The Untold Story Of How A Bull Became A Bubble

(First aired September 23rd, 1999)

I recall the summer of 1985. Europe was cheap. The British pound was scarcely worth more than a dollar. And this was thanks to Paul Volcker.

Volcker squeezed inflation out of the U.S. economy by raising interest rates. Higher U.S. rates led to a higher U.S. dollar…which made things overseas seem cheap in comparison.

But in September, at the very same hotel that Janet Reno alleges served as a meeting place for conspiracy-minded tobacco executives 30 years earlier, things began to change. Central bankers from the G-5 nations, no doubt pausing occasionally for a smoke, set the world monetary system on a course that would ultimately lead to the creation and destruction of the world’s two biggest bubbles.

Readers will already be familiar with the blow-up of the first bubble. It happened 10 years ago, about 12,000 miles and 11 times zones from the Plaza Hotel. Tokyo stocks fell from 38,000 to 12,000. Real estate fell by a similar margin. The economy stalled, then dived. It has yet to recover.

But the second bubble? That is the bubble we explore and gawk at every day in these pages…it is the bubble on Wall Street…concentrated now on a few big Dow stocks and a few more tech and Net stocks…but held aloft by a whole economy that has adjusted itself to the promise of 20% annual gains on Wall Street…without the risk of a major market collapse.

Indeed, the average American household has leveraged its own balance sheet…doubling its debt level…in the belief that the bull market on Wall Street that began in 1982 will continue indefinitely.

Let’s go back to the Plaza Hotel in 1985. The most noteworthy decision made by the august group of bankers and officials present was to increase the value of the yen versus the dollar. This was not a decision welcomed by the Japanese. Because it made it harder for Japanese exporters (and what else was there?) to sell their goods at a profit. Japanese goods became more expensive. So, Japanese manufacturers scrambled to retool to make better quality goods with higher margins. Sensing the need for more capital and liquidity, the Bank of Japan lowered interest rates. From 5% in 1985…to 2.5% in 1987. Cutting interest rates in half while U.S. consumers were becoming ever more acquisitive had the inevitable effect…a boom. Stocks rose.

And rose.

Companies bought stock in other companies. They bought office buildings and land too. Everything went up. The “psychological cycle” that made Keynes rich functioned at least as well in the Orient as it did in the Occident. The higher stocks and properties were valued…the more people thought they were worth. So they bought more. And eventually, the boom turned into a bubble, as interest rates remained at 2.5% and the yen rose. Americans were buying more and more Japanese goods. The idea was to get market share. Forget profits. Stocks rose to an average p/e of 70. Golf club memberships reached into the hundreds of thousands of dollars. A single piece of property in Tokyo, the Imperial Palace, was worth more than all of California.

By June `89, the markets were so hot, the Bank of Japan got worried and decided to raise the Official Discount Rate above 3%. Nothing happened. Then, on Christmas Day they boosted it again…to over 4%. This had the same sort of effect as interest rate hikes in the United States in `29. The market crashed.

That is not the end of the story however. It wasn’t long before the Japanese realized their mistake. If lower interest rates could produce a boom, surely they could reverse the sense of doom in Japan’s markets and economy. The Bank of Japan began to lower rates again. And they continued doing so until rates reached a point where the Financial Times reported “short term rates are, effectively, zero.”

Wow. If 2.5% could touch off a spectacular boom and bubble in the world’s second largest economy…what would zero do?

Well…nothing. At least, not in Japan. Hmmm…Money is a little like any liquid. It cannot be compressed. Push it down somewhere…and it is bound to pop up somewhere else. In this case, the Bank of Japan had the spigots wide open…but little of it was showing up in Japan.

What was happening?

The trouble in Japan was that the psychological cycle had turned. Investors, so recently eager to buy stocks at 1,000 yen…would not touch them at 400 or even 300. Golf memberships that were worth $100,000 a year earlier could not be sold for half that amount in 1990. No one wanted to go into debt…even at zero interest.

What was true in the world’s second largest economy, however, was not in the first. The psychological cycle in America remained fully bullish. And institutional investors soon found a way to put Japan’s free money to use. They created the “carry trade.” The idea was to borrow yen…and buy U.S. Treasuries…and then use the bonds as collateral in an equity account. This worked like gangbusters. In effect, it funneled borrowed money from Japan into U.S. stock markets. Stocks lifted off and never really looked back. As stock prices rose, more and more people saw the stock market as a money machine. You just had to get in line. Get a ticket. Climb on board. The machine would do the work. Heck, you don’t even have to think about it. Just buy a index fund. Almost everyone in America wanted a piece of this action.

