From KALLISTE@delphi.comMon Sep 16 10:52:33 1996
Date: Sun, 15 Sep 1996 22:32:02 -0500 (EST)
From: KALLISTE@delphi.com
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Subject: Sell Stocks Now
Sell Stocks Now
by J. Orlin Grabbe
Stock market crashes are often related to spurious
"causes". It might be the Federal Reserve's hiking of
interest rates. It might be the indictment of Hillary
Rodham Clinton. But the real cause will be something
else: the puncture of a popular delusion, an awakening
from mass hypnosis, the end of a collective dream.
What is believed to be obviously true now (steady or
increasing real growth rates of GNP, record corporate
earnings, low inflation, steady commodity prices, stable
and sound financial institutions, and widespread peace
under a "new world order") will a year from now be
viewed as obviously false in light of the "facts" (declining
real GNP, falling corporate earnings, inflation in some
sectors accompanied by deflation in others, wildly
gyrating commodity prices, extended problems in the
banking and insurance sectors, a renewed crisis in the
savings and loan industry, and "old world chaos" in the
Middle East and in the area of the former Soviet Union).
Not because the world will have really changed
that much in a year. But perceptions of what is happening
will be radically different. Some might say, more
realistic. According to the Swiss economist Eugene
Boehler, the "modern economy is as much a dream
factory as Hollywood." It is based only a small part on
real needs, and for the greatest part on fantasy and myth.
The stock exchange, far from ruling economic life, is at
the mercy of tides of collective fantasies. Depressions
come about when there is a loss of economic myth
(Eugene Boehler, "Der Mythus in der Wirtschaft,"
*Industrielle Organization*, XXXI, 1962.)
An example of the Hollywood dream factory at
work was this year's Democratic Convention in Chicago.
We were lead from the sideshow entertainment of an actor
in a wheelchair, then cast down into the tear-jerking
death-throes of Al Gore's drug-addicted sister, but finally
swept upward in the euphoric crossing of the 21st century
bridge behind Pied Piper Bill Clinton. Or that was the
intention, anyway. The grand climax was instead
punctured by the reality of politics as usual. Dick Morris--
Clinton's closest advisor, whom *Time* magazine had
originally intended to depict as Clinton's brain on its
cover--was found shacked up with a hooker, confiding to
her that Bill was a "monster" and Hillary a "twister", and
that he had handled the details of secret Saudi Arabian
side-payments to the President.
The dream view of the stock market is, of course,
at variance with the prevailing doctrine of "rational
expectations." Rational expectations began as an
extremely useful view of price equilibrium created by
John Muth ("Rational Expectations and the Theory of
Price Movements," *Econometrica*, July 1961). But it
grew into a cult view that all economic and financial
decisions were "rational" in a quite different sense than
originally proposed by Muth.
The essence of rational expectations can be
grasped by imagining a long line of cars waiting for a
traffic signal to turn green. When the light turns green,
the entire line begins moving at once, uniformly
accelerating through the intersection. And why not? After
all, each person waiting in the line knows the light is
about to change from red to green. Each person knows
that each other person in the line knows this also. And
they all know they will get through the intersection faster
if they all move together. So each expects the other to
rationally act as he himself does, and they all make it
through the light before it turns red again.
People with these expectations are called
"rational" in economics. In real life, they are known as
"fender-benders". Because in real life, traffic doesn't
behave this way, and neither do people. There will
always be the curmudgeon who has just broken up with
his girlfriend and is staring out the side window at the
marquee of a topless bar, oblivious to the horns blowing
behind him. The Russian novelist Fyodor Dostoyevsky
explained it best more than a hundred years ago. One of
his characters describes the new (rational) economic
world order:
'Then,' (this is all of you speaking), 'a
new political economy will come into
existence, all complete, and also
calculated with mathematical accuracy,
so that all problems will vanish in the
twinkling of an eye, simply because all
possible answers to them will have been
supplied. Then the Palace of Crystal
will arise. Then [blah, blah, blah] . . . '
Well . . . why shouldn't we get rid of all
this calm reasonableness with one kick,
just so as to send all these logarithms to
the devil and be able to live our own
lives at our own sweet will? . . . One's
own free and unfettered volition, one's
own caprice, however wild, one's own
fancy, inflamed sometimes to the point
of madness-that is the one best and
greatest good, which is never taken into
consideration because it will not fit into
any classification, and the omission of
which always sends all systems and
theories to the devil. (*Notes from
Underground*, 1864.)
