Optimism is to be sold in Bear Markets
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Optimism is to be sold in Bear Markets
A new book "Bull!" by former Barron's journalist Maggie Mahar (Harper Business, $27.95), gives the best account I've seen of the great bull market of 1982-1999, including all the things that went wrong. There are lessons for us all in it, not just for 2030 or thereafter, when the next bull cycle of that magnitude comes, but for today. Many of the malpractices that besmirched the 1990s never died out, or have made a comeback in the market's upward movement since March.
Mahar points out that historically, long bull market trends of 15-20 years in the U.S. stock market have alternated with long bear market trends of the same duration. She goes into detail in explaining this, and on the whole I agree with her analysis. In the later stages of bull markets, survivors of the previous bull market are few and far between, and so market participants come to believe that this time, things are different, and conventional valuation metrics no longer apply. Equally, at the end of bear markets, participants come to believe that stocks are an intrinsically poor investment, so that stock valuations become depressed far below their mean historical levels.
Thus when the market finally turned bullish in 1982, after a bear market lasting since 1966, that had dropped the Standard and Poors 500 Index by three quarters in real terms, it was to be expected that it would remain bullish until at least the middle 1990s, and that the advance would raise the market to a substantial multiple of its 1982 level.
Mahar is also excellent on the pathologies that inevitably occur in the later stages of a long bull market. Individual investors move increasingly into stocks, whether or not it is appropriate for their life situation. Mahar gives a number of examples of individual investors caught up in the great boom, some of whom were lucky enough to sell out, partially or completely, in 1999-2000, and therefore did very well, while the majority rode the market down as well as up and generally, having been invested in relatively speculative stocks, found themselves in 2002-03 poorer than when they entered the market.
Stock market analysts at the top of a boom cease carrying out analysis, but instead become shills for the companies they analyze, and for the corporate finance operations of their employers. Financial journalists, too, seeking to maintain good relations with their analyst sources, become shills for the market and cease doing their job of exploring and reflecting reality.
In this context Mahar is sympathetic to the young Merrill Lynch analyst Henry Blodget, who at the top of the boom began to express doubts about the companies he was covering, doubts which have subsequently caused the authorities to end his Wall Street career in disgrace. She points out that other analysts, such as Morgan Stanley's Internet analyst Mary Meeker and Goldman Sachs' market strategist Abby Joseph Cohen, were protected from the authorities by their employers. They have thus remained employed and respected, even though their analyses were mindlessly bullish throughout the peaking of the market, and investors who relied on them lost their shirts, in the case of many companies not simply in a market downturn but in a swindle.
To some extent, one is tempted to regard the long bull market as being important, but without huge lessons for the future. Some people made money, lots of money, more in the end lost moderate or large amounts of money, but that's capitalism! However, two features of the latter stages of the bull market are concerning, and remain relevant: the sharp increase in market and accounting "shenanigans" and the question of who knew what in relation to the last four crazy years of the bubble.
Apart from the sorry saga of management stock options, which during the bull market became a means whereby management could divert ever larger amounts of shareholders' wealth into their own pockets, the most disturbing aspect of the bull market was the sharp decline in accounting standards, as evidenced by the Enron, WorldCom and Tyco debacles, and the demise of Arthur Andersen. Neither the leakage through stock options (for example Intel's third quarter earnings, released to much acclaim Tuesday, do not take account of stock option grants to executives) nor the blizzard of "extraordinary items" have let up since the boom ended.
Mahar gives a chart, showing that extraordinary items taken "under the line" and therefore removed from reported earnings, in members of the S&P 500, averaged a net 5 percent diminution of earnings until 1996 (with the occasional positive item providing an increase) but shot up to a peak of over 50 percent of net income in 2001-02, and were still 38 percent of net income in 2003. While some of those items are no doubt genuine, the huge increase in extraordinary items after 1997 cannot possibly be genuine. Therefore earnings in 2002-03 are really around 35-40 percent diluted, compared to those before 1996. (Any individual company normally takes its "extraordinary items" in one big negative quarter, and then reports earnings with only modest extraordinary items thereafter; for the market as a whole, however, there are big "extraordinary items" write-offs in every quarter.)
