"Detour On Easy Street": My Stock Market Warning in May 2000
Remnant Review
Tech Stocks: Everyone's Getting Rich! Here's how to get your share.
Money (May 1999), cover
The cover featured a thirty-something couple, smiling happily. Tech stocks were the road to riches a year ago. They were still the road to riches three months ago. Everything was coming up digital roses. Then came March 11. From that day on, Easy Street had a detour sign posted on it.
The cover copywriters know how to sell magazines. They sell to middle-class people at middle-class subscription prices. They know what their readers dream of: riches. Being middle class in the richest nation in history is not good enough for readers. They want the good life. Access to the good life is supposedly open to anyone with a dream and a few dollars to invest monthly.
We have seen all this before, though not on this scale. In the mid-1950's, a promoter named Bernard Cornfeld launched a mutual fund, Overseas Investors Services, Ltd. He started it with $300. The company sold shares to small investors, initially American servicemen stationed in Europe. He came up with one of the most brilliant marketing slogans of all time: Do you sincerely want to be rich? He sold shares of U.S. mutual funds to Europeans through a company registered in Canada and Luxembourg, where securities regulation was loose. In the go-go years of the 1960's, IOS shares skyrocketed. So did Cornfeld's Fund of Funds, which invested in 10 U.S. mutual funds. By 1969, Cornfeld on paper was worth $200 million (about $750 million today). IDS looked good until the recession of 1970. Then the financial press ran a series of exposes on IOS, which they had touted in 1969. The company's high commissions and expenses started producing losses. It collapsed when Cornfeld's successor, Robert Vesco, looted the company and fled to Central America. Investors who held on lost all of their money. Their sincere desire to become rich was their undoing.
The key to his slogan's success was one word: "sincerely." It seemed to transform what most religions have seen as a base motive into a righteous quest. It appealed to the power of positive thinking. Positive thinking -- sincerity -- would accomplish the miracle of multiplying loaves and fishes.
What was a promoter's slogan in the 'sixties has become a universal mantra today. American investors sincerely want to be rich. They sincerely expect the stock market to make them rich. They sincerely believe that the stock market will rise at 20% per annum, world without end, amen. The true believers also sincerely believe the Nasdaq is the market of the future.
The warning signals are all around them now. Their faith is sincerely wrong. Sincerely greedy people ignore these signals, or try to; This, too, is familiar. I remember reading an article in late 1969 or early 1970 which featured Hugh Heffner and Cornfeld, both of whom surrounded themselves with flashy young women. At the end of the article on their good life was a note that said that both of their empires were beginning to suffer losses. But investors ignored the warning. Today, the investing public still cannot quite believe that Easy Street always ends in a detour. Or worse: a dead end.
The Nasdaq's Blues
In my February 4 issue, "The Madness of Crowds," I wrote:
While the average stock has continued to fall in price in the last two years, the Internet and technology stocks soar to new heights. The discrepancy is becoming more obvious as time goes on. Investors are persuaded that the wave of the future is in Internet stocks. The wave of the future is assumed to be positive. But the discrepancy between the performance of the two worlds tells us that the mania cannot be sustained. When investors at last lose confidence in the ability of their portfolio to perform except on the basis of the "greater fool" theory, they will search for more conventional returns. When they do, a crash in this sector will take place. Reality will intrude.
Five weeks later, the Nasdaq's day of reckoning at long last arrived. The Nasdaq index plummeted by 34% from its high on March 10 (5,049) through April 14, though not in a straight line. It rebounded in the third week of March back to the 5,000 range. That was the market timers' last chance to bail out near the all-time high. In the final week of March, it collapsed. Then it rebounded by almost 1,000 points in the first week of April, only to fall again. On May 23, it fell below its previous low point for the year. These wild gyrations are unnerving. They reveal a nagging loss of confidence and an increase of confusion among individual investors.
Tech fund portfolio managers are not able to sell off their funds' holdings without collapsing the market for these stocks. Then why are the sector's prices falling? Because, at the margin, their prices are falling. New buyers will not offer yesterday's higher price to new sellers. A stock's price at the margin is imputed by the market to the portfolio holdings of that stock, which tech fund managers are holding. So, the portfolios fall in value even though there is no wild sell-off by the tech funds. wait until fund managers finally figure out that stocks with P/E ratios of 200 or 150 are going to kill their funds' performance in 2001 and beyond -- maybe way beyond.
