23rd February 2004
Thursday, September 2nd, 2010
Zbigniew Piekarski on Bubble trouble
"Looking forward, the odds of sustained robust growth are good although, as always, risks remain."
- U.S. Federal Reserve Chairman, Alan Greenspan
- U.S. Federal Reserve Chairman, Alan Greenspan
Some of the smartest, brightest and most powerful people in the world gather together at exclusive venues in order to discuss aspects of the world economy. They then attempt to provide solutions to whatever they see as being a problem. Such meetings have become media events and the answers to questions raised are treated with reverence and respect; for if these individuals cannot identify a problem and provide a solution, then who else can?
One such annual pilgrimage is located at the heart of Yellowstone National Park, Wyoming, at Jackson Hole and for the past few years, The Economist magazine has asked the attendees at this conference several searching questions.
In 2001 one question was: "Is this a bubble?" All the smart, bright and powerful individuals there said "NO." Since then, time has shown, rather conclusively, that it was a bubble, particularly for technology stocks.
Also in 2001 they were asked whether there was any possibility of a recession in the USA. Their unanimous verdict was "NO," implying that all was well in the world. Since then, events have proved otherwise.
In 2002, when asked whether interest rates in the USA could fall to one percent, they were united in their conclusion: "NO," they said and in 2003 when asked whether the dollar could fall to $1.25 against the euro at any time in the next 12 months; all except one said, "NO".
Now even The Economist, normally a promoter of conventional wisdom, has come to question the accuracy of these smart, bright, powerful and well-paid individuals when it writes that, 'In short, they provide an excellent contrarian indicator.'
In three hours of testimony, Alan Greenspan, the Chair at the Jackson Hole meetings, offered an upbeat economic outlook, playing down fears about the impact of the dollar's recent fall, although he did warn that the budget deficits were rather dangerous. At the time, the Consensus stock index and the Market Vane index of investor sentiment was around 81 percent bullish. Usually, above 65 percent is getting extreme. On that day, the Chicago Board Options Exchange Put/Call ratio reached 0.42, a level reminiscent of the optimism prevailing in the early months of 2000 (0.37). This ratio illustrates the number of bets that the market will be put down against those saying that it will be called up, also known as the 'fear factor'. Now just about everybody is bullish, and so much unanimity of opinion is rather scary.
This carefree attitude is based on a certainty that trouble is a thing of the past and that investors will continue to experience higher and higher prices, with modest 'profit-taking' occurring at predictable intervals. This was the state of mind of millions when the first phase of the present bear market struck in March 2000. A touch of trouble arrived and the markets fell. Yet investors remained buoyant and now have become more delusional than ever for they have included the 'survivor's illusion' among their many hallucinations. Having survived the bear market and recession of 2000-2002, they believe that they have some special grace and are now able to expect miracles.
Last summer, there were only 12 companies trading in the United States which had both a market capitalization (total value) of over $1 billion and a price-to-sales ratio of 10 or greater. This $1 billion/10-times sales hurdle is one of my favorite measures of bubble valuations: it's simple and objective.
When a very large company is trading at 10 times its annual sales, it's hard to imagine how it will be able to grow fast enough to provide an economic return for new investors. A new investor would have to expect the equivalent of 10 years' worth of sales in retained earnings to break even on the investment. Without a very high rate of earnings growth, that cannot happen. And a high rate of earnings growth in very large companies is extremely difficult to achieve, especially in a global economy characterized by poor pricing power and overcapacity. What scares me is that today there are 98 companies trading in the United States that investors have driven up to at least $1 billion in market capitalization and a price-to-sales ratio equal to, or greater than, 10.
Investors who bid up these stocks have not yet recognized the new division of labor in the world. China produces; the USA consumes; and Japan finances. The Bank of Japan has spent $250 billion, or $2,000 per head of its population over the past 13 months, in order to hold the dollar up. It has created money in order to buy U.S. Treasury bonds and, by doing so, drive down interest rates and underwrite U.S. economic growth. Quite recently, Japanese officials stated that they will defend the 105.00 level "vigorously" even though their efforts have failed to stem the yen's appreciation from its 130.50 low (December 2001).
The crucial question about to be answered is whether governments have finally discovered how to finance limitless deficits through the creation of paper money alone. History clearly shows that all attempts in the past have failed, with dramatic consequences.
Some institutions are beginning to protect themselves from the impending storm. Last September Prudential, which is the only major Wall Street brokerage that doesn't also conduct investment banking operations, altered its rating system. Instead of having its analysts decide objectively if a stock offered good value, Prudential instructed them to offer only 'relative' valuations. In other words, nobody was willing to tell investors that things were getting out of hand. Instead, as long as all stocks were getting equally overvalued, Prudential could still find something to recommend.
On the WSE: I note that the paper Parkiet has reported that the largest publicly listed companies are now worth 30 percent less than they were in 2000. As the WIG20 has retraced 50 percent of its fall and is meeting resistance, prepare for the largest publicly listed companies to decline by about another 30 percent over the next two years.
From Warsaw Business Journal
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