Stocks in a Close Parallel to 1999 Bubble

The SP 500 made new highs 33 times this year, the most since the 1999 tech boom. Only two months after the end of 1999 the SP 500 market topped out in March, 2000, and on a GDP adjusted basis has never come close to reaching the old 2000 high. The stock market has gone up this year much faster than had been forecasted by bullish experts, which implies that its appreciation rate is going parabolic, thus leading to a crash. The conditions now closely parallel the Federal Reserve induced stock bubble of 1999. In 1998-2000 the Fed kept creating easy money conditions and many new tech companies had IPO’s. Stocks went parabolic, peaking in March, 2000 and then collapsing in 2001. Investors should seek independent financial advice about the possibility that stocks could repeat the crash of 2001 and 2008.

The bulls’ case is based on the fact that current year PE ratios of roughly 14 to 15 are reasonable, though not cheap. However a one year or future PE ratio is not nearly as good data as PE10 which is the ten year inflation adjusted average PE. During the recession corporations increased profits which is very strange and suspicious. If they give back the profit margin increase and revert to the long term mean profit margin of 6% of sales then profits will decline 40% which would justify the view of the PE10 theory, which would make the SP 500 drop to 1050 from 1772.

If corporations maintained sales while cutting wages then how can workers afford to buy back the product? The answer is that welfare type of payments such as the “cash for cars” program helped to maintain demand. Another answer is that Emerging Markets economies purchased lots of manufacturing and mining equipment from Developed countries during the past decade. The EM countries (China, Brazil) may have over-consumed commodities and over-consumed capital goods which were financed with excessive and poorly underwritten debt. So their consumption offset the lack of demand by Developed country consumers. However, this is not sustainable, assuming the EM construction boom resulted in unneeded, uneconomical infrastructure and real estate projects. If the past decade of business to business sales to EM countries had not happened then U.S. corporations’ sales would have been far lower, thus damaging profit margins. What if the demand generated from EM countries was a false signal facilitated by a debt bubble? Their local debt bubble was enhanced by the Fed's QE which made capital flee to EM countries.

The trend of Brazil and China to generate a massive amount of growth through excessive debts will gradually come to an end, (as it did in Japan in 1990) thus reducing demand or at least slowing down the growth rate for demand, thus hurting profit margins for U.S. corporations.

The bulls’ case can be based on the idea that starting in the Reagan-Thatcher era since 1979 that business has gained more freedom, efficiency, and has escaped from unionization so that somehow justifies a new paradigm of permanently higher PE ratios and permanently higher corporate earnings.  However, there are still a lot of risks for each individual stock so stocks need to have an equity risk premium that rewards stock investors with a higher return than bonds. Assuming that bond yields return to a traditional 6% yield for the Barclays Aggregate index then stocks need to return their traditional 9% total return. But if they are too high priced then they can’t keep going up at a rate that provides an equity risk premium.

In the past 20 years corporations have reduced roughly half of their 35% tax rate by using offshore subsidiary corporations, so this increases net profits by 26% = 17%/(1-0.35). Also earnings manipulation by management who seek to get employee stock option windfalls can make income appear higher than it should be. Examples are characterizing expenses as capital investments, stretching out depreciation over longer periods, lowering estimates of future loan losses (thus unbooking loan loss reserves, which results in “income”). This is like a mine shaft where eventually all the ore will have been mined out. How long can companies continue to increase profits through legal accounting tricks?

Even if recent decades of globalization have cut wages thus increasing profits, I think eventually the world trend will be a growing reduction in the supply of cheap labor, especially for the complicated quality goods that really matter. The Third world is imitating the Developed world and having less children per family, more civil rights including the right to unionize, etc., so the tide is slowly turning against the trend of cheap globalized labor.

Investors should seek independent financial advice. Invest only in the least riskiest assets, keep expectations of appreciation in check, be suspicious of bubbles, and don’t be intimidated by those who boast that they benefited from playing the bubble. I wrote an article “If stocks are too high why didn’t they crash now?”.

About the author

Don Martin, CFP®

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