Consider the fact that stock index funds must buy more and more high-tech stocks when their prices rise. The managers have to buy them. As the tech sector's total capitalization rises, the index fund managers must increase their holdings of tech stocks. Example: as Cisco's capitalization rose to twice IBM's, index fund managers steadily had to sell IBM and buy Cisco. This process of replacement continued across the board after 1996. This is why tech stocks by March 10 accounted for over 20% of index funds' portfolios.
The great reversal has now begun. Index fund managers have begun to sell off tech stocks and replace them with conventional stocks. Again, they have no choice. An index fund has to reflect the overall market. A fall in the Nasdaq's tech stocks will pull down the index funds. The sale of high tech stocks by the index funds will further depress the tech sector. what was a pleasant upward spiral will become an unpleasant downward spiral.
This is what is scary about what is happening to the Nasdaq. The Nasdaq's top 100 stocks are built into the index funds. We are not yet seeing a panic sell-off of Nasdaq shares. The market is down by over a third, but selling has been orderly. But what has changed in the fundamentals? Not much. Not yet. On May 16, Greenspan announced a half-point increase in short-term interest rates. "So what?" investors shrugged -- briefly. They have been told that the New Economy pays little attention to interest rates. This seemed true until late in May. Stocks that have P/E ratios of 100+ had seemed immune to anything as minor as a half-point increase in short-term rates. The Nasdaq rose the day after Greenspan made his announcement. But then it reversed. All of a sudden, high-tech stocks seemed more vulnerable to the interest rate hike than Dow stocks did. The Dow started down, too, but not at the same gut-wrenching rate as the Nasdaq.
When interest rates go up, stocks go down. This is normal. But the tech stocks had seemed impervious to the FED's rate hikes. This gave confidence to new investors who got onto Easy Street late. The downturn in May tells us that the tech stock phenomenon is coming to a close. A Reuters story on May 22 reported: "The Nasdaq composite index fell to its low point for the year today as investors sold technology stocks on fears that earnings will be hurt by rising interest rates." Earnings? what earnings? when a stock sector sells for 200 times earnings, no buyer or holder is paying any attention to earnings. What was significant is this: that story invoked the language of conventional investing to explain the fall in the Nasdaq. Reality has at long last begun to intrude into the world of the Nasdaq, like the camel's nose intruding in the tent. The rest of the ugly beast will follow soon.
In the April 6 issue of Remnant Review, I asked rhetorically, "Is Cisco Kidding?" I expressed my extreme skepticism about the wisdom of owning shares in Cisco. At that time, Cisco sold for about $70 a share. It had a P/E ratio of about Z00. The largest stock brokerage firms recommended buying it. There were no exceptions that I saw. Two months later, Cisco was selling for about $50 a share. Its P/E ratio had fallen to about 140.
The entire investment world has been caught up in a frenzy. Anything resembling economic rationality was lost in early January, 1998, when the Nasdaq was at 1,500. At the beginning of 1996, it was 1,000. In 1998, the P/E mania arrived. (See the P/E chart in my February 4 issue.) Experts began saying that tech shares which sold for 100 times earnings belonged in a conservative stock portfolio. when the P/E ratio climbed to 200, they still said so. It could have climbed to 300. This would not have changed their opinion. A P/E ratio of 200 is economically irrational except as a crap-shoot. Why not believe in 300? It is only 50% more irrational than 200.
Whenever we find ourselves in the middle of a stock buying frenzy, it takes self-discipline to stay out of it. It takes a long-run view of market rates of return. warren Buffett knows more about long-term returns in stocks than any other multibillionaire investor. He stayed out of the tech-stock mania. He was criticized publicly for this decision a few weeks ago by a disgruntled investor in Berkshire Hathaway. Buffett brushed off this criticism. He has steadfastly stuck to his knitting -- knitting that has produced the highest rate of return for any stock holding company in history.
Buffett for a while was the target of criticism from the financial press. Writers whose only net worth is the home they own and a pension fund they don't manage said that Buffett's skills were developed in an earlier investment world. That world is over, they suggested. He supposedly was washed up, a 70-year-old dinosaur. He was still looking for shares with P/E ratios of less than 40. He was holding on to the past.
