Whither the Dow

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WHITHER THE DOW: 2000 IN 2000?

By Howard Ruff

September 28, 1999

I believe the Dow will fall to or even below 2000 next year, and I didn't pick that number out of a hat. If you put a gun to my head and made me bet, I'd bet on it.

First, we have to ask a big question. How did we get to 11,200? Bill Clinton is claiming credit for it.

A year ago, I spoke at the Money Show in Las Vegas. My workshop was packed with 300 people. I started off with a Clinton joke, and a man in the back row jumped to his feet and started raving at me.

He said, "Where was the Dow when Bill Clinton took office, and where is it now? He is the best thing that ever happened to the market?" He went downhill from there.

Finally, bigger men than he stood up and started shouting at him, so he left the room.

Millions believe Bill Clinton did it. In fact, stock-market profits were one big reason the polls got him off the impeachment hook. People didn't want to rock the boat.

But did Clinton create the record stock market? The answer is, no! But if he didn't do it, who--or what--did?

This market is a classic demonstration of asset inflation caused by too much money chasing too few goods. Money flowed into the market faster than the supply of stocks increased. We are told there is no inflation, but there has been big-time price inflation, channeled into equities, and the inevitable result was that prices shot up.

The foundation of this bull market was laid in the 70's and 80's, when we created IRA's, tax-exempt pension plans, and 401-K's, where people began automatically channeling their excess cash into the stock market as a form of savings.

Recent statistics seem to show new spending is exceeding "the savings rate," but they were just measuring classic savings, such as bank deposits. To most people, monthly payments into their mutual funds are savings, but it doesn't show up in the savings statistics. The national psychology has gradually shifted towards believing that regular payments into a mutual fund, a 401-K, or an IRA are virtually riskless savings, that the market only goes up, and all they had to do was automatically make their monthly contributions.

Wall Street and Clinton have, in effect, told us that we are on the road to eternal prosperity. The Administration projections of trillion-dollar surpluses in the future assume there would be no recessions, only steady growth, so putting your money into a mutual fund "saving plan" is a sure bet.

Then there is amazing ignorance. Untold numbers of people don't understand that mutual funds are the stock market. I don't know how many times people have said to me, "Howard, I know you are bearish on the stock market, but I' m not in stocks, I'm in mutual funds!" That boggles the mind.

To brokers and money managers, 90% of whom weren't even brokers during the last bear market in 1987, any dip is a chance to double your bet.

So this market is simply price inflation funneled into the stock market, rather than into consumer spending.

The cold, hard historic fact, however, is that all inflations eventually implode, and so will this one.

Another factor contributed to the Clinton luck; the end of the Cold War. The President says he is producing surpluses by hard-headed, old-fashioned economies in non-military spending. Not so! Defense spending fell to 3.2% of GDP (Gross Domestic Product) in 1998 from 6.3% in 1986. That's where the savings were! As Alan Reynolds, Director of Economic Research at the Hudson Institute, says, "this fully accounts for the entire drop in total outlays ... from 22.7% of GDP to 19.6%. If Defense were still 6.3% of GDP, 1999 federal spending would be $274 billion larger.

So Clinton claims credit for the surpluses, which really should be laid at the feet of Ronald Reagan and George Bush who engineered the end of the Cold War and made it possible for Bill Clinton to slash defense spending. Clinton is just plain lucky, coasting on the Reagan/Bush legacy.

In addition to that, corporate profits have been soaring. Why? One dominant reason dwarfs all others--the technology-driven increase in productivity. It takes less people and less capital to produce more goods because of the huge increase in the power of computers, where today's $1,000 PC has more computing power than a room full of corporate IBM mainframes did 20 years ago. This means more profits.

Why is Y2k the Catalyst?

So if this is true, why will this stock market end in a bloody crash, and what will Y2k contribute to it?

The stock market--especially the Dow -- is a gross, hugely vulnerable bubble with boggling valuations.

In the past, the price-to-earnings ratios and price-to-dividends ratios were universally accepted measures of value. The historical price/earnings ratio is 12. It reached 22 before the '29 crash. It's now 30! The historical average price/dividends ratio is 23. It reached 40 before the '29 crash. It' s now 70!

If the Dow were to reflect the valuations we've seen at the peak of historic bull markets during the history of the Dow, the Dow would be at 3400 to 4500. If it were to fall to the historic average valuations--what the mathematicians call "regression to the mean"--the Dow would be at 2500.

