November 5, 2000 - Are You Ready?
November 28, 2000 - Cult of Greenspan
July 11, 2000 - Questioning Fashionable Financial Advice - Part II
July 11, 2000 - Questioning Fashionable Financial Advice - Part I
May 22, 2000 - The beginning of the end or the end of the beginning?
April 20, 2000 - Let's Check Back with Larry
April 18, 2000 - What can Cisco stock buy
April 16, 2000 - Recession 2000
April 13, 2000 - What next?
April 5, 2000 - A Bear market is Born
March 30, 2000 - The Bezzel is Shrinking
March 23, 2000 - Running Out of Cash?
March 20, 2000 - Taiwan: The Real Story
March 16, 2000 - Not Bear nor Bull
March 13, 2000 - Recipe for a Mania
March 6, 2000 - We're Almost There
February 26, 2000 - The Art of Wishful Thinking
February 25, 2000 - DOW Blows Through 10,000... Backwards
February 24, 2000 -  The Buy and Hold Argument Again
February 2, 2000 - Oil Prices Don't Matter?
January 5, 2000 - Markets in Distress
November 24, 1999 - Who will pop the Internet Bubble?
November 15, 1999 - Back to the Future
October 7, 1999 - Death of Equities Part II
October 21, 1999 - Next?
October 20, 1999 - Duh
October 19, 1999 - What Happened?
September 23, 1999 - Stock Market Mysteries
August 25,1999 - Y2K Policy
Cooking the CPI

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 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


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

Are You Ready?
November 5, 2000
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. 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:

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 discussion forum.

"We do not, and probably cannot, know the precise nature of the next international financial crisis.  That there will be one is as certain as the persistence of human financial indiscretion."
Alan Greenspan, 7/14/2000
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.


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)

    Comments? | Back to Index

    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

    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.

    "Some European central bankers and economists have been watching the U.S. economy with utter amazement, some apprehension, and not a little  jealousy.

    "By all their rules, the U.S. economy should have started long ago to show the signs of strain that are the inevitable prelude to a bust. Yet, despite an expansion that has carried gross national product up a startling 30%, or $150 billion, over the past 4 1/2 years, the economy remains generally free from inflationary pressures and imbalances. And the businessmen who run the show fully expect their trouble-free prosperity to continue.

    "The underlying factor behind this remarkable performance, so baffling to the European traditionalists, has been a sharp rise in productivity. Measured by output per man-hour, productivity in the private economy has increased at an average annual rate of 3.5% during the past four years, compared with average rates of only 2.5% in 1953-57 and 2.7% in 1957-60.

    "Over the past five years, labor cost increases have forced us to innovate," a Milwaukee CEO told the magazine. "It's a process of continuous appraisal. I see no end to the gain in productivity. You achieve it in many ways."

    - Business Week, June 26, 1965
    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. 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.
    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. 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'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 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 -- 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 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? gets a lot of email from visitors looking for investment advice. is not an investment advice site  Rather than keep disappointing visitors with replies to the effect that they're on their own to figure out what to do, 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.

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    Let's check back with Larry Barrett in six months
    April 18, 2000
    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 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

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    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?

    Market Cap
    1999 Revenues
    1999 Earnings
    Price / Sales
    Price / Earnings
    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.
    Company Name
    Market Cap
    1999 Revenues
    1999 Earnings
    Du Pont
    Intl Paper
    Sara Lee
    Archer Daniels
    JP Morgan
    Anheuser Busch
    FOX Entertainment
    Con Ed
    Apple Computer
    Dow Jones
    Price / Sales
    Price / Earnings
    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.

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    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 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.

    ...there is no escaping the fact that the biggest risk to emerging economies is the same as for the world as a whole: financial shocks arising from US imbalances run up while the US baled the rest of the world out of its troubles.  The peculiarity is that the US itself should be running risks similar to those in the developing countries before the crisis.

    Financial Times, April 11, 2000

    But an alternative -- less likely -- scenario assumed a pickup in global growth and inflation, followed by higher interest rates, a 25 percent correction in highly valued U.S. equity prices and a 20 percent slump in the dollar in response to a reversal of capital flows, the IMF said.

    IMF sees economic risks despite rosy forecasts (Reuters 4/12/2000)

    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 predictions have in the past.  Only time will tell.

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    Bear Market is Born
    April 5, 2000
    "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 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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    NASQAQ down 10.72% in three days.  Why?

    The Bezzle is Shrinking

    March 30, 2000

    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
    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, 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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    Running out of Cash?
    March 23, 2000
    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 companies (see definition below), the kind of company that 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.
  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 company from the home page of

    Unfortunately, Barron's does not do a good job of distinguishing between the 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 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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    Taiwan: The Real Story
    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:

    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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    Not Bear Nor Bull
    We call 'em as we see 'em
    March 16, 2000 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, said: 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 high technology industry.  From personal experience we know that an equipment crisis such as eBay's is nearly always a buying opportunity.  It's counter-intuitive, but these kinds of crises are nearly always solvable and serve to focus a business and make it stronger.

    On the topic of Y2K, in our Y2K Policy August 25, 1999 we said:

    What the heck's gonna go down after Dec. 31, 1999?  Do we at 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.

    A big secret known to few except hundreds of thousands of software developers worldwide who write software and  hundreds of millions of sorry saps who use it is this: most software programs already have lots of bugs.

    If you'd been reading, you'd know that nothing significant was going to happen and why.

    Does that sound conventionally bearish to you?

    We take a skeptical view of the popular consensus and do as much homework as we can to figure out what's real.  For example, in early February when rising oil prices really started to get everyone's attention, you could turn to any station on television and see an oil industry expert explaining how the New Economy doesn't need as much oil as the Old so don't worry about it.  We did some analysis and found that while the economy (there is no New Economy or Old Economy, there's just The Economy) indeed uses half as much oil to produce a dollar of GDP than in 1973 when OPEC first cranked the oil supply wrench.  But... the US imports 646% more, so we need 257% more imported oil per dollar of GDP than before.  Oil prices are going to rise sharply as will the current account deficit.  They have and it has.

    Not to say we're always right, of course.  We have lapsed into such indiscretions as the October 18 crash prediction.  This detracted from our otherwise consistent message that while the bubble will pop eventually, no one can know when.

    If a label is needed to describe, contrarian will have to do, although skepticist is preferred.

    While we're convinced that the current speculative frenzy will end suddenly and many investors will lose a lot of money and hate the stock market for a long time, our long term view of the Internet industry is highly optimistic, as you'd expect from anyone who has witnessed first hand the steady progress of the high technology industry since 1983 as we have.  That's the problem with the Internet bubble.  The Internet is part of a steady progression of technological development that's changing the world.  What makes it appear explosive is an atmosphere of euphoria, falling interest rates, and an exploding money supply that support speculation in the stock of companies in the industry.

    One element of the so-called New Economy is almost never discussed.  During the past 50 years, private debt (corporate and personal) in the US never rose above 1% of GDP.  Now private debt is 5% of GDP.  No one knows a level of private debt that is optimal for an economy, certainly Japan's is too low, but current levels in the US represent an extreme divergence from historical norms.  While everyone acknowledges that consumer debt has funded extraordinary consumption and corporate debt has financed stock buybacks that keep stock in short supply and prices high (there are fewer stocks shares on the market now than in 1994), it would not surprise us to find that a fair amount of personal debt has funded  speculation in financial asserts to an extent that contributes significantly to current prices.  This extraordinary debt has helped create the illusion of prosperity and will in some future recession create an illusion of enduring malaise.  After the value of the collateral falls, this debt will be either defaulted on or inflated away some time in the future.

    Recessions used to be called depressions -- a more accurate term that describes how everyone feels at the time.  Even though few will believe so at the bottom of the next recession, it will end like all others have.

    We've likened the end of the Internet bubble to turning the lights on in a dive bar after last call.  Once the bubble pops and we realize we are all not quite as attractive and clever as we had thought, plans to be there after everyone sobers up to help point the way to what's real about the Internet.  When many are smacking themselves on the forehead while wondering what the hell we were all thinking when we bid up the price of profitless companies to market capitalizations of tens of billions of dollars, when the press is reporting the end of the world on every television and newspaper and magazine, we'll be there cheerfully reporting all the good news and the evidence that the best it yet to come.

    When we started in 1998, hardly anyone was calling the market for Internet stocks a bubble.  Now the idea is dogma.

    So what's next?

    The next new thing isn't about getting rich quick.  It's about building wealth slowly and participating in society in other ways besides trading stocks and running ponzi schemes in the public markets.