Consequently, the stock market is equivalently overvalued. Since the market, as represented by the S&P 500, is already trading at an earnings multiple of 20 times reported earnings, well above the historic mean of 14-15, the additional dilution to correct earnings for the excessive extraordinary items suggests that at an equilibrium level the S&P 500 Index should trade at its current level of 1,049, multiplied by 14/20, multiplied by 0.65, or around 477 -- less than half its current level.
Of course, nobody in the market is currently saying that. Instead the chorus from Wall Street is merely debating how quickly the S&P 500 will rise above 1,100. This in itself is an indication that the pathologies of 1999-2000 have not left us, and that investors should be very careful indeed before committing money to this casino.
The other question on which Mahar is very interesting is the behavior of Federal Reserve Chairman Alan Greenspan and Clinton-era Treasury Secretary Robert Rubin in relation to the bubble. It is well known that Greenspan in particular, and the Federal Reserve Board of Governors as a whole, felt in late 1996 that the market was outrunning any rational valuation level (the S&P 500 Index was at that point around 700) and debated whether to do something to cool the bubble. On December 4, 1996, Greenspan famously gave a speech denouncing "irrational exuberance," but then according to Mahar, concluded that the Fed could do little or nothing about the bubble. Indeed remarkably soon thereafter Greenspan became a cheerleader for the market, seizing on highly spurious and subsequently heavily downwards revised productivity growth data emanating from the Bureau of Labor Statistics. The traditional remedy available to him, an increase in stock trading margin requirements, was not tried.
Rubin, on the other hand, in contrast to George W. Bush's feeble Treasury Secretaries Paul O'Neill and John Snow, was a former chairman of Goldman Sachs, in a perfect position to recognize when the market had become overvalued, and according to Mahar did indeed so recognize in late 1996.
At that stage, as Treasury Secretary he arguably had a fiduciary responsibility to prevent a highly damaging bubble from growing out of control. When the current period of Fed-induced euphoria has ended, I would be quite surprised not to see either official action or a class action suit against him, seeking restitution of the losses suffered by many in 1999-2002. Treasury Secretary Andrew Mellon, far less responsible than Rubin for the equivalent 1920s episode (because the market of 1929 was much less overvalued than that of 1999, and in any case there was at that time no clear prior precedent to draw upon) was harassed mercilessly by the Roosevelt administration from 1933 on, particularly through his income tax returns, and only narrowly escaped a jail sentence before his death in 1938.
The enormous damage perpetrated by the last years of the bubble is well illustrated in another book "Starving to death on $200 million," by James Ledbetter (Public Affairs, $26) a riotously funny and yet sad account of the rise and fall of the "Industry Standard," a magazine founded in 1998 to carry all the news, gossip and ideas surrounding the Internet. This achieved enormous critical acclaim, a record volume of advertising in its second year of operation, and bankruptcy just 3 years after its founding. The Industry Standard's problem was not, as might have been expected from its origins, catastrophically amateurish management; it appears to have been reasonably well managed. However, it got far too big far too quickly, achieving $200 million in revenues in 2000 when it had originally expected to achieve $5 million, and then saw a 75 percent fall in advertising volume in a matter of a few months, after it had built up a staff of 500 and corresponding overhead. Warren Buffett could not have managed a business under such conditions; in the environment it faced, its death was inevitable.
That environment was a product of the neglect by Greenspan and Rubin of a bubble that was dangerously out of control by late 1996, and got worse later. Had the bubble been deflated, and had market conditions remained rational, the Industry Standard would almost certainly be with us today, to the great benefit of its staff and shareholders, and the significant benefit of the rest of us, for whom it was a well regarded and original publication.
From Mahar's analysis of long term bull and bear markets, it seems likely that the bear market that began in 2000 should run until at least 2015, by which time stocks should be well below their long term equilibrium levels. This makes the current prognostication exceptionally gloomy.
The market has recovered more than 30 percent in the last 7 months. It has been helped by two rounds of tax cuts, huge dollops of cheap money, and incessant market chatter about a "productivity miracle" since 2001. This new "miracle" is very likely to turn out as spurious as that of 1995-2000. After all, in marked contrast to the period after 1995, when the Internet was available as a plausible cause of a productivity miracle, today's bulls have no rational explanation for a productivity miracle in the middle of a recession, with U.S. capital spending sharply down. However, we are currently in this respect flying blind. The BLS's annual revisions for 2002, which revisions have in past years eliminated spurious miracles in the unrevised data, were not published in August, as is usual, but instead will be released this year only around December 10, 4 months later than the usual cycle.