Analyst Bob Prechter says a mania born in a long-term uncorrected bull market, involves broad public participation and ends in a time of historic overvaluation by all traditional measures.

Such bubbles don't just "correct," they implode! Everything from the South Seas Bubble to the Tulip Mania, to the low-margin-driven, over-inflated stock market of 1928-29. But most of the time, it takes a pin to pop the psychology bubble. Y2k is my candidate for the fatal pin. But the public has to stop throwing money at the money managers.

Why is Y2k a pin? There are lots of reasons.

1) Enough brokers could be non-Y2k compliant and mess up your account balances and cripple the markets.

The Financial Services Industry recently did "an industry-wide Y2k test" and proclaimed there were few or no problems. This is an industry with thousands upon thousands of companies involved in financial services, ranging from thousands of brokers to thousands of mutual funds, bond dealers, state and federal government agencies, transfer agents, clearing houses (the New York Clearing House in New Jersey has 12,000 square feet lined with cabinets full of computers that process 1.5 million electronic transfers a day worth $9 billion), etc., all connected by computers.

The so-called industry-wide test involved slightly over 400 of them. We know some of them had troubles, but we don't know which ones, because no one would participate unless the results would not be disclosed to the public, identifying which institutions had troubles. We don't even know, except for the big ones, which companies participated in the test. I think we can assume that those who did not were not Y2k compliant by the test date.

2) The public's Y2k fears could kill the market, especially if wide-spread concerns are raised about brokers' Y2k status. Some unknown percentage of the public will liquidate "just in case."

That's why we see this massive PR campaign by banks, government and the financial-services industry to tell people how safe their money is. That's why the Y2k managers are not telling us their real status. Rather than telling us they are "Y2k compliant"--a legal term of art that means fixed, online and technically ready, which is virtually a guarantee of success, they are saying "Y2k ready," another legal term of art which means they think they can deal with any problems that develop, with "workarounds," manual backups and a process they call "windowing," which I don't have space to explain.

These short-term patches are short of Y2k "compliant." That's why vacations are being canceled over the holidays so everyone is on hand to fix Y2k glitches that pop up.

That's why they may close the market the first one or two business days of 2000 to give them time to deal with any Y2k problems--maybe!

But when the public hears "Y2k ready," they think it is "fixed." They hope the widespread use of the term in optimistic press releases and letters to customers will fend off a general "just-in-case" stock liquidation, which could be catastrophic.

I believe the PR campaign will fail, that as the speculation crescendos toward the year end, millions of investors will take the just-in-case route.

3) If the banks run out of paper currency and general confidence in the banking system plummets, the impact on the brokerage industry will be huge.

We no longer have a paper-money system--it's a cyber-money system, and only a few savvy people know it. The money supply simply consists of data on computers. Just because they don't have paper cash to give you doesn't mean they are broke, but it will seem like it. These fears will have a devastating impact on the psychology of the endlessly growing economy and the endlessly profitable stock market.

4) Brokers' vendors could fail or produce faulty data. Brokers interface with government bond dealers and hundreds of credit-reporting agencies. They interface with each other, and depend upon the banks and transfer agents to consummate transactions by computer. At this point, we (and they) have no idea how compliant those vendors may be. A typical broker has hundreds of them, and any one could be sand in the operational gears.

5) Perhaps the biggest single threat to the stock market is that at least some major industries will have big Y2k troubles. We don't know precisely which ones, although we can make some educated guesses. Major companies unable to conduct normal operations because of computer failures will have a devastating effect on the stocks of other companies in those industries, and the ripple effect will hurt the whole market.

My top candidates for trouble are Airlines, Railroads (there goes the Transportation Index), Manufacturing, including automobiles, Textiles (most of the clothes we buy are manufactured overseas in countries that don't have a chance of being Y2k compliant), Shipping and Utilities, including gas, electric and water.

Y2k is so burdened with uncertainties and complexities that it is beyond human ingenuity to precisely calculate these complex inter-relationships and know exactly what will happen.

If one company is truly Y2k compliant but the people they interface with are not, their data will be contaminated and will get bad numbers. They will have to sever computer interfaces with non-Y2k compliant computers. But the problem is, they don't know which ones are or aren't compliant. Some of them may be but in an incompatible way, as there is no broadly accepted standard for compliance.

