic disaster insurance and discuss what the prudent investor may consider for protection, then open the topic up for discussion on the iTulip.com discussion forum.

 
What, me worry?

First question is, why worry about a financial disaster?  One reason to worry is because almost no one else seems concerned outside a small community of perennial bear newsletter writers and web site based bears who, by virtue of their permanent bearish stance, are generally ignored by the mainstream media.   We worried about the Internet Bubble back in 1998 and everyone told us we "just didn't get it."  Pick up any magazine then and you were treated to thousands of stories on the New Era of ever rising technology stock prices.  Now, of course, everyone knows that it was a bubble and it had to pop.  On the other hand, by August 1999 we stopped worrying about Y2K.  Once the mainstream press began to write literally thousands of stories warning us all of impending disaster, it became a virtual certainty that nothing was going to happen.

The world conspires against foreseen disasters.   It's the unforeseen ones that get you.  If you are living in Japan where the economy has been shrinking for over 10 years, you have long forgotten the 1980s when the Japanese economy was regaled as Japan, Inc in Time Magazine.   A prolonged period of economic stagnation used to be called a depression.  Now we use the more technical term "recession" to refer to periods of economic contractions, although the word "depression" more accurately describes the state of mind of those living in a recession.  Once the economic disaster strikes, you can be certain that the press will spew millions of words of analysis that will convince you that the end of the world has arrived and the recession will never end.  And most everyone will believe it, just as almost everyone now believes in the permanent prosperity of the New Economy.  But this impression is misleading.

End of the World!  Not.

The average length of a recession over the past 50 years since 1954 is 18 months and the average length of economic expansions during the same period is 35 months.  The U.S. economy has been expanding in the current cycle since March 1991, that is, for over 110 months.  The one economic expansion of similar duration since 1954 is the February 1961 to December 1969 period when the economy grew for 106 months.  While intuition suggests that the longer the expansion the longer the contraction that follows in the cycle, this is not born out by the data.  For example, the recession that followed the 106 month long 1961 - 1969 expansion lasted for only 11 months whereas the relatively brief 24 month expansion from April 1958 to April 1960 was followed by a recession that lasted almost as long, for ten months, until February 1961.  (See National Bureau of Economic Research.)  But there are other reasons to believe that the current cycle will conclude with a longer and deaper than average recession.

Bubblicious

What makes the down side of the current business cycle more ominous than cycles since 1954 is the overwhelming evidence of a U.S. credit and stock market bubble.

Too high stock prices.  S&P 500 up 300% since 1995 while GDP grew only 12%:  The stock market's overvalued by at least 40% (see Nikkei above)

Too many households own stocks for the wrong reasons. More than 50% of US households now own stock mutual funds but 67% of those households don't know why:  Most are likely to sell in a downturn (See Investors Flunk Vanguard Test)

Too much corporate debt.  Since 1995 corporate debt has grown by 67% to a record $4.5 trillion: Many companies will not be able to service their debt in a recession, will go bankrupt and default, increasing both unemployment and fueling contraction in the credit markets

Too much household debt.  Since 1995 household borrowing has risen 60% to another record of $6.5 trillion:  As  unemployment rises in a recession, many households will not be able to pay their debts, will default on mortgages, auto loans and other debt, causing a drop off in consumer demand

Too much credit card debt.  Average household credit card debt is now $7,500 up 250% from $3,000 in 1990: As unemployment rises, credit card debt will rise at first as households attempt to compensate for lost income with higher short term debt, then credit card debt will plunge as card-holders default and banks withdraw lending

Too much mortgage debt.  Mortgage debt has grown from 68% to 100.8% of income in the last 20 years while home equity has fallen: As unemployment rises, many home owners will walk away from mortgages as resale values fall below the amount of the principle owed

Too much sub prime lending.  Sub prime lending has increased 269% since 1995:  This overhead will fuel defaults as unemployment rises during a recession

Too little savings.  More than 62% of U.S. households have less than $5000 in liquid assets: In a recession, a lack of savings will contribute to falling demand for goods and services

Too much foreign debt.  38% of U.S. government debt is owed to foreign governments and individuals, up over 200% from 1995 levels, but only 18% of foreign owned debt is held by central banks: Sales of U.S. debt by non-U.S. individuals in a recession will fuel capital flight, putting pressure on the dollar and interest rates, in turn fueling inflation

Inflation or Deflation?

A deflationary recession, a contraction of the economy accompanied by a contraction of the money supply, is historically the most likely outcome of a collapse of a credit and asset bubble.  Japan has been battling deflation for a decade since their credit and stock market bubble collapsed.   The one wild card in the U.S. case is the strong possibility of capital flight as holders of dollars begin to doubt the ability of the U.S. government to repay its debts, or at least to repay them with better than devalued dollars.  In that case, the Fed will need to increase interest rates, an impossible choice in a deflationary recession.  In any case, the pressure on the dollar from capital flight may outweigh the impact of rising interest rates, or the Fed and U.S. Treasury may not be able to sustain a strong dollar policy for political reasons.

What to do?

That's the tough question.  In a deflation, cash is king.  But what is "cash" in all cases?  In the case of capital flight, for example, the dollar will lose buying power.  Holding dollar denominated assets that lose buying power will not preserve wealth.

(to be continued)

The beginning of the end or the end of the beginning?

May 22, 2000

[It] came with a kind of surrealistic slowness... so gradually that, on the one hand, it was possible to live through a good part of it without realizing that it was happening, and, on the other hand, it was possible to believe one had experienced and survived it when in fact it had no more than just begun. John Brooks (Financial Historian on the 1929 - 1933 period) The Go-Go Years: The Drama and Crashing Finale of Wall Street's Bullish 60s

The events of our lives we fear most.  We want them to happen when we expect them and then be over with quickly.  But life can be cruel.  A collapsing asset bubble is like a surprise visit by the in-laws carrying 10,000 photos from their Spring vacation at Disneyland.

Asset bubbles deflate more abruptly than they grow.  This explains the popularity of the bubble analogy.  But not only do the darn things fail to pop on cue, thus no more than a handful of lucky short sellers benefit, but after they are pricked they tend to deflate so tediously that almost everyone loses interest half-way through the process.  There's hardly any audience for the final stages of a bear market that follows a popped bubble.  By then most people who were previously invested, who had once obsessively checked prices on an semi-hourly basis, have moved on to other engagements, such as looking for work.  The great stock market mania machine devolves, grinding down in nearly imperceptible increments, like waves sloshing up a beach as the tide goes out.  The process is so slow that most investors don't realize that a long term reversal is in progress until they have lost a substantial amount of money.

Remember when you were a kid and you built a sand castle ahead of what you thought was a rising tide?  You hoped to watch the waves test the castle walls.  After a while you noticed that the waves were falling farther and farther from your castle.  You understood that tides do not reverse but once a day, but you were really hoping that you and your castle were at the right part of the cycle, since your parents weren't about to let you stay at the beach for 24 hours. Finally you decided that the tide was not going to come back when you needed it to, so you gave up and walked away.

The contrarian perspective

This leads me to my reason for starting iTulip.com.

Around the time I was a kid digging in the sand at the beach, my Dad got into the stock market.  The year was 1964. Near the top of the longest bull market since the 1920s.  Prosperity and stock market gains were discussed in the press without dissent as more or less permanent.  The following excerpt gives you a sense of the popular mind-set at the time.

My father was born in 1907.  He lived through the 1920s bull market and The Great Depression.  This experience made him naturally skeptical of the 1960s stock marketeers' arguments, especially since they echoed precisely the case my father had heard from the same camp in the 1920s when he was a young man fresh out of the Navy.  He held out through most of the 1960s bull market and finally relented in 1965.  My father had children late in life.  In 1965 he was 58 years old.

