The Earth Still Turns
Occasionally I am moved by the hopeless, forlorn desire to explain everything. Why is the Dow going down while the Nasdaq rises? Why do New York law firms put modern art on their walls when they can afford good paintings? Why do adults wear shorts in public?
It is, of course, impossible to explain everything. There is too much of everything to explain. So my letter today tries to explain one thing: how the greatest financial boom of all time came into being.
“It began,” says James Grant in his book, The “Trouble with Prosperity,” “with the Plaza Accord.” Grant refers to the Japanese Bubble. But, as you will see, the bubble in the United States actually got its first big puff of air here, too.
The Plaza Hotel, by the way, looms large in conspiracy history. It was at this same hotel in the 1950s, according to Janet Reno, that tobacco executives met and agreed to keep quiet about the health consequences of smoking. Reno contends that this silence shortened the lifespans of the tobacco industry’s most loyal customers.
But the conspiracy we are concerned with occurred 30 years later — in 1985. The G-5 central bankers at the Plaza colluded to rig international currency markets so that the dollar would fall. They thus set in motion a chain of events that would ultimately create the world’s two biggest bubbles.
The first bubble was in the world’s second largest economy — Japan. The second, for which I must use the present tense, is still in the world’s largest economy — America.
The first bubble popped decisively 10 years ago. Only in the last couple of months does it appear that the air has stopped going out. Deflation seems to have bottomed out in Japan — 10 years later.
The actual events are infinitely complex. But realizing that we cannot explain everything, I will caricature them: The Japanese were in a bit of a jam because of the falling dollar. The United States was their biggest market. How could they continue to sell to Americans at higher prices? The solution, they reasoned, was to invest vast amounts of money in order to create better quality and get more market share. Forget the profits; the Japanese ignored profit margins. Like Internet companies, the Japanese figured they’d get serious about earning money later. Besides, as we will see, the real profits were on the Nikkei stock market…not in the factories and showrooms.
The Bank of Japan led the way…reducing rates from 5% in ’85 to 2.5% in ’87. Naturally, the abundance of credit had a perverse effect. Only so much capital could be fruitfully invested in new machinery. So a lot of money began to find its way into the stock and real estate markets. Prices soared. Investors were sure Japan was different from other economies. It was fail-safe. Stocks soon reached an average P/E of 70. People paid millions for Gold Club memberships. A single piece of real estate, the ground on which the Imperial Palace in Tokyo stood, was valued at more than the entire state of California.
By June ’89, Japanese central bank officials were worried. Unlike Mr. Greenspan, they knew a bubble when they saw one. So they raised the official discount rate above 3%. Nothing happened. Then, on Christmas Day, this did the trick — more so than they imagined. The market crashed.
To this point, the U.S. market was behaving sensibly. A panic in ’87 had taken some of the wind from investors’ sails. Prices were rising…but the Dow was well below 4,000 and the Nasdaq had barely been noticed….
But the Japanese were in trouble. Having punctured the bubble, they now sought to plug the hole. They tried the familiar patch — more money. Over the next few years they reduced interest rates to the point where they were, in effect, giving away money. The “Financial Times” described interest rates in Japan as “effectively zero.”
But an economy in deflation mode has little use for borrowed funds. Instead, it was speculators who took up the cash offered by the Bank of Japan. They created what is known as the “yen carry trade.” The idea was very simple. Borrow money in yen at low rates…lend it or invest it in America, where rates of return were much higher.
This had the effect of exporting Japan’s credit expansion policies to the United States. Plus it allowed the United States to export its inflation overseas. Incoming capital lifted the dollar and lowered the cost of imported items. Dollars went out of the United States in the consumer economy — to pay for Toyotas and Walkmen — and came back to Wall Street, raising the prices of stocks and bonds. No finer or more fortuitous set of economic circumstances has ever been experienced by any economy in the world. The Japanese save. We spend. The Japanese toil. We consume. The Japanese are idiots. We are geniuses.
But the “best of times” cannot last forever. There must be “the worst of times,” too. And a lot of times in between.
The yen carry trade came to an end when the yen rose against the dollar. Traders were caught short yen and long dollars — and lost money. The great bull market in America probably would have turned into a great bear market late in 1998 except for another few happy events: The Asian economies melted down first. And Long Term Capital Management needed a bailout. So the world’s central bankers got to work again. This time they were led by Alan Greenspan who had a clear idea of how to handle the situation: flood the market with liquidity.
His solution worked. It turned the world’s greatest bull market into the world’s most grotesque bubble market. Most stocks on the NYSE were already in bear patterns, so the new credit tended to focus itself on the few that were still going up. These were the leading Dow and S&P stocks…and, of course, the Nasdaq — all of which reached bubble heights. The distance between Wall Street, which enjoyed the credit, and Main Street, which did not, grew to levels never before seen. In a nation in which everyone was supposed to be getting rich, most people clearly were not. They were going in debt. And working longer hours for only marginally more money. And holding stocks that went down, not up.
