It's Different This Time!
For most of this century, the stock market has peaked shortly after the dividend on the S&P 500 fell to 3%. It typically bottomed and turned up shortly after dividends exceeded 5%. Likewise, stocks were a bargain when priced at or below book value and expensive and risky when priced above 2.5 times book. Similarly, the market was expensive when stocks sold for 20 times earnings and cheap at 10 times earnings.
As I write this (12/18/98), the S&P 500 sports a 1.3% dividend yield, sells at 4.5 times book and at 30 times trailing earnings.
These measures of overvaluation have continued for years, roughly since 1993 (although not at the extremes achieved in 1998). Thus, valuation measures seem to have lost their predictive value for the purpose of making investment decisions.
From the pundits and Wall Street pros on the sell side, the argument is that "it's different this time."
And so it is!
However, none of the pundits or Wall Street pros are going to be candid about why it is different. And yet it is clear from their market behavior last summer that they know the reason perfectly well.
In late 1992, Congress enacted Internal Revenue Code section 162(m) to make corporate salaries above $1,000,000 non-deductible, effective in 1994. There was an exemption for "performance based" compensation based on objectives disclosed to and approved by shareholders in advance. Thus, beginning in 1994 most of a corporate executive's compensation would be dependent on the performance of his stock options.
In many ways this tax legislation merely reinforced a trend in executive compensation that had been underway since 1986 (wave 3 of III up), when corporate America began to realize that we were in a major bull market, and that options were the most valuable form of compensation because of the election of long term capital gain treatment available under Section 83(b) in the year of grant.
At about the same time that Section 162(m) was being drafted, the compensation consultants all began marketing to the fortune 500 what they euphemistically call "investment education" programs. At that time, employees were being "too conservative" with their 401(k) money by keeping 80% of it (on average) in the fixed income fund. The message of these "investment education" programs was that stocks always go up faster than any other investment, and that you had to own stocks or you would not be able to retire. Hence, you must shift your 401(k) balances from the guaranteed fund into one or more of the stock funds.
Now corporate CEOs are not fools. Beginning in 1993 these programs became wildly popular. With the help of the consulting firms (the same ones which were hired to structure executive stock option programs) the fortune 500 began circulating propaganda among their employees urging them to switch their 401(k) funds into stocks and keep it there.
Inflows into mutual funds began to rise in 1991 and then accelerated dramatically through July of 1998.
At the same time, investment bankers had little trouble convincing corporate CEOs that shareholders were better served by using profits to buy back shares rather than paying dividends. A simultaneous trend toward greater corporate stock buy backs ushered in a 5 year era of the lowest volatility on record as S&P 500 companies bought back their stock whenever it dipped in price.
With the employee investment education programs, the corporate CEOs produced generalized market demand for stocks in the form of increasing mutual fund inflows. With corporate buy backs, they produced specific demand for their own shares and convinced the investing public that buying shares was riskless.
These are the twin flows of money that have propelled the stock market higher throughout the 1990's.
There is no money standing on deposit behind a share of stock in a corporation. The share has value only if someone is willing to come up with new money to buy it. Thus stock prices are, by their very nature, dependent on new buyers.
Now before you can take an intelligent position contrary to this market, you have to know what might shake these twin sources of new money that have driven the market higher over the last 7 years.
In his volume "The Tidal Wave" Robert Prechter correctly notes that:
"Investors form a crowd whose collective action reflects a key aspect of man's nature as a social animal: He is strongly induced to adopt the feelings and convictions of the group. In a realm such as investing, in which so few are knowledgeable, the tendency toward dependence is virtually impulsive. As a result, market decisions are steered not by the rational decisions of individual minds, but by the peculiar collective sensibilities of the herd. The pervasive dependence among its members produces an emotional interpersonal dynamic that, like all feedback mechanisms, has form."
I would suggest that one of the two sources of fuel for the rally, mutual fund inflows, has already cracked, and that corporate buy-backs will also crack in stages, worsening with each new downturn in the market.
If you have not already sold your mutual funds, now is the time.
Prechter's book is a masterpiece. It belongs in the pantheon of WN greats under the umbrella of McKay's classic "Extraordinary Popular Delusions and the Madness of Crowds." However, I find Prechter's timing in the release of his classic in early 1996 somewhat strange. Mutual fund inflows were then rocketing upwards from the 6 to 7 billion per month level that persisted from 1993 through 1995 to a four month average exceeding 20 billions per month by February of 1996. Fund inflows demonstrated quite conclusively that the bullish psychology of the herd was accelerating dramatically in early 1996.
