The New Era
The 1990s will be remembered as the most fabulous decade in the history of Wall Street. Driven by visions of a "new economy" with its phenomenal technical improvements, the boom has set all- time records. From October 1990, the low point of a readjustment, to the end of the decade, the Standard & Poor's 500 index soared by some 400 percent, the National Association of Securities Dealers Automated Quotations index (NASDAQ) by more than 1,100 percent. This inordinate rise in stock prices is unique in the annals of American finance; it surpasses by far the increases preceding the crash of 1929 and the Japanese break in 1990.
The proven rules of stock valuation seem to be outdated. At its high in January 2000, the total market value of American corporate stock of $16.8 trillion exceeded the gross national product (GNP) of $9.5 trillion by a factor of 1.7. At the height of the Japanese bubble in 1989 the stock value exceeded the Japanese GNP by a factor of 1.4. And, in 1929, the American stock value surpassed national income by a mere 1.1. Even the trading of corporate stock surpasses all previous records. In 1999 the value of shares changing hands amounted to some 250 percent of GNP; in 1929 it barely reached 130 percent. Throughout many decades devoid of symptoms of stock fever it rarely ever reached 50 percent.
During the 1920s the driving force of the "new era" was great technical innovations such as the radio, electricity, and the automobile. Assembly-line production in the auto industry pointed the way to rising productivity in other industries, and the airplane promised a new mobility of man and cargo. Unprecedented technological progress caught the imagination of the American people who relished the new-found prosperity. They enjoyed rising labor productivity and wage rates, stable goods prices, and low unemployment. From 1922 to 1929 GNP expanded at an average annual rate of 4.2 percent, while corporate profits soared by more than 60 percent. Whenever stock prices seemed to sag, President Calvin Coolidge and his Secretary of the Treasury, Andrew Mellon, reassured and encouraged the market while the Federal Reserve System supplied the high-octane fuel. Between 1921 and the middle of 1927 the Fed lowered its discount rate from 6 percent to 3.5 percent. Stock exchange loan rates fell to under 4 percent and bankers' acceptance rates to 3¼ percent. When, in 1928, interest rates began to rise, the lure of stock market profits had caught the imagination of speculators who, clamoring for brokers' loans, borrowed large funds at rising rates of interest. The crash of October 24, 1929, finally signaled the bursting of the bubble.
During the 1990s the driving force was the sweeping growth of the Internet which caught the imagination of many investors. It revolutionized the flow of information and knowledge throughout the world and ushered in a new, long phase of economic expansion. Just like the radio during the 1920s, the Internet opens new vistas for consumers and producers alike. It imparts and uses information within seconds. It facilitates the marketing of homogeneous financial products and services (credits, equities, insurance) and simplifies the sale of some consumer goods. The Internet offers the greatest benefits in inter-business relations by reducing transaction costs. Consequently, U.S. gross national product rose some 3.6 percent annually from 1991 to 1999, accelerating to more than 4 percent in the last three years. Business profits soared to some 9 percent annually, while wages rose by just 3.2 percent. The improvements occurred without much inflation, which gave rise to the notion of a "new era," just as they had during the 1920s.
The explosive growth of the Internet and the World Wide Web ("the Web") has touched most Americans. Research organizations estimate that, by the end of the decade, some 90 million Americans used the Internet, that 56 percent of all U.S. adults were on-line, and that American Internet users spent an average of some eight hours on-line. While the number of on-line shoppers was jumping by leaps and bounds, many on-line companies made little if any profit. They nevertheless attracted not only numerous speculators but also corporate buyers. Internet companies suffering start-up losses payed billions of dollars to acquire other Internet companies suffering losses.
A popular form of commerce on the Net is on-line Wall Street brokering which allows investors to buy stock at lower commission rates and to trade stocks at times when the stock exchanges are not open. These stock-trading sites handle hundreds of thousands of stock trades daily, which often overwhelm them. They may suffer extended periods of being out of service. Some big Wall Street firms have joined on-line brokering and offer dependable services. In the marketing of dissimilar products and services, the Internet still has many basic limitations. Moreover, it still lacks a dependable and secure institutional setting and legal framework not only in the United States but throughout the world.
