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Generational Dynamics Web Log for 30-Dec-06
Financial analysts gush at stock market's meteoric rise

Web Log - December, 2006

Financial analysts gush at stock market's meteoric rise

Meanwhile, more sober commentators worry about credit derivatives

The meteoric rise of the stock market this year, especially during the last six months, has led to pundits' predictions of similar rises next year, continuing into the future.

Jack Bouroudijian of Brewer Investment Group gushes over stock market <font size=-2>(Source: CNBC)</font>

Jack Bouroudijian of Brewer Investment Group gushes over stock market (Source: CNBC)

Here's what Jack Bouroudijian of the Brewer Investment Group said on Friday morning on CNBC:

"This has been a wonderful six months for the market. And the worst thing about it is that we underperformed the rest of the world. So it's really of question of whether we're at the beginning of a multi-year run in equities. I guess that's the big debate. When you've got these superstar fund managers like the Bill Millers of the world, that are underperforming that are still unbelievers out there, that makes me even more bullish than I am. And we see all this data coming out and this is absolutely everything that you want."

The mention of Bill Miller refers to the fact that his Legg Mason Value Trust Fund has done less well than the overall stock market for only the first time in 16 years.

Apparently Bouroudijian believes that since a "superstar" like Miller didn't do as well as expected, it means that the market can go even higher. His reasoning is a little obscure, but here's what he apparently means: Miller wasn't clever enough to beat the market in 2006. Therefore, if he and people like him had just been a little more clever, then they would have beaten the market and pushed it up even higher. Now they've learned their lessons, and next year they'll be even more clever, and so the market will continue to go up.

I have to tell you, dear reader, that I just never cease to be absolutely, totally astounded by these statements. This guy probably makes a few million dollars a year in salary, and probably just received another few million in year-end bonuses. And yet, his gushing is one of the stupidest statements I've ever heard. Though really I should hedge this last sentence by saying that I can't be sure, since I've been hearing so many incredibly stupid statements by high-paid financial consultants. It's almost beyond belief.

Randall Dodd, director of the Financial Policy Forum <font size=-2>(Source: CNBC)</font>

Randall Dodd, director of the Financial Policy Forum (Source: CNBC)

Shortly after Bouroudijian spoke, another financial pundit, Randall Dodd, director of The Financial Policy Forum, came on to CNBC and gave a much more sober assessment of the marketplace.

The discussion centered on risks that might affect the stock market next year. CNBC economics expert Steve Liesman asked Dodd: "If we're going to have some kind of meltdown or crisis next year, how does it happen, where would you be looking for to be the source of it?"

Dodd answered as follows:

"I don't want to be alarming, I'm just trying to raise people awareness about these issues. I would look at the credit derivatives market. We've had some problems in clearing and settlement of those contracts. We've had problems with people trading more credit derivatives than there is underlying debt. And right now there's one big issue we have to look at -- it's that a lot of our major banks and broker dealers are moving their credit risk off their books and into hedge funds. So you have financial institutions with capital requirements reducing the amount of capital they use by moving that credit risk into hedge funds which have no capital requirements and often use very high leverage to manage their credit risk of selling credit protection through this credit derivatives market."

The reason for Dodd's obscure language is that he doesn't want "to be alarming." This kind of obfuscation was also a speciality of Alan Greenspan.

Dodd is referring to derivatives in general and credit derivatives in particular, as used by hedge funds. This is an issue that I discussed in detail last month, and for those financial analysts who are still capable of rational thought, this is where most of them expect a meltdown to be triggered.

What Dodd is describing is some of the elements that make the current financial market into a pyramid scheme. If you look at the the Wikipedia article on pyramid schemes, you can see that it lists a number of different types, and gives the following list of "key identifiers" of a pyramid scheme:

"A highly excited sales pitch (sometimes including props and/or promos)."
Well, just take a look at Jack Bouroudijian's gushing statement above.
It's worth remembering that investment advisors have a major conflict of interest that biases their view on the stock market. If they say that things look bad, then people won't make investments, and the investment advisor won't make a commission; by hyping the stock market, they encourage more investments, and their commissions are much higher. Don't ever think that these people are neutral, unbiased observers; their entire income depends on hyping, and lying if necessary.
(Incidentally, I personally have nothing on the line except my own credibility. I sold my home and moved into an apartment just before the real estate bubble burst, and my financial situation will not be materially affected by whether I'm right or wrong. However, almost all investment advisors have a big financial stake in hyping.)

