The Perfect Crash Scenario
(April 2, 2000) - Two Days Prior to the 15% Intraday Crash in the NASDAQ
Please note that since the following article was written on April 2, 2000, some of the information or links contained herein may be outdated.
This will probably be my last email regarding the stock market. This is because I don't believe another will be necessary. As the subject implies, the writing's on the wall. What you are witnessing is history's greatest speculative bubble that is about to burst. Following will be my final thoughts and also a summary of how weak and unstable our current domestic and world economy is. The reader will be left to reach his or her own conclusions. Always being the optimist, however, I believe we'll have at least a severe recession if not a depression (I'm not being sarcastic here). For those who are getting this the first time and are indifferent to the current state of the market, I have incorporated some of the discussion in the current state of the economy within that also!
I'd like to start this email with another quote. For the various admirers of Alan Greenspan out there, here is what he essentially thought of the stock market back on October 14, 1999 when the Nasdaq was hovering at around 3,000 (that's only five months ago!):
"Whether Dutch tulip bulbs or Russian equities, the market price patterns remain much the same."
Greenspan was referring to the Tulipomania in Holland back in the 1630's--when commoners liquidated all their possessions and speculated on tulip bulbs. After the tulip market crashed, Western Europe didn't recover for decades. But maybe you don't like Greenspan? Okay, how about Paul Volcker--the former chairman of the Federal Reserve? His comments on the market back in September, 1999:
"The fate of the world economy is now totally dependent on the US stock market, whose growth is dependent on about 50 stocks, half of which have never reported any earnings."
And this just about summarizes it. Here's a quote from Charles McKay, in his most famous work, the "Extraordinary Popular Delusions And The Madness Of Crowds," published in 1841 (just goes to show that history really does repeat itself--and pretty often too). The following pretty much sums up the state of the market for the last five years:
"Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper. To trace the history of the most prominent of these delusions is the object of the present pages. Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."
The Nasdaq in particular has been quite mad for the last five to six years. But nowhere as near as mad as it is now. At various times, the market has been complacent about certain things. For instance, interest rates and earnings. Nowadays, those don't matter anymore. In fact, nothing matters. Fundamentals, news, nor earnings (which are already severely inflated anyway, as I'd outline later in this email). All we need nowadays is a few talking heads on CNBC to move stocks. Or if you want to play it "safe," buy stocks such as CSCO, INTC, or just QQQ (the Nasdaq-100 index) instead. At the least, you will get a 20% annual return. If you buy stocks with a home equity finance loan and then buy on margin, you can pay it off in a couple of years! And hey, you can buy another house within the next five years too! Believe it or not, this is what most "investors" really are thinking nowadays.
And hey, here are more thoughts. Why did former SecTres Robert Rubin resign his position back in 1998? Why did Greenspan liquidate his blind trust and put everything into short-term U.S. Treasury notes in the same year?
Following is a link to more notable quotes. A must-read I believe:
The first is from a speech by Robert Rubin at the London School of Economics (pretty much the most prestigious place to study economics in the world) earlier this year. Funny how none of the mainstream media bothered to cover it. All the others speak for themselves.
The Beginning of the End - the Mad, Volatile, and Unstable Market
Recall my last email regarding the current market in a "blowoff phase." This phase usually overlaps with the "widows and orphans phase"--when even the most risk-averse members of society are getting into the stock market. This phase of the bull market is usually the most optimistic and the most deceptive phase of all. This is the phase when all the bad news out there is ignored. Greenspan's warnings. Press releases about margin debt from both the NYSE and the NASD. Interest rate hikes and tightening from the Fed. Rational dissent is scoffed at. We will have consecutive sessions when the major indices would rise in a parabolic manner. Analysts with absurd target prices for major stocks for no reason at all--a one trillion dollar market cap for Cisco, a $170 price target for Intel from out of the blue, and $500 for Rambus. Volatility is the order of the day, and momentum investing is the way to make money. A phase where even perpetual bears are tempted to jump in. A bit of trivia: On approaching the top on September 3, 1929, the Dow Jones Index (or some other major index at that time which I don't recall) rose in value for 19 consecutive sessions. Thanks to Roger Babson, prices broke the next day. I believe that was probably the turning point--when reality started creeping back into the minds of investors. The market traded sideways with great volatility for the next five to six weeks--until prices started breaking in mid-October.
