THE SKEPTICAL INVESTORTM

Issue No. 1. Mid-June 1997

Posted 15.VI.1997

On Friday 13th June 1997, the Dow Jones Industrial Average briefly broke through 7800, finishing the day at 7782. This was the 2436th day without a correction of at least 12%. Back in 1990, the Index stood around 2000.The extent and longevity of this bull market are utterly unprecedented: the previous longest market advance without a 12% correction ended after "only" 1492 days. Compared with today's roaring bull, the market that had lasted for just 1126 days until terminated by the 1987 market crash seems rather tame.

The main driving force behind the stock market boom is the healthy economy. The fundamentals are sound: the USA has been experiencing a period of unparalleled steady growth, with low inflation, falling interest rates, and now almost full employment. The appearance is that the politicians and the central banks have got it right, and some time ago credible market analysts and economists began to raise the possibility that a New Era has been entered: that the old boom to bust inflation cycle has finally been conquered and the world is embarked upon almost perpetual inflation-free growth and prosperity.

New Era thinking is now widespread and apparently deeply entrenched. It is accompanied by a very sanguine view of the investment potential of the stock markets: that a buy-and-hold strategy is essentially without risk now; the markets over time always go up. The worst that we can now expect, goes this New Era thinking, are short-lived market corrections or, in the worst case, something akin to the 1987 crash in which things were back to normal after a few months. Severe market crashes and long grinding bear markets, are, they opine, a thing of the past.

It would be impossible now for anyone to argue that share prices are not at extreme valuations by any and every historical measure, but the New Era analysts explain these valuations as reasonable given the international trends that are in play: the introduction and spread of new technology; the opening up of vast new markets in Asia and elsewhere; the breakdown of trade barriers and spread of "free trade" (actually managed trade, but that is another story); the growing international competitiveness of the USA; inflation-fighting central banks; and all the rest.

Phooey! The New Era is a myth. This is not to deny the vigorous economic fundamentals or the reality of the international trends: these things may be being overstated but do indeed seem to reflect the world as it is today. But there is a problem, a spanner in the works, and ironically it is these healthy fundamentals and booming economy--together with one thing that no so-called New Era will ever be able to eliminate, namely human greed and a propensity to expect something for nothing--that is the root cause of the problem. This problem is that the stock markets themselves have become so overvalued that they no longer bear any realistic relationship to the underlying economy. And at some point they are going to plummet.

In this the first issue of The Skeptical InvestorTM I will make my case for this statement. In the next issue--provided that events have not already overtaken me--I shall attempt to develop a scenario for what may happen and what effect it may have, not only on the stock markets but upon the wider economy. I am also researching suitable conservative investment strategies for coping with these possible events.

Stock Valuations

A price/earnings ratio of 30 or more is not unusual these days i.e. the price that you will pay for the stock represents thirty years' worth of earnings at present (most recent twelve months) levels. That is obviously a nonsense. To put it in perspective, earnings would have to be 200% higher than they are to bring the P/E down to a reasonable 10. A P/E of 30 must thus represent extremely optimistic expectations for the growth of the company's earnings over the next few years, or, alternatively, the projection of continuing healthy steady growth over an extended period of a decade or more. No one who has experience of the real world of business will be happy with the latter, because even projecting a mere twelve months into the future is fraught with pitfalls; projecting a decade is entering the realm of pure fantasy. The former, on the other hand, implies a short-term rate of growth more akin to that of risky venture capital financed start-ups than that to be expected of an established corporation.

The undoubted productivity gains and increasing international competitiveness achieved by many US corporations is also suspect as justification for such high valuations. A company's customers, not just its shareholders, will receive a significant proportion of these gains through lower prices and better service. That is how free enterprise and competition work. And, within the extended time scales that are implied by such valuation models, employees will demand, and get, a share of the proceeds as well. Meanwhile, if the New Era analysts are correct, share prices will still continue to increase, year after year, at double digit rates of growth.

The Lessons of History

It is easy to fall into the trap of thinking that market crashes must be triggered by some unexpected, negative, event. The 1973 OPEC oil crisis for instance. This can indeed be the case, but it usually isn't. Surprisingly, the opposite is more often true: a crash is typically caused by irrational optimism resulting from a booming economy. The classic example is the great Wall Street Crash of 1929. The same appears to be true of 1987. In both cases, the counter intuitive nature of the sudden plunge in the face of an apparently rosy outlook is the reason why economists are still today arguing the causes. Bogus explanations are still being wheeled out: margin trading in 1929; program trading in 1987. Unfortunately fixing such bogus causes by regulations such as the restrictions on program trading that were introduced by the New York Stock Exchange results in complacency and a totally spurious sense that events are henceforth under control. The fact is that in both cases (and in many other financial debacles of history) the markets had become overvalued and were certain to behave the way they did. Incidentally, the reasons for the exact timing--why did they crash on the specific days that they did-- are still unknown. It follows of course that no one will be able to predict the day that the DJIA will collapse.

Rather than attempting the probably futile exercise of even roughly estimating the timing of the next crash--it is in my opinion better to be out of most stocks altogether now--it is more useful to examine the reasons why markets became overvalued in the past, and look to see if the same or similar things are happening today. If we can find enough parallels, that is good evidence that the markets are indeed overvalued, rather than that things are, as we so often hear, "different this time".

The American business and investment environment in the years before 1929 was very much like todays. The underlying economy was doing extremely well. Profits were healthy. Industrial productivity was improving; much of which was to do with the benefits of new technology. Inflation was low. Interest rates were at historic lows. There was little unemployment.