"Little to no information offered about the company unless an investor purchases the products and becomes a participant."
As Dodd points out in his statement above, hedge funds have no capital requirements, and in fact are not regulated at all. Hedge fund managers are generally very secretive, and of the 10,000 or so known hedge funds, 8,000 are registered in the Cayman Islands where they don't have any regulatory requirements.

"Vaguely phrased promises of limitless income potential."
Once again, that's what Bouroudijian says. Other financial pundits predict even higher results.
The worst and most irresponsible is Harry S. Dent, who has predicted that the market would go up to Dow 35000-40000 by 2008, though he's partially tempered those predictions recently to 20000 by 2009.
But the promises of limitless income potential are abounding in today's stock market.

"No product, or a product being sold at a price ridiculously in excess of its real market value. As with the company, the product is vaguely described."
What's the "real market value" of a share of stock? Today's investment advisors don't recognize any such "real value." To them, a share of stock has no intrinsic value, but is valued at whatever someone is willing to pay. That explains Bouroudijian's idiotic remark about Bill Miller.
Up until the 1980s, when the last generation of people who lived through the Great Depression were still around, investors did worry about real market value, and the only valid measure is the Price/Earnings ratio (P/E ratio).
At the present time, the stock market is overpriced by a factor of about 240%, with price/earnings ratios around 20 or higher since 1995. A fall in P/E ratios to below 10 is long overdue. Note that the P/E ratio index has fallen below 10 several times in the 20th century, most recently in 1982, so this is a common occurrence.
But none of this matters to giddy investors. If you went to the market and bought a dozen eggs for $1.50 one week, and then they cost $3.00 the next week, you'd wonder what the hell was going on. But when stock markets go up like that, idiot investors only cheer.

"An income stream that chiefly depends on the commissions earned by enrolling new members or the purchase by members of products for their own use rather than sales to customers who are not participants in the scheme."
This is exactly the case for investment advisors. They earn money on sales commissions, so they're highly biased to claim the stock market will rise.

"A tendency for only the early investors/joiners to make any real income."
True. If you purchased your stocks prior to 1995, the beginning of the stock market bubble, then you may be OK.

"Assurances that it is perfectly legal to participate."
Yes, this particular pyramid scheme is legal.

You should understand that you could start your own hedge fund and make a great deal of money. You borrow $100 million, and purchase $100 million in shares of other hedge funds, and put them all into a pool, and register in the Cayman Islands, and call your company MyHedge. Then create 200 shares of your pool, so that there are now 200 MyHedge shares available. Keep 100 shares for yourself, and use your magnificent sales skills to sell the other 100 shares to investors for $1 million each. You've now already made back the $100 million you borrowed, and you still own 100 shares of your pool, which have a market value of another $100 million (since that's what investors paid -- 100 shares at $1 million per share). Now remember those $100 million in shares from other hedge funds that you purchased? Well, if you invested prudently, then those hedge funds will increase in value -- let's say to $300 million. Now the 200 outstanding MyHedge shares are worth $300 million -- $150 million for you and $150 million for your investors. Then you can use your magnificent publicity skills to convince investors that MyHedge shares are worth a lot more. Your investors will start selling them to other investors for more money -- let's say $3 million per share.

So now your 100 shares are worth $300 million (market value), and your investors' 100 shares are worth $300 million (market value), for a total of $600 million, even though the value of the underlying hedge funds is only $300 million, inflated from $100 million.

So you started out by borrowing $100 million, which you've already paid back. But you have a market value of $300 million, and your investors have a market value of $300 million.

So you've made $600 million for yourself and your investors. But more than that, you've "made money." I mean that literally. It's as if you had a printing press. You created $600 million of new money that didn't exist before. Of course you have that money in the form of MyHedge shares, but that's no problem: Just sell them to other investors and get cash.

That's what's been going on. Here's a summary of the financial marketplace for the last decade or so:

You start with real, actual companies, and their "real value." Today, that's about $30 trillion for all companies.

