Разное:: On the impeding crash of the speculative stock market


It is now very popular among investment columnists and recently emerged money managers to point out at good fundamentals as a reason for the market to go up and for them to keep their jobs. Hardly a few of them understand the topic.


Current valuations have nothing to do with earnings. Less than half NASDAQ companies have any considerable positive earnings. Even of them, many have earnings in non-core activities, namely income from money market operations with IPO proceeds. Those companies, which have earnings, can't justify valuations of those without earnings just by being their NASDAQ neighbors.


Earnings can't justify valuation of profitable companies either.



The observation is attributed to Disraeli that there is a lie, big lie and statistics. The latter is inherently incorrect, being always based on the models of past.


In periods of rapid changes, statistical models lose their touch with reality, failing to accommodate new realities. Earnings calculation is based on one of such outdated models. It does not take into the account the source of earnings and the possible limitations of that source.


Neither is the calculation of inflation. When price of butter is up 2%, it's called inflation. When price of YHOO skyrocket 3000%, it's an increase of valuation. Actually, since at least 1995 inflation was concentrated largely in stock and real estate markets.


Stock market inflation is as good as any other, though not calculated by traditional CPI or other indexes. Stock price inflated under massive speculative demand until it was fully met and even overweighed by supply of (mostly junk) IPO's.


Why earnings are increasing?


Earnings can increase for 2 reasons: higher spending or higher profit margin. It is well known to every student of economy that high profit margins are unsustainable in competitive environment. High profits may be only temporary, following deficit of new product and effective monopoly of sole owner of a technology.


Liquid labor market leads to fast dissemination of skills and knowledge, creating fierce competition in technology sector. Profit margins of most technology companies, actually, deteriorated or moved into the red.


Most companies are losing money under fierce competitive pressure, and have no monopoly advantage to hope to ever come into the black. The whole market is fueled by profit growth only in a relatively small number of companies.


But these profitable companies are largely not creating new earnings. They are sucking out earnings of dumped competitors. Overall market earnings are not increasing that way.


Let us see if higher spending can increase earnings. Neither monetary base nor velocity increased significantly over the past 10 years. So we should look beyond money base.


Amount of consumer and corporate spending actually increased a lot due to obvious reasons: drainage of savings and reckless borrowing against overvalued assets. Popular forms are mortgage for consumers and stock and bond for corporations.


One shouldn't be fooled be a notion that stock formally doesn't represent a liability. In this speculative era, minor short-term stock holdings are no longer associated with corporate rights. Investors expect their stocks to be redeemable at any time.


It doesn't make any difference that such stocks are redeemed through the market, not directly with issuers. Obligation to redeem means liability. Thus stocks are liability of economy, if not directly of corporations. Moreover, recognized policy of corporations to support their stock during sell-off means accepting even some kind of direct liability.


Bonds are obviously loans against overvalued equipment, goodwill and, most importantly, market capitalization. In fact, most defaults result in change of ownership, not in sale of inventory. Preference by creditors of convertible bonds is just another illustration.


Stock market boom tremendously increased borrowing capacity of corporations by ridiculously multiplying their collateral. Paper wealth of consumer also increased as their share holdings rose in price. They also benefited from options, distributed by start-ups to their employees.


Besides borrowing, redistribution of assets also accounted for increase in spending. In effect, consumers and corporations tapped the savings of previously "sleeping money": foreign dollar deposits, bond holdings, pension funds (latter mostly by relative decrease of new money inflows in favor of mutual funds, offering IRA investing). In exchange, they offered something cheaper than the glass jewelry used to buy Manhattan Island from Indians: stocks of no or tremendously overstated value.


We can see now that the main reason for earnings growth is increase in spending. But this is not spending of a new wealth. It is savings, owned, borrowed or redistributed, that are being spent.


Stock growth and spending indeed form a self-reinforcing cycle. Initial speculative stocks' growth leads to shareholders profits. Spending of those profits leads to higher corporate earnings. Higher earnings lead to rise of valuations and stocks' growth. This spiral goes through the roof until one day it crashes when shareholders can't find buyers and realize their profits.


Though new technology adds a lot of value, it's not much compared with increase in paper wealth, mostly represented by market cap. Besides, a lot of old wealth becomes outdated, and partially offset that increase.


We're now witnessing not that much a creation of value but historical redistribution of accumulated wealth. Crowd madness, fueled by the actual technology revolution multiplied by dreams, provides a fertile soil for mutually agreed swindle.


It is interesting to note that, from pure monetary perspective, stocks are not much overvalued. If foreign dollar holdings, central bank reserves and other dollar assets held at below reasonably attainable income (actually, held for non-business purposes) were redeemed into goods and services, prices in the US will skyrocket, justifying even ridiculous stock valuations. But, of course, we don't expect this redeeming scenario to be allowed by the US government to happen.