The seeds of disaster lay in the booming economy and the low interest rates. As profits rose, so too of course did stock prices, to perfectly reasonable levels at first. At the same time, due to low interest rates, bonds and other interest bearing instruments became relatively less attractive. Stocks became more attractive. This effect snowballed into a widespread switching out of cash and interest bearing vehicles into real or financial assets, especially by people who had little investment experience and knowledge.

" A preference for investing in equities instead of bonds was fostered by a number of statistical studies, published in books and articles, which showed that almost always in the past, bonds have produced less income for the investor than had been (or could have been) produced by a diversified assortment of common stocks." This quotation is from Irving Fisher's "Booms and Depressions" published in 1932.

These purely financial effects, driven as they were by a perfectly reasonable desire on the part of investors to achieve better returns on their money, would presumably not have led to any major problems had there been a general understanding that equities were getting overvalued and thus the real risk of holding them was increasing. Such an understanding would have reduced the flow of money into the stock markets: risk averse investors would have gotten out and stayed out, and prices of stocks would have been self-limiting. Economics 101. Risk increases with the potential reward.

This didn't happen, largely because there came to be a widespread belief thatthe risk was not increasing. The idea that a "New Era" (that was the term used) of perpetual prosperity had arrived had been proposed and had taken widespread hold.

Once this idea had been accepted, there was no turning back. Like today, there was a wealth of optimistic investment advice; books on the stock markets and mutual funds became bestsellers; newspapers were full of optimistic advice; equity mutual funds became very popular (there were many such funds in 1929); cash positions of investors and investment funds were very low, and there was a historically high use of credit to buy stocks. The psychological effect of positive reinforcement also certainly became increasingly powerful. Stock valuations rose and rose until by 1929 they had reached extreme historic highs, though they were not as not as high as they are today.

Then, and now, equity mutual funds were a particularly insidious driving force behind the stock market bubble. They separate the investor--the individual putting his money at risk--from the stock purchase decision. The typical mutual fund investor hasn't the foggiest idea how equities are valued: all that he sees is that the price of fund units is rising. Fund management on the other hand are not putting their own money at risk: it is in their interest to draw in as much money from investors as possible. Witness the advertisements. Could anyone imagine an equity fund manager advising investors to put their money somewhere else?

And, like today, there were plenty of verbal warnings, but these were shrugged off. By the summer of 1929, there was a widespread acceptance that a market correction was to be expected, but few investors were concerned: "Buy and hold: the markets always recover" was believed by most. Today, we are again hearing warnings, and again they are being ignored. Last year for example Alan Greenspan, Chairman of the United States Federal Open Market Committee (affectionately known as "The Fed" by market watchers) and arguably the most powerful financial figure in the world today, warned of "irrational exuberance" in the markets. At that time the DJIA stood more than fifteen percent below where it is now. Rational verbal warnings actually seem to become less effective the further the markets rise. That is because earlier warnings have always proven "wrong"--the warning was issued but the markets have continued to go up--so, perversely,the credibility of such warnings decreases almost in proportion to the overvaluation of the market !

But not only were there verbal warnings as the financial markets soared towards the end of the twenties. First appearing at the outer margins of the economy, unappreciated for what they portended, there appeared some real economic signs that, in hindsight, we know indicated that everything was not as rosy as it appeared. Although it was not recognised at the time, it is now known that the first stage of the Great Depression began when economies such as the Dutch East Indies and Australia began to experience problems and to contract in 1927. By 1928, countries such as Argentina and Germany were already in slumps. Today, several Pacific Rim economies are shaky and their stock markets are at or near long term lows. The worst affected is Thailand. As of 13th June, the Stock Exchange of Thailand Index stood at 520, off a staggering 70% from its 1994 high of 1754. Japan, not long ago considered economically invincible, suffered a market crash a few years ago, plummeting about 50%, and has not recovered.

Another piece of evidence that all was not well in the late 1920s was an increase in personal bankruptcies. Another sign of too easy money (low interest rates and easy credit). The same thing is happening today. In 1996, personal bankruptcies in the USA were at an all-time record, close to one million. Mortgage delinquencies are also becoming more common. The dangers of easy money used to be remembered from bitter experience, but the lessons have now mostly been forgotten. When I was growing up in England in the 1950s and early 1960s, I remember considerable government restrictions on credit ("hire purchase"). A lingering result of the Depression I suspect.

In Conclusion

Both actual asset values and the obvious parallels with the period leading up to the 1929 Wall Street Crash support the contention that US markets are experiencing a severe over valuation. The historical parallels especially are too close to be ignored. I interpret them as extremely strong evidence that the New Era is nothing more than a post hoc rationalisation attempting to explain what is really a common or garden financial asset bubble: it is not "different this time". The problem we now face is the overvalued stock market itself, not the underlying economy, and the cycle will in due course end in a powerful corrective crash. Likely there will be no warning signs. One day it will just happen.

CANUCKS' CORNER

For those Canadian residents hoping for some relief from the confiscation of their wealth by the Government through the device of a low dollar, the reelection of a Liberal majority government in the Federal General Election earlier this month offers nothing. The Liberals have deliberately followed a low dollar policy and appear set to maintain the exchange rate with the USD in the range of 72 to 74 cents.

A stock market crash in the USA is certain to be reflected in Canadian markets, the two economies are so closely linked.


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