Then, in the last half of ’99, the trick was tried again. This time, it was the Y2K threat that loomed over the world’s markets. Again credit was expanded. This time it was the Nasdaq that got most of the loot. During the last quarter of last year, the Nasdaq seemed to reach new highs almost every business day.
But what now? A study done by the Economic Cycle Research Institute, reported by James Grant, says that the Japanese deflationary cycle bottomed out in March of last year. If that is so, the people on the other side of the world who have been so contentedly absorbing U.S. inflation and so cheerfully providing money to the entire world may be changing their habits.
Maybe they will want to consume as well as produce and spend as well as save. Maybe the world still turns.
Paris, France February 25, 2000
*** It was an exciting day on Wall Street yesterday. The Dow dropped below 10,000 and was down as much as 300 points in the afternoon. But a late rally brought it back to close down 133.
*** The Advance/Decline ratio hit another low yesterday. There were nearly twice as many stocks down as up. And there were an amazing 354 stocks on the NYSE hitting new lows. The last time the A/D ratio was this bad was in May ’95…when the Dow was at 4,300.
*** Everything seems to be going down. The Dow is now down 12% for the year. Transportation stocks are down 20%. The companies that make the things we use…food, homes, cars, cigarettes, gin, handguns…all seem to be having trouble. Many of these are very good companies — now selling at bargain prices.
*** Who can be making any money when so many stocks are doing so poorly? William Fleckenstein of SiliconInvestor.com website has a quote taken from a Yahoo message board, from a man who had mortgaged 125% of the equity value of his home in order to play the stock market. Unfortunately, the stock he bought crashed:
“I’m now working 2 jobs and am moving back in with my mom, with my wife who is 6 months pregnant. My wife is also working 2 jobs[,] days at Shoprite and nights at RiteAid. She’s making pretty good money but her feet are getting real swollen.”
*** I’ve been arguing that somehow the Old Economy and the New Economy have to get reacquainted. The man quoted above seems to have discovered the Old Economy on his own — with hardly an introduction.
*** But the convergence I am predicting is not yet happening in the markets. While the good companies go down, the bad ones go up. Companies without a prayer or prayer book continue to zoom to new highs.
While the Dow went down, the Nasdaq went up — 67 points. It’s up 13% for the year. But even though the Nasdaq hit a new record, the Advance/Decline ratio for the Nasdaq weakened. Like the Dow before it, Nasdaq growth is getting more and more concentrated on fewer and fewer companies.
*** Cisco, the company that can do no wrong, added $100 billion to its capital value in something like 36 hours. The forecast for Cisco apparently includes no storms. No clouds. No rainy days. Not even any bad hair days.
*** Compared to gold, the Nasdaq went up even more, because the price of gold fell by a couple bucks.
*** TheStreet.com is very much in the news again. We’ve followed the progress of the TheStreet with morbid curiosity ever since the company went public at $71 per share. You may recall that Barbra Streisand called then- CEO Kevin English offering tickets to her show in exchange for getting her in on the IPO. Perhaps the mistress of shriek sold soon after. She should have. Now the stock is at $12 and rumors abound that the TheStreet is getting desperate.
*** DR readers are cautioned not to take this as a contrarian opportunity. Not yet. TheStreet is a penny share. It just hasn’t realized it yet.
*** Senate testimony revealed that the average customer of a day trading firm makes 29 trades at $16 per trade. Of course, it is almost impossible to overcome that kind of friction. Few do. About 77% of the customers lose money — some of them lose all their money. One manager testified that 80% to 90% of his customers lost all their money within 6 months.
*** Also in Congressional testimony, Alan Greenspan told the nation that there are “no signs of inflation, except in the price of gold.” And he also told us that margin requirements had no effect on stock prices…and that he could only tell a bubble after it had popped.
*** Hmmm…this seems to free the Fed chief from any responsibility to “do something” about the bubble in stock prices that he surely sees as well as anyone. This is the same Fed head who warned the nation about “irrational exuberance” in the markets, when the Dow was 4,000 points lower and the Nasdaq was…do I recall correctly…less than 10% of its current level.
*** And in the headlines: Mayon, a volcano in the Philippines, is erupting. And the front page of today’s “International Herald Tribune” has a photo of Svetlana Raznatovic, Arkan’s widow. There is nothing quite so beautiful as a good-looking widow; maybe it is the proximity to death that makes beauty more appealing.
*** I know I am getting old…yesterday I saw a woman on the street as beautiful as Arkan’s widow. At the same time an old Citroen DS21 — one of those remarkably quirky cars with a broader wheelbase in front and a suspension system that raises up the car when you turn on the motor — pulled out of a nearby garage. I found myself staring at the car.
*** And a 19-year-old college dropout has written a software program called “Napster” that makes it so easy to send music files over the Internet the record companies are trying to get it banned. Napster is going public.