THE LIBERTARIAN ENTERPRISE
Number 534, August 30, 2009
"Ding Dong the Drunk is dead!"
Special to The Libertarian Enterprise
Do you remember the "new economy" back in 1998? Amazon was trading at $331 per share (28 December 1998). But where were the earnings? There were none. People were swept up in a stock mania to rival the Dutch tulip mania of the early 17th Century. Companies like Yahoo were trading at 320 times projected earnings for the coming year. A more normal valuation would be 18 times trailing earnings. But in many instances there were no earnings.
We were told that was okay. There was a revenue model. Fool.com would report that a CIBC Oppenheimer analyst had projected a stock price of 15 times projected revenues and had plugged in a 2000 forecast of $1.5 billion to come up with a "strong buy" recommendation for Amazon. Why would anyone expect a stock at $240 to go to $400? Because they were crazy, that's why. And after a 3:1 stock split in early 1999, the forecast came true, anyway.
At the height of the Dot.com bubble there were zombie companies trading at ridiculous stock prices. And everyone was swept up in the mania. It was a new economy. Earnings didn't matter. Anyone could play. Simply bet on a company with a business model you didn't understand based on revenues that were barely available and earnings that might arrive in a future decade.
One is reminded of the little girl in the Poltergeist sequel saying "They're back!" Welcome to the nifty world of 2009. Instead of wacky entrepreneurs like Jeff Bezos, now it is AIG. Yes, AIG.
You remember AIG? They were this gigantic insurance and re-insurance company. They took enormous risks on behalf of Goldman Sachs and other Wall Street slime. Then it became clear in September-October 2008 that they wouldn't be able to meet their obligations. Their before tax income for 2008 was a loss of $108,761,000,000. Very nearly 109 billion. That works out to a per share loss of $669.44.
Now AIG is trading at $50.23 per share. Huh? Do...what?!
How does that make any sense? Well, from a price to earnings ratio perspective, it doesn't. But "past performance is no indication of future profitability." Uh, right. So all their problems are in the past?
No, clearly not. In fact, the new CEO (who spent one day on the job and then took a vacation) is apparently consulting with Hank Greenberg, the old CEO who got AIG into this mess. You know, the one who recently settled with the SEC on securities fraud charges for millions? He paid up $15 million. And even with the recovery, one analyst estimated that his shares are worth 90% less than a year ago.
How does this work? The government props up the company with $180 billion of taxpayer money and takes an 80% ownership position. And then what? Magic? Razzle-dazzle?
I think it works this way. Most of the money now being invested on Wall Street is "other people's money." So stock brokerage firms have billions of dollars to invest. They buy positions, then make recommendations. The positions go up on their recommendations. Or, worse, they get trading orders on a daily basis, trade their own positions first, and then the orders from their clients. Magically, they make more money.
Is the government strong-arming the brokerage houses? Demanding that "we're all in this together" and in some cases having a stock position to back it upso coercing the buying of government held securities? We'll know, one day, after the empire falls and the archives are opened. Maybe.
What of the broader markets? Why was the S&P 500 trading at a price to earnings ratio of nearly 150 earlier this month? No reason.
Check out this image from Casey Research:
Kinda nutty, huh? Why are stock prices so high compared to earnings? They've never been this high.
Part of the answer is inflation. The government has created trillions of dollars of new money through borrowing. The Federal Reserve has created trillions of dollars of new money through ...well, magic. The Fed says there is money, and there isno printing press required. Where does all that money go?
Much of it is going into financial stocks to create the ersatz rally we are now seeing. Some of it is going into the broader market.
Consider foreign central banks. They have huge positions in the dollar. So do a lot of foreign individuals. They don't want those dollars to become worthless. But they don't exactly want to hold onto all of them either. So they are using those dollars to buy into the stock market rally now going on. And so are Americans, often through their 401K or other pension portfolio, often without any control individually. Portfolio managers buy and everyone else hopes for the best.
How is it going to end? The same way it always ends. Look at the chart again. The bubble we're in now didn't start in 2009. It didn't start in 1999. It goes all the way back to 1982 when stocks were last seen reverting to a mean price to earnings value, and the long "boom" or, as it will come to be know, the "fake boom" began. Greenspan inflated. Bernanke is inflating faster.
It won't last. Oh, sure, it may last weeks or months or even years. Speculative bubbles are market manias, generally push up by monetary inflation. Doug French has done some wizard analysis going all the way back to the aforementioned Tulip mania. (That one was monetary inflation caused by new gold and silver coming in shiploads from the Western hemisphere, mostly from slave labor camps run by the Spanish and Portuguese.)
The bubble will collapse. The currency will be destroyed. Its had a good long run for a purely inflationary currency. The dollar used to be gold and silver (see 1792 Mint Act) but that ended in 1971. The silver was taken out of the coins. The option for foreign banks to redeem dollars for gold was removed (by the hated villain Nixon). Currencies, to quote my friend Clyde Harrison, have not been floating, but have been sinking at different rates ever since.
So should you buy AIG? I wouldn't. But, I sold GenCorp in the mid 1980s because I didn't understand its valuation then. I don't generally buy things that have valuations I don't understandwhy should I own something that has value because of what other people think? What evidence have I ever had that other people do think? And how could I possibly know when they start thinking something else?
During the Dot com bubble people talked about how it was a "new economy." And I thought about that as a title for this piece. But, I really think "nude economy" works better. The emperor has no clothes, so why should the economy?