Bubble Trouble

by Todd Strandberg

If we categorized all the possible end time warning signs by their level of importance, financial despair would certainly rank near the top of that list. War, revolution, political and financial enslavement, and trends toward immorality have all resulted from economic meltdowns.
The Bible tells us there is coming a day when one man, the Antichrist, will have control over the world's financial system. He may achieve this goal during a time of continued prosperity, but it is highly likely his consolidation of power will be aided by a global crisis.
Adolph Hitler owed a great deal of gratitude to the Great Depression for his rise to power. The 1929 crash was the genesis of many of the social programs that now constantly watch over us.
When you consider the lateness of the hour and the incredible opportunity presented by a global recession, it would seem foolhardy for the devil not to take full advantage it.
When I look at our financial markets today, I feel like a passenger standing on the deck of the Titanic, watching a mountain of white emerge from the darkness.
In case you haven't heard, we are currently in the midst of a bubble economy. The insanity that has gripped investors has caused them to push stocks to never before seen levels. The Dow Jones has reached historic new highs, the dividend yield on equities has dropped to new lows, and internet stocks have shattered all records for revenues and earning multiples.
By definition bubble economies occur when asset prices rise to a point where they become grossly over valued. They often fuel their own rise. Soaring stock valuations makes people feel wealthy, so they spend more money, which fuels earnings, which in turn fuels stock prices.
All known bubble economies throughout history have ended with a crash. Once you reach the point where you run out of buyers, down is the only possible direction for equities to head. The following are some of the reasons why I think we are in deep bubble trouble.

The Greater Fool
When you buy a share of stock, you are purchasing a stake in the company's assets - desks, chairs, computers, pencil sharpeners, etc. A company's stock price normally reflects the market's expectation of the future income the corporation can produce with these assets.
Many of today's companies are trading at huge never before seen multiples. These companies have little or no operating income, and yet they have total dollar values that run from 100s of millions to tens of billions.
The prices of these stocks are not based on future earnings potential. They are solely based on the hope that someone will buy the shares at a later date for a higher price.
The investor that was foolish to buy a stock trading at 200 times earnings becomes wise when he finds a greater fool to buy the stock from him at 1000 times earnings.
Falling Earnings
In a normal world, higher earnings causes a stock to rise and lower earnings causes a stock to fall. During the stock market's steep rise of the last several years, this long standing rule has been repeatedly violated.
The profit performance in the U.S. economy has been dreadful. Compared to a year ago, profits per share on the S&P 500 have declined from $39.72 to $37.71, and on the S&P Industrial Index from $42.13 to $38.37.
Stock Options
An option is the right to buy or sell a stock at a given price. As an incentive to motivate employees to make their company grow, many firms have option programs that allow workers to buy stock in their company.
Many of these programs allow employees to buy shares far below the market price. When a company issues stock options, the action dilutes the value of all outstanding shares. A growing number of companies have huge option plans that if fully realized would severely depress the value of the company's stock.
The widespread use of stock options to compensate employees has caused corporate earnings to be grossly overstated, since the options reduce the amount of wages charged against profits. One London-based research institute found that if properly accounted for, stock options would have lowered aggregate published profits by 50 percent.
A "proper accounting" at Microsoft would have resulted in a loss of $11 billion in 1999 even though the company reported earnings of $8.7 billion. This loss will probably exceed $20 billion for 2000.
Yahoo is very good example of an incentive program gone crazy. On March 31, 2000 Yahoo had 536 million shares outstanding. At that same time they also had 100 million options on the books.
Because of option executions and stock swaps, in just 10 months, the market capitalization of Yahoo went from $45 billion to $60 billion with the stock price staying at the same level.
Stock options are even used as a type of payment to other companies for goods and services. This practice is very dangerous because it falsely inflates a company's earnings.
If option inflation is allowed to continue, eventually it's going to have a very negative affect on the stock prices.
Going Into Hock For Stock
As high tech companies dilute the value of their company through stock options, well established firms like IBM; Tosco; 3M; and EDS are engaged in a campaign of share reduction. Throughout the past decade they have borrowed heavily to buy back their own shares.
The original intended purpose of the stock market is to serve as a means for companies to raise capital buy selling shares to the public.
If a firm reaches the point where it's generating surplus cash, it has the option of enhancing the value of its outstanding equity by retiring a portion of those shares through a buy back. It is a very different matter for companies to finance their stock repurchases by going into debt.
In the short run, buying your own shares has a tendency to enhance the bottom line. If a company generates earnings of $5 per share one year and they buy back 10 percent of the float, the following years earnings would seem to have grown by an extra 50 cents per share.