For how long?


It is easy and fun to spend the unearned income. But we suspect the redistribution a little bit exhausted.


Of course, yet not all the old world' wealth was transferred to stock issuers but the pressure is beginning to equalize. Greed and ignorance of those controlling the old money can't any more outweigh the madness of stock valuations.


Loose money were spent for stocks and redistributed in earnings. Extra capital is kept more tightly. Besides, more and more IPO's are competing for that money. That supply-side competition push to reduce valuations.


And here's a catch. Cynic brokers like to recite "greater fool theory": for every fool who is buying at high price there is a greater fool who will buy off him at higher price. Crowd confidence is a necessary precondition for this theory to hold true.


Stop of continuos increase in valuations undermines the confidence as nothing else. Now recall that crowd mood change in a moment. One morning soon we will wake up and see stock investment unfashionable. Investing public will be considering as foolish as non-investing in 1999. That day the market will crash.


Could governments help?


Let's not argue about cutting-edge NASDAQ. DJIA represents mostly old, stable companies, which have just no room to grow. It grew threefold over the last few years.


Another example is market cap loss of $2 trillion in a week, in the US alone. And that wasn't yet a panic. May we guess that given overvaluation at least 3:1, market cap of $8 trillion, panic will erase at least $4 trillion. Nothing less than 20% of that amount will cool down the market. Necessary increase in money base is something like $100 billion, considering the urgency. Not probable.


Besides, it will not help in the long run. No government has enough resources to continuously fight the market. By delaying the crash, government will only make it worse.


Would the crash be painful?


Not that much as 1929. Most of the wealth lost was not owned by consumers in the first place. They acquired it through redistribution.


Old money will lose, those who spent their real capital to purchase phony assets.


Massive bankruptcies of start-ups will be there. They will be unable to continue financing of inherently money-losing operations by sale of stock.


Consumers, who took an excessive debt burden in expectation of exorbitant income from stock market, will be unable to pay. But law is protecting them. They will file bankruptcy and walk away. Banks will suffer a lot. Large depositors will have to restructure their debt. FDIC will bear losses of small depositors.


As usual, taxpayers will cover bank debts through subsidies in FDIC payments. What they enjoyed in boom years as consumers, they will have to give back as taxpayers.


What would follow?


Consumer spending will not suffer a lot. 5-year increase in physical consumption is not that significant. Most of spending increase was concentrated in real estate, stock and money markets.


Prices of real estate will go down. Technology stocks will drop minimum 70% with many stocks going all the way to pink sheets.


As the most increase in earnings was concentrated in hi-tech, elimination of unprofitable demand will affect it at first. But because such suppliers and their employees have fundamentally valuable skills, many of them will readjust on lower price and wage levels. It's important that lower wages will mostly decrease demand for stock market products, not for everyday consumption. Real economy thus wouldn't be affected a lot.


Temporary increase in interest rate will be soon offset by inflow of overseas dollars. We don't see strong preconditions for lasting depression.


In the world of abundant capital, it's no doubt that companies with sound plans will found financing. Crash will not affect American technology industries but will definitely wipe out most of unsound start-ups we saw IPO'ing in the last few years.


Government spending and social security system will suffer the most. Not only they lose revenues increased during the market boom. Revenues will be below 1995 levels, as taxpayers will declare tax carry-forward losses. Budget deficit is likely to increase.


What's going on right now?


Stock market has striking similarity to physics models. Over the last year we've seen increasing amplitude of ups and downs. That means the system is losing stability.


Recent 20% moves clearly signal that the system is entering chaotic stage. It can come back to stability in two ways.


One is employing a force (energy) higher than that of the market itself. Given the current size of markets, even the strongest government doesn't possess that power.


More likely, we think, is for the system to lose most of its energy and stabilize on much lower power (valuation) level. We don't think anything will stop the market now from crash.


This time, there will be no meaningful average drop. While Dow may suffer 30-50%, many NASDAQ inhabitants will go down 70%, with probably more than a thousand stocks going to zero.


What to do?


Get rid of technology and investment banking stocks. Sell their immediate suppliers. Going short will not help, as stocks will be reclaimed by their owners on downside.


Expecting real estate meltdown, you can short CMO's (collaterilized mortgage obligations). One can benefit from a sharp drop in their prices. Short-term rate increase may further dump their prices. Interest rate options may prove to be a profitable game, if you enter it correctly.


For simple investments, look at stocks of small gold mines that have break-even at about $290 per ounce. Gold futures require professional approach because of expiration term.


Consider technology LEAPS, even though prices seem quite high.


And don't mortgage you house now to buy more stocks that are going up.


Designed studio Alexandr Ozverinoff
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