There is no way the professionals on Wall street would let those inflows go untapped. They promptly went out and showed their corporate clients these mutual fund inflows and sold a lot of corporate buy-back programs to reinforce the trend and keep prices and executive option values rising. At the same time, they ramped up their underwriting and new issues activity to rake in hefty fees from both investment streams.
And that, folks, is how Wall Street works!
You see, the largest source of funds for stock purchases, corporate buy- backs, has no relation to investment value at all, but is merely a compensation expense that happens to benefit all shareholders in the short term. As long as most shareholders approve, the activity will continue regardless of price and regardless of fundamentals.
But unlike 1996, the mutual fund inflows are now a disaster. The monthly data from the Investment Company Institute (ICI) for August, September and October 1998 show that the 12 month average has fallen to about 15 billions, a level that we have not seen since May, 1996. The 4 month average has fallen to 4.11 billions, a level we haven't seen since Sept., 1991. And it is not just the outflow in August, but the unusually weak inflows during the powerful rally of Sept. and Oct. that are causing the problem. Based on the AMG weekly numbers for November and December, it looks like the November ICI number will be weak and December, negative.
Here is what caused this shift among individual investors. First, the gold stock funds began falling in June of 1996 due to deflation, falling gold prices and falling profits. The gold funds lost 75% of their value. Next, emerging market funds took a pounding beginning in August of 1997 and ultimately lost 50 to 75% of their value. Emerging market funds were heavily touted to employees by the "investment education" programs sponsored by employers. About 40% of 401(k) plans make them available. Next, the forces of deflation started to reduce profits of small cap stocks, and pension funds and general equity funds began to sell these under-performers. This caused the price of small cap funds to lose 30 to 40% of their value beginning in May of 1998. The individual investor began to sell them as well.
The nasty price action in these three categories of funds has made the individual investor much more cautious. Mutual Fund Investing is no longer an easy way to make money. Finally, August's spill intimated that large cap funds could be subject to a similar pattern, and the huge inflows of 1996 through June 1998 simply stopped in August, September and October.
Now it is possible that the inflows might start up again in January. However, we have not seen four month average inflows this low since 1991. The only reliable evidence of a change in investor psychology is their actions. Because this caution is the result of price action over a period of 15 months and has persisted despite the most powerful rally in history from October 8 through November 11, it is hard to see why a modest rally here at year end is likely to restore confidence lost over the last 15 months.
Two or three bad reports from AMG in January will convince the Wall Street Pros to start betting against further price rises. They are likely to rattle the cages of their corporate clients to increase their authorized buy backs. At the same time, the Wall Street Pros are likely to cut back on their huge leveraged long trading positions, pay back the bank debt that finances those positions, and unwind their long derivative exposure and their highly leveraged spread trades that depend on a rising market.
Corporate buy-backs are tougher to analyze. The problem is that these buy backs are not based on investment fundamentals or values, but are intended to maintain price momentum in the short term. According to the Federal Reserve's flow of funds statistics, corporate buy backs totaled 266.7 billions in July, August and September of 1998, up from 117.7 billions in the previous two quarters, and 82 billions in 1997.
At the very time these corporate buy backs were being made in August and September, we had massive call purchases of over one million calls per day (outside of expiration week). No investor would volunteer to "catch a falling knife" by spending hundreds of millions on call options unless he knew that the market was going to turn around. And who would know that other than the very investment bankers and brokers who run the corporate buy-back programs for their corporate clients.
The option desk buys the calls, and then the corporate buy-back desk executes the buy-back purchases. You see, to protect you individual investors from potential conflicts of interest and insider dealings by corporate executives, the SEC prevents corporations from operating these buy-back programs themselves. So the law gives a handful of brokerage houses and investment bankers in New York all this information as well as the right to trade on it for their own advantage.
Thus, the best tipoff to a weakening volume of corporate buy- backs will be weaker call volumes during the next market plunge. Once the million plus call days start, you will know that the corporate buy backs are imminent. If the market falls, and call volumes stay low, the market has further to run on the downside.
Over the longer run, falling profits will break the psychology of the herd of corporate CEOs and stop them from engaging in corporate buy backs.
CEO's manage corporations in such a way as to maximize their power.
First, when profits fall, cash becomes scarce. Instead of presentations from investment bankers on all of the myriad ways in which CEOs can use free cash flow to hype the stock price and increase its value in takeover battles, the CFO's start getting calls from their lenders and creditors. Calls from creditors mean that your power is slipping away.