Can you imagine the effect upon the stock market of any or several of these problems all at once, especially if it breaks the back of the psychology and panic ensues--first among the wet-behind-the-ears brokers and money managers, then with the public. If 1% of all public companies can't function, that's tens of thousands! 10% is hundreds of thousands!

6) Foreign economies are incredibly threatened. Japan is toast! You'd think with all their technical skills and corporate efficiencies they would have been leading the pack. But in Japan, corporate decisions are made by consensus, and it can take a long time to come to consensus. They needed bold decisions by strong leadership 2 1/2 years ago in order to be ready in time, and the Japanese business model just doesn't work that way.

Any corporate board would think long and hard before committing millions of dollars to do the Y2k repair job, knowing it would eat up maybe the next two or three years' profits. That's how CEO's lose their jobs!

We hear the mantra from Congress and John Koskinen, the President's Y2k Czar, that foreign economies may have trouble but we will be okay. That's like saying, "we're okay because the leak is in the other end of the life boat."

We are a world economy. The major money-center banks like Chase Manhattan, City Bank, Bank of America, etc. earn from 40-60% of their profits through their overseas operations. Money center banks are exposed to the collapse or even big slowdowns of foreign economies. And small banks park overnight deposits in these big banks to earn interest. These foreign countries are suppliers of cheap finished goods and huge quantities of raw materials. Their ports are highly computerized, especially in the more primitive countries we rely on for basic commodities and raw materials. Their ports are also obsolete and non-Y2k compliant, and these countries also depend on the functioning of the canals. We have been told that the Panama and Suez Canal will not be Y2k compliant, and no one knows if they will be able to open and close the locks.

7) Transportation is very much in danger. The airlines did their so-called industry-wide test, but to call it that is flagrant false advertising. The FAA has 222 major mission-critical systems that manage thousands of planes in the air at any one time. Their carefully rehearsed test was one airplane and six systems, after which the Air-Traffic Control System was declared "Y2k ready."

The railroads transport the bone and muscle of American industry. They no longer have the ability to do manual switching, and certainly not the personnel for manual backup. It's all computerized. That's how they keep track of individual cars and route the trains in the right direction. They' re not ready yet, and they deliver the coal to the power plants.

The FAA has a backup plan, which consists of increasing separation between flights.

I'm a pilot; I've used the Air-Traffic Control System. I know a busy airport depends on being able to bring the planes in every minute or two on parallel runways--in good weather and bad. If the controllers don't trust the information they are getting on radar, they will increase separation by as much as 50% when there is good weather on both ends. If there is bad weather on either end--instrument conditions--they will be slashed 80%. This will create a huge choke point for American business, not just for passenger flights, but for UPS, Fed Ex, and the Postal Service. What effect will that have on the economy and the stock market?

8) Periodic power outages and brownouts will be a problem. Only one electric utility I know of claims to be fully Y2k compliant. Most simply tell us they are "on track" to be "Y2k ready." There are thousands of power companies in America, and they are dependent on each other to pick up the slack when they go offline. The stresses and strains on the power grid are impossible to predict, but at best they will be significant, and at worst, devastating!

The biggest problem is the great unknown. The market hates uncertainty. The sheer complexity of the Y2k problem, coupled with the innate tendency of important industries and government PR types to lie, makes this impossible to quantify.

Some companies may be compliant, but their lawyers won't let them say so for fear that if they have made a mistake, it exposes them to huge legal liabilities. Then, of course, those that are not ready or will not be ready will lie in a desperate effort to keep their customers from panicking while they still try to fix things.

We are in a desperate race against an inflexible deadline, and that's why it is impossible to say exactly what will happen. All I know is there is more than enough at risk that if too many things go wrong, the stock market psychology will crash, and millions could decide to liquidate.

When bubbles burst, they tend to "regress to the mean," which means to come back to traditional valuations before the conflagration is put out. That's why 2000 seems like a reasonable number to me.

-- Ed (ed@lizzardranch.com), September 29, 1999


"The railroads transport the bone and muscle of American industry. They no longer have the ability to do manual switching, and certainly not the personnel for manual backup. "

not to pick at a nit, but that is just not true; i.e. 'manual switching' IS possible and is done all the time; been discussed many times...

otherwise, not bad stuff - for Ruff


-- Perry Arnett (pjarnett@pdqnet.net), September 29, 1999.

Another minor point: The savings rate DOES include contributions to the retirement plans. It does NOT include appreciation and capital gains.

-- Dave (aaa@aaa.com), September 30, 1999.

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