After the Asian currency crisis, the money spigots all over the world were opened even wider. Again, most of the money seemed to flow in the U.S. markets. But into fewer stocks…the boom had become a bubble. American consumers did their part too. They eagerly bought the world’s surplus production…and paid for it in dollars. Now the world is awash in dollars. And America is awash in wealth – on paper. The source of this wealth is not savings…not additional productivity…not the Internet…not the new era.

It is debt.

This can clearly be seen by looking at a chart of gross debt relative to GDP. Debt as a percent of GDP has gone from about 150% to 260% since the Plaza Accords. GDP is about $9 trillion. This implies an increase of about $10 trillion in debt. Meanwhile, the paper value of the stock market has gone from in the neighborhood of $5 trillion to nearly $15 trillion…an increase, coincidentally, of about $10 trillion. This is the juice…the expansive energy that has ballooned stock prices in America, taking them far above the ground of gold, oil and the economic output to which they were formerly tethered. Many stocks are now at prices equal to those in Japan at the peak of its bubble. AOL, which advanced yesterday, trades not at 70 times earnings…but 200 times. (Note: Last Thursday’s Commerce Dept. release puts the current total GDP at $9.3 trillion… the NYSE estimates the total market cap of the US stock market as of May, 2000 at just over $16 tillion… and today, AOL is down nearly 50% from it’s 52-week high of 94 – but it’s still trading at 109 times earnings…Addison)

The bubble in America must be near its end. Because, as Bill King puts it, “Japan has gone Volcker.” Oil is priced in dollars. Japan imports all its oil. It can no longer afford to export valuable goods and get U.S. paper in return…pretending that each dollar is just as valuable as the last. It has to use those dollars to pay for oil…which has gone up more than 30% this year.

The carry trade is finished, too. It only worked as long as the yen fell…or remained steady…against the dollar. Those days are over. (Note: by August of 1998 the yen had fallen to nearly 145 to the $US, today it’s trading at 109…Addison)

This is the drama that is unfolding now…and why “all eyes are on Japan.” If Japan really has “gone Volcker,” the yen will rise further…the dollar will fall…and the bubble will burst soon. Stay tuned.

Your correspondent staying tuned,

Bill Bonner

*** “WOW DOW 21,500 TO 43,000 BY 2008.” So reads the headline of a letter I received from a stockbroker. “Hi again,” begins the letter from a man I’ve never heard of. “I trust you remember me.” The letter goes on to suggest that I follow the advice of Harry Dent’s book, “The Roaring 2,000’s” and prepare “for the greatest boom in history, from 1998 to 2008.”

*** The source of the “WOW DOW” boom is identified as baby boomer spending. No mention is made of where the baby boomers get all the money they’re supposed to spend.

*** The public’s confidence in stocks is extraordinary. Over the last 12 months the gain from stock investing has only been about 1%. Still, in the last quarter a record $73.4 billion was invested in mutual funds.

*** Occasional rallies give cause for hope. The Dow rose another 84 points yesterday, for example. More stocks rose on the NYSE exchange than fell – 1675 to 1179. And more hit new highs than hit new lows – 98 to 40.

*** But the Nasdaq continued its decline, giving up 81 points. The Big Techs are slipping. Intel lost 2 1/8 yesterday. Cisco lost 2 1/4. These big techs will be the source of much of investors’ losses as the bear market develops, simply because there is so much of the public’s money in them.

*** While the public continues to put its money in the stock market, the pros are taking their money out. Yesterday, Goldman’s partners announced that they were getting out while the getting was still good – selling 10% of their holdings to the public.

*** And bonds and utilities – favored by professional and more serious private investors – both rose yesterday. Even a 6% coupon from a bond is better than a 1% return from stocks.

*** The euro fell to a 2-month low against the dollar — at 91 cents. The dollar is still below it’s May peak, however. Two very important things happened in May that, I believe, signaled the end of the ‘New Era” illusion. The dollar topped out. And first quarter productivity numbers returned to more normal levels – following rather spectacular numbers from the final quarter of ’99.