Earnings have been deteriorating for 3 quarters, but so far, the buy-backs have only accelerated. But then the brokers know exactly which companies still have good enough profits to sponsor buy-backs, and that is why the market is narrowing. Institutions buy only those stocks that have growing profits and authorized buy backs, euphemistically referred to as "liquidity" in the trade.
Thus, once the institutional investors begin to sell a stock because of falling earnings and drive its price down to a point at which most executive options are under water, the compensatory aspect of further buy-backs for the executives themselves disappears. The executives themselves are better served by issuing new options at a lower price and then waiting for an earnings turnaround before committing cash to buy-backs. At some point, institutions stuck holding the stock realize that the only thing that will boost the stock price is an earnings turn-around. They too will realize that corporate cash is better used for investment in new projects than in buying back stock.
In a market where corporate buy-backs provide the largest share of investment funds flowing into stocks, market breadth is a very important indicator of changing psychology. A narrowing market means a narrowing group of companies with the incentive to aggressively use their cash to ramp their stock prices.
As I write this piece, only 32% of NYSE companies are trading above their 200 day moving average. The NYSE and NASD advance decline lines look terrible. From Oct. 8 through Nov. 7, the Russell 2000 outperformed the S&P 500 and the advance decline line improved dramatically. At that point, it looked like the start of a new bull market. But the Russell 2000 has under performed the S&P since then. The Advance decline line has turned south as has the percentage of issues above their 200 day moving average.
This is very important. There is a reliable 4 year stock market cycle which bottoms in 1998. In addition, there is an eight year cycle and a weaker 12 year cycle of relative performance of small stocks which should bottom in 1998 as well. The failure of the small stocks in November and December (as well as the failure of mutual fund inflows) is the first evidence that a longer, more powerful cycle is a work, thwarting the expected out-performance of small stocks.
It is the first evidence that Prechter is right, and that the Grand Super Cycle (the last one of which peaked with the collapse of the South Sea Bubble in 1720) is beginning to exert its force in the market, overruling the 8 and 12 year cycles of small stock out performance and calling into question the 4 year cycle as well.
It is true that the advance-decline line often lags at the beginning of new bull markets. However, it does not outperform and then reverse at the beginning of bull markets. Nor do mutual fund inflows fall to 7 year lows at the beginning of new bull markets.
Unlike January of 1996, evidence of a psychological change is clear and unmistakable now. If the current trend of under-performance of the small caps and the below trend mutual fund inflows continue in January, you must sell!
You will notice that to this point in the discussion, I have confined the analysis of the effects of the declines in the gold stocks, the emerging market stocks and the small stocks to their effects on the psychology of individual investors. Similarly, I have confined my discussion of the slowdown in earnings and the poor breadth of the latest advance, to its effect on the psychology of CEO's who authorize corporate stock buy- backs.
It is these psychological changes that have an effect on demand for stocks, and thus have some predictive value for those of us trying to make money in the markets.
However there is a background that is equally important for framing expectations of the contrarian, looking with a wary eye for a change in trend.
The problem is deflation. Where does it come from?
Over the past year, we have had three very powerful trends: - Falling commodity prices, falling interest rates, and collapsing economies in the developing countries, the emerging markets.
In the presence of wildly accelerating monetary aggregates M-2 and M-3, we get falling commodity prices - both oil and copper are at multi-decade lows - while interest rates fall.
So why this disinflation or deflation? Where does it come from?
We have heard much discussion about the crisis in the developing Asian economies and the deflationary forces that have been unleashed in that part of the world.
But the truth about developing Asia is that American, European, and Japanese manufacturing jobs have been exported to those countries. American, European and Japanese money has been spent on factories in those countries for the purpose of satisfying demand in America, Europe and Japan.
If you look at the economies of Thailand, Indonesia, Malaysia, and China you find a relatively small fraction of the population working in the transaction economy. Most work in the self-help and barter economy of the farm and village where money does not often change hands. You will read horrific statistics about average per capita incomes of $700 or $900 per annum (a figure that includes much higher middle class incomes) and wonder how the typical person in those countries survives. The truth is that they are nowhere near as poor as the statistics on the transaction economy would make them appear. They grow much of their own food, make much of their own clothing, and build their own houses.
Joseph Schumpeter noted that economic development is a matter of "culture." That is to say, the habits and attitudes that allow people to abandon farm and village, acquire a specialized set of skills and trust that some employer will provide a paycheck are required before development can take place.