Euphoric investors and speculators readily supply e-commerce newcomers with start-up capital, which guarantees the presence of keen competition. But the presence of many actual and potential competitors casts doubt on the high profit expectations of the speculators, especially since rapid technological progress may soon deprive a newcomer of his innovative position. In a market free of entrance barriers and undergoing rapid technological change, the start-up losses may be followed by ruinous competition rather than monopoly profits. But speculators may not be guided by the possibility of dependable returns on their purchases; they may be led by the hope of a quick profit on an actively traded stock.
On September 5, 2000 Barron's published a list of the 20 largest NASDAQ companies along with their earnings and yields, price-to-sales ratios, and market capitalizations. Eighteen of the twenty companies paid no dividends and two paid less than one percent. The valuation of these 20 stocks completely ignored the well-proven criteria such as satisfactory dividend returns and earnings records and the presence of marketable, tangible assets. Instead, stocks are judged according to expectation of future earnings. But expectation often fails, and most often, where it promises most.
Psychologists may be able to explain the phenomenon of a speculation bubble by analyzing the psyche of speculators. Seeking to explain the extraordinary size of the bubble, some point at the managers of the giant mutual fund industry who have become quite reckless dealing with other people's money rather than their own. If they are successful, they reap huge rewards for their prowess. If they fail, the losses fall on others, while their own holdings, if any, may be unaffected by their misjudgment. Other psychologists speak of the "herd instinct" of man, an innate impulse that often seizes the herd of speculators. It is especially powerful when hope turns into fear and panic; they produce market crashes.
Economists must search for the monetary framework that permits the financing of the lofty price structure at the stock exchange. An ever-larger share of the total supply of money must be diverted to the financing of soaring stock prices, which reduces the share available for consumption. It helps to explain the "new" combination of stable consumer prices and soaring asset inflation, which characterized both the 1920s and 1990s.
Many observers applaud Federal Reserve Chairman Alan Greenspan for his exemplary monetary policy. Since 1995 when the Internet growth potential came in clear sight, he supplied the economy with ample credits, as the M2 and M3 growth rates clearly indicate-- M2 (cash plus demand deposits and small time deposits)rose from 3.7 trillion in December 1995 to 4.7 trillion in December 1999, and M3 (M2 plus large-denomination time deposits) from 4.6 trillion to 6.5 trillion. Yet the monetary expansion, which exceeded by far the GNP growth rate, did not cause consumer goods prices to soar despite the great consumption propensities of American households. The Internet brought greater market visibility and transparency which restrained producers from raising prices. The rising demand for labor springing from the rapid economic expansion was met by a reduction in unemployment and by immigration; the rate of unemployment fell to a record low of just 4 percent. Just as during the 1920s, the Federal Reserve sought to meet its assigned task of preserving price stability and simultaneously promoting economic growth. And again just as during the 1920s, the monetary expansion of the 1990s not only stimulated economic activity but also roused the speculative fervor of many Americans.
Alan Greenspan frequently intervened verbally, scolding investor exuberance, which proved to be rather ineffective. His interventions not only may have been too numerous to be believable but also differed significantly from the actual policies of the Fed. In the Fall of 1998 the financial crisis in the emerging countries in Asia and South America induced the Fed to reduce its rates no less than three times. The Fed Funds rate was lowered in three one-quarter phases from 5.5 percent to 4.75 percent. Thereafter, the forces of speculation could no longer be restrained; stock prices soared to unprecedented heights despite later boosts in interest rates. When, in May 2000, the Fed Funds rate finally was raised to 6.5 percent, the stock market fervor showed some hesitation.
Mainstream economists now wonder whether the Fed should heed the movement of stock prices and mitigate the effects of significant changes. After all, soaring stock prices are boosting consumer spending which may raise consumer goods prices. Since 1995 the soaring S&P 500 is estimated to have boosted private household spending by more than 4 percent, which is bolstering the looming danger of price inflation. To the spenders, high stock prices seem to afford a measure of security against uncertainties. Since 1990 the high prices of stocks personally owned, together with those owned indirectly in pension and mutual funds, more than doubled American household wealth.
