TCS Daily


Dead Cats Dont Always Bounce

By Bondus Marketus Maximus - May 22, 2000 12:00 AM

At TechCentralStation, we're extremely bullish about the transforming power of information technology. Still, it's interesting to read a bear's take on the markets, especially when it's as entertaining as the offering from this week's guest columnist. Furthermore, BMM's advice for policymakers in the event of a crash is right on the money. And we agree that recent Fed interest-rate hikes represent a new element of risk for technology investors. This piece by a New York bond trader is longer than our usual fare, but we think it's worth the trip.

In February of this year I traveled to Tokyo to meet a portfolio manager at a large Japanese bank in order to discuss the U.S. economy and financial markets. Upon meeting him, I followed the standard Japanese business formality of bowing and staring at his business card for a count of ten-Mississippi. We sat down in his office, and I reviewed the prevailing wisdom among American investors: the Internet has ignited a productivity revolution, the U.S. economy will continue to benefit from the slow growth/low inflation policies of the Federal Reserve, and constant infusions of Baby Boomer retirement dollars will allow U.S. equities to deliver consistent 20% annual returns.

My client smiled at me and started shaking his head. "During our stock market bubble, we thought the very same thing. Your NASDAQ is the same as our NIKKEI in 1989. Your bubble will burst as well. It will be very, very painful for U.S. consumers. You are in for quite a rude awakening."

I'm no raging bull, but the certainty with which he pronounced the death sentence for U.S. prosperity took me by surprise. And when a Japanese investor starts talking about stock market bubbles, I pay attention. It's like Daryl Strawberry talking about drug rehab: he knows of what he speaks. The implosion of the NIKKEI from a high of nearly 40,000 in December of 1989 to a low near 12,000 in 1998 is proof that stock market crashes are not myths conjured by James Grant. Markets do crash--just ask anyone in Tokyo. In fact, you probably won't have to ask. Almost everyone I met found a way to work the term "NASDAQ bubble" into the first thirty seconds of a conversation. They seem to be sitting back with detached amusement, watching America sprint towards what they believe to be certain economic calamity.

The word "crash" is thrown around loosely these days, so I should define the term. It seems that every time the NASDAQ hits a 200-point air pocket, someone in the financial media starts talking about a "tech crash". That is not a crash. As painful as the recent "correction" in the NASDAQ has been, it has not crashed. Even "Black Monday" in 1987 was not a true crash, despite the hype. The index still ended up with a slight positive return for the year. A crash is when a market goes down 60% and stays there for 10 years, as happened in Japan. A crash is a cataclysm that destroys all sectors of the economy, in and out of the financial industry. A crash halves real estate values. A crash wipes out retiree's lifetime savings. A crash topples governments. There are no "dips" to buy because the market never goes up.

Even the most die-hard optimist cannot help but be set a-tremble by how bad things have been and for how long in Japan. Coming from the American bull-market echo chamber, a visit to Japan to see the inverse of "irrational exuberance" is like a cold cup of black coffee after an all-night bender. We've all seen the charts showing how equities outperform all other investments over the long term. Terms like "buying on the dip" and "new economy" are taught in kindergarten, just after finger painting and the afternoon nap. The percentage of U.S. household income currently held in stocks is the highest in the history of capitalism.

Considering so many of us own so much stock, it's not surprising that challenges to the concept of aggressive equity ownership are rarely heard. Sure, there are a few bearish analysts left on Wall Street and in the financial media. They're generally kept locked in a dark closet, wheeled out only on special occasions like a crazy aunt. Few of the senior strategists at major brokerages that recommended anything but at least 80% equity exposure and an over-weighting of technology stocks lived professionally to see the new millennium.

Bull market delirium once swept Japan as well. Investors bought stocks on margin. They borrowed against Visa cards to own the latest hot IPO. New valuation metrics like the "Q Ratio" were devised to rationalize insanely high prices. Apartments bought in Tokyo in 1986 tripled in value by 1989. Japanese investors went on an international shopping spree, buying premier properties such as Rockefeller Center and Pebble Beach for nosebleed prices. American companies sent executives to Japan to study the miracle of Japanese efficiency. Then the bubble burst, and ten years later the Japanese economy is still on its knees.

To a visitor, Tokyo appears to be a bustling, prosperous city. Knowing in advance the devastation of the Japanese economy, I stepped off the airplane half expecting a scene from "Escape from New York". I found just the opposite. Tokyo today looks like a boomtown. There are massive construction projects underway. The shopping districts are jammed with people flooding in and out of high-end U.S. and European retailers. The streets are filled with enough brand new BMW's to make West Palm Beach feel inadequate. People are well dressed, the subways are packed and the streets are clean. So where was the depression? The soup kitchens? The homeless? I was expecting to find a Stienbeck novel and instead found something that looked weirdly like a big, crowded Upper East Side.

