If the markets go off-line

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Friday, December 17, 1999 If the markets go off-line

Technology heavy: monitors at New York's Nasdaq whose chairman, Franck Zarb, has unveiled a plan to create an electronic stockmarket aimed at helping to lure investment. Agence France-Presse photo


Historians may look back on Y2K not for the inconvenience of computer bugs but as the bursting point of the world's first global stockmarket bubble. It is the United States, in particular, which has lost all contact with financial reality. But the virus of delusion, or the madness of crowds, has spread far beyond American shores. It is rampant throughout Europe and a milder version has been infecting Hong Kong.

To the tech-stock craze has been added a deluge of liquidity, particularly surprising in Hong Kong where money supply had been growing at snail's pace because of a sluggish economy and high real interest rates. How come? Ask US Federal Reserve chairman Alan Greenspan. The man who is credited with all kinds of economic wonders and is the guardian against inflation has, pre-Y2K, been printing money at quite an alarming rate. US money supply (M3) has risen by US$140 billion (about HK$1 trillion) or an annual rate of 15 per cent in the past two months. At the same time, supposedly to ease global financial markets through Y2K, he has made all kinds of new repurchase arrangements available.

According to Grants Interest Rate Observer, the Fed's own balance sheet has expanded by US$30 billion since September. No wonder a small rise in prime interest rate makes little impact. This is more fuel for investor madness and paper-financed takeover action, which is supposed to produce greater efficiency but will more likely lead to debt burdens and huge goodwill write-offs.

When the public loses its critical faculties, crooks and shysters flourish and even respectable institutions believe that there is a ''new morality'' as well as a ''new economy''. Let us start with Nasdaq, the golden calf of the new religion. This writer has observed a succession of market bubbles going back to the late-60s Australian mining boom, through the 1973 Hong Kong phenomenon, several ramps of Malaysian penny stocks, the Red Chip nonsense of 1997, etc. But it is the scale of the Nasdaq bubble that is so frightening when combined with the very high level, but not totally outlandish, level of all other US markets, and many in Europe.

Most of Asia is thankfully exempt. Nasdaq (US domestic stocks only) is now a US$3 trillion market, which makes it almost as big as Tokyo and bigger than all other markets except the US$11 trillion New York Stock Exchange. Yet this market is trading on a price to earnings ratio in the region of 150, compared with around 60 in Tokyo at the maximum of its bubble a decade ago.

As for Nasdaq dividend yield, it is so small 0.19 per cent as to barely cover the cheque postage. An example is Internet portal Yahoo! which actually has earnings and has just been admitted to the benchmark Standard and Poor's 500 index but which is selling on 1,000 times current earnings and 380 times its prospective earnings in 2001.

The idea that earnings do not matter, that momentum (that is, follow the crowd) is the way to invest, is the most pernicious of all the nonsense being spouted by brokers and so-called investment advisers. Wait until these overpaid juveniles get to the age of 45 with portfolios which at best (the Standard and Poor's 500) have earnings yields which match inflation and dividend yields which are half today's low inflation and one-quarter the Treasury bond yield.

The coming tragedy meanwhile is that the baby boomers, now around 50 and who will need retirement income in a decade or so, are seeing their savings invested in assets with negligible yields so that today's paper millionaires will have pauper income when they retire. But of course earnings, or at least their direction, do matter even in this market, which is why even mainstream companies are bending the accounting rules to meet market expectations.

Recently, Intel announced profits up by 21 per cent by departing from normal accounting standards and omitting acquisition costs which would have meant a small drop in profits. If giants are up to this without much criticism, God alone knows what's happening among the smaller players. Dividends are another matter. Why give shareholders their due when the managers can pump up the value of their stock options through share buy-backs, if necessary using money borrowed at eight per cent to buy assets yielding two per cent?

It is curious how little notice fund managers, who ought to be looking after investors' interests, take of the quiet rape of corporations by their executives. The explanation lies partly in an unwillingness to rock the boat and partly because mutual and pension fund revenues mostly come from the size of assets under management, so the higher the market the more their income.

The quality of self-regulation also appears to be in decline. Just this week, a US federal judge ruled that NYSE procedure ''makes a mockery'' of the ban on brokers trading in accounts in which they have an interest. As for so-called analysts of tech stocks, they will have a lot to answer for when it all comes crashing down. Expect a rash of billion dollar class action suits against the brokers and investment bankers and some fund managers now celebrating huge year-end bonuses.

As for the follow-the-crowd mentality of fund managers, a process encouraged by three-month assessments of portfolios which should be judged over 10 years at least, Hong Kong provides a reminder of their inability to think independently. Who were the main sellers of Hang Seng Index stocks to Financial Secretary Donald Tsang Yam-kuen in August 1998? And who has bought them back from him at twice the price?

Meanwhile, huge disparities have opened up between the front- runners in their manic market and many perfectly good companies which have good earnings but no ''momentum''. In the US, Tenneco, a competent but unfashionable auto parts manufacturer, was removed from the S&P 500 to make room for Yahoo!. It sells on five times earnings and 0.1 times revenues (against Yahoo!'s 200 times revenue).