Men forget: what's past is prologue. Fashions come and go, but a dark blue pinstriped wool suit still won't get anyone into trouble in most social circles. Maybe it would be a liability in Silicon Valley, where a 1,200 square foot, two-bath, one-bathroom home sells for $800,000. But Mr. Buffett lives in Omaha. I would rather own real estate and pinstriped suits in Omaha than real estate and T-shirts in San Jose. Think of a dark blue pinstriped wool suit as a P/E ratio of 15. A P/E ratio of 100 is a pair of Nike running shoes and a T-shirt that says, "whoever dies with the most toys, wins."
Interest Rates and Stock Markets
Stock market investors are today betting on the greater fool theory. They can maintain the illusion of a steady stream of fools only if the market continues to appreciate. The name of the game is capital gains. But this bet has failed badly since March 10 -- and failed very badly in the tech stocks.
Today, dividend returns are so low that taxation and inflation more than consume them. In a May 1 column for the London Times, William Rees-Mogg summarizes the way capital consumption works today.
On the latest figures, the Dow Jones index has a dividend yield of 1.5 per cent; that is the gross income. From that, the private investor, if he lives in New York, probably has to deduct 50 per cent in federal and state income taxes, leaving a net dividend of 0.75 per cent. The latest figures for inflation show an annual rate of increase in consumer prices of 3.2 per cent, and this inflation is rising. Even before meeting the costs of running a portfolio, the investor has a negative real income of 2.45 per cent; with costs that loss is much bigger.The justification that is given for investing at a loss is that Mall Street has gone up in the past, and will go up in the future. This has been true over the very long term; it is not necessarily true of every year, or even of every decade; it may not prove true this year. It has historically been very difficult for stock markets to go on rising when interest rates were being increased by the world's central bank.
In the end the interest rates win. Interest rates have recently been raised by the central banks of the United States, Europe and Britain.
May 1 was the day to sell Nasdaq shares. Rees-Mogg then quoted from the Lex column in the Times (April 28). It is a widely read column. Its opinions are taken seriously in the investment world, Rees-Mogg says. I have no reason to doubt him. Lex thinks the bloom is off the rose.
Lex is forecasting a rise in US interest rates from the present 6 per cent to 7 per cent or 7.5 per cent. Lex considers that will either produce a crash, presumably a drop of 25 per cent or more from present levels, or lower stock prices, presumably a fall of 10 per cent or more. That means that Mall Street faces a real negative return of somewhere between 12.5 and 27.5 per cent, or conceivably higher, over the next 12 months, if Lex is correct. Those fund managers who share this view, and they are probably the majority, will try to protect themselves. They will be selling the more speculative stocks and increasing their cash holding. If they do, the correction on Wall Street, and in other markets, is not over yet . . .We are seeing a battle between central bankers and consumers, between interest rates and inflation, between prudence and optimism, between the old economic realities and the new technological hopes. At present, the fortunes of this great battle are measured by the fluctuations of Wall Street. At some point the central bankers, interest rates, prudence and reality are going to win the war; they always do.
May produced something approaching a crash in the Nasdaq. On May 1, it was at 4,000. Three weeks later, it was under 3,200. The Dow fell, too, but it has not approached crash status. The Nasdaq has.
Two weeks before he wrote this column, Rees-Mogg wrote another on the same topic (Times, April 17). In it, he made a significant point:
An unsustainable boom creates a greater psychological momentum than a more normal one. One can see that in the earlier history of wall Street. From the late 1890s to the early 1920s, the stock market in the United States, despite big fluctuations, maintained what seemed a natural growth rate of about 6 per cent. In the eight years from 1921 to 1929 the stock market rose by about 340 per cent, a compound growth rate of approximately 20 per cent. Just as the boom psychology of the 1990s was supported by the new Internet technology, S0 the boom of the 1920s was supported by the then new technologies of telephones, radio and automobiles.
Rees-Mogg is saying that we are seeing a replay of the roaring twenties. He does not forecast a replay of the 1930's. He says that the Great Depression was caused by failing banks. This will not happen again, he says.
This prediction assumes that the central bankers are in control of the world economy. It assumes that the gigantic increase in the derivatives markets in the 1990's is not beyond the power of central bankers to control, despite the fact that this market is international and is in the range of $150 trillion - dwarfing the reserves of any central bank.
