Market View - February 1999

The stock market action over the last month was typical for the season. We started off with the usual sharp January rally, it fizzled a bit and then finished on a positive note. The one thing you couldn't help notice was the numerous stock split rallies. A number of prominent blue chip companies announced stock splits during the month. As is usually the case, their stocks immediately rallied sharply. Of course splitting a stock has nothing to do with the value of a business or the percentage of it you own. But it does highlight something I've been saying about this environment all along. It's not being driven by fundamentals. It's a speculative mania that's out of control. This sort of irrational behavior has also caused me to become a bit confused about the valuations of the high flying drug companies. Either a lot more Americans than I previously thought are in need of pharmaceuticals, or a lot more than I previously thought are already on them.

In case you didn't read the transcript from one of Alan Greenspan's recent speeches, I'd like to share a few excerpts from it. He spent a lot of time discussing the stock market.

"As I have testified before the Congress many times, I believe, at root, the remarkable generation of capital gains of recent years has resulted from the dramatic fall in inflation expectations and associated risk premiums."

"Capital investment, especially in high-tech equipment, has accelerated dramatically since 1993, presumably reflecting a perception on the part of businesses that the application of these emerging technological synergies would engender a significant increase in rates of return on new investment."

"Moreover, the impressive capital gains of recent years would seem also to rest on a perception of relatively low risk in corporate ownership."

"While discussions of consumer spending often continue to emphasize current income from labor and capital as the prime sources of funds, during the 1990s, capital gains, which reflect the valuation of expected future incomes, have taken on a more prominent role in driving our economy."

"There is little doubt that capital gains have increased consumption relative to income from current production over recent years."

"Reported personal income is reduced when corporations cut back payments into defined-benefit pension plans owing to higher equity prices."

If you read the above quotes carefully, they summarize a lot of what I have been saying all along.

My typical assessment of the situation has been this:

"Overall, the market is discounting low interest rates, high return on equity and late business cycle margins as a permanent state of affairs. For this set of assumptions investors are receiving a risk premium that is significantly below the long-term average."

I had this to say last month.

"In a bubble, a significant amount of economic activity and earnings are based on sustaining the prevailing inflated asset prices and continuing the outsized capital gains. As a result, the income streams that investors base their valuations on are somewhat suspect."

In his speech, Mr. Greenspan identified most of the fundamental elements of this bull market, but he failed to address the single most important question for investors.

Is the current set of conditions economically sustainable?

That's what ultimately will determine whether we are mildly or wildly overvalued.

My view throughout has been that the sustainability of a low cost of capital and a high aggregate return on equity is highly unlikely. A continuation of the 20% annual capital gains that is driving consumption, making pension funding easier, and generating the excess capital gains taxes for federal, state and some local governments is impossible. Furthermore, since these are at least reasonable questions to ask, one would think that risk premiums should be higher than usual and not lower. If the bet is riskier than usual, as it is right now, the return relative to safer assets should be higher than usual and not lower.

Alan Greenspan may also have put the cart before the horse. He implied that stocks are higher because the fundamentals have improved so much. Under normal conditions that makes sense. But a reasonable case can be made that it's been the other way around for most of the 90s. That is, the combination of easy credit and rising stock prices is driving the improved fundamentals.

I suppose it should be no surprise that he failed to mention that during his tenure as the Fed chief, the financial system has been flooded with easy credit or bailed out every time there's been a financial crisis. Easy credit or a bailout followed the 1987 stock market crash, the early 90s commercial real estate bust and banking crisis, the Mexican currency crisis, the Asian crisis, and again during the credit crunch last fall. Much of this easy money was sloshing around prior to any sustained improvement in the fundamentals. Certainly this accounts for some if not most of the rise in financial asset prices. These various bailout and support programs also caused every Tom, Dick and Harry to come to the conclusion that stocks aren't risky. The new mantra is that the Fed can be counted on to come to the rescue. No doubt that accounts for the low risk premium.

As to high "aggregate" return on equity, here are a few relevant comments from Jeffrey M. Herbener of the Ludwig von Mises Institute.

"At first, central-bank monetary inflation seems to make good on its promise of perpetual prosperity as its open market operations supply banks with a new stream of funds to lend, drive up bond prices, and push interest rates below natural levels. Flush with funds, banks lend to entrepreneurs who are eager to obtain credit at below natural interest rates to pursue projects whose profitability has been artificially inflated.