The same phenomenon exists in Hong Kong. Most China stocks have been languishing despite WTO. But China Telecom is now at 70 times earnings while mainland power companies, which mostly have real earnings and solid growth prospects, are on single digit multiples. As for most Internet and e-commerce stocks, and the property developers trying to dress up in new clothes, almost all are momentum-driven hype. Many will never have any revenue, let alone worthwhile profits.

This is not to decry the importance of the digital revolution, or suggest that leaders in hardware, software and usage will not enjoy excellent earnings growth. But the tech bubble is on the tip of an iceberg towards which the investors' Titanic is headed, all the while celebrating Y2K.

-- Homer Beanfang (Bats@inbellfry.com), December 17, 1999


Forget the SS Dowtanic, contact me for a real deal on tulip bulbs.

-- JB (noway@jose.com), December 17, 1999.

>> US money supply (M3) has risen by US$140 billion (about HK$1 trillion) or an annual rate of 15 per cent in the past two months. <<

A negative US savings rate and ever-increasing US consumer spending ensures that new money has to pour into the system from somewhere. It appears that the international financial community is balking at lending enough money into the USA to finance our bubble to the end of the year, so Greenspan is making up the difference.

If Y2K is a BITR in Europe, Japan and the USA, I'm guessing the dollar will slide fast and far against the yen and Euro in the first quarter of 2000. Maybe down to 90 yen or lower. The problem for cautious investors is that there is a severe shortage of safe havens.

-- Brian McLaughlin (brianm@ims.com), December 17, 1999.

This all sounds like an implementation of the "greater fool theory." That's when it is OK to buy anything at any price, as long as you can find a greater fool to unload it on at a higher price!

-- Mad Monk (madmonk@hawaiian.net), December 17, 1999.

Brian McLaughlin,

With the Tokyo Exchange not Y2K compliant and Deutsche Bank admitting some implementation shortfalls (both were reported on this forum), I can't see the Euro, the mark or the yen appreciating much versus the dollar.

Rather, after Y2K and the need for the liquidity infusion becomes a liability; I would look for much higher US interest rates that slow economic activity and make debt servicing a ball and chain for most debtors.

I think it quite possible that most global currencies will collectively loose value versus tangible assets like crude oil, gold, silver, palladium, platinum, chromium, nickel, coffee etc.

As an investment, Warren Buffet and Bill Gates have invested heavily in silver - as silver has yet to make a big profitable move, I think some safe haven might be found in physical silver as in circulated US coins pre-1963.

-- Bill P (porterwn@one.net), December 17, 1999.

Following just received from Patrick Shannon's Sanger Review:

Pre-Y2K Money Supply Surge: a Huge Risk, or a Non-Issue? (Michael Casey, Dow Jones Newswires -- requires paid registration) http://interactive.wsj.com/archive/retrieve.cgi?id=DI-CO-19991217- 004373.djml

I'm seeing more and more articles like this one: "Money supply growth is surging at a phenomenal rate and that's fueling speculation the Federal Reserve will aggressively raise interest rates next year to cool the economy down. But economists seem deeply divided on how much of a risk this trend poses to financial markets. Where they stand depends entirely on how each expects the general public to prepare for the year-end Y2K transition. What's clear is that banks have used a variety of financial instruments to raise an enormous amount of precautionary backup cash in case they are besieged by a flood of withdrawals from depositors fearing a breakdown in computer systems. What's not clear is how many bank customers are going to act on such fears, nor whether they will use their excess cash to go on a New Year spending spree." It goes on to say that "banks are sitting on a 'humongous' supply of vault cash - he estimates $40 billion in additional notes, up from $10 billion at the end of September - but... they are reluctant custodians of that currency." Lou Crandal, chief economist at R.H. Wrightson & Associate in New York, said that come January, "you'll see Brinks trucks lined up around the blocks of each bank... That money is costing the banks $10 million a week to hold, and they will be shipping it back to the Federal Reserve as fast as they can." Kevin Flanagan, money market economist at Morgan Stanley Dean Witter in New York, said, "M3 (the Fed's broadest measure of money supply) has grown by nearly $90 billion. That speaks for itself - it's unprecedented... What really is at issue is the sheer magnitude of money we are talking about." He added that "consumers are inevitably going to spend a large amount of this excess cash. A Fed rate hike of 50 basis points in February can't therefore be ruled out."

Money Supply Soars as Y2K Nears (John D. McKinnon, MSNBC/Wall Street Journal) http://www.msnbc.com/news/347594.asp

This piece puts it a little more succinctly: "In trying to ensure a smooth run-up to the year-2000, U.S. Federal Reserve officials might be helping create the potential for economic bumps down the road. Thanks in part to Fed policies that are making money more readily available, businesses and individuals appear to be loading up on cash, much of it borrowed, some analysts say. That is helping to swell values on U.S. securities markets, heating up an already strong economy, some analysts believe. But what happens after the Y2K phenomenon has come and gone? Some analysts say that, at a minimum, the big bucks suddenly sloshing around in the economy could provide further encouragement for Federal Reserve officials to tighten monetary policy again after January, particularly if the increases continue... In November, the Fed's broadest measure of money in the economy, the M3 supply, grew by about 18% on an annual basis, compared with 5.7% for the first six months of the year..."

-- Bill P (porterwn@one.net), December 17, 1999.

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