Then you have the stock market, which contains shares of real actual companies. The total of all stock market shares is around $65 trillion.

Next, you have investment funds. These are funds that purchase stock market shares, put them into a pool, and sell shares to investors.
In the 1920s, these were called "investment trusts," and because of huge abuses leading to the 1929 crash, investment trusts were heavily regulated in the 1930s. Today they go by various names, usually ending in the word "Fund," such as the "Legg Mason Value Trust Fund" that we mentioned earlier. These funds are normally considered to be good guys.

Next you have "funds of funds." These funds purchase shares in other funds, pool them, and sell shares in the pool. Some of these are regulated.

Then you have "hedge funds," which are funds containing shares of almost anything else. They're almost completely unregulated, especially when they're registered in the Cayman Islands.
As of June 2006, all hedge funds together are worth $370 trillion, up from $300 trillion at the beginning of the year.

That's what's going on in today's world economy. The hedge fund industry has "made money" -- literally, as if they had a printing press.

We end up with this table:

    Item                          Value ($ trillion)
    ----------------------------- ------------------
    All public firms-"real value"   30
    All stock market shares         65
    All hedge fund shares          370 (June, up from 300 in Jan)

[[Correction: "All hedge fund shares" should have read "all credit derivative securities."]] (Correction made on 13-Nov-2007)

Where did all that money come from? It came from exactly the kind of trading that I described above with your MyHedge shares. You have hedge funds based on hedge funds based on hedge funds based on hedge funds, and all with little or no intrinsic value. Every time they trade shares with each other at higher prices, the total market share goes up, so the "value" of all hedge funds keeps going up.

Now go back and read some more about pyramid schemes. Just type the words "pyramid scheme" into a search engine and read about it. You'll see that the current financial markets are, quite literally, nothing more than a huge, worldwide pyramid scheme.

This worldwide pyramid scheme is "making money" and injecting it into the system. It "made" $70 trillion just between January and June of 2006 alone.

Now, where do credit derivatives fit into all this?

Recall from the MyHedge example that you had to start out by borrowing $1 million. Why would a bank lend you $1 million? Because they can "protect" themselves using credit derivatives.

As we've explained in detail several weeks ago, credit derivatives are a kind of insurance against loan defaults. So banks can loan money to investors and then purchase credit derivatives to protect themselves against the borrower-investors' defaults.

In "normal" times, banks are required to keep a certain amount of money -- so-called "capital requirements" -- in their vaults at all times, as a cushion against such things as loan defaults. But banks and other financial institutions aren't doing that any more, according to Randall Dodd. Let's repeat one sentence from the lengthy quote above:

"So you have financial institutions with capital requirements reducing the amount of capital they use by moving that credit risk into hedge funds which have no capital requirements and often use very high leverage to manage their credit risk of selling credit protection through this credit derivatives market."

According to Dodd, banks no longer have that financial cushion. Instead of keeping, say, $10 million in their vaults as a cushion against emergencies, they've simply spent $1 million to purchase credit derivative hedge funds as "insurance" against emergencies, leaving the other $9 million free to loan out. By spending $1 million instead of keeping $10 million, they've "used very high leverage to manage their credit risk," in Dodd's words.

So credit derivatives turn out to be the grease that keep keeps the hedge fund markets churning. Anyone can create a new hedge fund, a new kind of financial derivative, a new kind of financial derivative hedge fund, and mistakes can be papered over by borrowing more money from banks that "protect" themselves by purchasing credit derivatives. These new hedge funds create new shares that are sold back and forth among other hedge funds, increasing their market value each time (though they have little or no intrinsic value), essentially "making money" in the form of this manufactured market values.

Let's take a moment and go back to the simpler times of the 1950s. I was in school then, and my teachers always talked about the Great Depression. They talked about how greedy people were in the 1920s. They said that people were so greedy that even if they were rich, they'd borrow more and more money so that they could make even more money.

My teachers often referred to the greatest evil of them all: margin. A greedy investor could buy stocks and pay only 10% of the purchase price. The 10% was called "margin," and the other 90% was borrowed. My teachers emphasized how evil this was, that some greedy rich person would pay only 10% of the price of a share of stock in order to make more money.