    For now, we offer one hint.  Business to business internet companies will change the world economy.  They may get bid up to the sky and fall back to the ground in the bubble, but the increased efficiency they will create in the economy in aggregate and the profits they will make in the process will generate a lot of wealth for a lot of people the way a non-speculative stock market is supposed to, one dollar of profit at a time.

    As great fans of our country, the USA, it pains us to suggest that the leader in the next major technological advance may not be the US.  History is unkind to nations that build their castles in the sky on foreign borrowing and the US owes 40% of its sovereign debt to individuals, corporations and governments outside its borders.  Maintaining confidence that we can repay these debts and continue to offer competitive returns in real currency terms will be a neat trick after the bubble pops.

    Keep your eye on the dollar.  Where the dollar goes so goes the USA.  Pay special attention to the circumstance where the US stock markets rise yet the dollar falls.  The markets are giving you fair warning.


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    A reasonable expectation from here is that money will continue to concentrate in speculative stocks.  A similar dynamic between Fed tightening and intensified stock speculation developed in the late 1920s.  In an attempt to slow the speculative frenzy, the Fed raised rates and slowed monetary expansion to a crawl throughout 1929.  The money supply in June 1922 stood at $33 billion while brokers' loans, a fair relative measure of speculative activity, reached $1.7 billion.  Nonetheless, momentum carried the money supply up to $45 billion by September 1929 and brokers' loans to $8.5 billion.  In spite of tightening by the Fed starting in December 1928, by September 1929 brokers' loans increased by $2.1 billion from December 1928.
    The New York Times 
    (August 24, 1929) 

    A Sidelight on Selective Buying

    "While a group of stocks has enjoyed a very rapid run-up since last Spring, more than twice the number have dropped to new low points and appear to be neglected by all casual traders in stocks. It has been remarked that it is harder to get a low-priced stock up a point than it is to push a market favorite up 30 points."

    Perversely, the more the Fed increases rates to reduce speculation the more intense the concentration in speculative stocks as money flows out of stocks in companies perceived to have profits that are rate sensitive and into stocks in companies that have no profits at all.  The Fed experienced this contradiction of textbook versus actual economics during the late 1970s as it raised interest rates to quell real estate speculation only to see the speculation intensify.  This process is likely to continue until a random exogenous event causes the speculation to come to a sudden end.

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    We're almost there...

    March 6, 2000

    Careful students of financial manias -- and daily readers of -- 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.  The lack of such wide participation is the primary reason why I have for years deferred a judgment of an imminent end to the present stock mania which has recently expanded to include the biotechnology and semiconductor industries.  However, in the past nine months, Finland, The Netherlands, Denmark, France, Germany, China, Hong Kong, Australia, South Africa, Japan, Brazil, Mexico, Canada -- nearly every nation on earth has seen Internet- and technology-related stocks take off to achieve absurd prices, helping to raise the stock indexes of those nations to historically extreme multiples of earnings.  Asia, Europe, and the Americas are now into the game.  Not only is tech stock gambling now a global phenomenon, but it's sucking money out of non-speculative stocks worldwide, as evidenced in the falling DOW versus the surging NASDAQ since January 2000, but perhaps even more intensively in the FTSE 100 in the past few months:

    When the surges in technology, media and telecommunications shares - TMT stocks as the City has dubbed them - are stripped out of the FTSE 100 index's performance, it becomes clear that British industry has endured a stock-market fall on a similar scale to the one in 1987. It is being called the virtual eclipse, where loss-making blue-sky TMT companies with multi-billion pound valuations have displaced blue-chip industrial and engineering companies.

    The Hidden Crash (The Sunday Times 3/5/2000)

    After so many years of speculative excess, the final stage is at last set.

    This still does not mean the end will come tomorrow, although the beginning of the end may come as soon as this Thursday -- a guess that I won't refine here.  As long as the dream stays alive and new money chases it, prices of stocks can rise to meet growing demand.  Recent deregulation of financial markets in the US has yet to have the desired effect -- the introduction of new sources of money into the already well capitalized equity markets -- and these new funds may have arrived in time to preserve the bubble for the terminal stage of expansion, the Widows and Orphans phase.  In this the last phase, the most risk-averse members of society finally give in to the siren song of risk-free sudden wealth and, against their better judgment, enter at the top of the market.

    As evidence I offer the following example.  Yesterday I went to a BankBoston ATM to get some cash.  I look on the ATM screen and what do I see for the first time?  A stock chart showing the DOW and NASDAQ.  To my jaded eye the appearance of a stock market chart on a bank ATM screen seemed as out of place as a cigarette machine in a doctor's office.  One associates the concept of "bank" with "low risk/low return" thanks to laws enacted in 1934 in the US as a result of the painful lessons of the era.  Many millions suffered the eventual cost of neglect and sometimes active suppression of risk information by marketers of financial products where laws did not protect them.  Banks have shown they will do just about anything to pay as little expensive FDIC insurance as possible, a burden placed on them by said 1934 laws that eats into banks' profits, first fighting for the right to offer money market accounts then mutual funds and now, well, anything.  An FDIC insured savings account is the last place a bank wants a customer to put her savings.  The trick is to lull her into thinking her money is just as safe in a mutual fund or a money market account as in a FDIC insured savings account, a task  accomplished by merely saying nothing about it and allowing the depositor to work the new higher risk investment products into her generalized notion of "bank," i.e., a safe place to put money.  However, history informs us that the risk differential among investments work themselves out in the end.  Bad enough that she now has the option to loose her savings in a non-FDIC insured money market account in an extreme (unlikely) financial crisis.  How long before she's able to buy shares in Akamai (AKAM) from her ATM and lose all her money at her bank in a not so unlikely stock market crash?

    In the new world of free-for-all financial markets, we are treated to paradoxical finger wagging by the head market regulator, SEC Chairman Aurthur Levitt.  He alluded today to certain ill-informed investors who are in the markets without fully knowing how they work, "...these investors could fall victim to their own wishful thinking due to this failure to understand markets.  ...worried that investors were borrowing not just on margin, but also against other assets, such as their homes, to invest in the market without taking any account of the risks they were running."

    SEC╠s Levitt: Investors overextended (MSNBC 3/6/2000)

    Why is he whining about investors taking too many  chances?  Isn't it obvious that investors are only following the sage advice of equity product retailers who tell them to "buy and hold" stocks with their retirement money?  Of the 60 year olds accidentally engaging in speculative behavior by following this advice, more than a few will be eating dog food post crash.  Arthur's the police.  Can't he do anything about it?  Those of us who are keeping to the stock market's historical 65 MPH speed limit are hoping that the cops will slow the folks who are doing 130 MPH before they wreck and in the process slow down our capital gains commute into retirement by a decade or two. 

    When the history books are written post mania, all of this panicky buying, driven by the urgent desire to get rich quick, will be traced back to the folks providing the primary input of speculative fuel:  US Federal Reserve Bank and its policy of easy money it undertook starting in 1996.  You can argue that the Fed is merely the attendant gassing up the economic car as needed and as such is not responsible for how the car is driven once it leaves the station.  Many times the same amount of gas does not result in the car reaching dangerous speeds.  I argue that the attendant has a responsibility before adding more fuel to check that the car is not on fire.  The policy, apparently justified by low inflation rates created by the deflationary effects of ever-growing global industrial capacity, itself fueled by cheap credit worldwide, spins the mania up in a vicious cycle of speculation -- a financial hurricane -- that can only be brought to an end by restrictive monetary policy that the markets cannot price in before the fact.

    Gentle readers of, with their now extensive knowledge of the inexorable mechanics of financial manias, are also aware of the eventual effect of the tightening that central banks engage in to attempt to slow the financial hurricanes of their making to a gentle breeze rather than a tropical depression, so to speak.  The Fed has for the past nine months been raising rates in an attempt to slow the growth of the real economy in the apparent hope that asset inflation, presumably at least influenced by the profit performance of corporations, will be secondarily diminished.  Recently the Fed has made noises about increasing rates to target the mania directly.  The Fed did the same in 1987 and 1929 in the US and the BOJ did likewise, attempting to deftly thwart the bubbling Nikkei in 1989, which has more than ten years later recovered to only 50% of its peak after the resulting crash.  No matter how gently applied, the rate hike cure always seems to bring such a grand and enduring speculative mania as ours to a catastrophic end.

    That's because manias are not built upon the object of speculation, whether land or Internet stocks or gold, but always upon the recurring dream of sudden riches.  Reality does not appear as sweetly as a country pasture in a golden summer sunrise but shows rudely like the inside of a dive bar when the light's turn up after last call.  The complex and intricate new relationships, belief systems, firms, and careers built to exploit the dream of quick riches collapse in a heap of fear, guilt and recrimination.  With nearly all the nations of the world now engaged, one hopes that the treasured peace of our time survives the trial.