This elusion of growth has a cost attached to it. Borrowed money is not free. At 6.5 percent a billion dollar stock repurchase would take away 65 million dollars from future yearly earnings.
Multi-billion dollar stock repurchases run the risk of putting companies under an unmanageable debt load. It's bad judgment when a firm goes into default because of debts resulting from the acquisition of other companies, but it's pure folly to go bankrupt from buying your own stock.
Bears: A Vanishing Species
A bull is someone that thinks the market is going to rise, and a bear is someone that believes the market is headed lower.
Traditionally stock analysts at the large brokerage houses performed two duties. Their first role was to tell investors what potential winner stocks they should buy. Analysts second job was to tell investors what stocks were potential losers.
In this age where stocks only go up, finding an analyst willing to put out a sell signal has become rather difficult. Most large investment firms have come to view sell recommendations as bad for business. Because many of the companies that brokerages report on are also their corporate clients, we have entered into a new era where downgrades have become uncommon for big name companies.
In recent years many analysts that were bearish on the market have been forced out of their jobs. The chronic shortage of bears has created an environment of incredible optimism. Bullish analysts have become engaged in a bidding war over how high the Dow will climb - 15,000; 30,000; 50,000; and even 100,000 have all been picked as short to long-term targets.
Derivatives
A derivation is a financial agreement that is based on a commodity; monetary; or equity related unit. Derivatives are not tangible assets, they are simply bets that offer traders the right to buy or sell things likes stocks, bonds, or money itself at a predetermined price.
Derivatives can insure individual market participants against risk, but not the system as a whole. Ultimately they have spurred higher risk-taking through leverage, exposing the global financial system to the prospect of devastating failure.
The fact that there is $100 trillion worth of Derivatives in the world today indicates that financial risk has reached a new high. A derivative crash could wipe out entire countries.
The Savings Rate
Currently there is hardly any savings going on in America. Most people are taking more out of their savings than what they are putting back in.
A negative savings rate in a time of prosperity is very unusual. You would have to go back to the depression year of 1933 to find a time when the savings rate was in the minus column.
Money that is saved is going into stock funds. This is very dangerous because people are putting all their eggs in one basket. If the stock market crashes, a large percentage of the population would be in an instant bind.
People need to remember the story everyone was taught as a child - the one about the grasshopper and the ants. The grasshopper played all summer, while the ants worked hard to save up for the coming winter season. When winter came, the ants lived in splendor drawing from their stored reserves, and the poor grasshopper went on a prolonged diet.
A Sea Of Debt
The consumer debt situation is one that has set a record high in every conceivable category. The average amount of consumer debt now stands at $40,000 per house hold. Last year 1.3 million personal bankruptcies were filed in the United States.
Just like in the game of Monopoly, it's hard to win if all your property is mortgaged to the hilt and you're living from one GO to the next GO.
The Federal Reserve's massive gift to debtors has found its way into the mortgage markets. In 1999 homeowners ran up new borrowings to more than $1.5 trillion, nearly two-thirds of it in refinancing.
A third grade math student could easily determine that millions of borrowers are setting themselves up for financial ruin by not taking into account the possibility of a recession coming their way.
In Greenspan We Trust
The Federal Reserve and its fearless leader, Alan Greenspan, have proven by their actions that when the markets stumbles, they will come to the rescue with a rate cut - the 1987 stock crash and the 1998 Asian crisis.
The idea that Uncle Alan will come running if the boys on Wall Street gets into hot water has helped give traders the confidence to push stocks up to these ridiculously high levels.
Because the stock market has risen so high, any cushioning offered by the Fed will likely prove useless.
If you jumped off a 3 story building into a huge pile of pillows, the pillows could easily catch your fall. If you jumped off a 40 story building into that same pile of pillows, you'd probably break every bone in your body.
Right now, we appear to be leaning dangerously over the top railing of the World Trade Center, and that pile of pillows down there looks mighty small.
Scams And Shams
At one time analysts did their best to properly project the earnings of companies they reported on. They were right about 50 percent of the time. Today it would seem these same analysts need to get new batteries for their calculators. They now report earnings too low 75 percent of the time.
The low-balling of earnings has become a fine art, where a company projects an earnings window and the investment analysts consistently forecasts earnings a few cents below that window.
Reporting numbers that beat expectations gives companies the distinction of beating earnings estimates. Shareholders are given a false impression that the company is doing better, even if the year to year earnings are lower.
One of the biggest scams taking place in the market today is the practice of bating investors with initial public offerings. A thin slice of the total outstanding quantity of shares is offered to the public below the expected market price.
With just a limited number of shares in circulation, the stock zooms up on the first day of trading, and everyone jumps in to get a piece of a rocketing internet firm. It's become very common for IPOs to increase more than 100 percent the first day of trading.