The market crashed in 1970 and headed into a protracted bear market.  The DOW did not return to its pre-crash peak until 1981.  At least on paper, my father broke even a mere 17 years after he got in.  However, one of the boxes of papers that my family dragged from one home to another over the years contained a list of stock investments which when traced shows that a third the companies he invested in went out of business in the recessions that followed the 1970 crash.  By my calculations, increases in the prices of stocks in those companies that didn't go out of business would have made up for his losses to put him in the black by 1993.  Unfortunately, my father passed away in 1992, so he never got to see his long haul stock market investment pay off.  If he'd purchased US Treasuries instead of stocks in 1965, he'd have more than doubled his money by 1992.

Wishful thinking

My father was a Harvard trained physicist.  He invented the Janszen Electrostatic Loudspeaker, the first commercial product of its kind.  He was no dummy, yet he fell for the great stock market lie: that in the long run you'll always make money in the stock market.  This is simply not true if you need the money when when the market is down, say, to pay the mortgage when you're unemployed, to buy an engagement ring for your fiancé, or send your kid to college.

Why did my father in 1964 like millions of investors now believe that the stock market lie is not a lie but is instead a truth?  I figure it's because he was too busy trying to make a living and take care of his family to find the information he needed to figure out that equity products companies were acting in their own interest to get him to take unnecessary  risks with his money.

History is a story of a general rise in prosperity punctuated by setback periods of discontinuity and uncertainty, the seeds of which are planted during long periods of stability, prosperity, complacency and, often, arrogance.

Human nature implores us to extrapolate the present into the future.  Memory mischievously informs those of us living through lengthy stable and prosperous periods that things were always thus and shall continue.  The longer the prosperous period lasts, the less the people save and the more debt they take on.  They also look for higher than historically normal returns on their surplus income and are willing to take greater and greater risks to achieve high returns.  If those returns are consistently forthcoming for many years, they forget the risks and come to count on the returns.  They continuously increase their liabilities on the assumption that their assets will always grow in value and their incomes will increase as well.  They believe that if a shift comes, an alarm will be sounded and flags waved to give ample warning and allow plenty of time to make the necessary adjustments to outstanding liabilities and to the asset portfolio.  Political leaders and central bankers can be counted on to reinforce these beliefs by stepping up to take credit for a boom and promise continuation into perpetuity, or at least for as long as they are in charge.

Booms always engender the widespread belief that things will continue as well as they have, that any negative change in economic fortune will occur with sufficient warning that we will all have time to prepare and compensate, and that our leaders have the great economic boom machine under their control.  These beliefs create an economic and social dynamic which reinforces the most naive wishful thinking, one that eschews the obvious and makes common sense unpopular.

iTulip.com has sought since its inception in 1998 to bring obvious yet unpopular evidence to light, apply common sense thinking to the evidence, and make a few sensible predictions.  Not an easy task.  In our time, the obvious is so unpopular that it's nearly impossible to locate.   It cannot be found in the major media.  Large media companies cannot please stockholders by offering unpopular information that appeals only to small audiences as small audiences do not support broad circulation and big advertising revenue.  One must go digging in places where vested interests are not in hopeful fiction, in the international press and the most obscure Web sites.  There one can find the hidden realities that are staring us all in the face.

The record

iTulip.com's success at making predictions based on contrarian evidence is mixed but good on balance.  Here's a brief chronology of the record.  Keep in mind that for the most part these predictions were considered more or less heretical at the time, judging by the vigorously worded email we received from visitors.  If readers can find similar opinions that predate these, please let us know.

November 1998 - Stated that the stock market itself and Internet stocks in particular represented an asset bubble that we owed to a special set of economic, political and market conditions that attend all financial manias.  The bubble began in 1996 where the bull market ended, following a policy change by the US Fed to permit the broad money supply M3 to increase at historically abnormal rates (M3 grew 4% from 1990 - 1995 and 32% from 1995 to 1999) and an influx of foreign investment that doubled foreign holdings of US debt between 1995 and 1999.

December 1998 - Described how financial bubbles form, their characteristics and how the US stock market bubble conformed to the profile.

January 1999 - On Internet stock prices, we predicted: "The average Internet stock will lose 87% of peak price."  As of May 10, 2000  our watch list of Internet stocks is down 70%.

August 1999 - On Y2K, we predicted: "What the heck's gonna go down after Dec. 31, 1999?  Do we at iTulip.com envision a world in chaos ruled by tribal warlords marauding the strife torn land in ox drawn Rolls Royces, plundering suburban America for precious caches of bottled water and canned tuna fish?  Time to invest in a bomb silo apartment?  Nah.  After the clocks roll over into 2000, a lot of crappy software that doesn't work very well and breaks all the time will continue to be crappy and not work very well and break all the time."

October 18, 1999 - On the market crash, we predicted that the market was to crash on October 19th.  Obviously, this was unwise.  This broke with our tradition of not attempting to target specific dates, a tradition we returned to after that.  We were however able to predict the NASDAQ drop on April 16 within a few weeks by taking careful note of trends that paralleled past bubble declines.

November 24, 1999 - On the triggers for the future collapse of the Internet stock bubble: "Credit Squeeze, Bankruptcy, Fraud, and Weakness in the Real Economy."  The first of these triggers, revelations of fraud, did not occur until the early part of 2000 with announcements of accounting irregularities among certain Internet companies.  The credit squeeze did not really begin until late March, the delayed effect of Fed tightening nine months earlier.  Bankruptcies among the dot coms are only just now beginning. Weakness in the real economy will not show up until Q3 or Q4 2000.

March 6, 2000 - On the final top in Internet stocks, we predicted: "Careful students of financial manias -- and daily readers of iTulip.com -- know that the entire world and a wide array of economic segments of each nation's society need become engaged in a speculative mania for it to develop to the terminal stage, set for a  maximally destructive global collapse."

April 5, 2000 - On the bear market, we predicted: "A bear market is born."

April 16, 2000 - On Recession 2000, we predicted: "We believe that this crash is the result of the markets pricing in a long overdue US recession."  We will have to wait another six months before this prediction is proved accurate or not.

May 9, 2000 - On the month of May: "One thing is certain, by the end of May, you'll wish that back in March you'd had the Wall Street Journal from June 1, 2000."  We have one week to go before this prediction is proved accurate or not.

Near term, Long term

Now the iTulip.com message is that the US stock market bubble has only begun to deflate and that the process will last for years.  No one knows how the devolution of the current financial and economic arrangement will progress.  In a way, it's easier to guess at how it will all turn out in the end than at the order and type of steps in the process.  We will attempt to do at least as well as we have in the past, relying heavily on our understanding of how similar sets of circumstances played out in the past.  For example, due to imbalances in debt to asset ratios and in foreign exchange, the dollar will lose up to 40% of its current buying power by the time the next recession ends.  In the short term, interest rates are likely to rise and inflation will rise as well, then later as the cycle continues and debt contracts interest rates will fall again, perhaps as far as they have in Japan while the dollar continues to lose ground.  How we get there is more complex because political influences on the process are unpredictable.

A number of social changes will accompany the market decline.  I'll spare you the dark prophesies.  Here are a few lighter ones.

Gambling "get rich quick" culture will be replaced by a moralistic "labor for money" ethos

State run lotteries and private casinos will close

Public fascination with wealth creation will diminish and contempt for the wealthy will rise

Faith in free markets and open trade will be replaced by support for government intervention in markets and for new tariffs

Tolerance for behavior outside societal norms will decline

Clothing fashion and media programming will become more conservative

What to do?

iTulip.com gets a lot of email from visitors looking for investment advice.  iTulip.com is not an investment advice site  Rather than keep disappointing iTulip.com visitors with replies to the effect that they're on their own to figure out what to do, iTulip.com will review sites that offer a range of potential investment opportunities and notify visitors about the ones we like on a twice monthly basis.  These will range from sites that enable private investing in start-up companies to those offering formerly obsolete financial instruments that are likely to become fashionable again.  We hope this will expose our visitors to opportunities for real asset allocation.  If you want to receive these notifications, please add your name to our mailing list.  Our privacy policy states that the information you give us will never be given out to anyone without your written permission.

As long as we're making oddball predictions...

