How Y2K Could Sink the Stock Market

The stock bubble of 1999 constitutes perhaps the most dangerous, speculative investment climate ever. Exactly three score and ten years after 1929, the world seems poised on the verge of an equally ruinous stock market collapse.

As the Dow Jones Industrial Average of blue chip American stocks passed 10,000 and then 11,000—the last extremely volatile surge representing the fastest 1,000 point rise ever—the speculative orgy of day traders ramping the price of Internet firms and other unproven enterprises started to resemble a casino, with the players punch drunk on the free booze of easy credit. Overvalued markets tend to become even more overvalued; in normal times it would be hard to predict just how long this unstable situation would last.

But this is not a normal market. In light of the historic Y2K or Year 2000 computer crisis, the complacency, blindness and greed of the stock orgy has been nothing short of astonishing. The vessel is now out of control, the S.S. DowTanic is recklessly into overdrive.

But the DowTanic is racing headlong into an obstruction it cannot avoid: Y2K is now less than six months away. The general public has dismissed warnings that this epochal event may be considerably more than the trivial weekend glitch the bubble-blowers would have them believe. Yet Wall Street and Bay Street continue to pump air into the stock balloon, singing the calming refrain of "Y2K-OK."

The financial establishment and investors, which wish desperately to believe Y2K will indeed be OK to their stock prices and industrial infrastructure, has put all their hope into a misunderstood declaration by Canadian, Peter de Jager, who issued the Y2K distress call in 1993.

In March 1999, a perceptual if not a technological catastrophe suddenly reversed itself when de Jager declared "we have broken the back of Y2K." The impact on Y2K hoarding activities, the stock market and media coverage, was immediate. Public sentiment swung from 'Y2K Apocalypse' to "Happy days are here again".

If the Dow's resurgence wasn't enough, statistical surveys soon backed up the new complacency. The Canadian Bankers Association (CBA)—engaged in a relentless campaign to dissuade people from withdrawing cash from the banks—found that only 28 per cent of adult Canadians were concerned about the personal impact of Y2K in April 1999 from 41 per cent in December 1998. The media returned to ridiculing or ignoring Y2K. Radio advertisements joked about camping equipment. Power generators and wood stoves, supplies of which had all but dried up in January, were suddenly available again.

We are not saying that Y2K is the end of civilization as we know it. We expect the world will muddle through somehow technologically and logistically. The fallout we care about is the financial and investing one.

Amazingly, the CBA showed that while the percentage worried about Y2K's impact on banking dropped from 16 per cent to 10 per cent, those worried about their investments fell from a miniscule two per cent to a negligible one per cent. Complacency indeed! This was at odds with an Angus Reid Survey, which found 42% of Canadians were somewhat, very, or extremely concerned about the impact on their investments; but only 15% (of the 42%) planned any changes to their portfolios.

Even Peter de Jager is astounded by the complacency that greeted his widely reported Doomsday Avoided essay, which ran first on his Internet site and was quickly disseminated—with varying degrees of accuracy—throughout the world's mass media. As he told us in frustration, "the media can't sing in middle C." Even after issuing his seeming "all clear," de Jager himself remains out of the stock market and does not intend to reenter it until July 2000. That fact, or the equally ominous observation that the Y2K problem outside North America continues to threaten, seems to have been omitted in the Y2K-OK headlines. And so the U.S. stock market has entered another dimension, unrestrained by fears of Y2K, or indeed any traditional notion of value, fundamentals or sanity.

The question remains—if Main Street is worried about a possible Y2K-KO (as in Knock-Out punch), why isn't Wall Street? With the exception of the odd voice in the wilderness, such as Ed Yardeni of Deutsche Bank Securities, the investment industry seems oblivious to what is about to take place. The fact is that even without Y2K, the stock market is seriously overvalued and headed for a fall. You should understand that even if Y2K were a trivial phenomenon, there would still be serious concerns about stock price valuations. Y2K is just the disastrous icing on a very volatile cake.

It is inescapable that Y2K threatens to be the trigger to a stock market implosion and subsequent recession/depression that will threaten the financial lives of today's over-stretched, over-leveraged North American investors. We use the term "investors" loosely, for many of today's stock punters are merely gambling with their life savings.

Without Y2K, the stock bubble was set to burst but the precise timing was indeterminate: perhaps 18 months from now, maybe three years. But because the timing of Y2K is so precise, we can foresee almost exactly when the debacle will begin—December 31, 1999, plus or minus a few months. A gradual sell-off appears to be taking place. It could even be delayed a few months into the century, as North American markets slowly fall once the mess of Overseas Y2K becomes apparent.