This dauntless optimism, according to Mahar, is typical of the early phase of a secular bear market. At some stage, probably within the next few months, the long grind downwards to 477 or below on the S&P 500 Index will resume.
By: Martin Hutchinson
Mahar points out that historically, long bull market trends of 15-20 years in the U.S. stock market have alternated with long bear market trends of the same duration. She goes into detail in explaining this, and on the whole I agree with her analysis. In the later stages of bull markets, survivors of the previous bull market are few and far between, and so market participants come to believe that this time, things are different, and conventional valuation metrics no longer apply. Equally, at the end of bear markets, participants come to believe that stocks are an intrinsically poor investment, so that stock valuations become depressed far below their mean historical levels.
Thus when the market finally turned bullish in 1982, after a bear market lasting since 1966, that had dropped the Standard and Poors 500 Index by three quarters in real terms, it was to be expected that it would remain bullish until at least the middle 1990s, and that the advance would raise the market to a substantial multiple of its 1982 level.
Mahar is also excellent on the pathologies that inevitably occur in the later stages of a long bull market. Individual investors move increasingly into stocks, whether or not it is appropriate for their life situation. Mahar gives a number of examples of individual investors caught up in the great boom, some of whom were lucky enough to sell out, partially or completely, in 1999-2000, and therefore did very well, while the majority rode the market down as well as up and generally, having been invested in relatively speculative stocks, found themselves in 2002-03 poorer than when they entered the market.
Stock market analysts at the top of a boom cease carrying out analysis, but instead become shills for the companies they analyze, and for the corporate finance operations of their employers. Financial journalists, too, seeking to maintain good relations with their analyst sources, become shills for the market and cease doing their job of exploring and reflecting reality.
In this context Mahar is sympathetic to the young Merrill Lynch analyst Henry Blodget, who at the top of the boom began to express doubts about the companies he was covering, doubts which have subsequently caused the authorities to end his Wall Street career in disgrace. She points out that other analysts, such as Morgan Stanley's Internet analyst Mary Meeker and Goldman Sachs' market strategist Abby Joseph Cohen, were protected from the authorities by their employers. They have thus remained employed and respected, even though their analyses were mindlessly bullish throughout the peaking of the market, and investors who relied on them lost their shirts, in the case of many companies not simply in a market downturn but in a swindle.
To some extent, one is tempted to regard the long bull market as being important, but without huge lessons for the future. Some people made money, lots of money, more in the end lost moderate or large amounts of money, but that's capitalism! However, two features of the latter stages of the bull market are concerning, and remain relevant: the sharp increase in market and accounting "shenanigans" and the question of who knew what in relation to the last four crazy years of the bubble.
Apart from the sorry saga of management stock options, which during the bull market became a means whereby management could divert ever larger amounts of shareholders' wealth into their own pockets, the most disturbing aspect of the bull market was the sharp decline in accounting standards, as evidenced by the Enron, WorldCom and Tyco debacles, and the demise of Arthur Andersen. Neither the leakage through stock options (for example Intel's third quarter earnings, released to much acclaim Tuesday, do not take account of stock option grants to executives) nor the blizzard of "extraordinary items" have let up since the boom ended.
Mahar gives a chart, showing that extraordinary items taken "under the line" and therefore removed from reported earnings, in members of the S&P 500, averaged a net 5 percent diminution of earnings until 1996 (with the occasional positive item providing an increase) but shot up to a peak of over 50 percent of net income in 2001-02, and were still 38 percent of net income in 2003. While some of those items are no doubt genuine, the huge increase in extraordinary items after 1997 cannot possibly be genuine. Therefore earnings in 2002-03 are really around 35-40 percent diluted, compared to those before 1996. (Any individual company normally takes its "extraordinary items" in one big negative quarter, and then reports earnings with only modest extraordinary items thereafter; for the market as a whole, however, there are big "extraordinary items" write-offs in every quarter.)
Consequently, the stock market is equivalently overvalued. Since the market, as represented by the S&P 500, is already trading at an earnings multiple of 20 times reported earnings, well above the historic mean of 14-15, the additional dilution to correct earnings for the excessive extraordinary items suggests that at an equilibrium level the S&P 500 Index should trade at its current level of 1,049, multiplied by 14/20, multiplied by 0.65, or around 477 -- less than half its current level.