I keep track of the prices of nearly 200 stocks in various industries and sectors--from telecommunications, biotechnology, B2C and B2B internet plays, financials, aerospace, all the way down to energy, gold and silver mining and I can conclude that the market is now irrational. Stock prices move in huge percentages in both directions for no reason at all. The "hot money" shift from one sector to the next depending on which sector is hot during that day. Throw out the macroeconomics 101 that you learned in high school about "rational expectations." And while you're at it, the term "efficient markets" as well. The economy has never been rational because the public has always acted in a herd (or sheep) mentality. Most have no idea on the effects of monetary policy decisions, shifting of economic trends, and even demand and supply. Like I said in my previous email, because of that, they are held hostage to the views of the mainstream media, which in the majority of times when major economic trends shift, is incorrect. The stock market acted in a rational manner before most of the public got in. Now, it is not.
Take the 1998 collapse of the hedge fund Long Term Capital Management and the Russia Crisis, for example. Alan Greenspan testified in Congress shortly after the debacle and he stated that, in his opinion, if LTCM was allowed to become insolvent, the world economy would have collapsed. Can't envision it? Well, not everything will implode at once but there will be a domino effect--large banks would fail, countries after countries would be embroiled in financial crises, and they won't be alone. The United States would suffer a huge devaluation. All those years of current account deficits would finally catch up with us when foreigners start dumping our dollar. Banks would fail and Greenspan would be forced to go to the printing presses and bail them out--resulting in hyperinflation. The bubble in equity and real estate prices would implode and the myth of a significant amount of investors committing suicide in 1929 won't be a myth anymore. To envision this, you need to have a good background of what LTCM was all about. Check this out: http://slate.msn.com/Dismal/98-10-01/Dismal.asp
As mentioned in the article, LTCM had an asset base of approximately $2 billion and a notional asset value of approximately $1 trillion. Now, look at this: http://www.cornerstoneri.com/derivatives.htm or this: http://www.occ.treas.gov/ftp/deriv/dq499.pdf. This is much bigger than LTCM. I honestly do not know how to interpret these numbers but they are HUGE. For example, Chase has an asset base of a little over $300 billion but a notional asset value in derivatives of over $12 trillion. J.P. Morgan $160 billion and $9 trillion, respectively. A mere 3% move on their outstanding positions against them could wipe out their entire asset base, and if LTCM had been allowed to collapse, possibly trillions of dollars in losses on top of that. Finally, I have also mentioned the current account deficit. This is a simple concept, equivalent to international finance 101. Basically, we have this equation:
Current account balance + capital account balance + official reserve account balance = 0
That means a deficit on, say, the current account balance must be offset by a surplus in either or both the capital and official reserve account balance. The former involves a transfer of real or financial assets while the latter involves the governmental transfers of various currencies, gold and SDR's. Currently, the cumulative current account deficit (the current account balance) is at over $2 trillion with each new monthly figure breaking records (http://dowjones.wsj.com/i/bank/ON-CO-20000330-000141-d-industry-c1-bank.html). This deficit in the current account balance has been offset by foreign governments holding American fiat currency (which has no intrinsic value, by the way) and foreigners purchasing American bonds, stocks, and real estate. These two factors have been of great importance in supporting our currency. Without them, the value of our currency could not have held. It would have had to have decline to an extent where imports would be so expensive and exports vice-versa that our current account deficit would turn to a surplus. The benefits stop here, however. Ironically, these two factors have been precisely the factors fueling our current account deficit. In a way, they have artificially supported the American currency, the current spending and the speculative boom. Of course, it doesn't matter as long as the funds keep flowing in, especially with this "bull market" that we have been experiencing. However, when the funds start to leave (similar to what caused the Asian Crisis), watch out below. All those years of paying "monopoly money" to other countries in exchange for the BMW's, DVD's and other foreign gimmicks would come back to haunt us (in a way, it's almost funny to think that they would accept money from us--money straight from our printing presses). The potential trigger? Most obviously, a crash in the equity markets (the flight of capital could also cause a crash, however). Yesterday was another significant day when George Soros decided to transfer some of his funds to the Japanese market (http://cbs.marketwatch.com/archive/20000331/news/current/soros.htx?source=blq/yhoo&dist=yhoo). The value of the dollar relative to the yen declined by 3%, and in the process, I'm sure that he has sold most if not all his domestic technology holdings.
But I digress. Basically, when LTCM collapsed, the world economy was, according to Greenspan, on the verge of a financial collapse. When the news hit the wires, fund managers started to sell their equity holdings--hence the mini-crash in 1998. Most of the individual investors that day, however, were actually buying stocks! Coupled with the support of Greenspan and the CPT (Crash Protection Team) the next day, the market actually recovered. My point is that investors nowadays are either ignorant or irrational or most probably, both. To them, every "crash" is a good buying opportunity. There can never be a secular bear market which we experienced during the early 1930's and the 1970's. I've actually run into a few people who are now sitting on cash and who are going to buy into the market when it crashes. Doesn't a 1000-point decline in the Nasdaq in a day mean anything to these people? How about the term "Great Depression II?" Or maybe, just maybe, "common sense?"