Consider foreign trade. America's current account deficit in 1999 was almost $340 billion. In 1998, it was $220 billion -- bad, but a lot less than in 1999. So far this year, we are running a trade deficit as large as it was last year. This can be interpreted in two ways, both of which are accurate. (1) Americans are importing more than they are exporting, and borrowing the difference from foreigners. (2) Foreigners are investing heavily here, and are selling Americans cheap goods to get the dollars to invest. The size of the trade deficit is unprecedented. Does this mean that foreign investment in the U.S. is also unprecedented? Yes. What happens when this process ends? The savings rate by Americans is at an all-time low: under 1%.
In 1990, investors held about $450 billion in Treasury debt and a little more than this in other securities. This rose steadily until 1996, when it reached $1 trillion in Treasury debt and $1.2 trillion in other securities. By 1998, foreigners' holdings of Treasury debt had risen to a little over $1 trillion, but had leaped to $2 trillion in other U.S. securities. This indicates how vulnerable to a sell-off by foreign investors the U.S. financial markets really are. (See the chart on page 8 of Robert Blecker, "The Ticking Debt Bomb," Briefing Paper [June 1999], published by the Economic Policy Institute: http://www.epinet.org/briefingpapers/debtbomb.pdf) A sustained fall in U.S. stock markets will make it less desirable for foreigners to invest here. They will stop selling us so many goods. This will force up the price of imported goods, which will increase the rate of U.S. price inflation. This will lower the international value of the dollar. This in turn will make it less desirable for foreigners to own dollar-denominated investments. It's going to be a downward spiral. This is why the fall in the Nasdaq and the weakness of the Dow threaten the value of the dollar.
We can see what is coming in the graph produced by Robert Blecker. It traces the decline of the United States as a creditor nation. It 1983, the U.S. was no longer a creditor nation. It was not a debtor nation, either. But then a relentless decline began. In 1993, the deterioration accelerated. With the trade deficit now in free fall, the graph's projections are coming true. This is from page 2 of his article, "The Ticking Debt Bomb."
Blecker's assessment of the threat is worth considering. He makes a good point: if U.S. interest rates rise, the outflow of dollars to foreign investors will make the U.S. balance of payments deficit worse. The deterioration will accelerate even faster. Interest rates are now rising.
Moreover, as shown earlier, higher interest rates would imply greatly increased net outflows of interest payments to foreign creditors, which would worsen the current account deficit and depress U.S. national income. Thus, the large domestic and foreign debts of the United States could potentially turn a soft landing into a hard one. This could happen if bankruptcies rise, banks fail, and domestic incomes have to be squeezed to permit greater outflows of net interest payments . . .How big a "hit" could the U.S. economy take in the event of such a crisis? Some simple calculations reveal that a serious economic depression could easily result. Suppose that the U.S. was forced by a withdrawal of net foreign lending to balance its current account. Conservatively, this would require shrinking the current account deficit by 3% of GDP, or about $270 billion at current prices (given a GDP of approximately $9 trillion in 1999). Suppose further that the dollar falls only by enough to eliminate half of this gap. It can easily be estimated that to close the rest of the gap (i.e., to reduce the trade deficit by $135 billion) via income adjustment, national income would have to fall by about 6% in real terms. This would be an adjustment on the order of magnitude of what has been felt in crisis countries such as Brazil. Mexico. Korea. and Thailand in recent years. and much larger than the drop in output in any recent U.S. recession. (p. 12, emphasis added.)
This estimate could be way off. Economies are not easy to predict. But the threat is not an illusion. This nation is now a net debtor. This places U.S. decision-makers in a bind. As Moses warned Israel 3,000 years ago, "The stranger that is within thee shall get up above thee very high; and thou shalt come down very low. He shall lend to thee, and thou shalt not lend to him: he shall be the head, and thou shalt be the tail" (Deuteronomy 28:43-44). The stranger need not reside inside the U.S. to gain this power. The modern telecommunications system sees to that. One word displays this power: "Sell!"
The strength of the dollar internationally has kept this from happening, so far. But now we are facing a recession. The economic boom is longer than any in U.S. history. The technology stock mania is sagging. A Republican President will probably replace a Democrat. Traditionally, this has resulted in a recession early in his term (Nixon, 1970-71; Reagan, 1981-82).