    I leave you with a quotation of President Coolidge on December 4, 1928 lifted from John Kenneth Galbraith's classic The Great Crash 1929.  In the context of subsequent events, the quotation suggests that world peace may depend significantly on the prosperity afforded by ever-rising stock markets, so much is at stake and we are not surprised that the Fed, knowing this, is reluctant to reverse the trend.

    "No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time.  In the domestic field there is tranquility and contentment... and the highest record of years of prosperity.  In the foreign field there is peace, the goodwill which comes from mutual understanding."
    Tech Stock Mania Goes Global 

    Japanese bubble may be first to go (3/13/2000)

    HK stocks end morning sharply higher on hot techs (Reuters 3/6/2000)

    Latin Stocks Seen Partying Higher (Reuters 3/6/20000)

    Toronto key stock index climbs into uncharted turf (Reuters 3/6/20000)

    Nikkei above 20,000 at midday, Nasdaq spurs techs (Reuters 2/27/20000)

    UK CBI head warns against dot-com obsession (Reuters 3/9/2000)

    FTSE ends down as investors fret over tech bubble (Reuters 3/15/2000)

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    DOW blows through 10,000... backwards.  Now what?

    February 25, 2000

    Visitors to have been voting in a Mutual Fund Sell Poll since September 1999.  The poll question: "At what DOW value will you consider selling your mutual funds?"  The results as of 2/25/2000 were as follows.
    DOW Level
    Below 10000
    Below 9500
    Below 9000
    Below 8500
    Below 8000

    The consensus among visitors is that the 10,000 level is key.  The majority said they planned to sell when that level is breached.   The next significant level, according to the poll, is all the way down near 8000.

    Now that a sub-10000 DOW is here, will they really sell?  If market participants behave as in past speculative markets, most probably will not.  Many investors are still looking at a gain from the point where they entered the market, that's probably what the 8000 number tells us.  For fear of paying capital gains taxes, they will sit and watch as the market heads toward 8000 and their gain disappears.  Then they will sell between 8000 and 5850, at a loss.  That's what happened in every previous speculative market decline, when investors who bought into buy-and-hold marketing came face to face with market reality.   The professionals sold, the market tanked, and Joe Sixpack got left holding the mutual fund and 401K bag (see Sheeple Shall be Shorn).

    The DOW broke upwards through the historic 10,000 barrier to a din of media hoopla in April 1999.  The media coverage of the index's break through in the opposite direction has been predictably more muted, although the topic did make the front page of the business section of most US newspapers and got front page attention in the US financial press.  Most of the coverage centered on the pronounced split between the DOW and NASDAQ.  On Sunday, February 27, The Wall Street Journal stated:

    The Dow Jones Industrial Average tumbled below the psychologically important 10000 mark on Friday as further signs of robust economic growth made investors uneasy about higher interest rates.   The blue-chip average is mired in a correction, or a drop of 10% or more from its high, and a close below 10000 is seen a defining moment. Some market watchers say it is an indication that the mood on Wall Street has turned decidedly bearish.

    Analysts were watching the industrials' performance with great concern to see whether investors were going to jump in to prevent the blue-chip average from deteriorating further after breaking below five digits. The 10000 level was considered a key support level for stock market bulls.

    While investors traditionally have stepped up to the plate, buying back stocks when the average dipped, that wasn't the case Friday. Fears of rising interest rates combined with momentum selling after Thursday's 133.10 drop to keep investors away.

    An article in Barron's said the reversal may portend the beginning of a correction in technology stocks.
    The Dow Jones Industrial Average and the S&P 500 are continuing their downward spirals, as investors fret about the effect of higher interest rates on old-line industrial companies. The Dow closed at 9862.12, a 6.6% decline on the week. The S&P didn't fare much better, tumbling 3.9% to 1333.36.

    The carnage in the Old Economy stocks is nothing new, of course, though it was significant that the Dow slid back under 10,000, an important psychological barrier. The real question, however, is whether tech stocks are beginning to capitulate.
    Friday, the Nasdaq Composite Index ended at 4590.50, down 27.15 from Thursday's close, although still up 4% for the week.

    Jeffrey Applegate, chief strategist at Lehman Brothers and one of the most bullish market strategists on Wall Street, acknowledges that at some point, tech stocks will undergo some kind of correction. "The Nasdaq couldn't defy gravity forever," he says.

    The overseas press tended to cover the story in a less bearish vein.  The Sunday issue of the South China Morning Post said:
    The root of the Dow's troubles is a shift in market perception about stocks and rising interest rates.  Fast-growing, young high-technology firms, once seen as risky investments, are now considered better able than Dow companies to withstand the profit erosion that higher rates bring.

    So the Dow is tumbling and the Nasdaq is soaring.

    We side with Barron's in this debate.

    The market will regress to the mean -- NASDAQ, too.  The DOW is only 1888 points and 14.2% down toward a 40% correction needed to get the index in line with historical P/E averages.  Of course, speculative markets always over-compensate on the regression trial, so a total drop of 50% or more from the peak is possible.  That means the DOW still has 3987 points to go to get to 5875 before recovering to 7500 or so.

    The expectation of a significant drop in the DOW is enhanced by the universally bullish tone of economic pundits here at the top of the economic cycle.  The latest issue of Fortune, for example, is chock full of gee whiz pieces about the marvels of the US economy.  As anyone who has been in business for long knows, success depends as much on luck as good planning and hard work.  An honest appraisal of America's recent success has to account for a huge dose of good luck.  But luck, if you are keeping an eye on two significant developments, may be about to change.

    The first change of fortune we discussed in the February 2 piece Whistling in the graveyard that notes that the New Economy is running on cheap imported oil and that increases in oil prices are, contrary to what nearly everyone else is saying, a really big deal.  Cheap oil isn't all luck, of course.  Well engineered cartel busting is necessary.  But the reformation of that cartel in a more modern and effective form is a revealing itself as a force to be reckoned with.  This opinion contradicts most economists who toe the party line that the so-called New Economy is oil shock resistant even as energy secretary Bill Richardson jets around the world for urgent meetings with oil producing nations and makes alarming statements such as those reported in The Sunday Financial Times in the article US warns unstable oil prices threaten the world economy:

    Bill Richardson, the US energy secretary, said recent sharp movements in oil prices posed a threat to the world economy.  His remarks in Oslo came as oil markets look set for another volatile week, with the US continuing intense diplomatic efforts to persuade leading petroleum producers to increase exports in response to rising prices.
    It will be interesting to see how OPEC responds to this West-cetric plea by the United States on behalf of the "World Economy."  OPEC members may pointedly ask, "What was your 'World Economy' doing for me back when oil was $10 a barrel?"  Demand is less of an issue when you control supply.  One can always limit supply further to accommodate falling demand.

    Meanwhile, the BBC announced Sunday that the average price of a gallon of regular unleaded gasoline in the US had risen to $1.47, the highest price ever.  Can it be that gasoline prices can rise to their highest level in history but have no significant impact on inflation and consumer sentiment and thus the economy and the stock market?   More likely the stock market is correctly pricing in an oil shock that will take the speculative air out of a stock market that's been frothing since 1996.  NASDAQ is the new center of speculation so it's taking a bit longer to get the message, but it will catch up to the DOW sooner or later, perhaps as soon as this week.

    The second piece of luck that the US has enjoyed as the markets have partied on is a long period of peace.  Far easier to keep inflation in check without the giant inflationary government public works project that is war.  But the significance of the growing tension between China and Taiwan should not be underestimated.  This issue has been on slow boil for many years, and is set to erupt into something more dicey in the next month heading into Taiwan's national election.  No one can say what's going to happen, but don't be surprised if the US winds in a nerve-wracking confrontation with China in the next few weeks.

    All in all, the fall in the DOW signals a change in fortune for the speculative US equity markets.  Indicators point to a continued decline in stocks going into March.  Naturally, as always, the information herein is based on sources which we believe to be reliable, but we cannot warrant its accuracy or completeness. Such information is subject to change and is not intended to influence your investment decisions.  Just because we've been right so far, doesn't mean we'll be correct in the future.

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    The Art of Wishful Thinking

    February 26, 2000

    NEW YORK (Reuters) - It's a tale of two markets. The "new economy" technology stocks are the shooting stars while the ''old economy'' industrial stocks are keeling over. How can that be? How long will it last?

    It could go on for a long time. Technology is the thing that has powered one of the greatest bull markets ever, one expert says. And unlike the old economy stocks, techs are not as vulnerable to interest-rate increases by the inflation ghost-chasing Alan Greenspan, the Federal Reserve chairman.