While not a winner in the stock market, my Dad was successful with an investment which was at the time a very screwy play.  In 1973, Nixon took the US dollar off the gold standard.  The price had been fixed at $35 an ounce before then and US federal law prohibited Americans from owning gold.  Once gold was demonetized, everyone predicted that the ancient and obsolete store of wealth was destined to decline to a price determined solely by industrial demand.  The chairman of the Bank of International Settlements even predicted a price of US$8.00.  By 1974, gold was trading at $100 per ounce, which is when my father made his purchases.  He made the decision based on the belief that the dollar was doomed by Fed policy and balooning government liabilities.  By 1980 gold peaked at over $850 or $1,774 in year 2000 dollars.  Beaten down by 20 years of effective inflation management by central banks and bad press, gold is currently trading at $274, at 15% of its inflation adjusted peak price.  The consensus on gold, as is the case with in any bear market, is that the price will fall the remaining 15% to zero.  Perhaps it will, but this seems less likely than the possibility that the DOW will soon rise to 36,000 or 100,000 as recent popular books on the subject suggest.

For centuries gold and stocks have been counter-cyclical.  The question is, are gold and stocks still counter-cyclical?

Peaks and Troughs of Investor Sentiment - Greed/Fear Ratio
Demand for Return on Assets/Demand for Asset Preservation

Chart by sharefin

This chart graphs the ratio of the price of gold to the value of the DOW Jones stock index.  Historically, the two meet at close to a one to one ratio from time to time, usually a few years after such an event is deemed virtually impossible by just about everyone.  Will they meet again some day and where?  If ever, they will meet when the DOW is closer to 274 and gold is closer to $10,500.

"But gold is dead," you say.  Not two months ago we were in a New Era.  Now the New Era is over.

Stay tuned.  Big changes have just begun.

Larry advises "Instead of whimpering and whining about the recent correction in the stock market, investors need to show some backbone, quit feeling sorry for themselves and get back in the game."

ANALYSIS: 10 reasons why investors should buy tech stocks now (ZDNet 4/16/2000)

Larry, you haven't been reading your bubble history.  So let's review.

Once everything Internet related was "hot" and any company hitting the IPO market with a product or service even vaguely related to the Internet was guaranteed a ride up.  The term "hot" of course didn't mean that the product or service was needed by anyone or that investors understood anything about the product or service, the market opportunity for it, or any particular company's prospect for success in the market.  In fact, investors' interest in these matters of due diligence was sufficiently low that they'd sometimes bid up an another company's stock, rather than the "hot" company's stock, because they hadn't bothered to get the stock ticker symbol right.

"Hot" is a catch word that cued speculators to bid up stocks in companies in the sector so the sheeple can pile in the for ride.  Later, after the stock prices went up, investment bank "analysis" invented creative reasons why.  They didn't actually know why, although a cynic might suggest that their creative explanations were inspired by the prospect of large fees earned from underwriting any public offering acceptable to a credulous public.  In any case, like all good sales people they made something up that sounded plausible to anyone who lacked the motivation to look beyond the ticker symbol and the thrilling and all encompassing monosyllabic adjective "hot."  To the speculators and sheeple, the explanations sounded pretty good, so they kept piling in.  As with all Ponzi schemes this created a self-fulfilling dynamic.  The stock price continued to go up.  The "analysts" must be right!  Early investors who sold out made lots of money.

Then the bubble popped, for whatever reason.  Doesn't really matter why.  The speculators decided to leave with their profits and the sheeple started getting shorn.  Sector by sector the bubble collapsed as investor enthusiasm for plausible albeit idiotic justifications for stock prices of companies without revenues or profits, or prospects for revenues or profits in the foreseeable future, gave way to more sober reflection.  Investors in one sector after another decided that many Internet companies that haven't made money never will.  As each sector collapsed, the remaining ones were defended.

"B-to-C companies don't represent 'real' revenue and earnings potential, but B-to-B companies do," said the defenders of B-to-B company stock prices after B-to-C company prices had fallen 80% or more.   Even though I happen to agree in the revenue and profit potential of B-to-B companies that improve transaction efficiencies among participants in certain industries, that doesn't mean that P/Es with commas in them are justified.  The B-to-B stocks collapsed, too.  The good are taken down with the bad as fear replaces greed and the bubble collapses.

Now, Larry and folks like him hail such stalwarts as Microsoft and Cisco as the stocks to buy.  These are great companies.  They are highly profitable and have incredible track records.  The markets they so competently serve are growing fast.  But this is a collapsing bubble, Larry.  It doesn't matter.  That's not how popping bubbles work.  P/Es that are a multiple of historic levels will find their way to parity with historic levels.  It's time to regress to the mean, and then some.

Once speculators' greed is replaced by fear, the first objective is to get out at a profit, then the objective is to get out with anything at all.  As we have warned since we started iTulip.com in late 1998, all the speculators and their followers come to this conclusion at more less the same time; they run for the exits together, causing prices to collapse.  But the taste for speculation doesn't end instantly.  Rallies -- always big and sudden -- happen as bubbles collapse.  In bubble collapse mode, rallies are used by self aware speculators as selling opportunities while the anxiety of the followers increases with each wild swing in prices until they finally capitulate as well.

Your suggestions that investors "show some backbone" and "set an example to the rest of the world" are reminiscent of the words of bull market leaders in 1929 who suggested it was un-American to not buy stocks, irresponsible to sell and permit the market to continue falling.  These are lousy reasons to buy stocks.  Markets are brutally insensitive to anyone's moral position, and bubble investors deserve compassion for the unhappy experience of getting caught on the downside of a speculative market, not remonstrations for lack of backbone for failing to ride it down to the bitter end.   I neither condemn them for the thrill they experienced when they were caught up in the mass psychology of the bubble on the way up nor for the fear they are now, inevitably, experiencing on the way down.

While I'd never advise anyone to sell into a collapsing market, to convince me that the worst is over and get me to recommend to anyone to buy any stocks at all, the market needs to level off and volatility must decrease until volumes are at more normal levels.  Until then we will see wild swings driven by fear -- fear of missing the next rally alternated with fear of getting caught in the next wave down.  Unfortunately, history tells us leveling off will not happen until the market over-compensates in the other direction past the point where the bubble began -- in1996 when the DOW is near 5000 and the NASDAQ near 1000.  And when that finally happens, you're going to find yourself with a few unhappy readers if they are foolish enough to follow your advice.

Glossary: sheeple

What can you buy with Cisco stock?
April 18, 2000

Imagine that you are the sole owner of all shares of Cisco Systems.  The value of your shares on March 23, 2000 is US$541.27 billion.  Despite Cisco being an excellent company, you decide to sell all your shares.  You have a buyer to take all the shares and, for the moment, you can ignore taxes and transaction costs.   Once you complete the sale, you ask yourself, "What do I do with all this money?

You decide that there are other companies you would like to own and you compile a list of names. The difficulty you face is choosing which names to buy from your list.  As you cannot decide which ones you want, you buy them all.

And you still have $30,000,000 left over.

(Contributed by Adrian Spitteres)

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Recession 2000
April 16, 2000

And so the stock market bubble pops, as we said in an interview with the BBC and with Reuters exactly one month ago, like a light turned on at last call in a dive bar.  One's companions suddenly look curiously less attractive and witty than just moments before.  Just how unattractive and unwitty are we all going to look once we sober up from a four year credit binge cum stock market bubble?  That depends on how much leverage there was in the market when the crash began.  We won't know the answer for a few months.

But, as the title of this piece suggests, that's not the point of this story.  Over the weekend, between pints of Maalox, equity investors feverishly flipped newspaper pages and TV channels to avoid the endless stream of theories on the cause of the world wide stock market crash now in progress (the Nikkei is down 8.5% at this writing).   The question on the minds of the experienced and opportunistic: Is this a run-of-the-mill worldwide financial panic we predicted in March that will create blood-in-the-streets buying opportunities for the level headed with dry powder, as in 1987 when the market ended up for the year?  Or is this the start of a grinding bear market, propelled downward by a cycle of inflation from dollars coming in from foreign creditors and a weakening economy?  Or is this this The Big One, the start of the disintegration of a complex and possibly highly leveraged financial system riddled with systemic risks by millions of speculators drunk on paper profits and gambling a quarter trillion dollars of margin debt, hedge funds gambling tens of billions on probable albeit not guaranteed changes in the values of underlying instruments?  And if the latter's the case, what is the Fed likely to do?