Greenspan says that he is still worried about price inflation. The U.S. has a 3% rate of price inflation, which is higher than Europe's by 50%. But the CPI officially reached almost a 4% annual rate in late December. It fell back in the first quarter. what about monetary inflation? If we look at the chart of the adjusted monetary base, which the Federal Reserve can control, we see a sharp decline since December. The box within the chart indicates that from January 12 to March 22, the decline was 26.6% per annum. Then it reversed slightly. But this is still a substantial decline for the year. I recall nothing like it.
The FED ran up the currency supply as a Y2K defensive measure. Then it cut way back. In mid-April, the FED began expanding the base again. This was one month before Greenspan raised interest rates half a point as an anti-inflation measure. He is no doubt looking at other monetary statistics. M-1 is flat. M-2 is up. Greenspan has never used any one monetary statistic to formulate policy. He has testified that economists really don't know what indicator reveals what money is. But they do know what the monetary base is, and it's in a deflationary mode today more than I have seen in 25 years of monitoring it.
Then why announce an increase in short-term rates as an anti-inflation measure? To send a signal to investors: the FED is determined to end the "irrational exuberance" of the U.S. stock market. The monetary base is not a major topic of discussion in the financial press. Interest rates are. The contraction of the monetary base is unknown to most people. when Greenspan goes in front of the cameras and says the FED will raise rates, and it does, this sends a signal. The rise in short-term rates was assured by the sharp contraction of the monetary base: boom demand facing a coming contraction of money. This way, the FED has positioned itself as being in control of rates directly rather than indirectly. The public pays more attention.
Greenspan has weathered every storm since the October crash in 1987, when he had been on the job for about a week. He got through Bush's 1992 recession. He sought his reappointment as Chairman. There is no doubt in my mind that he believes that he can re-establish rational exuberance. Nobody voluntarily signs up as captain of the Titanic.
The boom in the stock market in the second half of the 1990's was fueled by the expansion of money. Look at both M-2 and M-3 in the following graph. The growth in M-3 began in early 1993., The growth in M-2 began in early 1995. The rate of growth in both of these monetary aggregates peaked in late 1998: M-3 at more than 10%, M-2 at 8%. They both fell back to the 5% per annum rate by late 1999. But by then, irrational exuberance had taken over. The markets kept rising despite the reduction in the rate of growth in the money supply. Bear in mind, however, that nothing like this year's contraction of the adjusted monetary base took place.
It does not look as though Greenspan cares if the price of the "New Economy" stocks drop. Why should he? This sector is too small in the overall economy: less than 5%. It has received lots of publicity, but it's small potatoes overall.
If the Dow falls too far, I think the FED will pump in money. But this strategy assumes that the heart of the economy is money. But this stock market boom has been fueled by non-bank credit.
Dr. Kurt Richebächer, who is a retired central banker (Germany). in his April newsletter emphasized the importance of credit growth for the stock market boom. The same mutual growth phenomenon took place in 1925-29, he says, but today's credit growth dwarfs anything in history. He writes: "Mr. Greenspan has presided over a credit explosion that simply defies reason and comprehension. Looking exclusively at the inflation rate, he readily sanctioned a free-for-all in credit expansion. In 1995, total financial and non-financial credit had expanded by a little more than $1 trillion. After a rise to $1.4 trillion in 1997, credit flows abruptly swelled to more than $2.1 trillion in 1998 and further to $2.25 trillion in 1999. In comparison to GDP growth of $459 billion in 1998 and $500 billion in 1999, credit creation has been truly running amok." But what could Greenspan do about this? Most of this growth of credit is taking place outside the banking system, Richebächer says. Greenspan is a hands-off economist most of the time.
The biggest difference between 1929 and today, he says, is corporate finance. Companies in early 1929 had sold stock and built up near-cash assets. Today, corporations are increasing their debt and buying back shares. They buy shares that pay 1% in dividends with money borrowed at 7%. (Even if they do not borrow the money from outside the company, they still forfeit the income that the money could have earned.) This strategy drives up the price of the shares. It increases the value of management's stock options. It looks brilliant as long as credit is loose and optimism remains high. The problem will come when credit tightens, optimism fades, and interest must be paid.