    James Dines, publisher of the Dines Letter, an investment advisory firm in Belvedere, Calif., said technology stocks can stand up better to the bear market that is being induced by Greenspan.

    The reason: The companies don't rely on traditional lending sources for cash to run their businesses, unlike the old-time Dow stocks such as Caterpillar(CAT.N), General Electric (GE.N), Minnesota Mining & Manufacturing (MMM.N) and General Motors (GM.N).

    "The Internet companies, for example, attract venture capital and they sell stocks to the public," he said.  "Tech stocks don't have to worry about Greenspan and they don't care where interest rates are."

    A Tale of Two Markets (2/26/2000)


    Dines, the gold bug turned Internet bug, is wrong about this short term but correct long term.  Venture capital and stock market investors will support Internet companies in a down market?  That's silly.  Where does Dines think the venture money comes from?  What does Dines think happens to venture funds when the old economy stocks turn down enough to hurt the pension funds and other sources of capital for the venture funds?

    To understand what happens, you first have to understand that an $800 million venture fund, for example, is not a mutual fund account with $800 million in it that the venture firm draws on to finance investment in start-ups.  The fund represents the commitment by a number of individuals and institutions to provide capital as funds get allocated to various deals.  If the markets turn ugly enough, the fund investors refuse the capital calls.  Is the venture fund going to take legal action against any fund investors for doing so?  No, not if they ever want to approach them again in the future.  So there's no real cost to the investor for punting.  Only the promise of high returns and apparent low risk keeps them in.  One loud bang and they take off like rabits.  If enough individuals and institutions fail to meet capital calls, the fund returns money to those investors that didn't punt, kills the deals in progress, and closes the fund.  See ya later.  If this keeps up, private financing dries up and unprofitable Internet companies run out of cash and go out of business.  Guess how the public markets will react?  They'll withdraw their money, too.  IPOs fall off and another bunch of Internet companies go by the wayside.  This process happens very quickly, by the way.  In a matter of weeks or at most a few months.

    This is not a good thing, of course.  The availability of public and private financing for start-ups gives creative individuals the chance to get out of big companies where their innovation is squelched by bureaucracy.  Often these start-ups are then sold to the very companies which the creative individuals came from -- a win-win for everyone.  The aggregate positive effect on the economy of all this innovation is apparent in the productivity numbers, although the numbers are still suspect due to poor accounting of the increase in the number of hours worked by everyone tethered to the workplace by cell phones, email, and fax.  There are also huge tax advantages for investors that fuel this trend.  For example, if as an accredited investor you put $50,000 in a private placement and later make $1,000,000 on a sale or IPO, you pay zero taxes if you reinvest the capital gain into other start-ups within 90 days.  (But don't take our word for it.  See your CPA for details.)

    In the long run the trend toward private and public equity financing of start-ups is likely to continue.  Even during the 1930s, profitable new technology companies powered through The Great Depression, albeit each at more normalized market capitalization, making technology companies the best targets for investment.  But to say that Internet companies are immune to interest rate and market effects is wishful thinking at best.

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    The "buy and hold" argument, again...

    February 24, 2000

    NEW YORK (CBS.MW) -- Oil prices zoom. Interest rates climb. The stock market quivers.  Oh, what a terrible time this is to invest!

    As a matter of fact, it's always a terrible time to invest in the stock market -- at least in some respects. Now a Philadelphia firm named 1838 Investment Advisers, which is an MBIA Asset Management Company, has published an instructive report.

    66 reasons to steer clear of stocks
    And one big reason to get into the market and stay there (2/23/2000)

    ...and what the mutual fund salespeople don't tell you about "Buy and Hold"

    A compelling case, no?  Completely agree that "it's always the worst time to invest."  Always feels that way when you're plunking down your cash, even in boom times.  Also true that equities offer greater returns than any other asset class over very long periods, say 30 years or so.  The problem with the author's argument is that he does not explain that there are long periods when stocks perform very badly.  The question is not whether one should invest in the stock market or when, but how much of one's wealth is appropriate for stock investment, assuming the need to withdraw funds to finance expenses over time.  The current climate has inspired many investors to place all of their investment capital into stocks, including funds they may need access to in the medium term, and some to borrow to do so.  Writers such as this one need to stress that carefully selected stocks or stock index funds are long term low risk, short term high risk.

    The author says, "Buy now because $10,000 invested in the Standard & Poor's 500 Index in January 1934 grew to be worth over $22,738,948 by December 1999."  This implies that $10,000 invested now may be worth tens of millions in 65 years.  Three problems with this argument.

    1) Is 1934, the bottom of the market, a fair starting point?  If the investor started in 1929 at the top of the market he'd have to wait 25 years, until 1954, to break even.  Or  if the investor bought in Dec. 31, 1964 when the DOW was at 874.12, he had to wait 17 years until Dec. 31, 1981 when the DOW reached 875.00 to get back to where he started.  If he needed access to the money at any time during those periods, he'd have sold at a loss to get it.

    2) Is $10,000 a fair starting amount?  Using $10,000 creates a dramatic effect when an average 12.6% compound rate over 65 years is applied, but is it realistic?  The buying power of $10,000 in 1934 is equivalent to $125,155.76 in 1999 dollars.  (See Inflation calculator.)  How many investors had $10,000 to invest in 1934, in the depths of The Great Depression?  Probably about as many as will have $125,155.76 to invest after the current stock bubble pops and the economy goes into recession.

    3) There have been periods when all other asset classes performed better than stocks.  As Warren Buffet stated in a recent Fortune article:

    Let's say you put $1 million into the 14% 30-year U.S. bond issued Nov. 16,1981, and reinvested the coupons. That is, every time you got an interest payment, you used it to buy more of that same bond. At the end of 1998, with long-term governments by then selling at 5%, you would have had $8,181,219 and would have earned an annual return of more than 13%.

    That 13% annual return is better than stocks have done in a great many 17-year periods in history--in most 17-year periods, in fact.  It was a helluva result, and from none other than a stodgy bond.

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    Oil prices don't matter?

    February 2, 2000

    Those of us who depend heavily on the stock market for our livelihood are comforted by the consoling words of pundits who seek to reassure us that rising oil prices, up 300% since the start of 1999, do not necessarily mean rising inflation in the US.  The reason?  Oil makes up a much smaller part of the new US economy than in the 1970s when OPEC's monopoly pricing hammered the US with rising import prices and energy costs.  Not to worry, say the experts.  Now we have an Information economy.  Oil is less important.

    The perfection of the New Economy is demonstrated in the most recent CPI and PPI figures.

    Consumer Price Index(1)
    Producer Price Index(2)

    (1) All items, U.S. city average, all urban consumers, 1982-84=100, 1-month percent change, seasonally adjusted
    (2) Finished goods, 1982=100, 1-month percent change, seasonally adjusted
    US Bureau of Labor Statistics data (January 28, 2000)

    Why, then, has the Fed embarked on a program of interest rate hikes when inflation is so clearly in check, when the New Economy is obviously running with such efficiency that not even a three fold increase in the price of oil in less than a year moves the inflation needle off the Extra Low mark?

    As attractive as the CPI and PPI figures are, the US Import Price Index tells a more ominous story.

    Import Price Index
    All imports, 12-month percent change, not seasonally adjusted
    US Bureau of Labor Statistics data (January 28, 2000)
    If we dig deeper into the sharp Import Price Index increase we find that most of this rise in import prices comes from imported oil.

    If you lived through the inflationary 1970s in the US you recall that rising oil prices was the primary cause.  High oil prices effected all industries, businesses, and wage earners.  Can high oil prices have a similar impact on the so-called New Economy?  The answer, unfortunately, is: yes.  The paradox of the New Economy is that fewer tons of remnants of millions of years old dead plants are needed than before, but the Old Economy used far less from overseas.

    When the pundits say that oil doesn't matter, do they mean the US is less dependent on imported oil than it was the last time OPEC ramped prices in the 1970s?  Let's take a look.

    Millions of Barrels.  Source: US Energy Information Administration

    In fact the US economy imported 646% more oil in 1998 than it did when OPEC made the scene in 1973.  Maybe the pundits mean the US is importing less oil relative to real GDP growth, so that while we're importing more oil, this represents a smaller portion of economic output.

    Source: US Bureau of Labor Statistics

    That claim doesn't seem to hold water either.  While oil imports rose 646% between 1973 and 1998, real GDP grew by only 200%.  From a real GDP growth perspective, oil imports are more than three times as important now than when  OPEC manipulated oil prices up in the 1970s.

    One factor does support the contention that the US economy is less oil dependent now than in 1973.  Even though oil imports are rising, this is primarily because domestic production has slowed due to falling prices.  The US is indeed consuming less oil now relative to GDP than in 1973.