I have emphasized in my two previous emails that this party could go on as long as we have enough liquidity. Stocks were probably already overvalued in 1995, but there were enough funds and "greater fools" out there to support these overvalued stocks. Of course, it took some more convincing down the road to induce more risk-averse people and the Common Joe to buy, but thanks to Greenspan's bubble preservation policy, the 83% advance in the Nasdaq in 1999, and CNBC, we have achieved just that. People could never have envisioned this in 1995, and thus most, if not all, bears were incorrect in their timing of the beginning of a bear market. Bears, if there are any left, are now ridiculed. In the latest development, Julian Robertson, a value investor, legendary founder of the Tiger Fund (probably most well-known besides George Soros), is now forced to shut down his business. This is after a >30% annualized return since the founding of the company twenty years ago, and a 70% annual return as recently as 1997. People are now basing expectations on "historical results" (ie. performance for the last eight years instead of the last eighty years or the last century) and extrapolating rosy performance and annualized gains of >20% for the foreseeable future. I hate to break the news to these people but all Greenspan has done is to further over-extend the business cycle. The Fed's original goal was to "smooth out" business cycles since with laissez-faire, these cycles (peaks and troughs and everything in between) could be pretty volatile. If the Fed has stuck by its goal, it would have ended the party by late 1996--right before the onset of the Asian Crisis. If the Fed had just left the economy alone, the current "boom" would have ended in either 1997 or 1998. Instead of "smoothing out" business cycles, however, Greenspan and his minions have now "eliminated" them by fostering and preserving a bubble. Imagine a roller-coaster ride. The Fed is supposed to regulate the builders so that they can't build it as high as physical limits would allow. If the Fed leaves them alone, the builders will build it higher. Sure, the ride may get bumpy but it is theoretically still safe. Instead of regulating, however, the Fed has induced the builders to build the roller coaster ride much, much higher than physical limits would allow, and they are still not done. The public actually thinks this roller-coaster ride up could go on forever, but this is dangerous and not sustainable. If one still believes in the fundamental characteristics of a business cycle, then the way down could be worse than any downturn we have ever witnessed.
I would never send this email out if it wasn't for this. I have emphasized and re-emphasized it and this is getting more apparent with the everyday developments. Liquidity is RUNNING OUT. First of all is the premise that "everyone" is already in the market--from the highest to the lowest of society (I have seen many more examples about this after my last email). Everyone that is a potential "investor" is already "in." A share is only worth what the next person is willing to pay for. If there are no more willing buyers left, then a stock is essentially worth nothing. And of course, there is always margin debt: http://www.nyse.com/pdfs/margin.pdf.
From November 1 to February 29, 2000, outstanding margin debt increased nearly 45%. Year-over-year, this figure increased >75%. Never has outstanding margin debt increased so much so quickly. Prior to the peak in September, 1929, outstanding margin debt only increased 55% year-over-year. And remember all that $$$ that Greenspan pumped into the economy in anticipation of Y2K (this is the major reason why the Nasdaq has experienced a parabolic rise since November of last year)? Well, the Fed is now reining in the monetary base: http://www.stls.frb.org/images/publications/usfd/page2.gif. Coupled with the latest tightening and the threat of a 50 basis point hike in May, it is apparent that the Fed is cutting back liquidity. Of course, the expansion of the money supply is not solely the Fed's doing--as banks have been the main culprits for creating money in the last few decades or so. That being said, the latest release by the Federal Reserve shows the latest weekly average of M3 actually DECLINING from the prior week (http://www.bog.frb.fed.us/releases/H6/Current/). This is something I have rarely seen. Finally, fund inflows traditionally start slowing in April. Potential for disaster? That's an understatement.
In fact, I would be bold and declare no matter how you look at the current stock market it is very, very reminiscent of the stock market from late August to mid September of 1929. Current pricing patterns of the stock market. All the economic and social indicators. A tightening Fed, an unprecedented cumulative credit creation, a feeling that "stocks would always go back up" (similar to the first-time teenage driver thinking that he or she is "invincible"), distorted valuations, "widows and orphans writing naked put options," and the dirty deeds of companies being finally revealed--such as that of the investigation by the FTC of Yahoo! and the Justice Department of eBay (as more companies start filing their 10-K's, the truth will finally come out), etc, etc, etc. As the title implies, the writing is on the wall. In my first email that I sent out approximately seven weeks ago, I made a prediction of within six to nine months for a major crash. I am now revising my prediction to within two to three months. Prices are in the stratosphere while liquidity has all but disappeared. What remains now is merely a game of musical chairs with no chairs. When the music stops, the ones who get stuck holding say, CSCO, would lose it all. It could get ugly.