Current stock prices, which (except for a severe
downturn in the first half of 1994) have been rising ever
since the Gulf War, have ridden a vision of new-found
American strength, our return as the world's policeman,
putting down the evil Saddam Hussein, and bringing
lasting peace to Bosnia. With the demise of the Soviet
Union, the vision saw the U.S. leading a resurgent United
Nations to a political solution of all the world's ills. But
this was only an idea, a voluntary con. The U.S.
intercession in Bosnia quietly overlooked the Russian
intrusion into Chechnya. The U.S. reaction to Iraq's
intrusion into the Kurdish zone equally overlooked the
Turkish intrusion into the same area. The U.S. cannot
dictate either Japanese trade policy or Chinese missile
sales. And so on. A false illusion that began with Saddam
Hussein is likely to end with Saddam Hussein. After all,
for all its saber-rattling, the U.S. needs Saddam to avoid
an Iranian takeover of the Middle East.
It is inevitable that such punctured illusions will
puncture the inflated balloon of asset prices. Starry-eyed
investors who see the owning of mutual funds as the sure
way to new-found wealth, would prefer to quietly
overlook what has happened in Japan since 1989. In 1989
the Nikkei 225 reached 39,0000. From that peak, it fell 64
percent by mid-1992. Each dollar invested had turned
into thirty-six cents. An equivalent fall in today's Dow
Jones Industrial Average (say from 5850) would leave it
at about 2100. The carnage on Wall Street would be
something to behold.
As is probable in the U.S., the Japanese inflation
in asset prices was followed by a restriction in the money
supply. The rate of growth of the Japanese real money
supply, which had come to exceed 10 percent in 1989, fell
to minus 2 percent by 1992, a year in which industrial
output fell by 8 percent, the worst since the oil-shocks of
the mid-1970s. At its peak in 1989, the Tokyo stock
market was valued at more than Yen 500 trillion ($3.6
trillion), or about 30 percent higher than the listed value
of all U.S. companies. Japanese stock PE ratios stock
were 70 to 1 in 1989, then fell to 38 to 1 in 1992, but by
end of 1993 were back above 70 to 1 because of falling
corporate earnings.
The drop in land and stock values put the Japanese
banking system into jeopardy. No one any longer thought
the land around the Imperial Palace was worth more than
all of California. Corporate stock, which was held as part
of bank capital, and fluctuates with the market, became
one of the reasons the Ministry of Finance in early 1993
used money from the postal savings system to purchase
stock in an attempt to bolster stock prices. (The
difference between Japan and the U.S. is that the U.S.
Federal Reserve has recently intervened to purchase stock
at a market *peak*. This in itself will exacerbate the
ensuing crash in the U.S.)
But things seemed different in the late 1980s in
Japan. There was an image, supported by continued credit
creation, that land and stock prices would always rise.
Equity-linked corporate finance, such as convertible
bonds, seemed destined to drive the cost of capital to
almost zero. Equity and equity-related sources of funds
for manufacturing companies rose from 25 percent in the
first part of the 1980s to 70 percent by 1989. Forty
percent of the funds raised by manufacturing companies
were then invested in other financial assets. And as
banks' lending base to manufacturing fell (from 50 to 16
percent), the banks began lending to households, property
companies, and service firms to make up the slack. The
latter in turn invested in land and stocks, because their
prices, it was thought, would continue to go up. In 1989
the Bank of Japan helped bring the party to an end.