Capital Gains Taxes and Price Floors
A major reason why the stock market has reached such a low rate of return for dividends is the tax structure. 'The public has decided that dividends are taxed at higher rates, so capital gains taxes are better. But people are paranoid about paying capital gains, too. They think, "The market will come back. It always does. So, I had better not sell." Taxation penalizes those who sell their shares. They hold on, no matter what risks they are facing.
If their funds are in a tax-deferred pension account, they can shift from stocks into bonds and/or a money market fund without paying taxes. They look at their gains, and they refuse to switch. They stick with what they've got.
This has driven P/E ratios to unprecedented levels. A P/E of 7 to 8 was considered acceptable in the summer of 1982, which was the market's bottom. Today, it's 29 for the S&P 500. These are not high-flying stocks. Nor is this the peak. About 60% of these stocks are down from their highs two years ago.
But the public won't recognize that we are coming off of a market top. The top is behind us. The threat of a move back to normal P/E ratios is unthinkable to investors. The S&P would have to fall from its top by at least 50% to approach conventional P/E ratios. But if it fell this far, panic would ensue, as it always does.
This has been the warning of a declining number of stock market analysts for four years. They know the past. They look at what has happened to every "new era" in the past. But this bull market has kept rising, despite Europe's stagnation and Asia's contraction in 1997. Investors are convinced that prices will rise, no matter what happens abroad, no matter what Greenspan does with interest rates, no matter how high P/E ratios go.
What they are saying is that stock price appreciation is independent of the economy. It does not matter what the rest of the world does. Next year, someone will offer more money to buy U.S. stocks. Stocks should not be sold because stocks will rise. Dividends are beside the point. who needs them? The problem with this investment strategy is that people need income to live. They can either earn it, or they can sell assets. The retirement funds eventually must move from pay-in to pay-out. We know when this has to begin: no later than the 2010. A person born in 1945 turns 65 in 2010. This is the beginning of the baby boomers' retirement years. Demographics works against retirement portfolios from that point on. There will be too many people looking for income rather than capital gains.
Will there be another decade-long economic boom that will match the 1992-2000 boom? Such a duration for an economic boom has never happened in U.S. history. So, only the continuation of pension fund investing can sustain the stock market. If there is any sign that people want to reduce their exposure to a falling stock market, pension fund managers will have to move from stocks to bonds. The result will be rising bond prices due to falling long-term interest rates, as money moves out of stocks and into bonds, driving up bond prices (lowering rates). This will mean less income for those who move into bonds late. That will add to men's fear.
The low savings rate today tells us that Americans are not worried about their economic futures. They are not worried about their retirement. They are thinking about getting rich through the stock market. They think a rising stock market will enable them to sell off a few shares if and when they need the money to live on. So, they ignore dividends. The dividend yield on the S&P 500 is under 1.2%.
They assume that American investors are now immune to the kinds of trials that threaten retirees around the world. They do not believe that the government could ever default on pension promises. They think they will remain healthy, and that Medicare will be there forever if they get sick. They really do believe that someone else will cover their expenses if they ever reach a crisis. So, they look at their investments as the secure road to riches. They really do think they will die rich.
Pareto's Law and the Levitating Stock Market
Who owns most of the wealth of the United States? Not the poor. The middle class? You might think so, but you would be wrong. The middle class has too much debt. The richest 20% own most of the tangible, marketable wealth. This is nothing new. This is the same old story. It is a story that will smash the middle class dreams of easy, automatic, "buy and hold" riches. The only question is: How soon?
Back in 1897, economist-sociologist Vilfredo Pareto's study of income distribution appeared. He surveyed the-larger countries of Europe and found that there was a strange income distribution curve in all nations that he studied. Something in the range of 20% of the population received about 70% to 80% of the income. This figure has not changed much over the last century. Later studies by other economic historians indicated that in 1835-40, 1883, and 1919 in Great Britain, the richest ten percent received fifty percent of the nation's income. An economist wrote in 1965: "For a very long time, the Pareto law has lumbered the economic scene like an erratic block on the landscape; an empirical law which nobody can explain." (Josef Steindl, Random Processes and the Growth of Firms: A Study of the Pareto Law [London: Charles Griffin, 1965], p. 18)
A 1998 study by the Centre for the Study of Living Standards in Ottawa, Canada, revealed that the 20-80 rule still applies quite well in the United States. The top 20% percent of the population owned 81% of household wealth in 1962, 81.3% in 1983, 83.5% in 1989, 83.7% in 1995, and 84.3% in 1997. For the top 1%, the figures are as follows: 1962: 33.4%; 1983: 33.8%; 1989: 37.4%; 1995: 37.6%; 1997: 39.1%. [http://www.csls.ca/new/rtw.html#17] These changes have been in the direction of greater concentration of tangible wealth in the United States.