For instruction, we turn to the words of Alan Greenspan as he spoke to the Committee on Banking and Financial Services, U.S. House of Representatives, October 1, 1998 following the LTCM fiasco.  In the interest of comprehensibility, we offer plain English translation in parentheses such as the SEC requires in an S1 filing:

Quickly unwinding a complicated portfolio that contains exposure to all manner of risks (stupid bets), such as that of LTCM, in such market conditions amounts to conducting a fire sale. The prices received in a time of stress do not reflect longer run potential, adding to the losses incurred. Of course, a fire sale that transfers wealth from one set of sophisticated market players to another (a bunch of really rich guys to another bunch of really rich guys), without any impact on the financial system overall (without destroying the markets for everyone else), should not be a concern for the central bank.  Moreover, creditors should reasonably be expected to put some weight on the possibility of a large market swing when making their risk assessments (creditors shouldn't be surprised that really stupid bets usually fail).  Indeed, when we examine banks we expect them to have systems in place that take account of outsized market moves (we expect banks to protect themselves from bunches of really rich guys making really stupid bets).  However, a fire sale may be sufficiently intense and widespread that it seriously distorts markets and elevates uncertainty enough to impair the overall functioning of the economy (the bets can be so big and so stupid and banks so careless that we have to jump in and save their asses so the rest of the population isn't impoverished as a result).  Sophisticated economic systems cannot thrive in such an atmosphere.

In other words, the Fed has to bail the system out, no matter that the source of systemic risk  is a bunch of morons playing the world financial system for a lousy few millions bucks in profits, otherwise we can't have a sophisticated economic system.  Presumably instead we'd wind up with a primitive one, perhaps drawn by oxen.  Certainly millions of clever institutional investors and Joe Sixpack speculators, blithely heaving buckets of cash into the NASDAQ bubble cash disposal and now going down the drain together deserve the same protection as wealthy speculators if the systemic risks they pose are similar.

While it is fair to hope for a 1987 type outcome, citing the ability of the Fed to rescue the markets, the tendency for the Fed to do so in an election year, the strong "fundamentals" of the US economy, the apparent resiliency of world financial markets (witness Asia's apparent speedy recovery from the 1998 crisis), and so on, the truth is that we will not know until the crash has run its course.

But, of course, we have a theory.

We believe that this crash is the result of the markets pricing in a long overdue US recession.  We have no hard evidence of this, and no one will until long after the recession has been in progress.  But we have strong circumstantial evidence that we find compelling.  And if you ask around, you'll no doubt find some, too.

No one knows where recessions start, but the literature suggests that they start in people's heads.  Just as a market crash starts when someone, for some reason, starts to sell, recessions start when many people stop buying things.  Houses, cars, microwave ovens, beanie babies... stuff.  Perhaps they have decided they have enough stuff.  Or maybe their credit card debts are getting out of hand.  Or maybe they sense, somehow, that they may not have the same income in the future to pay debts.  No one really knows.  All we know is that friends who sell houses and mortgages, design additions to houses, sell cars and furniture, and so on, say that business has been falling off, inexplicably and rather suddenly, starting in March.  We're old enough to recall the significance in hindsight of these kinds of conversations in the past, so we decided to ask around among our honored friends who sing for their supper -- sales people -- and, lo and behold, from coast to coast business seems to be falling off.  A drop off in sales leads can be a seasonal event, but if it happens at a time of year when sales people are used to getting lots of new prospects to stick in the pipeline, it's a good bet that their sales forecasts and actuals will be lighter than usual.

Historically, market crashes presage recessions about 80% of the time.   That's why the 1987 crash was such a pleasant surprise.  But 1987 was probably an exception, just as The Great Depression was also likely an aberration in the other direction.  The average recession in the US over the past 50 years is 18 months long.  In the scheme of things, no big deal.  But the recession we are claiming will be traced to Q2 2000 is likely to be longer than the average and accelerated by several factors.

First of all this is no normal market crash.   It represents the collapse of a very large asset bubble.  The bubble took over where the bull market ended in 1996, meaning it's been developing for over four years.  The market would have likely become a brief bear and the economy mildly recessionary if not for the largess of the Fed since 1996.  That means the markets are due to fall below 1996 levels, with intermittent rallies that may last for weeks or months, before the markets begin to recover in earnest.  That puts the DOW around 5000 and the NASDAQ around 1000 at the bottom.  Not to worry.  We'll see the DOW at 10,000 again in, say, 2010.  Needless to say, the US economy will not be looking quite so bright to foreign investors on the way down. Certainty of repayment of the trillions the US owes the world may be questioned.  In return for the added default risk, the world will ask for a better return, meaning higher interest rates.  Alas, this requirement works at cross purposes for a central bank attempting to nurse the economy to recovery from recession.

After reading Gary Shilling's fine book on deflation and hearing every argument for deflation post bubble or otherwise, we still make the case for a reversal, for a period of several years, of the previous 20 year trend of disinflation and increasing dollar strength.

First, assume the bubble has popped due to a looming recession as we contend.  Then assume that the crash itself is less than salutary in a recessionary environment.  (No doubt endless argument will ensue as to whether the crash caused the recession or not.)  The Fed has a choice of two evils: 1) lots of credit defaults, credit contraction and a shrinking money supply, rocketing unemployment, rising real incomes for the few that have jobs, a strong dollar and stable or falling prices or 2) fewer credit defaults, less credit contraction, a steadily growing (ideally) money supply, less unemployment, and rising nominal wages for those who have jobs (more than in the deflation case) and prices rising faster than wages.  If you believe as we do that the Fed has a choice, B looks a whole lot better.  On close inspection, more advantages appear.

Inflationary government spending is much more politically viable than the alternative. Deflation may increase real return on capital but as was discovered in the 1930s in a democracy the unemployed (who greatly outnumber owners of capital) vote for jobs and increased nominal wages, in other words, for inflationary government programs.  True, inflation lowers real return on capital and hurts creditors, and the rich and the financial community have pull in elections.  But that's not how it worked out in the 1930s when The New Deal looked a lot better than socialism, a real possibility for the US government at the time.  And don't feel too bad for the banks. When the process is reversed, as it was in the early 1980s, the banks make out like bandits. Later in the cycle, when interest rates are raised again, the banks continue to pay low interest rates on savings while lending rates go to the roof.  Nice work if you can get it.

The alternative is higher taxation to pay for government programs to increase employment, ala The New Deal.  Deficit spending and increased taxation is the track that Japan took after its bubble collapsed more than a decade ago. High tax rates are acceptable in Japan where history has evolved a culture of economic equality.  Supporting the redistribution of wealth via taxation in hard times is seen as a citizen's duty, even among creditors and owners of capital.  Further, the Japanese experience with hyperinflation after WWII is as deeply imbedded in the culture as deflation after The Great Depression is in the US culture. A rate of inflation that is acceptable in the US may cause Japanese savers to flee yen denominated assets. With trillions of yen in savings to fall back on before the bubble burst, the Japanese have been able to take a deflationary approach with little risk of either creating a deflationary spiral or exposing the yen to exchange rate risk.

The US experience with The Great Depression makes the US intolerant of deflation, which may quickly take on a life of its own and run out of control.  In a deflationary environment, few want to pay back debts with more expensive dollars later and credit-worthy borrowers are few, so borrowing and lending slows significantly.  Purchasing slows as everyone waits for the next price reduction before buying. Redistribution of wealth via taxation is not politically viable in the US where economic equality is not a widely accepted political goal.