Governments are now committed to down playing Y2K in order to minimize widespread panic by their citizens. Don't rely on large corporations to fess up: no CEO wants to torpedo his or her stock price. And the major media? They too are publicly traded corporations and reluctant to upset their advertisers.

The crash of the century could rival that of 1929-1932 in its depth and breadth. Most equity mutual funds would lose value, with the possible exception of precious metals funds.

What if we are wrong? The downside will be that you will "only" gain five or six per cent by being in bonds and cash, plus a few more aggressive investments for those with money to burn. The risk/reward ratio of a stock market that has denied such disruptions as Y2K is so far out of whack that the possible upside of remaining in the market isn't worth the far more devastating downside.

Where 1929 featured a mania over radio stocks like RCA, 1999's exuberance is focused on Internet stocks like AOL and Amzon.com. Yet 1929 had no obvious, time-dated trigger point to ignite the meltdown, certainly nothing as marked in stone as the immovable December 31, 1999 deadline. The "pinprick" that will deflate the stock market bubble may be an understatement—Y2K could be the detonator that will usher in the most devastating transfer of wealth ever seen in history.

With a polarization between those with a vested interest in Y2K-OK and those with the opposite hope for Y2K-KO, it's understandable that the average person is confused and tuning out altogether. Indeed, Peter de Jager says if he had to choose between media neglect and media sensationalism, the neglect option would be preferable because it carries less chance of the "self-fulfilling prophecy" carrying the day.

For the last year, Internet investors have been living a double life: they believe in e-commerce and are confident the "greater fool theory" will always make them short-term trading profits on the Internet stocks. They know the supply of greater "fools" will run out and they are also well aware of the Y2K problems discussed on the Net. Never before experienced in stock market investing and "market timing," for the first time, we know precisely when a financial crisis will occur.

The Internet stock investors are not so foolish as to believe they can wait till December 31 to unload their stocks. They believe they can play "chicken" with the oncoming train and milk the last few months of profits out of the game. Sometime in the third quarter—unless political pressure is applied—two or three Hollywood blockbusters on Y2K will come out, feeding the panic even more. Instead of a meteor colliding with the earth and ending life as we know it, Y2K will bring in the digital apocalypse, or digital Titanic. If these films don't make it to the silver screen, the very fact the Washington-Hollywood axis took Y2K seriously enough to censor such films will in itself be a valuable insight into what is about to take place.

If you remember August/September of 1998, then you have an inkling of what October, and more likely September, 1999 could be like. To this potent mix, we must also add another major ingredient: mutual funds. A worst-case scenario was described by Richard Band back in 1996: he predicted a coming mutual fund sell-of as the "panic of the bear market virgins." Even without considering a trigger event like Y2K, Band described a panic with frenzied selling both by middle aged investors and by young mutual fund managers, 90 per cent of whom were not in the business during the crash of 1987.

If and when the sell-off picks up steam, it won't matter what kind of equity fund you are in or which geographical region it specializes in. Perhaps, technology funds and NASDAQ-heavy funds will vaporize first, followed quickly by U.S. small caps, then the blue chip funds. Canadian equity funds will go down with the U.S.

Even if the massive public relations campaign to deny or ignore Y2K succeeds in North America, gradually the mess of Overseas Y2K will infect complacent North American investors. While North American bulls and bears are duking out in the Y2K-end game, Y2K will have already triggered a slump in non-North American funds. Asian, Latin and Emerging market funds are all invested in countries where Y2K compliance is minimal or non-existent. Europe will also be a casualty because of its focus on the Euro currency instead of Y2K fixes. Global equity funds will have nowhere to hide and once the U.S. market falls, the bear market virgins could be trampled in their rush to the exits.

On the topic of more general Y2K survival, we are moderates. Civilization continues but not without huge economic and financial stresses. Canadian and major U.S. banks should be fine and the average person will have to withdraw only a few thousand dollars in cash for the century change: not every penny you have in the bank. In closing, as difficult as the Y2K chaos could be, there is a silver lining to the Y2K cloud. As the debris of stricken financial systems is swept aside, don't forget that there will be a terrific investment opportunity of a lifetime—an opportunity to buy equities "on the cheap". In this regard it is good and timely advice to recall the words of English entrepreneur Thomas Lodge who, on the topic of making money, uttered the now famous phrase "buy cheap, sell dear" in 1595.