This seems impossible. Don't middle-class people own their homes? No; they reside in them, but they borrow to buy them. They pay mortgages. The rich are the holders of these mortgages. Title is passed to the home owner, but the asset has a debt against it. Most middle-class Americans own very little debt-free marketable wealth. They use debt to buy depreciating assets: consumer goods. They do not save more than a small fraction of their income.
There is no known way for any industrial society to alter significantly the share of tangible wealth owned by the rich. whenever political force has been applied in the form of tax policy, the percentages have stayed pretty much the same. It is not even clear that there will be different wealth holders after the new taxation policies are in force, unless the existing wealth owners are deliberately expropriated or executed, as they were in Communist nations.
Getting rich is simply not possible for 80% of the population. Anything that offers the hope of riches to the middle-class majority is a delusion. There was a time when Communist revolutionaries offered this dream to the poor. Those dreams failed to come true. The same dream is being offered to middle-class Americans today. It will also fail to come true.
The next President will get to put up the detour sign on Easy Street. This will probably be Mr. Bush. I wish him well. I hope the junior Senator from New York decides not to run for President in 2004. But I can see what is likely: a political reaction against Bush as the destroyer of dreams.
This stock market is levitating because of the promise of pension fund money, which seems to insure a floor. This faith is a faith in the debt-burdened middle class. Somehow, they will stick with this market, no matter what. Their pension fund managers will continue to pour their clients' money into stocks, no matter what. Somehow, they will not cash out when they retire. Somehow, there will be enough of them to sustain this market.
This market is a market that is being sustained for the benefit of the richest 20% of the U.S. population. It seems self-perpetuating. But the fact is, this market is the product of the credit system, which is based on faith in a stream of income to maintain interest payments. what happens to these hoped-for income streams when those who are the major investors, who hold most of the nation's wealth, derive most of their money from stocks? How will a 1.17% S&P dividend yield pay for the margin debt system that demands 7% or more?
Americans' investment money is now about 75% in stocks. Margin debt is holding up this market as never before. Margin financing must be paid for. How can it be paid for if dividend yields are under 2%? The dividend income generated by the capital assets underlying the shares does not support the level of debt used to purchase the shares. The stock margin's debt meter is ticking relentlessly. It is being fed today mainly with after-tax money generated from outside the stock market. Those buying shares on margin must have a fast return; otherwise, they cannot feed the meter. The market's boom phase has ended for the Nasdaq's high-flyers. Any hope in a fast profit sufficient to enable the speculator to sell shares and pay off his debt with the profits is now utterly naïve. We are now ominously close to the day when stock market investors will run out of coins to feed the ticking meter. I presented evidence for this in my March 3 issue. I quoted Alan Newman:
Margin debt now stands at $228.5 billion -- 2.41% of GDP -- the first time since the Roaring Twenties margin debt has been above 2% of GDP. Note that even in the manic year of the 1987 Crash, margin debt only amounted to 0.9% of GDP. Adjusted for the effects of inflation, the picture becomes even worse. Margin debt is up 3.3 times since the mania began in 1995 and is nearly double what it was only two years ago.
How will this end? Badly. How badly? The international credit markets would completely unravel in a worst-case scenario. The derivatives market would become illiquid. This is what Jim Cook describes in his new novel, Full Faith and Credit. Cook's narrative offers one of the best introductions I have read on the nature of the systemic risk of a rapidly falling stock market. His main point is this: it's not just the equity markets that are at risk. It's the credit markets, too. The spread of credit to finance every aspect of the world's economy has put this economy at risk. This is not just a domestic American problem today. There are too many foreign investors in U.S. markets.
Originally published in 2000 as Remnant Review Vol. 27, No. 6
Any footnotes in original have been omitted here. They can be found in the PDF link at the bottom of this page.
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