Inflation is the most politically viable method of redistributing wealth from creditors and owners of capital to wage earners in the US after the recession gets underway.  Inflation allows more wage earners (voters) to stay employed and gives them the perception of increasing wealth, even though real incomes are falling since prices will rise faster than incomes. Inflation also spurs further spending, as purchases are made in anticipation of future higher prices. Inflation also allows debts to be paid off quickly with cheap dollars.  Best of all, unlike taxation, inflation can be created by the "independent" Fed without any politician having to explain to his or her constituency why they voted for it. The Fed makes itself the whipping boy for a few years.  Better yet, a fall guy appears, such as OPEC or, in the present case, all those foreigners turning in their dollar denominated assets for cash in their own currency.

Maybe that's why Greenspan decided to stay on, as penance for allowing the bubble to develop in the first place.

Finally, since we get asked about gold so often...

If the dollar tanks, will gold rise?  In a world where capital can flow instantly to safer lands and derivatives can usually hedge nearly any currency risk, and as gold has been demonitized and demonized, gold seems an unlikely beneficiary of a collapse in equity prices and a resulting fall in the dollar.  That said, if extreme exchange volatility develops and the currency futures market seizes up, a sustained and significant rise in the price of gold is likely.   Worth keeping an eye on.

What Next?
April 13, 2000

Jimmy Carter earned an unpleasant distinction.  "For the first time in history," as Henry Reuss complained, "a democratic President put the economy into recession."  And during an election year, bearly eight months before the voters would decide whether Carter deserved a second term.

In the classic manner of business cycles, the downturn fed on itself.  When the demand for goods falls off, the producers find their backlog of unsold products growing and so they cut back on production.  The laid-off workers lose income and the lost income further reduces the demand for goods and leads to still more unemployment.  The only difference this time was the speed of the contraction.  In the second quarter of 1980, the Gross National Product shrank by $39 billion dollars in real terms, adjusted for inflation.  For the past four years, real GDP had grown $60 to $70 billion a year.  Industrial production decreased by more than 8 percent.  Unemployment rose from 6.3 percent in March to 7.8 percent by July, an additional 1.6 million people who were out of work.  Real disposable income per capita -- the best measure of what average citizens are earning after inflation and taxes -- grew weakly in 1979, but by the spring of 1980, it was shrinking.  Real per capital income fell from $4,503 to $4,435 in the 1980 recession -- wiping out the gains of the previous year.  In a nation where everyone came to expect steady progress in his or her economic status, the average worker was, in effect, pushed back to 1978.

Secrets of the Temple
William Greider, Simon & Schuster 1987

The NASDAQ has lost more than 20% of its value from its peak.  The DOW, once the beneficiary of so-called "sector rotation," is below its peak and falling, too.

You have two questions.  First, is this it?  Second, What's next?

You already have my answer to your first question.  The second is much, much harder.

If by "it" you mean the end of the world, the answer is, No.  If by "it" you mean the start of a bear market in stocks, again the answer is, No.  The bear market in stocks started April 5 with the near 14% NASDAQ plunge, as we explained in A Bear Market is Born.  Bear markets begin when the mob's mood of confidence is broken by a pivotal, defining event.  Subsequently, the market falls like a tide going out.  Each successive wave of buying brings the indexes back up, but not again as far as before.  Each wave of selling brings the indexes down to new lows.  Will we see the NASDAQ up over 5000 again?  Yes, but perhaps not for many years.

The tougher question is, What comes next?

To answer that we need to bring together a number of themes that iTulip.com has covered starting in late1998.

We stated that while the United States economy is enjoying the fruits of restructuring, free trade, lower inflation, reduced government spending and deficits, and greater productive efficiency, the government has borrowed a greater portion of GDP from foreigners than any nation in history and the nation's citizens and corporations have also engaged in the greatest debt binge in history.

We stated that there is no new era, only the latest period of disinflationary boom -- the second this century.  New technology and increased international competition increases capacity (deflationary) is balanced by the Fed's increases in the money supply (inflationary) to produce an environment of benign inflation and low interest rates.  A similar balancing act in the 1920s ended abruptly when the stock market crashed, banks failed, demand collapsed, and the money supply imploded.  We don't expect that to happen.  But the future always holds new surprises.

We explained the special conditions that are necessary to create a financial bubble and how all of these were present to form the current stock market bubble starting in1996.

We stated that while the Internet will effect as large an aggregate positive impact on the US economy as the railroads did in the 1850s, the extreme prices of Internet stocks like those of railroad stocks before them are the result of speculative activity whereby stocks are turned into commodities, their values bid up and maintained only by the existence of buyers at a higher price.  We suggested that some day only buyers at a lower -- much lower -- price would exist in the market.  We predicted in late 1998 that the average Internet stock would fall to 13% of its peak price.

We explained the four triggers that would cause Internet stock prices to start to fall -- Fed tightening to preempt inflation, the first signs of weakness in the real economy, revelations of fraud, and a bankruptcy that calls into question the viability of companies in the sector.  As it turns out, the Fed did start to tighten, there are signs that the economy has started to slow (consumer confidence has been falling for months), we were all recently treated to stories about several Internet companies inventing revenues, and of a few well known Internet companies are known to be close to bankruptcy.

We showed that complacency about rising oil prices is disastrous to one's stock portfolio.  The Old Economy versus New Economy distinction is BS, that there is only The Economy and it runs on cheap oil.  We argued against the wishful idea that OPEC's new power is transient and expensive oil is temporary, that in fact sooner rather than later expensive oil is going to show up in the CPI and whack the stock market.

We also predicted that at some point some event would trigger Internet stock investors to sell and that they were likely to panic and unload at any price.  As it turns out, the trigger was the announcement of a greater than expected jump in the CPI due to rising energy costs.

So much for the record.  On to the prognostications.

Much as the Japanese economy was hailed as the model for the US in the 1980s, the weaknesses of the Japanese economy weren't widely reported until after the Japanese stock market and real estate bubble collapsed in the late 1980s.  The "strong" US economy of the 1920s didn't show its frailties until after the stock market crash in 1929.  This time, once the US economy begins to slow -- as in the 1920s, before the stock market fell and then later because the stock market fell -- it will slow far more and more rapidly than most expect.  The big surprise in 1930s was persistent deflation.  The big surprise this time?  Persistent inflation due to weakness of the dollar.

Not only stocks, divorced from value, have become a commodity but the US dollar has, too.  At the moment the dollar is in great demand around the world.  This is a function of the relative high return on risk for investors on dollar denominated assets (stocks and bonds), and that is a function of the apparent relative strength and stability of the US economy and political system.  The US economy has been the demand engine for the world, especially since the Asia crisis, as US consumers have whipped out their credit cards and bought imports to rack up the largest current account deficit as a percentage of GDP of any nation in history.

The balance of trade always balances, so a capital account surplus (the amount of stocks and bonds purchased by foreigners versus the amount of foreign stocks and bonds purchased from them by the US) supports all of this spending on imports.  The world buys US government paper to the tune of 40% of the nation's sovereign debt.  That's the deal the US keeps with the world.  The US buys the world's stuff to the benefit of its export-dependent economies while the world buys US capital assets (stocks and bonds) to the benefit of its consumption dependent economy comprised of debtors with little savings -- outside of retirement plans that are invested in the stock market.  The world saves and invest its savings in the US, converted from local currencies into dollars.  This works as long as the US generates high relative returns on foreigners' savings    By this mechanism, demand for imports in the US equates to demand for dollars overseas.  But what happens if the US goes into recession and is no longer the demand engine for the world economy?

Many have predicted that the dissavings of US consumers will reverse.  US citizens will turn from borrowers into savers.  That's always true in a recession when real incomes (adjusted for inflation) fall.  Before consumers can pool sufficient savings to begin purchasing again, they first pay off their debts and this time they have more debt as a proportion of assets than at the start of any recession in history.  This will tend to prolong the recession.  One of the factors that intensified the 1930s depression was the consumer buying binge that preceeded it.  Most Americans had enough "things" to last them for many years.  This is certainly the case today, and is especially  pertinent since cars and most consumer goods are now built to last ten years or more.  This suggests a prolonged period of falling consumer demand.  Capital spending may suffer a similarly stubborn contraction as corporations, swimming in debt taken on to buy back stock to reduce supply and keep prices high, have unproductive debts to pay back before new debt can be taken on to fund capital expenditures.  As the pool of credit worthy borrowers decreases, already low now that we're at the top of a credit cycle, lending is likely to slow even if term interest rates are lowered to slow the contraction.  The current level of private debt may set the US for a future "liquidity trap," a situation as in Japan where new lending continues at subnormal levels even though interest rates are close to zero.