    Source: US Energy Information Administration

    US oil consumption has risen only 27% between 1973 and 1998 while real GDP grew 200%.

    In 1973, 1.5 barrels of oil were consumed to create one dollar of GDP growth while in 1998 only 0.7 barrels were needed.  This does support the argument that the new US economy needs a lot less oil than the old.  However, in 1973, 0.14 barrels of imported oil delivered a dollar of real GDP growth whereas in 1998 0.36 barrels of oil were needed.  While around half as much oil is needed to run the economy now than when OPEC last raised prices, nearly three times as much imported oil is needed.

    If reliance on oil imports has risen so much more quickly than real GDP since 1973, how is that the US economy is less vulnerable to OPEC's price hikes prices now than it was then?  The answer is that it isn't.  The pundits are wrong.

    In the 1970s oil price-induced inflation was eliminated only by Fed Chairman Paul Volker's interest rate shock treatments to the US economy.  This produced a period of stagflation.  GDP fell as inflation continued to rise.  Unemployment rose to levels not seen since The Great Depression yet prices continued to rise rather than fall, contradicting the dogma of economics textbooks before that time that claimed deflation as an inevitable price effect of falling demand.  This was a period of economic and monetary trauma that caused the world to question the efficacy of the US central bank.   Safe to guess that the Fed is likely to want to avoid a repeat fiasco.  If the price of oil merely stays where it is, around $30 per barrel, the Fed must raise rates significantly or the US will likely suffer a significant inflationary event.  The inflationary impact of rising oil import costs may explain why the Fed is planning to raise interest rates when the CPI is lower than at any time in the past thirty years.

    How likely is oil to stay at or above $30 a barrel?

    Oil probably has a better chance at staying at or above $30 than in 1973.  OPEC has a more diverse composition, representing a broad range of geographic interests rather than primarily middle east nations, and is a far more economically sophisticated organization than it was 25 years ago.  The current OPEC membership conrtols a larger portion of oil production than in the 1970s.  And of course, as we've demonstrated, with a three fold greater depenence on imported oil now than in the 1970s, OPEC has the US over a barrel, so to speak.  The group may choose to increase supply to keep the price under $30, but then maybe not.  If $30 oil is good then isn't $60 oil better?  Expect OPEC to test the limits of price elasticity -- the Saudis are likely to surprise the US in the coming months with obstinate refusals to increase supply.

    If the price of oil stays high long enough, domestic prodution that is not profitable at oil priced below $30 will come on line to compete with imported oil and new conservation technologies that reduce demand will become cost-effective.  In the mean time, a period of rising inflation and rising commodity prices is a reasonable expectation.  On the other hand, the current rise in oil prices may signal the start of a secular trend.

    An excellent analysis Secular Trends in Financial Markets written in 1996 by Global Financial Data states:

    "...different factors drive the supply and demand for stocks, bonds and commodities. Stocks are primarily driven by earnings expectations which depend upon the business cycle. Bonds depend primarily upon nominal interest rates which are driven by inflation and by default risk. The long-term world bull market in bonds from 1865 until 1900 was driven by reduced risks to bondholders, and the current bull market in bonds has been driven by falling inflation rates. These structural adjustments can take decades. Because it can take years to bring into production new sources of oil, gold, or other commodities, raw material prices can remain stable for years, then jump in price suddenly. For these reasons, secular cycles in stocks, bond and commodities behave differently."

    If you read the whole piece it becomes abundantly clear from the analysis that the beginning of an inflationary trend such as is indicated by the rising price of oil may mark the start of a bull market in commodities and a bear market in both stocks and bonds.

    If a $30 oil price or higher is maintained and the Fed does not agressively raise rates, inflation can be expected to rise as a function of the rate of increase in import prices and in proportion to the ratio of imports to GDP.  This cannot help the current account deficit, and will put further pressure on the dollar.  Lucky for the US, Europe and Asia are even more oil price sensitive than the US, so the effect on the dollar will likely net out in the dollar's favor.  In any event, domestic inflation will rise or interest rates will rise or, worst case, both will rise.

    Look on the bright side.  Inflation isn't all bad.  It benefits those who have a lot of debt, little savings, and own hard assets, especially real estate.  In other words, the average American in the year 2000.

    No article on the the threat of inflation is complete without an acknowledgment of the possibility that the current euphoria is justified, that we have indeed achieved economic nirvana.  Perhaps we have. Or perhaps...

    Outlook & Independent
    August 7, 1929

    "IN MANY WAYS this has been the most remarkably cheerful summer in recent financial history. The stock market speaks for itself. After the serious decline in May, prices of the leading securities have been marching steadily upward... This prosperity might be disquieting if it were accompanied by any of the symptoms of inflation."

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    Cooking the CPI

    Is the Bureau of Labor Statistics cooking the CPI to show low inflation?  This memo was intercepted by

    To:         All Departments
    From:     Patty Jackman. US Dept. of Labor, Bureau of Labor Statistics
    Date:      February 3, 2000
    Subject:  Revision of CPI

    Due to rising oil prices, the Bureau of Labor Statistics annouces a new formulation of the CPI retroactive to January1, 2000.

    All items, U.S. city average, all urban consumers, 1982-84=100, 1-month percent change, seasonally adjusted.

    Old CPI Cost Items New CPI Cost Items
    Food and beverages Food and beverages at discount grocery stores
    Housing Tenement housing
    Apparel Consignment store clothing
    Transportation Non-powered transportation (bicycles, skateboards, feet)
    Medical care Self-medication (beer, martinis, pornography)
    Recreation Same as above
    Education and communication Network television shows and Buck-a-Book store items
    Other goods and services Air, sun, snow
    Energy Burning old tires in the back yard


    Patty Jackman
    Division Weasel
    US Dept. of Labor
    Bureau of Labor Statistics

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    Markets in Distress

    January 5, 2000

    Normally I try to stay out of the prediction business, but this one was relatively easy.  Late last week I stated that we'd see no Y2K relief rally, in fact we'd see the Fed backing off the Y2K liquidity gas peddle (lowering reserves) at the same time as the markets priced in the rate cuts that were deferred from December due to Y2K liquidity problems that never materialized. The result, heavy selling.

    The fall started with selling in the bond market as foreign investors decided that holding US debt bought for safety made no sense if every other country on earth isn't having any more problems due to Y2K than the US.  This short term cause only added to a trend fueled by recovery in Asia, a trend confirmed by a stubbornly falling dollar for the second half of 1999.  As bond yields started to rise and the trend that started last year appeared destined to continue and even accelerate, equity markets began to price in the impact of the rising cost of money as well as the no-brainer consensus that the Fed was to raise rates 50 to 75 points in the coming months.

    While many observers have predicted that the US economy is so strong that yields up to 7% will not effect it significantly, it's important to keep in mind that this economy is highly leveraged and thus extraordinarily interest rate sensitive.  In 1995 only $2.5 in debt was needed to produce $1 in GDP growth.  By 1999, the ratio had risen to $5 per $1 of GDP.  Also, keep in mind that the three Fed rate hikes last year don't impact the economy instantaneously.  A lag of six months is typical.  So the effect of those hike ought to be showing up... right about now.

    Consider the following hypothesis.  What if foreign selling of US debt turns out to be the catalyst for the start of what we'd termed The Unvirtuous Cycle?  Smelling a US recession brought on by earlier rate hikes, foreign holders of US debt begin to increase their selling.  The US experiences this as a falling dollar exchange rate and, ultimately, as inflation as import prices rise.  The logical response from the Fed is to increase rates.  But if foreign sellers are correct about a recession in the US, the rate hikes may only increase their fear of a recession, causing further capital flight.  This is not unlike what happened in Brazil last year when the IMF insisted that Brazil raise interest rates in the face of capital flight following the collapse of the long over-valued real.  The rate hikes had the opposite of the intended effect.  Instead of reassuring investors that they'd be paid a good return on risk, investors became even more concerned that the Brazilian economy was a mess and headed even deeper into recession.  Capital flight actually increased.  If market psychology were taken into account and rates were lowered instead of raised, there's a good chance that capital flight would have slowed.  Instead, textbook prescriptions were followed with unfortunate results.

    With no evidence that the Fed learned a lesson from Brazil's experience.  So what if the Fed does the same in the US"  We have argued that the dollar is perhaps as much as 30% overvalued, if the current account deficit and a 40% dependency of the US on foreign borrowers to finance the economy are taken into account.  Certainly a strong dollar policy will be maintained and short term rates be raised.  Foreign investors may then get the very event they were afraid of, the recession that caused them to sell US debt in the first place, causing capital flight to increase further, as in Brazil.  It's reasonable to expect the Fed to see this and say, "Oh.  I guess we didn't raise rates enough."  So the next event is another rate hike to protect the dollar, more fear of recession, further repatriation of US debt, more inflation, worse recession, and so on.   At this point the dynamic may get out of the Fed's hands as in the late 1970s.