Of course, nobody in the market is currently saying that. Instead the chorus from Wall Street is merely debating how quickly the S&P 500 will rise above 1,100. This in itself is an indication that the pathologies of 1999-2000 have not left us, and that investors should be very careful indeed before committing money to this casino.
The other question on which Mahar is very interesting is the behavior of Federal Reserve Chairman Alan Greenspan and Clinton-era Treasury Secretary Robert Rubin in relation to the bubble. It is well known that Greenspan in particular, and the Federal Reserve Board of Governors as a whole, felt in late 1996 that the market was outrunning any rational valuation level (the S&P 500 Index was at that point around 700) and debated whether to do something to cool the bubble. On December 4, 1996, Greenspan famously gave a speech denouncing "irrational exuberance," but then according to Mahar, concluded that the Fed could do little or nothing about the bubble. Indeed remarkably soon thereafter Greenspan became a cheerleader for the market, seizing on highly spurious and subsequently heavily downwards revised productivity growth data emanating from the Bureau of Labor Statistics. The traditional remedy available to him, an increase in stock trading margin requirements, was not tried.
Rubin, on the other hand, in contrast to George W. Bush's feeble Treasury Secretaries Paul O'Neill and John Snow, was a former chairman of Goldman Sachs, in a perfect position to recognize when the market had become overvalued, and according to Mahar did indeed so recognize in late 1996.
At that stage, as Treasury Secretary he arguably had a fiduciary responsibility to prevent a highly damaging bubble from growing out of control. When the current period of Fed-induced euphoria has ended, I would be quite surprised not to see either official action or a class action suit against him, seeking restitution of the losses suffered by many in 1999-2002. Treasury Secretary Andrew Mellon, far less responsible than Rubin for the equivalent 1920s episode (because the market of 1929 was much less overvalued than that of 1999, and in any case there was at that time no clear prior precedent to draw upon) was harassed mercilessly by the Roosevelt administration from 1933 on, particularly through his income tax returns, and only narrowly escaped a jail sentence before his death in 1938.
The enormous damage perpetrated by the last years of the bubble is well illustrated in another book "Starving to death on $200 million," by James Ledbetter (Public Affairs, $26) a riotously funny and yet sad account of the rise and fall of the "Industry Standard," a magazine founded in 1998 to carry all the news, gossip and ideas surrounding the Internet. This achieved enormous critical acclaim, a record volume of advertising in its second year of operation, and bankruptcy just 3 years after its founding. The Industry Standard's problem was not, as might have been expected from its origins, catastrophically amateurish management; it appears to have been reasonably well managed. However, it got far too big far too quickly, achieving $200 million in revenues in 2000 when it had originally expected to achieve $5 million, and then saw a 75 percent fall in advertising volume in a matter of a few months, after it had built up a staff of 500 and corresponding overhead. Warren Buffett could not have managed a business under such conditions; in the environment it faced, its death was inevitable.
That environment was a product of the neglect by Greenspan and Rubin of a bubble that was dangerously out of control by late 1996, and got worse later. Had the bubble been deflated, and had market conditions remained rational, the Industry Standard would almost certainly be with us today, to the great benefit of its staff and shareholders, and the significant benefit of the rest of us, for whom it was a well regarded and original publication.
From Mahar's analysis of long term bull and bear markets, it seems likely that the bear market that began in 2000 should run until at least 2015, by which time stocks should be well below their long term equilibrium levels. This makes the current prognostication exceptionally gloomy.
The market has recovered more than 30 percent in the last 7 months. It has been helped by two rounds of tax cuts, huge dollops of cheap money, and incessant market chatter about a "productivity miracle" since 2001. This new "miracle" is very likely to turn out as spurious as that of 1995-2000. After all, in marked contrast to the period after 1995, when the Internet was available as a plausible cause of a productivity miracle, today's bulls have no rational explanation for a productivity miracle in the middle of a recession, with U.S. capital spending sharply down. However, we are currently in this respect flying blind. The BLS's annual revisions for 2002, which revisions have in past years eliminated spurious miracles in the unrevised data, were not published in August, as is usual, but instead will be released this year only around December 10, 4 months later than the usual cycle.
This dauntless optimism, according to Mahar, is typical of the early phase of a secular bear market. At some stage, probably within the next few months, the long grind downwards to 477 or below on the S&P 500 Index will resume.
By: Martin Hutchinson
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