	Generational Dynamics
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Generational Dynamics Web Log for 8-Dec-05
Wall Street Journal's page one article on Bernanke contains the usual errors and omissions

Web Log - December, 2005

Wall Street Journal's page one article on Bernanke contains the usual errors and omissions

Let me try and explain this a different way.

Yesterday's lengthy article on Ben S. Bernanke's research on the Great Depression explains why the man expected to replace Alan Greenspan as Fed Chairman believes that he has complete control of the economy.

We've recently called the youthful Bernanke the "man without agony," and that comes through loud and clear. He has his hand on the levers of control. He knows exactly why the 1930s Great Depression occurred (he's begun writing a book about it, called "Age of Delusion: How politicians and central bankers created the Great Depression"), and he knows exactly how to prevent any new Great Depression. Only someone from the Baby Boomer generation could be so arrogant.

As usual, his attitude conflicts with that of Greenspan who, born in 1926, grew up amid the horrors of the Depression, and is still VERY concerned about the fragility of the economy, as he indicated in a harsh doom and gloom speech on Friday. The WSJ article points out that Bernanke believes he's also much smarter than John Kenneth Galbraith, who was born in 1908 and wrote a seminal book on the Great Depression in 1955; Bernanke hopes to replace Galbraith's book with his own wisdom.

I'll write a detailed critique of Bernanke's research when I have more time, but today I'd just like to hit a couple of points, and try a different way to explain why Bernanke must be wrong, almost as a matter of mathematical necessity.

Some obvious errors

One of Bernanke's biggest and most often repeated errors is his naīve comparison of the 1987 stock market crash with the 1929 crash. Here's a quote from a 2001 article:

"One often-heard hypothesis is that the Great Depression was caused by wild speculation on Wall Street, which provoked the stock market crash. But though stock prices may have been unrealistically high in 1929, there is little evidence to suggest that the fall in stock prices was a major cause of the Depression. A similar crash in October 1987, when stock prices fell a record 23 percent in 1 day -- an event comparable in severity to the crash of October 1929 -- did not slow the economy significantly."

He mentions that "stock prices may have been unrealistically high in 1929" as if it were a minor thing, but in 1929 stock prices were more than double book value of the underlying companies -- something we'll explain more below -- but in 1987, stocks were AT book value. So the stock market rebounded quickly from the 1987 crash, because the stock market was solid. Thus, the 1987 crash was not a "similar crash" to 1929, since the market was completely different. Today, the market is again priced at more than twice book value.

And that's the problem -- that Bernanke doesn't even acknowledge any of the problems today. The nation's public debt is at 1930s levels and is still increasing rapidly. This concerns Greenspan, but why not Bernanke?

There's an even more subtle issue: Bernanke has no explanation for why the 1990s stock market bubble occurred, but he doesn't believe that the Fed had any way of controlling it. He doesn't even mention today's real estate bubble, but believes that no bubble can be controlled; attempting to "prick market bubbles" causes stock market crashes, he "would argue."

Also, like Greenspan, Bernanke has no explanation for why the 1990s stock market bubble started in 1995. Why not 1990 or 2000? What was important about 1995? That's a question that no one and no theory has the answer to, except for just one: Generational Dynamics. The stock market bubble began in 1995 because that was EXACTLY the time that all the top financial managers, who had been very risk-averse from having grown up during the Great Depression, all disappeared (retired or died) all at once, and were replaced by a new generation of risk-seeking top financial managers with NO personal memory of the Great Depression. The new risk-seeking managers created the bubble, and today still continue to be oblivious to the danger.

The point is that Bernanke could not stop or even explain the most recent bubbles. But he's so arrogant, he believes that he'll have no trouble containing the aftermath when the bubble finally bursts. If he can't explain or stop a bubble, how can he possibly believe that he can stop a Depression? It's absolutely bizarre.

One more conundrum: Bernanke certainly doesn't believe he understands the psychology that caused such a large bubbles in the 1920s and 1990s. (Once again, Generational Dynamics is the only theory with an explanation.) Then he can't possibly believe that he understands the psychology that caused the crash and depression of the 1930s. Then how can he possibly know that whatever prescription he uses will defeat that psychology?

If anything, it's obvious that nothing will work. If a bubble is caused by psychological exuberance, then a depression is caused by psychological hopelessness. After a guy loses a big chunk of his overpriced assets, it'll take more than a drop in the Fed funding rate to get him interested again.

The value of stock

Let me try a different approach to showing why people like Bernanke are not just wrong, but mathematically wrong.

