Are we Hearing Voices from the Past?

Why this time the resulting bust will be worse:

The 1929 bubble was largely not participated in by the majority of the public. The majority of the speculators at the time were the wealthy. Today, stock market investment by the public is at all time highs and is deeply intertwined with the economy. More than half of American households now have some exposure to the stock market, either through direct ownership of shares, through mutual funds or through the nearly ubiquitous 401k retirement plans, according to Federal Reserve Board studies. The Fed goes on to report in more detail that individuals now hold more than half of all stocks and another 20 percent in mutual funds. More than a third of households now have money in mutual funds, up from a quarter in 1990 and up from only 6 percent in 1980. In fact, last year Americans had more of their assets tied up in stocks than in their homes, the first time that has been the case since the booming market of the late 1960s. Currently, more than 28 percent of household assets are in stocks, which is the highest level since the Fed began keeping figures after World War II.

The savings rate of U.S. investors hit a post-World War II low of 3.8% in 1997, or half the savings rate of the previous generation. As of September 1998, the U.S. savings rate turned negative for the first time since 1938, during the Great Depression. Over 90% of the total new investment in mutual funds has been comprised of transfers from retirees and near-retirees switching from a lifetime of safe, traditional savings accounts, GICs, annuities, and bank CDs into mutual funds. The question is who is left to buy when the stock market beast eventually begins to reverse course and march downward? Even municipalities and state pension funds have jumped wholesale into the stock market in the last 5 years. In late June 1997, the State of New Jersey finalized an arrangement to borrow 2.8 billion dollars at an interest cost of 7.6% and an up-front fee of fifty million dollars in order to invest the money in U.S. equities. In other words, the state of New Jersey went "on margin." With President Clinton recently announcing his intention to invest a portion of Social Security funds in the stock market, who is left to jump on the bull bandwagon?

Finally, the U.S. is currently the largest debtor nation in the world with an enormous trade deficit whereas in 1929 we were the largest creditor with a huge trade surplus. The burden of the U.S.'s enormous national debt (that currently consumes around 25% of the annual Federal budget in interest payments) will make it difficult if not impossible to use fiscal stimulus to get out of the hole that the U.S. is digging. In 1929 the U.S. government was running surpluses. Today, despite what President Clinton and Congress may claim by using accounting gimmicks to show a budget surplus, the U.S. government is running deficits that will only get worse. The deficit is likely to balloon as capital gains taxes that have flooded in over the last few years in response to the stock market boom grind down to a trickle. The only alternative to fiscal stimulus will be to run the printing press which Alan Greenspan has already begun doing with his 3 rate cuts in the Fall of 1998 and has been his pattern anytime problems pop up in the economy or financial markets. Since history shows that countries cannot print their way out of their problems, the U.S. will likely end up destroying the dollar in a vain attempt to paper over her problems. A consequence of this will no doubt be to make things easier on the rest of the world by making it easier to repay their dollar denominated debt, but by the time the dollar's decline comes to pass, it may be too late for many countries as many central banks (who historically sell at bottoms and buy at tops) have dumped their gold for worthless U.S. paper. The panic out of dollars will likely be unprecedented. In 1929, the US was on the gold standard so there was something to back up our paper. Today, we are not. We have NO foreign currency reserves to speak of. Imagine what Hong Kong would have looked like in 1997 or Brazil in 1999 if they had no foreign currency reserves with which to defend their currency when the rush to liquidate the country started. It was bad enough for those countries when they had reserves. There will truly be a disaster in the dollar. That is for certain.

What will end the bubble:

Bubbles by their very nature are unpredictable. This one will likely be no different, but there are a few likely "pins" that could prick the bubble and bring on a disaster. The U.S. dollar will likely be the key but not the catalyst.

The dollar topped in August of 1998 and is down around 9% against most European currencies and more against the Yen (see Figure E). Obviously any weakness in a currency is an early "heads-up" to investors of coming trouble in that country's economy, but U.S. investors continue to frolic in internet and tech stock shares totally oblivious to anything but dreams of profits. A falling bond market will likely sober up these drunken participants in a hurry. The market has seen consistent selling by the Japanese in both the bond and stock markets since mid-Summer 1998. Additionally, huge borrowings of yen by hedge funds (yen-carry trade) are now "losing" positions and are being liquidated and repaid as the Yen rises, accelerating the dollar/yen decline. Bank of Japan has recently lowered interest rates to almost zero, and the entire planet knows that Japan's economy is awful…. that likely marks a bottom in the yen. It can't get much worse for Japan and its currency unless the island sinks into the Pacific, or they start dropping yen from planes on the populace. More importantly, the Japanese government announced on 12/22/98 that they would cease purchase of Japanese long-term government bonds. In essence, they have decided to allow their long-term interest rates to approach those of most European countries. While still below nominal yields on U.S. long-term bonds, the effect of higher Japanese rates will serve as significant competition for U.S. Treasuries, since the yen generally appreciates against most currencies over any extended period of time due to their consistent trade surpluses. Also, the Japanese themselves, historically substantial buyers of U.S. Treasuries, will be more inclined on the margin to purchase their own country's bonds. The multi-year recession in Japan and the BOJ's recent intervention to slow the Yen's advance have dampened the speed of the yen's appreciation, but the up-trend is still clearly intact and more importantly the BOJ seems to be committed to a stronger Yen in the long term. This is evidenced by recent statements on 1/4/99 of Japan's vice finance minister for international affairs, Eisuke Sakakibara, in which he responded to a question of what the dollar/yen rate in 1999 should be and how Japan was going to respond to the recent soaring Yen. He said:

''it all depends on relative strength of Japanese and U.S. economies. The U.S. economy has entered a slowdown phase. Should the Japanese economy pick up from the middle of the year, the base trend will be a stronger yen.''

Reinforcing what the currency markets are saying were his comments regarding the U.S. as "bubble-like." He said:

''My upmost concern is high U.S. stock prices. The U.S. economy already looks fairly bubble-like. A nation whose saving ratio is negative is consuming a lot. Such an economy is bound to slow once stock prices fall. Measures to stimulate the economy and additional interest rate cuts will be high on the U.S. agenda this year.''

Even more concerning for U.S. investors regarding Japanese psychology towards the U.S. markets were his recent statements on 1/22/99 in which he said:

``I hope that in the next 10 to 20 years we could avoid both depressions and war, but there is a definite risk of world financial collapse."

Sakakibara also predicted that what he called the regime of laissez faire or market fundamentalism dominated by the United States in the 1980s and 1990s would not continue into the 21st century. U.S. dominance, political and economic, was declining, he said, citing the unification of Europe and instability in global capitalism.

In addition to the Japanese selling, large amounts of U.S. treasuries are owned throughout the world by central banks that have begun to diversify some of their reserves out of dollars and into the new Euro and gold. With 60% of the world's central bank currency reserves being in U.S. dollars, there is no shortage of supply to the market. More than likely, at some point in the future there will be a panic out of dollars as the world realizes that the "emperor has no clothes."

Dr. Lawrence B. Lindsey, former Federal Reserve member and now private economist and scholar with The American Enterprise Institute testified on 1/20/99 to the Senate Budget Committee. He stated:

"In each year of this decade, foreigners have invested more here than we have abroad. That means, if we were to somehow "settle up" we would have relatively less to sell them than they have to sell us. In short, we are becoming increasingly indebted, on net, to foreigners."

This is a big part, obviously, of what formed the bubble. Foreigners have poured capital into the U.S. for the last five years as shown by the strong up-trend in the dollar since 1995 (see figure E) as well as the corresponding ballooning of financial assets since that time. The Asian crisis and Russian default peaked dollar buying as investors panicked into so-called "safe haven" U.S. treasuries and stocks. There's nothing like a panic to mark a top or bottom, and no rational man could possibly call the current state of the U.S. stock and bond markets a "bottom." Mr. Lindsey continued and described exactly the scenario that I have put forth to mark the end of this mania:

"In the past three years this annual increase in America's international indebtedness has skyrocketed to well over $200 billion per year. Just like the ever falling level of personal saving, an ever rising indebtedness to foreigners is not a sustainable proposition. At some point foreigners will begin to question our creditworthiness and stop lending us ever-increasing amounts of money. If that were to happen suddenly, interest rates in the United States would have to rise sharply in order to ration the demand for credit given the reduced supply of financing. With higher interest rates, the rate of discount of future corporate profits would rise, the value of future income streams would fall, and the stock market would fall."

The result of this selling pressure by foreign investors in the bond market (which is even more leveraged than stocks due to the leveraged strategies of hedge funds such as those of LTCM) will most likely result in a crash in bonds at some point. The 30-year treasury will likely crash-up in yield to around 6% on the initial move and possibly 7+% after that (see figure I). Since low interest rates are the only thing keeping the stock market bubble inflated, a corresponding crash will likely ensue in the stock market as investors sell stocks to seek higher yields in the bond market. The actual catalyst for the initiation of a crash could be anything, but the fundamentals that set it up will lie squarely with the weakness in the dollar. The effects of this scenario will truly be a disaster for the U.S. and world economies, not mention U.S. stock and bond holders. The result would be higher long-term U.S. interest rates and lower U.S. corporate profits, since all U.S. corporations will have to borrow money more expensively. Compound this with the likelihood of a corresponding SEVERE recession because the economy has become so intertwined with continuing profitable speculation in the U.S. stock market. Then throw in the likelihood of a U.S. recession sending the rest of the world into a depression (as we are currently the only buyer of goods left on the planet), and you truly have a dire possible future. Just when you didn't think it could get any worse, there's also the fabled Y-2K problem that will cause capital investment spending by businesses to drop (most replacement purchases were done by late 1998 according to most U.S. companies) as they attempt to re-code their systems as well as possible supply chain failures from Y-2K "crashes" at numerous facilities around the world that will not be compliant in time.