You don't have to hang around Tokyo long to figure out things are not exactly as they seem. The outward prosperity of modern Tokyo is largely a government-funded illusion. The pols are running the Asian equivalent of the Tennessee Valley Authority. They're borrowing massive amounts of money and pumping it into public works projects in an unsuccessful attempt to revive a comatose economy. Japan's national balance sheet looks like that of a third world country. The national debt is currently 150% of GDP. The worst the debt-to-GDP ratio ever got in America was 80%, and that was after fighting the Cold War. Japanese corporations also contribute to the false image of prosperity. Historically it hasn't been acceptable for Japanese companies to lay off employees due to economic hard times, productivity be damned. Times are changing grudgingly and the unemployment rate has "spiked" to around 4%, but that is still artificially low. As for all the fancy cars and nice clothes, it was explained to me that appearances are extremely important in Japan. Some laid-off businessmen will still commute to work and wander around the financial district with newspapers under their arms so their friends won't know they're out of work. Two families will share a tiny three-room apartment 2.5 hours from work, yet they own BMWs. It's an ethic only residents of L.A. could appreciate.

If the health of Japan's economy can be measured by the soundness of its banks, then the country is still on life support. Many of Japan's largest banks such as Yamaichi and Nippon Credit have failed. Those remaining have had to merge in order to remain solvent. They're struggling to liquidate massive portfolios of bad real estate loans on a scale that makes the U.S. Savings and Loan crisis look puny. As I spent time in Tokyo hearing about lives destroyed by the bursting of the Japanese bubble, one question kept going through my mind: are any of the same circumstances that caused the NIKKEI to crash at play in the NASDAQ today? Most economists will tell you that Japan had a unique set of economic problems and that few if any of these factors apply to the U.S. That may be true, but there are enough similarities to make a prudent investor pay heed.

The most obvious comparison is between the Bank of Japan and the Federal Reserve. By April of 1990, the NIKKEI had lost more than 20% of its value from the high in December of '89. Yet due to fears of rising inflation, the BoJ raised interest rates by a whopping 100 basis points in March of 1990. They did a 75 bp encore in August, and the rest is history. When the reality of the economic tailspin hit, the BoJ was forced to lower interest rates 12 times over the next 9 years from 6.00% to the current rate of 0%. Is the Fed following the same bad script in attempting to temper the wealth effect? It's too early to tell, but with the NASDAQ down 30% since March and the Fed recently opting for a 50-basis-point rate hike, things looks eerily familiar to Japanese portfolio managers.

Another troubling similarity is the cross-holding of stock by corporations. One of the reasons cited most frequently for the collapse of the Japanese market was the "keiretsu system", whereby companies owned massive amounts of each other's stock as a way of boosting share prices. It worked great when prices were rising, but when the market crashed it spread the pain to companies in every sector of the economy. Are U.S. companies making the same mistakes today? Many of the best known U.S. technology companies have massive investments in start-up companies. Intel, for example, has an investment portfolio of more than 400 companies valued at around $10 billion. Even stodgy banks have gotten in on the action. Last year Chase Manhattan made a $1.5 billion investment in such New Economy blue-chips as "1-800 flowers.com". Landlords in New York and San Francisco are accepting stock options instead of rent from start-up tech companies. While the Japanese system of cross-holdings has been lampooned by economists as foolhardy, some American companies today might be making the same mistake.

Another mistake made in Japan in the wake of the NIKKEI crash that could easily be repeated after a U.S. crash involves the foolishness of politicians. Concerned about severe revenue shortfalls as a result of the economic slowdown, Japanese politicians reacted in 1994 with a massive tax increase. Aggressive easings from the BoJ were nullified and the economy accelerated its descent. Does anyone want to bet that U.S. politicians won't make the same mistake? In an era of massive budget surpluses Washington is unable to stomach a significant tax cut. If they won't give us back any of our money in times of plenty, how will they react when the capital gains cash cow dries up? My bet is that they'll react much like their Japanese counterparts: with fear, panic and higher taxes.

The argument heard most frequently as to why the NASDAQ is different from the NIKKEI is that there is substance behind the euphoria. There is a technology revolution happening in America today, the argument goes, unlike in Japan in the 1980s. Our stock market rally is sustainable because it is based on a tech-led productivity revolution, while the NIKKEI rally was not sustainable because it was based on vapor. This to me seems the weakest argument of all. The world is in a constant state of technological revolution. Certainly the productivity improvements being reaped by the Internet and the telecom booms are profound. But what about other less-hyped innovations of the past? With the introduction of the personal computer, you could retrieve files with the stroke of a key rather than a walk down to the Records Department. Pull your old Smith Corona out of the closet and try typing a letter and you'll see how revolutionary a word processor must have seemed to a secretary in the 1980s. With the invention of the office copier, documents could be duplicated quickly and cheaply. With the fax machine, papers could be sent instantly rather than via 3-day mail. Every decade has advances in technology. It's not clear that our current one is justification for buying stocks at 700 times estimated 2005 earnings.

I trade bonds for a living, but as a person with the majority of his net worth tied up in the equity market, it's my most profound hope that the Japanese experience is indeed irrelevant to our economy. I hope the bull market mantras of slow growth, low inflation and a credible Fed keep the markets rising. I hope the Fed doesn't repeat the mistakes of the Bank of Japan. I hope Intel's $10 billion technology investment quadruples in value. I hope the politicians don't raise taxes when the surplus dries up. I hope we're not over-valuing the economic impact of the Internet. I hope we all retire in 20,000-square-foot homes with SUV's the size of the Partridge Family Bus.

Ten years ago Japanese investors were also full of hope.

Bondus Marketus Maximus runs a bond-trading desk at a major Wall Street firm.
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