There are just two possible outcomes for a nation with high internal and external debt that's  headed into a serious recession.  One option is default and the other is inflation.  Which one will we see?  The question reminds me of a friend's invitation to go to the racetrack a few years ago.  "Great," I said.  I like horses.  "Horses?" my friend replied.  "Nah.  I only bet on dogs.  Betting on a horse isn't gambling.  There's a person on top."  Likewise, we have the Fed, the jockey on the economic horse.  The question is, What's the jockey likely to do?  Pull on the reins or spur the horse on?  We take our clues from history.

It's certain that the US, unlike the British government that defaulted on its debts to the US in the 1930s, will repay its debts to foreigners even as a recession deepens.  Otherwise, like the Pound Sterling before it, the dollar will lose its status as the world's reserve currency -- not likely.  One alternative is for the US to raise interest rates to stem the tide of fleeing capital, as Brazil did last year.  But such a move is likely to cause a US economy, the world's demand engine already in recession, to do an economic face plant.  The other alternative is for the world's central banks to lower rates along with the US, as during the 1998 financial crisis, to support the dollar as the US lowers rates to cushion the economic contraction.  But Japan's interest rates are already close to zero, limiting that option.

Our guess is that the Fed will not repeat the errors of the 1930s.  Post market crash, it will not permit thousands of companies to go bankrupt and default on bonds and other obligations or let hundreds of banks fail and millions go unemployed.  The indebted US citizen will not have to wait ten years to pay off his or her loans before sufficient savings support new growth in demand.  US bonds are backed by the full faith and credit of the US government.   The US will repay its debts... but in devalued dollars.  Capital flight, usually associated with nations like Brazil and Indonesia, may for a period plague the US.

In the process, the debts of US citizens will rapidly disappear with rising nominal incomes, as old debts are paid back with cheap dollars.  However, real incomes will fall as the buying power of the dollar decreases.

Later, the Fed can tighten to wring inflation back out of the economy.  Then the process will begin anew.

No doubt this all sounds far fetched, as other iTulip.com predictions have in the past.  Only time will tell.

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"From the foregoing it follows that the crash did not come -- as some have suggested -- because the market suddenly became aware that a depression was in the offing.  A depression, serious or otherwise, could not be foreseen when the market fell.  There is still the possibility that the downturn in the indexes frightened the speculators and led them to unload their stocks, and so punctured the bubble that in any case had to be punctured some day.  This is more plausible.  Some people who were watching the indexes may have been pursuaded by this intelligence to sell, and others may have been encouraged to follow.  This is not very important, for it is the nature of a speculative boom that almost anything can collapse it.  Any serious shock to confidence can cause sales by those speculators who have always hoped to get out before the final collapse, but after all possible gains from rising stock prices have been reaped.  Their pessimism will infect those simpler souls who had thought the market might go up forever but who will now change their minds and sell.  Soon there will be margin calls, and sitll more will be forced to sell.  So the bubble breaks."

John Kenneth Galbraith
The Great Crash 1929  (Houghton Mifflin Company, 1954)

We may be stating the obvious, but market psychology has changed in the past few weeks.  Greed has gradually been replaced by fear.  The irrational hope that stock prices always go up is now inexorably replaced by the irrational fear that stock prices always go down.  A bear market is born.  Keep in mind that bear markets can experience powerful rallies, but in a bear market the majority of market participants see rallies as opportunities to sell, whereas in a bull market declines are widely viewed as opportunities to buy.  Sellers at a lower prices outnumber buyers at higher prices.

As we predicted in 1998, many are losing a lot of money on Internet stocks.  We express our sympathy, and congratulations to those who got out or are getting out with their winnings.  But there's nothing funny about losing money.  Many husbands and wives are having heated discussions on the topic of the market these part few days, we assure you. We only hope that iTulip.com has in some way contributed to the rational decision by many to either stay out of the speculation or at least to speculate only with money that can be lost without risk to long term financial needs.

Always the optimists, we see a silver lining in all this.  Intelligent and hard working persons who might otherwise have been persuaded to waste their energy and talent starting an uneconomical dot com company to take it public 18 months from inception can now focus instead on building profitable businesses that serve real customer needs.  With the Microsoft bully soon to be tamed, we expect an enormous burst of new technology development in the future -- worldwide.  We can't tell you how many times over the years talented engineering, marketing, and sales people in the technology industry have told us of a great idea for a new software company that they'd start... if only they knew Microsoft wasn't going to crush or buy them before they really got off the ground.  This kind of thinking has become second nature over the past ten years or so.  Just imagine the explosion of exciting new products that we'll see in the next few years when this fear no longer shapes the thinking of the energetic and creative minds of the world's technology community.  Even Micorsoft will benefit, as huge development groups are broken up (we hope) and new more dynamic and efficient teams created.

Soon we'll be back to the business of building businesses for customers -- with the end of the Internet Bubble and the Microsoft monopoly.

Good riddance.

 

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In the past three days, the famous index of technology stock prices has collapsed more than 10%, qualifying as a correction.  Now you're probably expecting an "I told you so" editorial from me today.

But then I wouldn't qualify as a contrarian, would I?

Naturally, I have developed an unconventional theory for the NASDAQ drop.  And it suggests that if this drop is based on short term psychology then it's a healthy, temporary correction.  On the other hand, if this drop represents a true flight to value, then we may experience a liquidation more dramatic and sudden than is commonly imagined.

Here's why.

The drop started when investors began to read stories suggesting that the balance sheets of many of their favorite New Economy companies may not be kosher.  First came the revelation that MicroStrategy had failed to do what every service company has had to do forever -- amortize each month's service revenue as an annual recurring revenue stream, starting 30 days after the service is provisioned.  That any company, never mind a public company, managed to go for two years booking service revenue otherwise is shocking.  Next came the news from CDNow's accounting firm that the company was fairly certain to go belly up.  In this case the news of CDNow's impending death was unexaggerated by management -- was either oddly unknown by them or hidden from the public.  Neither possibility inspires confidence.  Then yesterday came the revelation that Yahoo!, known to the investing world as the pioneer Internet portal, is in the eyes of the SEC actually a mutual fund, since more than 75% of the company's assets are comprised of stock of other companies, themselves possibly classified as mutual funds.  Students of history are reminded of the convoluted corporate structures called Investment Trusts in the 1920s.  These companies owned shares in each other in complex and nearly untraceable arrangements wherein the majority of each company's assets was comprised of stock in other companies, whose assets were invested in kind.  They were engineered to create magical leverage as stock prices rose during the boom and delivered catastrophic anti-leverage when prices fell.  But more on that later.

The final straw for NASDAQ stocks came today after the announcement that Tiger Management, a family of hedge funds, will shut down shortly for failure to participate in the mania.  Tiger is run by the world famous money manager Julian H. Robertson Jr. who was once among the world's largest hedge fund families with $21 billion in assets.  In a letter to Tiger's limited partners, Robertson said, "The current technology, Internet and telecom craze, fueled by the  performance desires of investors, money managers and even financial buyers, is unwittingly creating a Ponzi pyramid destined for collapse."

My theory is that all this news of funny business has rapidly reduced the bezzle, resulting in a rapid drop in a significant part of the New Era money supply.

The bezzle?

To the economist, embezzlement is the most interesting of crimes.  Alone among the various forms of larceny it has a time parameter.  Weeks, months, or even years may elapse between the commission of the crime and its discovery.  (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss.  There is a net increase in psychic wealth.)  At any given time there exists an inventory of undiscovered embezzlement in -- or more precisely, not in -- the country's businesses and banks.  This inventory -- it should perhaps be called the bezzle -- amounts at any moment to many millions of dollars.  It also varies in size with the business cycle.  In good times people are relaxed, trusting, and money is plentiful.  But even though money is plentiful, there are always many people who need more.  Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly.  In depression this is all reversed.  Money is watched with a narrow, suspicious eye.  The man who handles it is assumed to be dishonest until he proves himself otherwise.  Audits are penetrating and meticulous.  Commercial morality is enormously improved.  The bezzle shrinks.