I can almost still hear one of my teachers saying: "Thank God! They've made it illegal to buy stocks on that margin like that! Those greedy investors will have to pay for the stocks they buy, so we'll never have a Great Depression again!"

That generation of teachers is long gone now. Fast forward a couple of generations to today, when the Fed Chairman Ben Bernanke is also a teacher, a Professor of Economics at Princeton University, and he's not worried about anything. As I explained in "Ben S. Bernanke: The man without agony," Bernanke doesn't believe in bubbles. When speaking about America's astronomical and exponential growing debt to other countries in March, 2005, Bernanke blamed America's debt on "global savings glut" in other countries.

That's the difference between teachers in the bad old 1950s, teachers who had actually lived through the horror of the Great Depression, and teachers in the 2000s, who think we're too smart today to ever let it happen again. This is Generational Dynamics in action.

But I wonder what my 1950s teachers would say if they could see what's going on today. Talk about greed!

Remember in the MyHedge example that I gave above, you get your $1 million back right away? That should give you a clue that hedge fund managers always make sure of one thing: That they make their money up front. Hedge funds are pretty much completely unregulated, so each hedge fund manager gets to write his own regulations. And you can be sure that his own regulations say that he gets his money up front, and all the people who invest in his hedge fund take all the risk. My 1950s teachers would consider these hedge fund managers to be out and out criminals.

In fact, there are a lot of people in the financial community today whom my 1950s teachers would consider as out and out criminals. Take stock brokers and financial managers who say that the stock market can only go up, or even the most irresponsible ones, like Harry Dent, who said (until recently) that the market would be at Dow 35000 by 2008. Or how about mainstream economists, like Bernanke, who doesn't believe in bubbles. How about financial journalists and pundits, at the Wall Street Journal and CNBC and other media, publishing false and misleading information, especially phony price/earnings ratio computations, that dupes millions of ordinary people to make unwise investments.

I never really paid much attention to the stock market bubble until one day, shortly after 9/11, when the stock market was down around Dow 8000, I opened the Boston Globe one day and on the first page of the business section, there was a headline "Nowhere to go but up," and a graph of the Dow back to the 1920s. I took one look at that graph and said to myself, "Omigod we're going to have a stock market crash like 1929." The reason was because, generally speaking, financial series must grow at steady exponential growth rates, no slower, no faster, and any variation must be corrected by "mean reversion." Since the stock market had grown "too fast" since 1995, a 1929-type crash and subsequent 1930s-style Great Depression cannot be avoided. Since then, I've done a lot more analytic work and supported this conclusion in many different ways.

I don't expect the average man on the street to understand all these things, or even the average investor. But I do expect major financial analysts, professors of economics, financial journalists and pundits to understand them.

But what's happened in the last five years is so overwhelming that it can barely be grasped by the human mind. An ordinary 1990s stock market bubble, as bad as it was, has been turned, with the connivance of economic experts, journalists, professors, investors, central bankers, pundits and politicians, into a worldwide bubble of incredibly fastastic proportions that's so huge and so obvious that every expert should see it. Or maybe it's like the whole planet earth has turned from being an ordinary planet into a huge bubble planet, so that it's impossible to see what's going on any more.

Do you remember what happened in 2001 after the Nasdaq crash and the Enron scandal? People wanted to put CEOs in jail -- ALL CEOs, even perfectly honest ones. People were going crazy. Well, it's going to happen again.

The Enron scandal is one historical example, but a better example might be the bankruptcy of the French Monarchy in 1789 that led to the French Revolution. In the Reign of Terror that followed, any person who was an aristocrat, a relative of an aristocrat, a friend of an aristocrat, a servant of an aristocrat, or even had a resemblance to an aristocrat, would be tried and quickly convicted and sentenced to the guillotine.

So as we enter 2007, I have some advice for the economics experts, journalists, professors, investors, central bankers, pundits and politicians that have been telling us that everything is OK and getting better: You'd better have your underground bunker picked out, because people are going to be coming after you, and the guillotine is going to seem mild compared to the punishment that they're going to want to inflict on you. (30-Dec-06) Permanent Link
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Generational Dynamics Web Log for 30-Dec-06 Financial analysts gush at stock market's meteoric rise

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Generational Dynamics Web Log for 30-Dec-06
Financial analysts gush at stock market's meteoric rise