The Case for a 90% decline in the Nasdaq
First of all, it is important to emphasize that I am not expecting this to happen overnight. Rather, this slow but sure decline will occur in the Nasdaq over the next three to four years. Just as P/E ratios never mattered in this bull market (as of early March, the P/E ratio for the Nasdaq Composite--which consists of approximately 4,800 stocks--was over 260), ironically, they won't matter on the way down either. Funds and pension plans would go back to bonds. A multitude of investors would swear they'll never own a share again. In a bear market, there will be ample opportunities to lose money! Stocks such as CSCO and YHOO would decline 50% year-over-year for the next three to four years. The smaller and unprofitable companies would either go out of business or be acquired. For people who are going to cling on to their shattered dreams and use what they have learned over the last three to four years and "buy on the dips", they will lose all their money. Even people who start buying former highfliers at 10 to 15 times earnings will probably lose 30 to 40% of their money as well.
This is not difficult to imagine. Like I said in my first email, when Disney and McDonalds crashed during the early 1970's, their respective P/E ratio sank to a mere six. As of the closing on Friday, Philip Morris has a P/E of approximately six. At the same time, Cisco has a trailing P/E of over 200 and Yahoo! over 1,600. If their respective P/E ratios ever decline to six, it'll mean a 97% decline in the former while a 99.6% decline in the latter. There will be a lot of tears and lost fortunes.
Why would investors flee the stock market, you may ask? Sure, the speculators would get wiped out by the initial crash, but there are also a lot of prudent people out there who aren't on margin--they will start buying when the stocks are "reasonably valued." Not so fast. Firstly, a significant amount of people out there (ie. people who have driven Cisco to 200 times earnings) are pure speculators. They are more numerous than you think--as exemplified by outstanding margin debt (not to mention home equity loans, credit card debt, etc.). The biotech crash during the last few weeks showed the destruction that margin debt can have. Secondly, most fund managers are also playing this game of musical chairs. They are forced to buy shit in order to achieve unattainable returns. When the market crashes and these funds take a hit, fund investors would withdraw their funds en masse. These funds would be forced to liquidate their stock holdings to pay their redemptions, thus further driving down stock prices.
However, the main factor that will be driving down stock prices is that a boom always sows the seeds for a bust. In a boom, nothing really matters when we have rising equity and real estate prices. Banks make bad loans, aggressive accounting is ignored, and people are generally very trustworthy. Conversely, in a bust, people are more suspicious. Every financial transaction is carefully scrutinized, and people tend to save more. It is this discipline which sets the stage for the next boom or bull market. What we currently have are numerous companies committing financial atrocities which range from aggressive accounting to something just short of outright fraud. In the following, I will outline some of this--discussing companies like Microsoft, Cisco, and Dell in the process.
And the following is rather long and controversial, but interesting anyway. If you don't have time, at least look at the first chart:
According to GAAP accounting, during the last fiscal year, Microsoft made a profit of $7.8 billion. $5 billion of that came directly from selling their own stock. $3.1 billion from a tax deduction of wages they did not have to pay in the first place, $1.3 billion from the employees in the same payroll deduction, and over $700 million from writing put warrants on their own stock. Because of its stock option programs, Microsoft also avoided paying $9 billion in wages. Reality check: Microsoft actually had a NET LOSS of over $10 billion during the last fiscal year. Of course, as long as the market and the stock price of MSFT keep rising, it doesn't matter. But after the market collapses, this whole pyramid scheme would also collapse (they will actually have to start paying their employees)--plunging Microsoft into the red and subsequently, its stock price.
Moreover, the latest news just came in and it looks like the latest mediation talks have failed. I believe the chance of a breakup of the company is now pretty high. If Microsoft is indeed broken up, then this pyramid scheme would finally be revealed as well. So would the collapse of the market result in the collapse of Microsoft or would it be vice-versa? We shall see.
Read this in sequence:
The author makes an excellent case regarding Cisco's fraudulent accounting. The use of stock options is again mentioned. A new one, however, is the number of acquisitions that Cisco has been making. The expense of these acquisitions, the author argues, should be charged as R&D, and therefore a business expense. Cisco has merely shifted these costs from the balance sheet through equity issuance. If prudent accounting prevails, all these expenses should be charged to the income statement.