John Kenneth Galbraith
The Great Crash 1929
1954

To bring this up to date and scale it to our current five year long stock market mania, and assuming many more MicroStrategy stories lurk in the books of New Economy companies, many hundreds of billions of dollars of bezzle which has been created by Internet companies over many years, in the form of stock wealth based on phony revenue, is now rapidly disappearing.  The money has been lifted from Internet company investors, but they haven't missed it until now because they thought they still posessed the wealth in the form of valuable Internet company stock.  In fact, the Internet companies (and investment banks and brokerages, etc.) have the investors' money, leaving poor Joe Six-pack investor holding only stock with no apparent value behind it, stock which everyone around him is feverishly unloading.

Billions of dollars of bezzle now evaporates, driving stock prices down, causing bezzle to evaporate, causing stock prices to fall, etc.

So now what happens.

Let's get back to the Investment Trusts of the 1920s.  Here's the 2000s version.

Company A makes a "strategic investment" of millions of dollars in Company B in exchange for warrants that Company A can convert to common stock after Company B goes public.  Company B books the investment as revenue and Company A books the value of the warrants, once Company B goes public, as income. I'm not making this up.  Naturally, the income improves Company A's balance sheet, even though this "income" is wholly dependent on the price of Company B's rising stock price.  Company B makes a similar "strategic investment" in Company C.  And Company C in Company A.  And Company F in Company B.  And so on.

Now, let's say, for reasons that no one expects after 20 years of fairly continuously rising stock prices except visitors to iTulip.com, that Internet company stock prices fall for a duration exceeding two fiscal quarters.  As Company B's stock price falls, so do Company A's earnings, which are significantly dependent on the price of other companies' stocks.  Since the price decline has lasted for an entire reporting period, Company A reports lower earnings, causing Company A's stock price to fall, causing Company C's earnings and stock price to fall, causing Company A's earnings and stock price to fall, and so on.  What happens to a company like Yahoo! that has 75% of its assets held in other companies' stock?

You get the picture.

Perhaps all of these companies have prudently hedged all of their incestuous stock positions and the hedges behave as modeled during a sustain liquidation.  But I wouldn't bet on it.

If the NASDAQ continues its decline and does not recover fairly quickly to a level that supports the economics of a lot of "strategic investments," then we may witness an deleveraging and liquidation in the Internet sector that rivals that of the Investment Trusts in the1920s.
 

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Many have written to us asking for comments on the March 20, 2000 Barron's article on cash starved Internet start-ups based on a study by Pegasus Research International that Barron's sponsored.  In the article, Burning Up, Jack Willoughby concludes "Internet companies are running out of cash -- fast."

It's a good piece, but Barron's covers half the story.  We have argued since late 1998 that a major risk to holders of Internet stocks is the psychological impact of even one major Internet firm running out of cash.  But just as dangerous to the valuations of Internet stocks is the revelation that the rest are actually profitable, but only modestly so.  The event will bring to a close a long period of speculation in Internet stocks.  Why?  One cannot speculate on the knowable, only the unknowable.  Given that the stock prices of most Internet companies reflect investors' mass delusion of infinite future profits, the stock prices of these companies will fall to reflect their true capacity for earnings growth once the delusion is dispelled.  During the railroad stock mania, for example, all of the speculative investing that drove railroad stocks to very high values happened over the land rights of railroad companies, before any wheels turned.  As soon as investors figured out how much a railroad company could actually profit from the business of running a railroad, the stock prices collapsed to reflect more traditional price/earning ratios, after of course over-compensating in the other direction for a while.

The instant that an overvalued Internet company reveals its ability to produce profits, or inability to produce profits, its stock price declines.  In the case of an Internet company that begins producing profits, the stock price adjusts to accommodate a realistic ramp in earnings over a period of several years.  Since the Internet company stock P/E pre-revelation reflects the hopeful belief that earnings will be infinite once the company "refines its business model," its stock price deflates when the company reports its first profits and investors discover that earnings will instead be finite.  As Bezos has learned, to justify a P/E that won't return an investor's principle before the sun goes supernova a few million years from now, better to keep digging for the super-high profit pony than to declare the evident low profit mule as the prize.  Better at least until the money runs out.

Many Internet companies will do even worse things for their stock prices than show a measurable profit; they will show that they can never do so.  These unfortunate companies were born in the atmosphere of apparently limitless private and public financing and have survived so far by counting on the greed of strangers.  These are iTulip.com companies (see definition below), the kind of company that iTulip.com parodies.  These companies were created for the sole purpose of selling stock to investors in the hope that the money thus raised will allow them to buy real companies.  It should surprise no one that these companies will never turn a profit if they cannot go public and buy the businesses that will make them profitable.
 

iTulip.com adj : a corporation that relies on the Internet to deliver products and services to its customers at a loss : an uneconomical Internet-dependent business as a : requires private or public capital to maintain uneconomical operations indefinitely b : raises capital through the public markets to achieve an historically unprecedented market capitalization influenced by the stock performance of similar companies, none of which are profitable

Definition of an iTulip.com company from the home page of iTulip.com

Unfortunately, Barron's does not do a good job of distinguishing between the iTulip.com companies and those Internet companies that can reach profitability more quickly than they can run out of money.  Barron's says, "Pegasus assumed that the firms in the study would continue booking revenues and expenses at the same rate they did in last year's fourth quarter."  We assume they used that metric to avoid a more complex formula they'd have to use if they averaged four quarters' revenue and expenses and included companies that were not public and reporting for the whole period.  But this one quarter metric has obvious problems.  For example, what about those companies that were trying new marketing programs in the final quarter of 1999 who incurred far higher than normal marketing costs?  The benefits of those programs are not likely to show up in the same quarter.  If they discontinued the program to measure results the following quarter, as most companies do, they are likely to show lower costs and higher revenue then.

An Internet company can do what all companies do under normal conditions when diminishing cash flow threatens the business.  They can cut expenses by reducing head count and marketing programs, eliminate unprofitable product lines (as distinguished from Amazon.com which continues to add them), and so on.  We've been involved with more than a couple of companies that dealt with falling margins, diminishing market share or a shrinking market.  It's no fun but these events are survivable.  Depends on how close the company is to profitability and to new sources of funding.  Statistically, investors nearly always overreact to these events and that makes for a great buying opportunity.  Bet you never expected to hear us use that expression.

Just about every successful technology start-up ever launched was once unprofitable.  What's new is that unprofitable start-up companies were once insulated from fickle public markets and the spread between expenses and revenue has never in history assumed wildly optimistic projections of the future enthusiasm of the public markets to fill the gap.  In the old days -- three years ago -- a company needed at least two quarters of profitability before investment banks were considering them for an IPO.  Sure, they had to deal with fickle venture capitalists and other private investors, but at least these investors have more experience with the roller coaster ride that is a new company, a stronger stomach and a greater ability to influence the outcome of inevitable setbacks.  This idea of "public venture" is, frankly, a bunch of bull.  The public invests because it thinks Internet stocks are not risky.  Remains to be seen what "public venture" does as it learns that there's a big risk coefficient related to those returns.

At some point the stock market expects predictability from public Internet companies, and not just predictable losses.  We'll stick to the prediction we made in late 1998.  When the correction in Internet stocks is over, the average Internet stock will fall to 87% of its peak price.  The average profitable Internet company that survives will fall 73% and those that never make it to profitability will, needless to say, go the way of the American Austin Car company's stock, to zero.