    All speculation, of course.  A worst-case scenario based on history.  No one knows what will happen.  But a country that needs to worry about maintaining a massive capital account surplus to run its economy doesn't have a lot of flexibility once a recession gets underway.

    From here it's reasonable to expect a volatile market for several months with stock prices generally falling in a one step forward, two steps back action as the upward trend on rates continues.

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    Who will Pop the Internet Bubble?
    November 24, 1999

    Special Editorial on the First Year Anniversary of

    November 1998, we started as a parody of an Internet company. The premise? Excessive money growth helped to produce an asset bubble in the late 1990s as deflation-driven loose money policy did in the 1920s in the US and in Japan in the 1980s.  Since 1996 the growth in the money supply has fueled the conversion of the US stock market from an investor's market into a speculator's market.  Only a few participants even noticed the apparently invisible transition.  The existence of silly, ill-conceived and uneconomical Internet companies funded by public capital is the defining feature of this particular asset bubble and the one we chose to ridicule to make our point.  The tortured logic that produces elaborate justifications for Internet company stock prices parallels the "scientific" explanations available during the early 1600s to explain why a single tulip bulb was really worth the equivalent of millions of dollars.

    Last year most visitors to the site were either unaware of the existence of an asset bubble or didn't believe one existed.  Often we got email from visitors who did not buy the argument.  But all this year newspapers and television publicized one Internet company IPO after another, each resulting in company valuations more absurd than the one before.  The public has gradually come to accept the existence of the bubble.  The email we receive now includes no protests.  Most recently even the mania participants seem to have stopped fighting the evidence and accepted that they are part of a mania.  From our research, this acceptance is a feature common to all manias.  During the final stages, the mania participants adopt the belief that they are in a mania but it's okay because they -- only they and not the other participants -- will get out in time. Of course, they are wrong.  Only the few with the luck to time their short positions well make out when a mania ends.

    Now that most have accepted the notion that the current US stock market is an asset bubble, many are asking, what causes a market bubble to pop and what will pop this one?

    Historically, there are four kinds of events that deflate an asset bubble.

    Credit Squeeze

    A credit squeeze induces a market crash.  Usually caused by sudden central bank tightening to stop or reverse the market speculation the Fed may have unwittingly fueled with previously too-loose monetary policy.  After all, it's the Fed's job to keep the money supply within limits to prevent unwanted inflation in the prices of goods and services.  The Fed also keeps an eye on real estate prices and has thwarted real estate market speculation with little hesitation.  But the Fed seems completely dense when it comes to speculation in the stock market, totally confused about how much stock price to assign to realistic expectations of future earnings and how much to speculation, and what to do besides talk if financial asset prices rise 300% in a few years while goods and services prices remain stable. We'll throw out a number: between 40% and 90% of the price of the average stock on NASDAQ represents speculative value.  Depends on the stock. is 90% speculation price and 10% value.  Cisco is 40% speculation price and 60% value.  Just a rough estimate.

    Sudden central bank rate hikes are credited with inducing the crashes in 1929 and 1987 in the US and in 1989 in Japan.  But just as often the credit squeeze that crashes the market is caused by what economists call a "random exogenous event" such as a major credit default as in the case of Russian bonds last year, or the collapse of a big bad bet, such as LTCM.  Greenspan has proven to be a gradualist -- no sudden big rate moves -- so his well forewarned mini rate hikes are not likely to cause the current US bubble to pop, at least not right away. But here's a possibility.  Markets take on average a month to respond negatively to a rate hike.  The real economy takes about six months to respond to a rate hike, so two small rate hikes spaced five months apart are likely to cause as severe reaction in the market as a single major rate hike.  For example, a .25 rate hike in mid July 1999 and mid November 1999 is likely to cause as significant a market reaction in mid December 1999 as a surprise .5 hike in mid December.


    A leader in the market goes bottoms up.  For example, if were to run out of money -- not too far fetched since Amazon spends so much more than it earns.  If the company is unable to raise funds by selling more stock or taking on more debt, the company may need to file for bankruptcy. Investors will likely storm for the exits to sell and just about every other company with a similar money losing business model, that is, most dot coms.


    A market leader is revealed to have engaged in unlawful business practices.  The effect is similar to a bankruptcy.  Investors lose confidence in all similar investments as a class, panic and head for the exits.  In September SEC Chairman Arthur Levitt woke up from his regulatory slumber to publicly call into question the "dysfunctional relationship" between analysts and the investment banks that employ them.  Among other self-imposed reforms, he'd like to see analysts use the "S" word (Sell) at least once in a while.  The message to the investment banking community was clear: fix it or I'll fix it for you.  Last week a sub-committee of the SEC announced that they were reviewing 20 accounting practices by Internet companies that they deemed questionable, including the accounting of barter as revenue.  The ruling has been put off until January.  Might this have an effect on the revenue numbers of some high profile .com players?

    What woke Arthur up?  Rumors are that the international banking community is starting to make noises about US accounting practices.  The US is supposed to lead the world in transparent and strict accounting rules, but the behavior of some corporations, investment banks and securities firms working the Internet bubble calls this into question.  This opens up a huge can of worms.  For example, what if the SEC decides that stock options have to be accounted for as an expense?  As Warren Buffett said recently, "If stock options are not an expense, what are they?"  Good question.  No doubt corporations improve their profit numbers by paying employees currency created to pay employees in lieu of cash, currency that it does not have account for as an expense.  Some estimates suggest that the average NASDAQ corporation's profitability will fall by 43% if stock options were reported as an expense.  All this new regulatory activity by the SEC raises the possibility that the Internet bubble will get regulated away.

    Weakness in the Real Economy

    Let's say economic data come out in December that suggest that the economy is slowing down fast.  What if retail sales in the first big Christmas buying weekend this November are far below last year's levels?  Some cooling of the economy is bullish, since this reduces pressure on the Fed to raise rates.  But if significant slowing shows up across several segments of the US economy, especially consumer spending, investors will realize that stock prices are based on earnings growth that the economy will not support.  Since the such data at this time is not expected and would appear to come from nowhere, investors will tend to panic and head for the exits.

    Name that Pin

    If we were to guess which cause is most likely to pop this bubble, we'd say number one, a credit squeeze in late November or early December as a result of previous Fed tightening.  In particular, a blitz of home refinancings ended last summer when mortgage rates moved higher, and the flood of cash released in the process has dried up.  But we expect that all four bubble popping causes will eventually come into play.  The credit squeeze will be followed by the second cause, a bankruptcy or one or more money losing .com players, since they will not be able to compensate for the absent profits by raising more money in the stock market or borrowing more from banks.

    What about fraud?  This mania has been running for so long that the financial mice have been playing for many many years while the SEC cats were away doing whatever they've been doing.  If this mania is like every other, the smell of easy money has attracted a lot of shady characters and motivated unseemly behavior among the otherwise ethical and lawful.  Don't be surprised if the management of a few Internet stock mania favorites turns out to have cut more than a few legal corners.

    Finally, since so much consumer spending is done due to the addition of stock market "wealth" on the family balance sheet, as if the funny money were actual savings deposits in the bank, and so much personal debt has been taken on with the false expectation that current low unemployment level will last forever, expect consumer spending to drop like a rock and accelerate the slowing of the economy as debt is paid off and saving increases.

    Ok, so then what happens if the bubble pops.  The Fed will of course pump up the money supply once again -- "flood the streets with money" as a previous Fed chairman was fond of saying -- as in late 1998 and the early part of 1999.  Two possibilities.  The bubble picks up where it left off and grows to the next stage of outrages proportion.  As scary as that is, the alternative is worse.  If the new liquidity doesn't succeed in reflating the markets and the economy...  The result of that unlikely event is a topic for another day.

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    Back to the Future
    November 15, 1999
    As we near the end of this, the biggest and longest speculative stock market in history, in progress for over five years with only one interruption, the boom begins to look permanent to just about everyone.  Books such as "DOW 36,000 and DOW 100,000" appear, engaging in mental acrobatics to offer highly inventive explanations for the perma-boom phenomena.  For perspective, I offer a few words said years ago during another time when stocks were considered the one asset with the highest return and the lowest risk over the long term, during a time of rapid productivity increases (43% between 1919 mand 1929) when the old rules of stock valuation were said to no longer apply, when investors stayed in the market even when stocks were at unprecidented high prices relative to P/E ratios -- for fear of missing out on even greater future profits.  Thanks to William A. Fleckenstein for digging up the information.  The full text of Bill's analysis can be read at Silicon Investor.
    "A new conception was given central importance -- that of trend earnings. If an attempt were to be made to give a mathematical expression to the underlying idea of valuation, it might be said that it was based on the derivative of the earnings, stated in terms of time.