*** If I’m right – admittedly a low-probability event – it is just a matter of time until confidence yields to anxiety and high prices yield to low ones. Foreign investors will lose confidence in the dollar as domestic investors lose confidence in stocks.

*** The big news yesterday was that baby boomers and other consumers are still spending more than they make. Consumer spending rose 0.5% in June, 25% more than expected…and 25% more than personal income. How much longer can spending exceed earnings? Until 2008? We don’t know – but we’re going to find out.

*** As I’ve been saying, today’s high stock prices do not rest on higher earnings, greater productivity, new metrics nor a New Era. They repose upon a bed of debt. (See “How a Bull Turned Into A Bubble” below…Addison)

*** The public, believing that it can get something for nothing in the stock market, has been willing to shed its savings in order to participate. But debt costs something. At an 8% interest rate, investors (who only earned 1% in stocks over the last year) paid 7% to own stocks. Unless stocks rise substantially, and soon, the public will begin to follow the professionals out of stocks.

*** An increase in stock prices is just what many people are predicting. I got an email from InvestorPlace – a service of my friendly competitor, Tom Phillips. On it, I found a prediction – from Richard Band, I believe — that the Dow would end the year above 12,000. And, of course, there’s Harry Dent…and the 21,500 Dow.

*** “Cast a cold eye on life…on death…Horseman ride on” – these are the puzzling words W.B. Yeats wanted on his grave. And there they were. We paid homage to the great poet by visiting his grave in Drumcliff, near Sligo. Then, we went on a tour of Lisadell House nearby.

*** The house was built in the 18th century. It is an unusual place – perhaps the ugliest important country house I have ever seen. It sits at the end of an untended drive, on a hill…in dark gray cement unbroken by anything save the large windows. It looks as though it would make a good reform school.

*** But for pure unattractiveness nothing about the house could match the tour guide. A hefty German woman, she wore a pair of dirty, striped pants made of some unnatural fabric that had been long since stretched beyond its limits. She had a full red face and glasses that looked as though they had been taken from Leon Trotsky after the axe fell upon his head.

But even less attractive than her appearance was her attitude. She welcomed us to the house as though we intended to spit on the floor and steal the silver. And she might have been giving a tour of a concentration camp – so little sympathy did she seem to have for the people who built the place and lived there.

Indeed there had been some illustrious occupants. One owner was an Arctic explorer – who, according to our guide, must have exterminated several species single- handedly. She made it clear that she did not approve of the heads of caribou and moose on the walls.

Nor did she approve of the way so many people were required to run the place. There were upstairs maids, downstairs maids, cooks, cleaners, gamekeepers, gardeners – all shamelessly exploited for the benefit of the rich.

(Where did they get this guide, I wondered?)

But there was one former resident she seemed to like – Eva Gore-Booth, daughter of the explorer. She fought alongside the American, Eamon de Valera, in the Easter uprising against the English in 1916. The rebellion was put down and the ring leaders hung – except for Eva, because of her sex, and de Valera, because of his American passport and Britain’s wish to keep the U.S. on good terms so as to bring American troops into W.W.I. Later, Eva went on to espouse women’s rights issues.

Eva looked very attractive in her portrait. But hearing our guide speak of her so admiringly made me wish they had hung her, too.

*** We drove out to Horn Head in the far North of Donegal yesterday. Looking for a beach where we could have a picnic, we drove to the end of the road and asked. A blond woman at a farmhouse good-naturedly let us park in her yard and showed us a path down to the water. It took about a half hour of hiking through sheep pasture, but it was worth it. The sand beach was about 100 yards wide, between rock cliffs jutting out into the Atlantic. The water was too cold for swimming but the kids had fun playing on the rocks. It was a beautiful spot – completely deserted.

*** Kathie Pediccord, publisher of International Living, moved to Ireland more than a year ago. She’s fallen in love with the island. If you’re interested she’s leading a small group on a tour of the western counties of Galway, Kerry, and Clare, in mid-September. They’ll be investigating retirement options… and other pleasures on the Emerald Isle. E-mail: for more information.

*** I’ll be back on the boat tomorrow – and unable to write until Friday. Until then, your faithful correspondent in the land of Joyce and Yeats.

Bill Bonner