The truth is that an entire nation of individuals is not going to transform its habits and expectations, learn marketable skills and migrate to the transaction economy in several years. It requires several generations. And the Americans, Europeans and Japanese building plants in these developing Asian countries know this perfectly well.
They build manufacturing plants in these countries to satisfy demand primarily in America, Europe and Japan. Indeed 80% of the market demand worldwide comes from the developed economies.
Thus the deflation in demand that crippled the developing economies of Asia was imported from America, Europe and Japan. A very small slowing in demand from these developed economies would easily trip the developing economies highly dependent on exports of consumer goods into depression.
The source of the Asian contagion is a very gradual subsidence of consumer demand from America, Europe and Japan.
This very gradual fall in demand was felt first in the developing economies dependent on low margin consumer manufacturing. As demand from the developed world continues to subside, the malaise will spread to higher margin capital goods manufacturing, including communications, computers and telecom. Finally, the effects will spread to business services, the sector of the advanced economies that generate the most high paying jobs.
And the reason for this falling demand is falling birthrates and falling working age populations throughout the developed world.
The numbers are clear. The consuming populations of Europe and Japan are falling very rapidly - by 30% with each generation. The same is true of the Euro-American population of the U.S. Birth Rate Table The data are less clear for the U.S. because the statistics include the effects of immigration, 75% of which consists of individuals with an average IQ a full half a standard deviation below the European population of America and all of which has a much higher birthrate. This 75% works in the minimum wage economy, and does not generate enough value to finance the education of their children, their medical care and their old age retirement. Third world immigration generates only third world levels of consumer demand while generating first world social safety net expense.
The easily recognizable truth is that we have falling working age populations throughout the entire civilized world - and especially, falling middle class populations - the populations that generate real economic demand. The governments of the developed countries freely admit that aging populations, and falling populations of workers relative to retirees will tax government resources to the breaking point in about 25 years.
However, economists and the government are only beginning to recognize that these same demographics mean that the "stocks for retirement" investment boom of the nineties constitutes an inter-generational transfer as well. Baby boomers are going to be forced to sell stocks to support themselves in retirement, a trend that will begin in about 6 years, as the lead edge of the baby boom retires at age 57 to 58. Here is an excellent piece from Barrons on the demographic problem.
Thus the demographic reality is widely recognized. What is not recognized is that about 10 years before retirement, people begin to cut back on consumption and repay debt.
Aging populations are poison for economic growth. Every advertising agency in the World understands that the prime advertising audience is the 18 to 30 year olds. They aspire to status and material comforts they do not yet possess and are the most susceptible to the irrational (high margin) purchase. In contrast, people over age 45 become highly price conscious and impervious to status messages in ads as their career and consumption expectations have, for the most part, become fixed. It is awfully difficult to stimulate consumption in that growing portion of the population that, for the most part, no longer has status aspirations that can be sated with more material goods.
Oddly, these facts, so very well understood in advertising and marketing departments throughout the developed world are so stubbornly ignored by economists and Wall Street strategists. Within the economics profession, ever rising populations are simply assumed in all the forecasting models. It is assumed in the "natural rate of growth" which is always plugged in at the beginning of every forecasting model.
To an economist, falling demand is irrational and wrong. It can only exist as some sort of temporary mistake and must be corrected with government policy.
But there is a reason why economists cannot accept the notion that falling populations driving falling demand. If they plug in minus 1% as the natural rate of growth in their forecasting model, then the conclusions that flow out of the model yield socially unacceptable conclusions - economic depression and falling prices as far as the eye can see.
We have not had falling populations since the collapse of the Roman Empire. It is indeed Grand SuperCycle stuff, and therefore must be rejected. There isn't a client or customer anywhere who will accept and act upon such a conclusion.
Not only are the economic conclusions socially unacceptable: they threaten profoundly and strictly enforced sets of social beliefs that mandate low birthrates and confer status on childless yuppie couples and "alternative lifestyles". Such conclusions would threaten the notion that the purpose of modern life is to enable the individual to "do his own thing" and threaten the secular moral imperative that reproductive choices of individuals are of no consequence to their neighbors and fellow nationals.
Deflation - falling demand - does not just fall from trees. It comes from an infertility that has been powerfully reinforced by social attitudes over the past 35 years.
In sum, European, Euro-American, and Japanese populations, representing about 80% of the world economic demand, are aging and falling faster than third-world populations can make the cultural transition from the self-help economy to the transaction economy.
