The Great Deformation

by David Stockman

  THE FED’S PHONY VICTORY OVER INFLATION AND THE ARRIVAL OF THE “CHINA PRICE”

  When CPI inflation soared above 6 percent in late 1990, the Fed claimed nothing was amiss except an oil spike owing to the Kuwait crisis, yet that was only partially true and wholly misleading. For the next several years the Greenspan Fed claimed that a one-time inflation bulge from the Gulf War was being squeezed out of the reported CPI numbers and its money-printing campaign was therefore fully compatible with its disinflation goals.

  Yet this was a double shuffle: what was really happening was that the “China price” was driving tradable goods inflation out of the CPI entirely, permitting the headline number to be backfilled with domestically generated inflation from the Fed money printing campaign. Accordingly, Wall Street got its juice while the monetary central planners in the Eccles Building claimed a great victory over inflation.

  During the next dozen years, the headline CPI did rise at only a 2.6 percent annual rate compared to the 4.6 percent rate of Greenspan’s initial four-year term. Yet true domestic inflation barely slowed down at all, remaining hidden in the bifurcated basket of prices which make up the CPI.

  Between 1991 and 2003, for example, there was no net rise in the price of durable goods and the index for some entirely imported categories, such as shoes and apparel, actually declined. By contrast, the index for services, which represented purely domestic production, rose at nearly a 3.5 percent rate during the twelve years after 1991.

  Quite evidently, the appearance of benign inflation was not owing to the Fed’s success, but was due to the “China price.” Imported consumer goods reflecting the great wage deflation coming out of Asia were dragging down the overall CPI. In reality, Fed policy was causing the tradable goods sector to be offshored, while accommodating excess inflation in domestic services.

  In the face of the great deflationary rise of East Asia, sound monetary policy would have generated a far different result. It would have resulted in falling domestic prices and wages in order to keep the American economy competitive and to curtail the massive deficit in the trade accounts. The actual policy of the Greenspan Fed simply hollowed out the American economy and shifted monetary inflation from the reported CPI to the S&P 500 index; it led to vast impairment of the Main Street economy even as it fueled a destructive eruption of bull market mania on Wall Street.

  STUDIES IN BUBBLE BLINDNESS:

  WHY THE DOZEN HIGHFLYERS HAD TO CRASH

  It was in this context that the next phase of the equity cycle gathered momentum after the 1991 recession and never looked back. By the time the bruising stock market crash of 2000 finally materialized, the get-rich-quick culture had sunk deep roots in both Wall Street and Main Street. All told, the S&P 500 index accomplished in eighteen years what should actually take a half century.

  The index rose from 110 in August 1982 to a level of 1,485 before it finally stopped rising in August 2000. That amounted to a 13.5X gain and a 15.5 percent rate of compound growth for nearly two decades. There had never been anything like that anywhere, at any time, in modern financial history. It did seem to prove that financial trees grow to the sky. That illusion was especially evident in the maniacal excesses that occurred underneath the overall stock averages. Indeed, the true extent of the Greenspan mania can only be seen in the case studies which taught a generation of investors that stocks can grow to the sky.

  Perhaps the poster boy is Dell Inc., the iconic manufacturer and make-to-order business model pioneer of the PC era. Between 1990 and March 2000, its stock price rose from the pre-split equivalent of $0.05 per share to $54—an increase of 1,100 times in ten years.

  Dell generated immense growth in output, profits, and customer utility in the course of its spectacular ascent, but it hadn’t invented a perpetual motion machine. Twelve years later in 2012, the PC was already becoming obsolete, and Dell’s stock price languished 85 percent lower at $10 per share. After tipping the scales at $130 billion at its 2000 peak, Dell’s market cap has shrunk to a current value of only $18 billion, notwithstanding that its sales have nearly tripled in the interim.

  The damage from Greenspan’s runaway bull market was not only that its inevitable crash left investors financially wounded and, in some cases, destitute. In drastically overvaluing the current earnings of Dell and thousands of other companies, it had also effectively stripped the stock exchange of its fundamental economic function, which is to rationally discount future corporate profits.

  In the case of Dell’s towering stock price at the bubble peak, its share price implied a future of endless, sizzling earnings growth. Yet Dell had no meaningful patents, no unique products, and was not surrounded by technology moats of any kind; its success had been based on an innovative business model—global supply chain management and assemble-to-order product delivery—which could be copied and was.

  Dell’s exuberant growth rate thus did slow sharply after the turn of the century, with net income rising at a prosaic 5.6 percent annual rate during the eleven years ending in fiscal year 2011. Needless to say, its 70X PE multiple at the 2000 tech bubble peak—13X its actual future growth rate—was not even remotely warranted and was a reflection of Greenspan’s financial bubble, not sustainable economics.