Entrepreneurs make more profit across the economy and fewer losses. They expand production and employment by using the borrowed money to bid more intensely for factors, especially capital goods. Since the additional funds have not come into the banks by shifting them away from other expenditures, revenues and profits need not fall in other areas of the economy to provide this stimulant to banks and borrowers of the expanded credit.

Central-bank monetary inflation and credit expansion cause a boom-bust cycle by distorting prices and profitability which incite entrepreneurs across the economy to malinvestments and misallocations."

Simplified, there are many companies that possess competitive advantages, superior business models or terrific reputations. Because of those advantages, they can enjoy high returns on capital and equity on a sustained basis. That's called goodwill. But in a normally functioning economy, those excess profits will come from someone else. That is, for every company that possesses goodwill, there will be some that are average and some that will possess "ill will". So in aggregate, everyone can't be above average. That is of course unless the Fed and banks have flooded the system with credit and created an artificial and unsustainable boom.

In last month's market view I had this to say about Brazil.

"Brazil appears to be an accident waiting to happen despite the current efforts of the IMF. A meltdown will have a significant impact on the rest of Latin America and in turn the U.S."

We haven't had a full-fledged meltdown yet, but the Real is still falling and interest rates in Brazil remain high. The impact of this event is twofold.

First, Latin America imports approximately 20% of all U.S. exports and Brazil represents the lion's share of economic activity in the region. Its devaluation and imminent recession will put other countries in the region under severe stress. In addition to the lower economic activity in Brazil, the others are now also at a disadvantage in trade. It's likely that before all these forces play themselves out, much of Latin America will be experiencing negative economic growth. As a result, the U.S. trade position will deteriorate further on both the import and export side. Considering that current earnings estimates for 1999 are already a fantasy, I expect some significant earnings revisions as the year progresses. Our trade imbalance will also start to approach the level (as a percentage of GDP) that preceded the 1987 crash. (around 4%) Our IOUs keep piling up and Washington doesn't seem to care as long as things don't blow up on the current watch.

Second, it demonstrates that the global financial crisis of the last year and one half is still in progress. Each devaluation and economic bust has weakened the trade position of another set of countries. At each stage, the next weakest member of the chain blows out. And around the world we go. It's my view that the core of the problem is excess credit. One might venture to say that there isn't enough profit in many parts of the global system to support all the debt that has accumulated over the years via bailouts, debt rollovers, and central bank efforts to prop up the system's prior attempts to remove the excess. I also believe that the latest round of global central bank interest rate cuts is doing nothing more than buying time, adding to that credit excess, and creating a larger gap between financial asset prices and the underlying physical economy. Stock prices around the globe continue to rise faster than the growth in earnings and assets that support their intrinsic values. The situation is therefore becoming more dangerous all the time.

It's a rare time when valuations become so high that a defensive posture becomes appropriate. By targeting a stable CPI and ignoring financial asset prices the Fed has allowed a dangerous bubble to form. Irresponsible and reckless promotion from Wall St. fueled it further. Evidence of the highly leveraged nature of our financial system became apparent last fall. Most likely we will pay dearly for this in the long term. In the mean time I have few suggestions on what to do with new savings or the proceeds of any stock sales. Most high quality businesses are trading at prices that are likely to produce disappointing results. Others that appear reasonably priced will be exposed as overvalued when the bubble bursts. While the Fed was unwilling to prick the bubble when the consequences would have been easier to cope with, it seems very willing to provide whatever amount of liquidity is necessary to support it now. So a deterioration in earnings or other fundamentals may not cause the decline in stock prices you would usually expect. We already experienced some of that in 1998. It may require something more significant to cause a more permanent decline. Perhaps a large fall in the U.S. dollar will do the trick. If the Fed takes the current path to its logical conclusion, it will require progressively lower interest rates and greater amounts of liquidity to keep expanding the bubble. Assuming productivity gains and the deflationary forces in the economy are strong enough to keep the CPI at bay, we are likely to end up in a situation similar to Japan. We will finally run out of bullets. But perhaps the U.S. will be short circuited well before then. Japan is a creditor nation with a large trade surplus. It had greater leeway to drop interest rates when the economy was in trouble. The U.S. is a debtor nation with a large and growing trade deficit that needs to be financed externally. Perhaps foreigners will keep us under control if we are unwilling to do so ourselves. Personally I hope so. The sooner the bubble bursts, the less the ultimate pain and the sooner there will reasonable investment possibilities. We will have to be very patient though. Policy makers do not appear to be taking a long term view when it comes to our financial health. All I can only say is be cautious and insist on a higher than usual margin of safety in the price of a stock before investing.