That is what is different this time - the final consequence of modernity - falling populations world wide.
The cause of our modern deflation is irreversible. Everyone involved in this drama for the next 30 years has already been born.
Further, there is no force in sight that might reverse the chronic infertility in the developed world, short of some alarm which might cause armed horsemen of the apocalypse to assemble, adopt the ancient social pressures of farm and village in the name of racial survival and propagate those pressures through modern means.
Thus my background "fundamental" expectation is that the forces of deflation will gather strength steadily for the next 30 years, but at a very slow rate initially. In other words, the change in aggregate demand will not be rapid enough to cause alarms among economists and Wall Street analysts who believe the thesis of Thomas Malthus. They will be content to dismiss deflation as a temporary aberration for years to come.
Thus, all other things being equal, I would expect to see a prolonged sideways movement in the American stock market over the next seven or eight years until the boomers begin to retire in serious numbers.
However, all other things are never equal, and thus there are several trends that could seriously destabilize the market and produce extraordinary up and down moves over the next seven years.
Sixty percent of new bank lending during the 90s has gone toward securities purchases, both bonds and stocks. Thus the wild growth rates of M-2 and M-3 over the past two years no longer have the kind of implications they once had for economic growth and inflation. In the old days, banks used to lend to main-street businesses, who would invest in plant and inventory, boosting economic growth. The incomes thus generated from real economic activity on main street would gradually filter through to Wall Street in the form of rising demand for bonds and stocks.
But now the banks have discovered ways to bypass main street altogether and lend directly to Wall Street for the purpose of propping up prices.
In short, the securities markets have become enormously leveraged, and are subject to severe sell-offs as this bank debt contracts. Falling rates of growth in M-3 are the tip-off to this process.
This bank lending for the purchase of securities means that the Federal Reserve has no real choice but to prop up the securities markets in order to ensure the survival of America's banks. A quick 60% market crash would wipe out bank capital at our money center banks, as would a 300 basis point increase in interest rates.
Look for the Federal Reserve's working group on capital markets to intervene whenever the S&P falls by 20%.
In addition to the enormous positions that have been accumulated with borrowed money, we have an enormous volume of option and derivative exposure. As long as prices move down slowly (as long as prices are "continuous"), the writers of these instruments can rebalance their delta hedges so as to prevent bankruptcy. See Courting Catastrophewhich argues that a 30% market crash would render the big brokerage houses insolvent. If markets start moving down rapidly, then expect the Fed's working group on capital markets to intervene directly to slow the progress.
The financial asset bubble has grown to such dimensions that it is now "too big to fail."
Irrational exuberance has captured the Federal Reserve and holds governmental policy hostage.
Given the damage that a market collapse would do to governmental resources and power, I would not expect a repeat of the collapse of 1720 in which the stock markets in Amsterdam, Paris and London fell 98% in two years. Rather, I would expect a zig zag market fluctuating in a broad trading range for the next 7 years, gradually sapping expectations of the public for positive returns. The government has too much at stake to allow a crash.
There is one final trend that might deprive governments of the power to prop up markets and that is the prospect of increasing currency volatility. As a result of high savings rates in Asia, and the aging of the European populations of the World, interest rates will be falling around the globe. As yields fall, more of the expected return from investment will involve expectations of appreciation from the currency in which the security is denominated and less from the coupon or dividend of the security itself. In an era of low yields, no investor can afford to rely on the coupon yield or dividend as he waits for prices to firm. In an era in which capital gains provide the only significant return, they will all be forced to shift out of securities denominated in falling currencies into securities in denominated in rising currencies.
Thus, in the low yield environment that is being produced by the forces of deflation, investors will be forced to move money around from one currency to another in order to achieve a yield that justifies the risk of holding low yielding securities.
Web investing has reduced costs to a point where individuals may participate in the international capital flight.
Ultimately, international capital flight will become so large that governments will be powerless to prevent market melt-downs. In the post WW-2 world of a single reserve currency, the Dollar, it was impossible for a currency led panic to develop in the U.S. However, with the advent of the Euro, there will be a competing reserve currency to which the huge pools of international capital may flee in times of dollar weakness.
The only means available to defend a currency will be interest rate increases. Thus, it is computer cipher currencies that will deprive the Federal Reserve of its ability to prop up U.S. markets. I expect this trend to be in full force within 8 to ten years.
It is different this time. Very different!
May you all prosper!
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