    "Along with this idea as to what constituted the basis for common-stock selection, there emerged a companion theory that common stocks represented the most profitable and therefore the most desirable media for long-term investment.

    "These statements sound innocent and plausible. Yet they concealed two theoretical weaknesses which could and did result in untold mischief. The first of these defects was that they abolished the fundamental distinctions between investment and speculation. The second was that they ignored the price of a stock in determining whether it was a desirable purchase. A moment's thought will show that "new-era investment," as practiced by the trusts [similar to today's mutual funds], was almost identical with speculation as popularly defined in pre-boom days... It would not be inaccurate to state that new-era investment was simply old-style speculation confined to common stocks with a satisfactory trend of earnings. The impressive new concept underlying the greatest stock-market boom in history appears to be no more than a thinly disguised version of the old cynical epigram: 'Investment is successful speculation'.

    "The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell."

    "An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy "good" stocks, regardless of price, and then to let nature take her upward course..."

    Security Analysis (Chapter on New Era of Investing)
    by Ben Graham, 1934
    "The boom had become a full-fledged stampede. Several years later, Otto Kahn looked back toward the early days of September 1929 and concluded that the speculative movement had gained so much momentum by that time that nothing short of a crash could have brought it under control. The American public, Kahn testified, was 'determined to speculate. They were determined that every piece of paper would be worth tomorrow twice what it was today. I do not believe the whole banking community could have prevented it... When it had taken full sway of the people and there was an absolute runaway feeling throughout the country, I doubt whether anyone could have stopped it before calamity overtook us.'

    "To liberal journalist Gilbert Seldes, the final days before the crash were the true time of panic. 'I call it panic to be afraid to sell at a profit, lest additional profit be lost,' Seldes wrote. 'The panic which keeps people at roulette tables, the insidious propaganda against quitting a winner, the fear of being taunted by those who held on, all worked together. It became not only a point of pride, but a civic duty, not to sell, as if there were ever a buyer without a seller.'

    "Although the Wall Street Journal, the chief journalistic promoter of the boom, maintained its traditionally optimistic front, the editors of Business Week charged unequivocally that 'stock prices are generally out of line with safe earnings expectations, and the market is now almost wholly 'psychological' - irregular, unsteady and properly apprehensive of the inevitable readjustment that draws near.'

    "In fact, only 388 of the nearly 1,200 issues listed on the New York Stock Exchange had advanced between January 2nd and September 3rd [1929], while more than 600 stocks already showed substantial declines from their highest point of the past few years. 'This has been a highly selective market,' observed the Cleveland Trust Company's resident market guru, Colonel Leonard P. Ayres. 'It has made new high records for volume of trading, and most of the stock averages have moved up during considerable periods of time with a rapidity never before equaled. Nevertheless the majority of the issues had been drifting down for a long time...In a real sense there has been under way during most of this year a sort of creeping bear market.'

    by William Klingaman, 1993
    "Fair weather cannot always continue. The economic cycle is in progress today, as it was in the past. The Federal Reserve System has put the banks in a strong position, but it has not changed human nature. More people are borrowing and speculating today than ever in our history.  Sooner or later a crash is coming and it may be terrific."
    Roger Babson
    September 1929
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    October 21, 1999
    I'm aware that some readers were not entirely satisfied with my explanation yesterday of why we didn't have a correction the day before.  I assume that most readers know it's not possible to predict a market correction; crashes and corrections are always triggered by random events.  In fact, I say that in several places on the site.  I just couldn't resist making a prediction -- the set-up was too tempting.  This market is highly reactive to news.  Volatility usually comes before the fall.  Had the trade numbers been different, we'd have gotten a very different result, though admittedly probably not a crash.

    Some of us have the stomach to ride out a correction and some of us don't.  Those who rode out the corrections in 1987 and 1998 were rewarded with a quick recovery of losses and fresh appreciation of stock prices.  Those who rode out correction of 1970 and the bear market that followed had to wait a decade to get their money back.  Those who bought into the stock market in 1928 had to wait 25 years.

    In fact, it's possible we won't have a crash at all, that we'll instead have a slow grinding bear market.  These operate like a tide going out, with each successive wave up not reaching as far as the last: 11,365 down to 10,200, back up to 10,900 and down to 9,800, back up to 10,400 and down to 9,400, and so on for months or years.  This is what appears to have been happening since this Summer.

    Unfortunately, bear markets lose more money for more investors than crashes in bull markets followed by recovery.  Just as any idiot can make money in a bull market, a bear market makes everyone look like an idiot.  The discouragement is self-fulfilling.  If you recently got your 401K statement from Q3, you probably have an idea of what I'm talking about.  What if it looked that way again next quarter?  The one after?  After months of stagnation and decline, investors drop out, further reducing the number of buyers in the market.  It's the opposite of the psychology of a bull market.  In a bull market, everyone you talk to, from your dentist to your mother-in-law, is making a killing.  Everyone is getting in.  In a bear market, they're all getting killed and getting out.

    Anyway, don't believe anyone who tells you there's gonna be a crash on day X or day Y. That's just rubbish.  Do check out some of the info on this site, such as the link to the Crash Index.  It doesn't tell you when a crash is going to happen, only when certain conditions for a crash exist.  So far this year, the index is two for two predicting major rallies.

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    October 20, 1999
    Ok, so we didn't have a crash, we had a relief rally instead.  A major correction is likely this year* and I had one chance in 365 of guessing correctly today was the day.  It was worth a shot.  I'd have looked like a genius!  Alas, I'm no better at guessing when a crash is going to happen than anyone else.   But there's still tomorrow.  The trade numbers come out and if they show a continuation of the last few quarters' trend, the market will react negatively.  Let's see what happens after the numbers are announced at 8:30 am EST.

    * Actually, with so many folks predicting a crash, the likelihood is pretty small.

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    What Happened?
    October 19, 1999
    By the time most of you read this, the market has already crashed.  You will read lots of post mortems over the next few weeks so I figured I'd get out in front of the crowd and write mine before the crash happens.  It's dated October 19 although I am posting this on October 18, one day ahead of the crash.

    Well, it had to happen eventually.  The market had to crash.  Just as the end of bear markets are often announced by a sudden spike upwards as in the gold market a few weeks back, bear markets frequently announce their official start with a major correction.

    Why did the US stock market crash today?  All the usual crash indicators were there -- yield spread, market breadth, etc.  But more importantly the psychology for a crash was present.  There were many indicators but here's one significant one.  When the psychology of the market was bullish, Greenspan's bearish comments were ignored.  They were not ignored Friday.  That's because we are no longer in a bull market.  Alan Greenspan, in his speech last week, warned banks to increase reserves to protect themselves against a crash.  In the old days, the Fed used to actively raise reserve requirements in an attempt to limit speculative loans by banks.  This rarely worked, which is why the Fed stopped doing it.  But the market has a longer memory than you may think.  Even a request for a voluntary raising reserve requirements was enough to set the professional money managers into a defensive posture Friday.  As for the public, the psychologically important 10,000 level on the DOW was broken briefly Friday.  As visitors to know, around 50% of all holders of mutual funds plan to sell if the market falls below 10,000.  A lot of them will sell today.

    So what happens now?  In the short term, the usual.  The Fed will "flood the streets with money" as they are fond of saying and the panic will abate.  I am confident that this will work as well in 1999 as it did in 1998 and 1987.  If not, God help us.  But what about the long term?

    We've been telling you since late last year that the US markets are a victim of the success of the dollar.  Back in the early 1980s, even as then Fed chairman Paul Volker's policies were rocking both the bond and stock markets, he was convincing foreign investors that the US was serious about inflation and the dollar began its long ascent.  As the dollar grew in strength, investment in dollar denominated financial assets grew.  This peaked after Asian markets corrected in 1997 and world capital poured into US financial markets and continued to fund a historically unprecedented current account deficit.  As a result, the US owes more money to foreigners as a proportion of GDP than any nation in history.  These obligations weigh heavily on the dollar.  Eventually, foreign investors will begin to question whether the US will be able to pay these obligations without effectively devaluing the dollar.  As the US financial markets began to slow this summer, these fears grew among foreign investors in US paper.  The growing mass realization of the impending reversal in the dollar's fortunes will frighten foreign capital out of US markets, launching a self-fulfilling prophesy that I have labeled the Unvirtuous Cycle.