In the U.S., the recent rise in stock prices has been
fueling by a shifting of household assets into stocks and
stock mutual funds. The average household exposure to
stocks is the largest it has been in U.S. history--larger than
before the 1929 crash.
"Speculative excess, referred to concisely as a
mania, and revulsion from such excess in the form of a
crisis, crash, or panic can be shown to be, if not
inevitable, at least historically common" (Charles P.
Kindleberger, *Manias, Panics, and Crashes: a History of
Financial Crises*, 1989). Financial crises are often
associated with the peaks of a business cycle. Booms in
asset markets (stocks and bonds) are generally aided by an
excess increase in the supply of money, which is then
inevitably restricted because of rising inflation.
The slow decline of the French bank Credit
Lyonnais is a foretaste of similar things to come in the
U.S. The S&L bailout of the 1980s may turn into an
attempted massive government/FDIC bailout of the U.S.
banking system by the turn of the century. Distortions
equivalent to those seen in the S&Ls have been created in
the banking system by the presence of federal deposit
insurance. The existence of deposit insurance has isolated
banks from market discipline in lending. It has allowed
banks as well as thrifts to engage "with impunity in all
manner of excessive risks--foreign exchange speculation
(Franklin National), speculative energy loans (Penn
Square), inadequately investigated loans (Continental
Illinois), insider loans (the Butcher banks), uncollectable
Third World loans (almost every top ten bank) and so
forth" (J. Huston McCulloch, "Bank Regulation and
Deposit Insurance," *Journal of Business*, January 1986).
The U.S. government has written enormous
amounts of unhedged put options on bank assets, and will
be faced with a massive increase in insurance obligations
at the same time tax receipts are drastically reduced by a
declining economy. Thus federal government quasi-
defaults (mandatory roll-overs of debt) are likely. Interest
paid on the debt is already one of the largest categories of
the U.S. federal budget.
Currently, government debt is largely in the hands
of professional portfolio managers. So the usual
temptation of a central bank, such as the Federal Reserve,
to reduce the real value of federal debt by inflation is
restricted. Any hint of a move toward an inflationary
policy will lead to massive dumping of government
securities, which will drive up long-term nominal and real
interest rates. Marginal borrowing rates of both
government and industry will rise. The U.S. may attempt
to maintain revenue through tax hikes. (In 1929 the top
income tax rate was 25 percent, but had increased to 63
percent by 1935, and by the end of World War II was at
93 percent.) But such efforts may not succeed, during a
time when the abolition of the IRS has become
increasingly popular.
The ensuing credit crunch will hit industry hard, as
the banking system becomes a circular conduit for
government funds*receiving payments of deposit
insurance, and (perhaps forcibly) purchasing government
securities as assets. Basle capital requirements currently
give a zero-risk weighting to OECD government
obligations. One of the consequences of this requirement
has been an increased incentive for U.S. banks to
purchase U.S. government bonds or similar obligations to
conserve on capital usage, to the exclusion of corporate
lending.
As securities are dumped, the mark-to-market
value of banks' remaining assets will fall. A similar
process occurred at the beginning of the 1930s: "Banks
had to dump their assets on the market which inevitably
forced a decline in the market value of those assets and
hence of the remaining assets they held. The impairment
in the market value of assets held by banks was the most
important source of impairment of capital leading to bank
suspensions, rather than the default of specific loans or of
specific bond issues" (Milton Friedman and A. J.
Schwartz, *A Monetary History of the United States,
1867-1960*, 1963).
There will be bank failures. Having the Federal
Reserve as a lender of last resort will not prevent this.
Canada, without a lender of last resort between 1930 and
1931, did not suffer any bank failures. The U.S. suffered
thousands. This was partly because Canada allowed
branch banking nationwide. In the U.S., a legacy of
prohibitions against branch banking have impacted both
the asset and the liabilities side of banks balance sheets.