The massive growth of consumer debt other than home mortgages seems to build on this new household wealth. Borrowing with credit cards, lines of credit, loans against insurance policies, and many other methods, consumers increased their debt from $863 billion in the first quarter of 1994 to some $1.5 trillion in the last quarter of 1999. Many acted confidently in the knowledge that their stock gains would cover not only the additional interest costs but also the new debt itself.
The speculators among them even financed some transactions on credit; in just 12 months, between February 1999 and February 2000, margin debt soared some 75 percent from $151 billion to $265 billion. But this debt is rather minuscule when compared with the total stock value of $16.8 trillion. Yet, total indebtedness of households surpasses by far that of the 1920s. In 1929 it amounted to some 53 percent of annual household income. During the 1990s, despite the phenomenal rise in stock profits, it rose from 47 percent in 1990 to more than 67 percent today. A sudden reversal of this trend would seriously affect not only the structure of production but also the configuration of stock prices.
While household indebtedness has reached record proportions, the international indebtedness of Americans is rising steadily, month after month. During the 1920s they prided themselves on balance-of-trade surpluses; during the 1990s they suffered record deficits now exceeding $250 billion a year. These deficits are rather innocuous and painless as long as foreigners willingly finance them through direct and portfolio investments. They would become a calamitous burden, if foreigners should wish to repatriate their funds for any reason. A rush to the exits undoubtedly would weaken the U.S. dollar, aggravate the price inflation, and deflate stock prices.
At this time we do not anticipate such a rush. With the Fed Funds rate at 6½ percent and the Prime Rate at 9½ percent, the highest in nine years, and with the American economy expanding at astonishing rates, foreign investors may be tempted to increase their American holdings. Some foreign Prime Rates are significantly lower than American rates: in Switzerland 5.25 percent, Germany 4.5 percent, and Japan 1.5 percent. International investors and financial institutions can profit handsomely by borrowing funds in those countries and lending them in the United States. But such interest-rate differentials are not market differentials; they are the creations of various national monetary authorities and, therefore are subject to sudden changes. The political setting of the authorities may change, or just the notion and perception of the situation guiding the authorities in the conduct of their policies.
No one can know whether we are facing a calamitous situation similar to that of the 1920s in the United States and the 1980s in Japan. We cannot plan the future by the past, and we cannot predict the future. But we may speculate on the consequences of certain actions and policies because we do have some knowledge of natural and economic laws that are basic and fundamental to human nature and are discoverable by human reason. This is why we look upon the equity market as a bubble area which will last as long as the common faith in the "new era" sustains it and the Fed provides the necessary funds for it. Austrian economists also know that any and all funds created by the Fed, even if they do not cause goods prices to rise significantly, falsify the market structure and necessitate corrections. Nine years of credit expansion have created countless maladjustments which the market sooner or later will correct. The severity of the correction will depend not only on the gravity of the maladjustments but also on the remedial policies intended to prevent the readjustment. During the 1930s the Hoover and Roosevelt policies aggravated and prolonged the readjustment, making it the Great Depression. Similarly, the Japanese government aggravated the maladjustment with monetary and fiscal policies that have prevented a recovery until now a decade later. Both examples make us fearful that the Fed and the U.S. Government will make matters worse as soon as a market readjustment comes into sight.
Mindful of the inevitability of a correction and a return to sound values, many observers brace for an early "landing". Some anticipate a "soft landing" when stock prices slowly drift lower, causing consumers to curtail their buying, which will reduce corporate earnings and cause the stock market to drift ever lower. Other observers question the "drift theory." They are convinced that, seized by the fear of losses, the herd of speculators is likely to stampede to the exits. They will not heed the reassurances of the President of the United States and his Secretary of the Treasury, just as their forefathers had paid no attention to them in 1929. But they may react to massive rescue operations by the Fed which will supply the money market with instant credit to all big debtors in need. It may rescue a few financial institutions but surely fail to prevent the overdue adjustment. In fact, the rescue actions may turn into prolonging and exasperating actions, just as they did during the 1930s in the United States and the 1990s in Japan.
With a national election coming up, the Federal Reserve System may want to preserve the boom, lest it be censured for interfering with the election process. Although it may succeed for a time, the market, which is more powerful than any Fed intervention, may soon force a readjustment. It may usher in a recession which would cast a lasting shadow on the new president and his victorious party. Fate laughs at political victories.
Hans F. Sennholz