    Briefly, the Unvirtuous Cycle is a circular dynamic whereby a weakening of the US economy and falling returns on US financial assets weakens the dollar.  Foreign investors respond by selling US Treasuries, stocks, and other US paper causing a net flow of dollars into the US economy.  Seeking to maintain a relative interest rate advantage of the dollar over other currencies and thus limit the inflationary impact of US paper sales by foreigners, the Fed responds by either raising rates or simply allowing them to rise by not lowering the prime rate or Fed Funds rate (demand for credit will rise relative to supply during the developing recession in the real economy, driving up rates).  The higher interest rates will restrict access to credit in the real economy, thus deepening the resulting recession but decreasing monetary aggregates to compensate for inputs from sources of dollars outside the US.

    There's no guarantee that this will happen, of course.  The world financial markets have a lot of moving parts and so it's not easy to predict how it will behave following a crash.  But it's worth keeping your eye out for the development of this dynamic because if it appears, the time to get back into the US markets will not appear until the cycle has finished, perhaps five years or more after it has begun.

    Good luck.

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    Death of Equities (Part II)
    October 7, 1999
    In my September 23 commentary (below) I said, " gold rise ala 1979.  Just about everything else will fall."  Good guess?  Maybe.  Gold spot price was then $277.  Now (I mean, right now) spot in Hong Kong is $329.  So I'm feeling pretty clever.  Naturally, the same folks -- my friends, wife and family -- who told me I was nuts for buying the "dead investment" between $270 and $258 are now telling me to sell it to take a profit.  But I think they ought to be telling me to sell my Interliant stock instead.

    They don't get it.  I bet a few of you don't either, so I'll explain.

    All bear markets end the same way, with a bunch of shorts betting that a market that's lost 80% or more of its value will lose the remaining 20%.  Of course that's just stupid but this "rational" market behavior seems to make sense to everyone at every market bottom, as witnessed by hundreds of "Gold is Dead" articles that you could read in the popular press until a few weeks ago and the half dozen crackpot, goldbug rants you could read on the Web.  The same will happen at the bottom of the coming bear market in stocks.  All the longs will run away leaving the shorts hoping ludicrously to mop up the remaining 10% - 20% fall to zero.

    The fact is that low demand in recession wracked economies in Asia was keeping the price of commodities, including gold, low.  This helped keep US inflation in check, even though labor markets continued to tighten and consumers continued to spend more as a proportion of income.  But Japan and the rest of Asia are recovering nicely.  So Mr. Demand Curve started putting pressure on gold.  To get the gold price moving, all the markets needed was a relief from fear of Central Bank gold sales.  Miraculously an announcement to the effect that all European banks were not going to sell any more gold for five years appeared seemingly from nowhere.  This couldn't be a ploy to exploit weakness in the dollar and spike the euro, could it? Nah.

    As we mentioned in our hilarious faux interview with Alan Greenspan last March (well, we thought it was funny), eventually the US$ is gonna get whapped for the US' current account deficit and the dollar debt to foreigners.  It's just a matter of time.  Since the balance of payments always balances, to have a current account deficit you have to have a capital account surplus.  The US has been running a historically unprecedented current account surplus and counting on the kindness (greed) of strangers to buy our dollar denominated assets to pay for all the stuff US consumers buy from them.  As long as dollar denominated assets offer relatively better returns than anyone else's, then this deal works.  But the deal isn't so great once the markets figure out there's more upside elsewhere for investment.  A recovering Asian economy is a better bet that the US economy -- as the Japanese are fond of calling it, and they ought to know.

    Geoffrey H. Moore and Anirvan Banerji of the Economic Cycle Research Institute put it like this in their October 6, 1999 analysis Concerted Cyclical Expansions Likely Worldwide:

    "The synchronized international expansion ahead presents a new set of challenges to policy makers, as the fortunate circumstance of imported disinflation may be less available to offset the pressures from tight domestic labor markets. While the much-vaunted "new era" may be thereby revealed as a mirage, the picture of business cycles presented on page 3 shows that expansions can last much longer than the current U.S. expansion.

    "Thus, upcoming global developments may signal a major realignment of the forces that have allowed the U.S. economy to enjoy an extended period of noninflationary growth. However, there is no reason to suspect that the end of this expansion is in sight."

    A concerted worldwide cyclical expansion sure sounds like a great thing.  It is, as long as you aren't in the USA.  In the USA this spells inflation as dollars rush home and we have to mop them up.  Payback time for years of allowing foreigners to fund our expansion.

    Expect a lot of volatility in the markets as world capital is realigned to this new reality.  The big surprise winner will be gold, the big probably not too surpising loser will be US equities, as demand for gold rises and demand for dollars falls.  In fact, with minor retracements I expect gold to clear $400 by the end of the year, if not the end of the month, and the stock market to finish its porpoising action and do the voyage to the bottom of the sea before the month is out and the dollar right along with it.

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    Stock market mysteries
    September 23, 1999

    Frequent readers of who want to guess at the direction of US stocks know to keep an eye on the dollar.   As we've stated since late last year, when the dollar's fundamental weakness begins to show through, that's when the US stock market will begin to to seriously deflate.

    You are seeing the result of a growing rift between the US and Japanese monetary authorities.  The Japanese are politically unable to slow the rise of the yen by printing money (they can't drop rates for obvious reasons) because of the risk of inflation.  Keynesians say a bit of inflation in Japan is a good thing now.  Unfortunately for Japan's leadership, Japanese voters are not Keynesians, they are recession weary inflation-phobes.  An inflationary monetary policy is politically impossible.  The US, on the other hand, is stock market bubble dependent and the US Fed is bubble popping-phobic.  The Fed has in its hand a 1/4 point rate hike bubble pin as its only tool to slow the fall of the dollar.  There appears to be no middle ground between these unsustainable positions.  A few currency interventions have bought some time but time is running out.

    G7 leaders ought to have worked out something last Fall when they had a chance after pouring liquidity into the world financial system to temporarily end that crisis.  Instead, they have behaved as if the essential problems with the floating exchange rate system were just going to go away.  If this crisis runs to its logical conclusion, we will have a world central bank sometime in the relatively near future.

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    Y2K Policy
    August 25, 1999
    It's hard to find anything new to say on this tortured topic.  The Y2K discussion founders in a sea of redundant speculation as journalists struggle to find any evidence at all of Y2K bug symptoms that might make Y2K tangible and the discussion more animated than an RMV clerk.  Alas, "significant" Y2K dates come and go and... nothing happens.

    What the heck's gonna go down after Dec. 31, 1999?  Do we at 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.

    A big secret known to few except hundreds of thousands of software developers worldwide who write software and  hundreds of millions of sorry saps who use it is this: most software programs have lots of bugs.

    No piece of code escapes human error.  At some point in the life of a program, a variable gets set to an unexpected value or the execution heads off on an errant code branch.  The program hangs or crashes.  Generally speaking, the larger the program the greater the chances of it going haywire.  Your Windows98 crashes all the time because an operating system, as an old computer science professor used to say, is a really big program full of bugs.  The world runs on such big application programs written by corporate software developers who are mostly occupied with fixing bugs.  They do it all day long.  They do it quickly, too, so you hardly notice, otherwise you might be tempted to go to another bank or online trading company or whatever.  This is unlike the bugs in Windows98 that you have to wait for months to see fixed because, what are you going to do, get another operating system?  (Janet Reno's working on that one.)

    If the software that runs the world is so buggy anyway, what's the big deal with Y2K bugs?  The doomsayer's argument is that there are so many Y2K bugs that programmers can't fix them all.  Yet Y2K remediation experts are running out bugs to fix a lot sooner than they're running out of time to fix them.  Why is that?

    Y2K bugs have been around for decades and they've been getting fixed for decades.  A program running in 1989 that calculated the 20th year principle payment on a 30 year mortgage had to do the math based on a 2009 date way back then, ten years ago.  As time goes on, programs run into Y2K bugs.  Not all at once on January 1, 2000 but at various times.  So Y2K bugs make applications break the same way programmers are used to seeing them break -- all the time.  Constantly.  Thus, they get fixed constantly.  The only programs that will have a problem are those that never have to deal with a 2XXX date until they are running in the year 2000.  Those are the ones that are getting fixed in a hurry.  Even if the bugs aren't fixed before Y2K, most bugs will get fixed as they show up, as usual.

    If the world isn't going to come to an end January 1, 2000 then is there nothing at all to worry about?  There are exactly four real problems.  Evidence of these are just starting to show up now.

    Four Real Y2K Problems

    1. Bank Custodians
    American Red Cross - Y2K Preparedness
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