Because banks do not branch nationwide, they are more
vulnerable to banking runs in a particular section of the
country. Because banks are local, they have
overspecialized in local loans--to oil and real estate in
Texas and Oklahoma, to timber in the Northwest, to
farmers in the Midwest. The money center banks,
meanwhile, may have overextended themselves in
international directions.
What are some of the other likely consequences?
Consider the declines of 1929-1932 and 1973-1974. On
September 3, 1929 the closing high on the Dow Jones
Industrial average was 381.17. Three years later, on July
8, 1932, it reached a low of 41.22, or 10.81 percent of its
previous level. In January 1973, the Dow Industrials
reached a closing high of 1061.14. Less than two years
later it closed at 572.20, or 53.92 percent of its previous
level. Using a hypothetical figure of 5850 for the Dow
Jones Industrials, these same percentage drops imply Dow
Industrial levels of 632.39 by analogy with 1929, or
3154.32 by analogy with 1973. The first would imply a
drop of over 5200 Dow points, while the second would
only imply a drop of 2695 points. Either would be
serious.
Stock investments take place under the influence
of an over-riding image of the future. The economist
Kenneth Boulding wrote: "A decision is essentially a
choice among competing images of the future, . . . and
with the development of complex images of the future,
decisions become an increasingly important element in
the dynamics of the individual human being and his
society. . . . The human race is not merely pushed by past
events or present circumstances, but it is also pulled by its
own images of the future into a future, which may not be
the same-and in fact is not likely to be the same-as its
images of it, but which is nevertheless powerfully affected
by those images" (*Ecodynamics: A New Theory of
Societal Evolution*, 1978).
The changed image of the future that brings about
a stock market crash will bring about a concomitant fall in
business investment, this decline to be reinforced by
government deficits and a banking crisis. Decreased
employment and a declining industrial output will follow.
At the beginning of the Depression of the 1930s, Keynes
wrote that in "the fall of investment . . . I find-and I find
without any doubt or reserves whatsoever-the whole of
the explanation of the present state of affairs" (John
Maynard Keynes, "An Economic Analysis of Unemployment," 1931).
International political consequences may be the
most tragic of the coming U.S. asset price deflation.
Following World War I (the Great War), disruptions
caused by the war itself, followed by the collapse of the
Austro-Hungarian empire, lead to hyperinflation and
social revolution in Germany and Eastern Europe. When
the U.S. went into depression following the 1929 crash,
and the depression spread internationally, the German
Weimar Republic (1919-1933) gave away to National
Socialism. Today a similar process is evidently taking
place in the remnants of the Soviet Union. The rise of a
new dictator in Russia of the order of Stalin seems
assured.
Carl Jung noted that times of major change are
accompanied by symbols of transformation (Carl Jung,
*Symbols of Transformation*, 1976). Among other
things, these include socially-observed "signs in the
heavens" (Carl Jung, *A Modern Myth of Things Seen in
the Skies*, 1969). Through the influence of archetypal
processes, the attention paid by the popular media to the
unexpected or the unexplained greatly increases. The fin-
de-siecle timing of the economic downturn will
undoubtedly generate an excess of eschatological fervor.
At the last major economic downturn, toward the end of
1973, the public eagerly awaited the arrival of the comet
Kohoutek and leading newspapers carried reports of space
creatures seen in Pascagoula, Mississippi. Today we
observed the popularity of the "X-Files," the movie
*Independence Day*, and speculation about cosmic
debris causing catastrophe on earth (e.g. Arthur Clarke's
*The Hammer of God*).
Given that the technological myth of space visitors
is already ensconced in the popular imagination, the
arrival of extraterrestrials either to save us or to destroy us
will also be widely anticipated.
But one thing is for sure: Bill Clinton will not be
around to lead us out of Egypt, and across the 21st
century bridge into the Promised Land.
September 15, 1996
Web Page: http://www.aci.net/kalliste/