Cisco's net income as touted by the mainstream media and the public:
FY 1996...FY 1997...FY 1998...FY 1999..FY 2000
Factoring in the stock options gimmick and R&D expense or, in other words, the true costs of running the company:
FY 1996...FY 1997...FY 1998...FY 1999...FY 2000
Like the author says, Cisco is purely a "concept story." In fact this whole "New Economy" concept is pure BS. What these new "visionaries" such as John Chambers have touted all along is hubris in the highest form. Of course, this mania has lasted so long 'coz there were still ample funds for us to play with (thanks to Greenspan) and more Greater Fools out there to buy the worthless paper. As I have argued, however, these funds (liquidity) and the number of Greater Fools are running out.
From fiscal 1996 to 1998, Dell had $2.5 billion in net income. During that same period, however, Dell's earnings from writing put options and buying call options on its own stock was $3.1 billion. They have used the proceeds from writing put options to buy the call options in a rising market--thus greatly inflating earnings. This inflated earnings resulted in a higher stock price, thus leading to a higher profit for Dell on its call options which in turn further inflated earnings. As one can see, this cycle continues on until it can no longer be sustained. Who wants to bet that last year's Y2K blowup of earnings (and Taiwan) wasn't mainly due to inventory problems? Dell's stock price was flat all last year--I bet they just haven't been making any money on its call options. Like the article said, the main business of Dell over the last four years have not been about selling computers at all, but rather, financial speculation.
The latest 10-K (annual report) filing was just made last Friday and the cat is finally out of the bag. On page 46 of the report, we have the following:
"Stock Compensation. The Company accounts for stock-based compensation in accordance with the provisions of APB 25. Had compensation expense been determined based on the fair value at the grant dates, as prescribed in SFAS 123, the Company's results would have been as follows (in thousands, except per share amounts):
Net income (loss) 1999 1998 1997
As reported $ 61,133 $ (12,674) $ (43,376)
Pro forma $ (256,023) $ (63,529) $ (50,043)
Net income (loss) per share:
As reported – basic $ 0.12 $ (0.03) $ (0.11)
Pro forma – basic (0.50) (0.15) (0.13)
As reported – diluted 0.10 (0.03) (0.11)
Pro forma – diluted $(0.50) $ (0.15) $ (0.13) "
So according to SFAS 123, Yahoo! actually lost over $256 million last year. I wonder how employees would feel if YHOO stops appreciating. The company may actually have to start paying them. When this happens, watch out below.
The most blatant form is exemplified by Priceline.com's aggressive accounting. Essentially, they have booked the whole value of the airfares and hotel rooms that they have sold over the internet as their own gross revenues, when all they should have booked are the commissions that they received. When this is corrected, the $152 million gross revenue figure that is found in the latest 10-Q should be revised down to a mere $18 million. This $18 million figure was actually termed "gross profits!" This is absurd. There is no way a company such as Priceline.com could ever make a profit on $18 million of quarterly revenue. Not now and not in the next millennium.
So there you have it. As exemplified by the biggest companies traded on the Nasdaq and in the world, the main business of America nowadays, whether it's the companies themselves buying and selling options or the employees trading stocks over the internet, is financial speculation. 40% of GE's earnings come from GE Capital, its financial services arm (http://cbs.marketwatch.com/archive/20000401/news/current/ge.htx?source=blq/yhoo&dist=yhoo). A couple of days ago, the SEC revealed that it is thinking of classifying Yahoo! as a mutual fund, since 75% of its assets (more than the 45% threshold allowed) is tied up in stocks and mutual funds. Then there's CMGI and ICGE. All these have served as the ultimate financial pyramid scheme which would further enhance the fall when it ends. Never has there been a spectacle such as this--a sort of financial incest paralleled only by the investment trusts of the 1920's. When the Nasdaq bottoms three to four years from now, I believe it will be trading at near 500.
I was going to spend a few moments to discuss the excess credit creation but I feel this email is getting long enough already. So I'll try to communicate this by appealing to common sense. In my local area during the last 12 months, there has been unprecedented real estate buying and construction. New banks, drug stores, shopping malls (Chinatown), restaurants and hotels/motels (Westheimer and Beltway 8) being built monthly. Newsletters touting the "New Economy" piling up in my mailbox. Are we really in such a prosperous society? It seems like all of a sudden, Americans have managed to discover an ancient pillar of wisdom, one that would eliminate all inefficiencies in the economy and produce a cure for cancer at the same time, if you will. We are either in such a society or a bubble. And I am betting for the latter.
Finally, to make this all humorous, here's an amusing link: http://gwbush.com/crash/