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March 20, 2000

I have been to Taiwan a half dozen times over the past eleven years that I have been married to my dear and delightful wife, who is from Taiwan and is half Chinese and half Taiwanese.  That doesn't make me an expert, but the heart of the conflict between China and Taiwan is so simple it's hard to imagine why the US and international press seem to have such a hard time getting to it.  You don't need to understand a thing about the intricacies of Taiwan's political party positions on the issue of independence versus "re-unification," or the composition of the parliament, or even much about recent Taiwan history.  All you need to know to make a fair prediction of the outcome is that Taiwan is much like any other colonized nation that has earned its independence in modern times, except that Taiwan has an oppressive and hostile nuclear neighbor that finds the newly independent nation's status intolerable for its own domestic political reasons.

Taiwan is a nation comprised of mostly ethnic Taiwanese much as Japan is a nation of mostly ethnic Japanese.  The difference is that Taiwan has been subjected to foreign and colonial rule for all of its modern history.  First the Dutch, then the French and Spaniards shared it, then the Chinese Ming dynasty invaded, then the Ching dynasty, then the Japanese, and finally the Chinese KMT.  For the first time in modern history, Taiwan is now ruled by Taiwanese, its indigenous people.  The Taiwanese have always wanted their country back and now, as of Saturday March 18, 2000 they finally have it.  This is a truly historic event.

The rule of Taiwan by Taiwanese has come about the way that the US and every nation in the west agrees is the right way, by democratic election.  The reason the Chinese communists are upset about this is that China is itself composed of provinces with ethnic divisions among them at least as profound as the differences between the Taiwanese and Chinese ethnic groups in Taiwan.  Only the communist state, through totalitarian rule, has managed to hold this enormous and ancient collection of tribes together at peace for so long.  The question on the minds of the people of China now is this: if the Taiwanese can earn self-determination by democratic process in Taiwan then why not various ethnic groups within in China?  The Chinese communists observed the breakup of the Soviet Union that resulted from the loss of moral leadership by the socialists.  They are determined not to make the same mistakes that the Soviet rulers made.

At stake for the Chinese communists is nothing less than the right of rule in China.  Taiwanese rule of Taiwan as an independent nation, which is the case as of last Saturday no matter what anyone does or does not proclaim, represents an intolerable challenge to the communist party's moral authority in China.
 

Representative posts from BBC forum on Taiwan It is easy for some people to say "I am sure in less than 10 years China will be united once and for all.  The best Taiwanese solution is 'one nation - two systems' However, if their children were kidnapped by China and became its children, they wouldn't say the same thing. Unfortunately, Taiwanese people have their own dignity. Most of us don't want to relate ourselves to Chinese people. No matter how strong the pressure is, I myself want to commit to Taiwan's democracy and independence. The status of Taiwan should be decided and be consented by Taiwanese people. I hope everyone who reads my message will support my opinion and condemn those who want to want to dance with China and sacrifice a small country's benefits like Taiwan's. The world needs righteousness in order to keep peace Ching-Yuan Chiu, Taiwan I am a citizen of ROC (Taiwan) and most of my friends fear for war if the DDP candidate become the new president. There are too many people in Taiwan that have no idea about the future, they just want independence, no matter what will happen. I hope a war will never happen. Peace!!! No war!!! Twvivian, Taiwan (R.O.C) Definitely - Taiwan should continue to pursue independence. Our beautiful island has been subjected to foreign and colonial rule for all of her history.  The Dutch, the French/Spaniards at some parts, Ming dynasty, Ching dynasty, the Japanese, and KMT. Now is the time for the Taiwanese people to stand up and show our independence for self rule!   Kellvan J Cheng, USA/Taiwan I, like many Taiwanese, want peace instead of war. If there is no choice to exercise my free will as a citizen in Taiwan, I will use my blood to fight for freedom for myself and my country. Ching-Yuan Chiu, Taiwan

In this context, let's look at the first words from the new Taiwanese leader of Taiwan in an interview with Time:

TIME: Is this a new era for Taiwan?

Chen: In this election we chose a new future, an end to the 55-year monopoly on power by the KMT.  It is Taiwan's first handover of power, and it is a consolidation of Taiwan's democracy.  The U.S. had its first handover of power 200 years ago. We are coming later, but we feel this moment is truly historic. We will complete Taiwan's first peaceful transition of power.

Time interview (3/19/2000)

Chen is saying that Taiwan has finally achieved democratic self-rule.  Taiwan is not about to turn its newly minted democratic state, one Chen reasonably compares to the United States 225 years ago, over to a communist dictatorship.   He also implies, by using US independence as an example, that the US as the self-proclaimed promoter and protector of the moral principle of democracy is obligated to defend Taiwan's independence against China's efforts to "re-unite" Taiwan with China, or in the eyes of Taiwanese, take over the sovereign, democratic nation of Taiwan.  The US has stated that it will not allow China to attack Taiwan.  Yet China says a delay in discussions of "re-unification" will result in war.

To fuel the problem further, the Taiwanese may use their new power status to get back at the KMT Chinese for brutal repression of the ethnic Taiwanese during the 1940s, 50's and 60s.  Like all suppressed group anger, this buried issue is potentially explosive when brought to the surface.  Best to keep an eye on the new vice president who was imprisoned for three years by the KMT for political subversion.  She ran beside Chen for a reason, to attract the anti-KMT vote.  She has an axe to grind and a reputation for toughness.  Add to this the fact that the ethnic split between Chinese and Taiwanese in Taiwan falls geographically to the wealthier north and poorer south of the island and you have the classic raw material for a civil conflict.

Western media consoles us all with the news that China's military is too weak to actually do anything to Taiwan.  It's true that Taiwan has significant defenses.  But how would you feel if you were the citizen of an island of 23 million next to a threatening China armed as follows:

• Total Army Members 2.5 million (Source: TIME Feb. 1, 1999)

• Budget of National Defense in 2000: 120.5 billion yuan RMB (about 14.5 billion US$) a 12.7% increase over the year of 1999) (Source: NPC news release, Mar. 2000)

• Air Force (470,000 airmen; 2,556 jet fighters; 400 ground attack jets.)

• Ground Force (Army) (1.9 million men; 14,000 tanks; 14,500 artillery pieces & 453 helicopters)

• Navy (250,000 sailors; 63 submarines; 18 destroyers; 35 frigates)

 

 
 
 

China's Military

I don't know about you, but I'd not be laughing them off.

The other line of consolation goes as follows: China has too much to lose to attack Taiwan.  Over 40,000 Taiwanese businesses operate in China, providing badly needed jobs and capital.  Entry into the WTO will be out of the question.  US imports of Chinese goods will fall to zero and China's rickety economy will be in big trouble.  Ultimately, China's desire to become a leader in the world economy will be set back who knows how far.

All this assumes that these issues are more important to the Communists in China than the authority of the Communist party to rule China, and it may be well to question the validity of that assumption.  Consider that a totalitarian state can manage economic catastrophe a lot better than can a democracy.  Government directives to the effect "We're all poor now.  Shut up and get back to work." are more effective in China than in, say, the United States.

Where is all this going?

Unfortunately, a long period of political stability in Asia, by historical standards, appears to be drawing to a close.  Asian financial markets may begin to price this in as soon as China shows the world what Plan B is since plan A, to intimidate the Taiwanese into voting for the KMT, failed.  How will US markets react?  While specific US stocks may be negatively effected, such as Dell and others that depend on Taiwan for technology, in the short term US markets are likely benefit from Asian flight capital as the political situation in Asia continues to deteriorate.  In the long term, if the US becomes involved in the conflict, US shares may suffer as well.

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iTulip.com is neither bear nor a bull, much to the chagrin of bulls and bears alike.  For example, in an interview in SmartMoney August 12 1999, iTulip.com said:

SmartMoney.com: What about eBay, with its recent server problems?

EJ: I'd go back and look at AOL when they were having all their problems. If you bought that stock back when everyone was beating them up and saying what losers they were, you'd have made quite a bit of money now. I'd say the same thing about eBay. EBay is doing something fundamentally significant and very different, and sure, they'll have some problems, but they'll iron them out. What they've got is a fundamentally great idea and they've built a business that's not easy to replicate, and I think they'll do well.

Back then, eBay was trading around 80, now it's at 219.  The reason we knew it was oversold is because we've spent 17 years in the