Here's a question: Suppose I wanted to sell you 100 shares of stock in Worldwide Widget Corp. You're not allowed to know the prices of any other stocks, but you can ask me any questions you want about the company. How would you arrive at the value of the 100 shares of stock?

If you're just in love with Worldwide Widget Corp., then you might value your stock based on that love. That's how you might buy a work of art. There's no way to value a work of art, except to go by your guts and feelings. That's the way you might arrive at a value of this stock. The value you pick is just a number in the air, with no solid reasoning behind it.

But suppose you don't want to treat it like a work of art; you don't particularly love or hate Worldwide Widget, and you just want to make money. The stock purchase is an investment, so you want to do an actual analysis that provides the actual investment value of the 100 shares of stock. What methodology do you use?

It turns out that there's another kind of investment where exactly this kind of analysis is done all the time: Investment real estate. Suppose you want to purchase an apartment building with 100 apartments, with the intention of making money. How do you decide what price you're willing to pay for the apartment building? This is called real estate appraisal.

Real estate investors will tell you that there are two common ways to appraise investment property, with the following GREATLY simplified explanations:

You compute how much money the apartment building will earn each year from rent collection, assuming a reasonable vacancy rate; you compute how money you'll have to pay each year for expenses and upkeep for the apartment building. You subtract the two to get annual cash flow. You divide that by the annual interest rate you expect to earn, say 7%. The result is the appraised value of the building.

You find out the replacement value of the building, the cost of building an equivalent new apartment building. The replacement value can, in certain circumstances, be the appraised value of the building.

A good investor doesn't allow himself to be swayed by emotion in computing these figures. You're not buying a work of art or having a love affair with the building; you just want to make money, nothing else. So you use real numbers, not wishful thinking numbers.

Wall Street Historical Price/earnings ratio for S&P 500

Wall Street Historical Price/earnings ratio for S&P 500

But that's nothing like how stocks are bought today. The prices of stock today are just numbers in mid air; they have no solid underpinning. No one even pays attention to whether they're overpriced. Investors buy when the price of oil goes down, and sell when the Fed Open Market Committee minutes come out.

But in fact the two methods for real estate appraisal work just as well for stock purchases:

You determine the annual cash flow to be earned from the stock. You can do this in several ways, usually from earnings or dividends or revenue. Once you determine the annual cash flow, you divide by the annual interest rate you expect to earn, say 7%, which corresponds to a Price/Earning ratio of about 14 (since 100/7 = 14.3). But stock market P/E ratios have been historically high for over ten years, as the above graph shows. Note that they were extremely high in 1929, but they were about average in 1987, something which, for reasons that are totally beyond me, Bernanke and others don't grasp.

You determine the book value of the underlying company, Worldwide Widget Corp., and you use that as the value of the outstanding stock shares. As I've discussed many times, both I and other analysts have computed, the "true value" or book value of the stock market today to be around Dow 4500, which means that the market is overvalued by a factor of more than two -- at about the level as just before the 1929 stock market crash. In 1987, by the way, the stock market price was just about exactly at book value, again something that Bernanke and others don't grasp, for reasons that escape me.

If you're under 40 years old, you may be shocked and surprised to learn that investors were using exactly these methods for decades, until the early 1990s. That's why the 1987 crash did so little harm to the stock market -- the stock market's position was solid, because senior investors had grown up during the depression and knew how to make solid investment decisions.

When that generation retired, a new generation of senior investors took over. These were people with who bought stocks like works of art, based on feeling good. These investors made one crazy investment decision after another, and created a huge market bubble.

Dow Jones Industrial Average -- 1896 to 1940 -- with book value shown as thin curve

Dow Jones Industrial Average -- 1896 to 1940 -- with book value shown as thin curve

Bernanke believes that the Fed can just wiggle the interest rate a little, and thereby defy the mathematically certain historical patterns that say that stock market prices will fall. He will not because he cannot. All he can hope to do is extend the bubble a little longer, as the Fed has been doing since 2002.

Stocks will fall. And not only will they fall to the solid market levels -- with an average P/E ratio and a book value price -- but they'll overshoot those values and fall by much more. In 1929-1933, the stock market fell by 90%. Something like that is going to happen again, and it's laughable to think that it can be stopped. (8-Dec-05) Permanent Link
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Generational Dynamics Web Log for 8-Dec-05 Wall Street Journal's page one article on Bernanke contains the usual errors and omissions

Some obvious errors

The value of stock

Web Log Pages

Generational Dynamics Web Log for 8-Dec-05
Wall Street Journal's page one article on Bernanke contains the usual errors and omissions