Individual investors step in and buy the stock, pushing the demand even higher. As the demand increases, the stock prices hit stratospheric levels. Once the big boys liquidate their initial positions, many stocks drop back sharply.
Crazy Computations
The average stock on Wall Street is over valued by nearly all historic standards. Internet stocks have absolutely rewritten the book on the assignment of value.
Every time I turn around I see some new levels of insanity. I recall one internet venture called Healtheon paying $5 billion for a privately held company called WebMD, that only had sales of $75,000. To top this story off, investor's reacted to the deal by bidding up Healtheon stock three fold.
Many internet companies have valuations that defy the wildest business models on valuation. At one point Amazon.com had a market cap worth all the books sold annually in the US. Priceline.com, which sells primarily junk airline tickets, at its high had a market cap greater than the top three air carriers. AOL's peek valuation implied everyone in North America was planning on becoming its customer.
The grand daddy of price to earnings ratios would have to be awarded to Ebay. It has a P/E of 14,400. Ebay certainly has investors faithfully believing it will substantially grow its earnings. To get back to a reasonable P/E of 25, Ebay will need to multiply its earnings 576 times.
Another good indication of how irrational investors have become is when they bid up the value of one company and don't even bother with the parent company that has a major ownership in what has become a multi-billion dollar firm. You have a situation where company A would be worth $1 billion, and yet it owns 50 percent of company B which is now worth $4 billion.
Uncle Sam's Bad Math
Our government has come under increased scrutiny for using rather strange formulas to measure the health of the economy. Believe it or not GDP growth is being largely measured by the rapid rise of computation power of each new computer chip. This practice is akin to measuring GM's auto sales by tallying the horsepower of all the engines in its cars.
The effect of using advances in computation power has been very pronounce. It has given the computer industry a whopping 93 percent share of GDP growth.
If GDP growth is being overstated, this would not bode well for the stock market. Because earnings are now being projected out several years, even a small decrease in growth would prove detrimental to stock valuations.
One of reason why inflation has been very subdued the past number of years has much to do with how the Federal bean counters factor inflation.
The price of housing has soared, and yet, this huge price increase is largely not factored into the final inflation numbers. The government measures housing inflation by calculating what it would cost you to rent your own home.
When a given commodity like say steak rises sharply in price, the folks in Washington assumes consumers will switch to cheaper hamburger. Gasoline has rising sharply the past year; I don't recall seeing anyone riding horses to work.
In its reporting of economic numbers, the Labor Department has clearly become bias to the point of fraudulence. The rolling back of unfavorable statistics, through the use of smoke and mirrors, should be as illegal as the rolling back of a odometer on a used car.
Money Heaven
When a stock market crashes, most of the value that was in equities vanishes into thin air. If a company has a market capitalization of $50 billion and its stock suddenly drops in half, the shareholders of that company would have lost $25 billion. The money did not redeposit itself into some other investor's portfolio it went straight to money heaven.
Rising stock prices over the past few years have created a wealth effect in the general economy. People are worth more so they spend more. If you have $100,000 in stock a $20,000 Visa balance is no real problem.
With a total valuation now standing at $10 trillion for all US stocks, a 50 percent crash would have a profound influence over the general economy. A five $5 trillion loss would severely alter the buying habits of millions of American's.
Catching A Falling Knife
Once it builds up enough downward momentum, a collapsing stock market is a difficult thing to reverse. Despite a number of attempts to halt its tumble, the 1929 stock market crash did not reach bottom until stocks were down 90 percent.
Microsoft currently sales for $100 per share. Can you imagine the world's largest software company dropping to $10. This can easily happen when people that bought in at higher prices continually sell as the shares plunge.
A bargain purchase of $70 a share becomes a grave mistake when the stock drops to $40. The downward cycle continues until panic selling finally becomes overweighed by panic buying.

You would think the predictable conclusion of all stock market bubbles would warn traders away from repeatedly making the same mistakes. History brims with financial manias, from the real estate bubble collapse in Athens in 333 BC to the Mississippi Bubble in 1720 to the US Cotton Panic in 1837 to the French Credit Debacle in 1868 to The Great Crash in the US in 1929, The 1990 Crash in Japan, and on and on.
Unfortunately, when it comes to separating foolish investors from their money, greed and fear make a great tag-team combination.
I have several books devoted to the subject of financial manias and bubble economies. Historians have record speculative bubbles that date back to the third century. Every single one of them ended in a ruinous collapse.
If we are headed towards a big crash, I'm wondering what God's plan is for this event. I'm hoping it's intended be a final warning sign, telling us to get ready the end-times. Come boom or bust we need to keep our eyes on the everlasting investment trust - the Kingdom of God.