  When the dot-com crash finally came in the spring of 2000, Dell’s share price fell hard, causing more than $100 billion to rush out of its market capitalization, as if it had been bottled air. Yet this was not evidence of free market exuberance being brought to ground, nor merely the correction of a mistake emanating from the market’s endless process of price discovery.

  Instead, it was proof that printing-press money had touched off a speculative mania of historic proportion. It had afflicted millions of retail investors who had ridden the Dell stock up its spectacular 1,100-fold ramp with the delusion that instant riches are only a matter of good stock market timing. Even when this particular ride ended in tears, newly enabled punters viewed their losses as a matter of poor exit timing, not the fact that Dell’s moon shot had been the result of a mania-driven stampede.

  The tech bubble was not historically unique. Dell was just one of a multitude of new-age companies of the 1990s whose spectacular rise and then flaming descent was reminiscent of the trail blazed by new-era highflyers of the 1920s. In that age, radio had been the booming new industry, and Radio Corporation of America (RCA) the archetype for stock prices which grow to the sky.

  During the five years ending in October 1929, RCA had soared from $5 per share to $400. Thereupon it proved that companies valued at 200X earnings, no matter how brilliant their invention or breathtaking their growth, are the result of bull market manias, not entrepreneurial genius. Back at $10 per share after the 1929 crash, this lesson was powerfully taught and remained embedded in Wall Street’s institutional memory for the better part of six decades.

  So another ill-effect of the 1990s Greenspan stock bubble was the erasure of what remained of Wall Street’s hard-learned lessons. Cisco Systems was a dramatic case. Its stock price had started at the equivalent of $0.10 per share in 1990 before reaching a peak of $77 in early 2000. That amounted to an 880-fold gain, causing Cisco to become a “must own” stock in millions of 401(k) portfolios.

  At its momentary peak in March 2000, it became one of the first companies to reach $500 billion in market cap, and in that figure the frenzied extent of the mania was plainly evident. It represented nearly 26X Cisco’s sales during fiscal year 2000, and nearly 200X its net income. Not surprisingly, $400 billion, or 80 percent, of Cisco’s half-trillion-dollar capitalization at the NASDAQ peak consisted of the same bottled air as Dell’s exaggerated worth. Today, Cisco’s market cap is just $100 billion, notwithstanding the fact that it has continued to soldier along inventing new products and steadily growing its sales.

  Cisco’s moon shot valuation was evidence of a far more malignant force than stock market exuberance, irrational or otherwise. What it actually illuminated was the stunning financial aberration that had been f
ostered by the Greenspan Fed. Cisco had plenty of company in the shooting-star trade. Yahoo!’s market cap, for example, skyrocketed from $5 billion to $120 billion in only twenty-four months and then collapsed to only $4 billion shortly thereafter. And the mania extended far and wide. During the final stages of the stock market’s two-decade-long ramp, nearly every sector was levitated, whether new economy racers or old economy warhorses.

  The five big telecoms—Lucent Technologies, Juniper Networks, Nortel, WorldCom, and Global Crossing—went from being valued at about $90 billion before the LTCM bailout to nearly $1 trillion at the peak. Then they crashed, plummeting to hardly $10 billion. And in that violent deflation, the fundamental deformation of the financial system was plainly evident. The free market does not make pricing errors of this colossal size unaided; speculative bubbles of this magnitude are always and everywhere a product of central bank money printing.

  The PE multiple of AIG, which consisted mainly of a prosaic insurance company subjected to pervasive regulatory constraints on profitability, reached nearly 40X. AIG’s stock price quadrupled in the four years ending in October 2000, lifting its market cap from $125 billion to $500 billion. But General Electric, with its stock rising from $12 to $60 per share during the same four-year period, was the real canary in the coal mine. Its old-line industrial businesses plus its far-flung finance company operations most definitely did not warrant the 30X new economy multiple that lifted its stock price skyward. Indeed, prior to the Greenspan Bubble it had traded at 10X, or a steep discount to the broad market owing to its lumbering portfolio of low-growth legacy businesses like locomotives, light bulbs, and washing machines and its heavy reliance for upward of 40 percent of its profits on the “low quality” earnings generated by its finance company.

  In truth, GE did nothing to warrant the spectacular expansion of its earnings multiple during the 1990s. Jack Welch made a cult of managing quarterly earnings to the penny and the ferocious extraction of costs from its prosaic businesses. Yet the artificial smoothing of short-term earnings is irrelevant to the long-term capitalization rate of global-scale corporations, and cost cutting is inherently a dead-end street that does not merit a high terminal value.

  At the end of the day, therefore, it was not Neutron Jack alone who brought good things to GE’s shareholders. In fact, it was Alan Greenspan who turned the legendary leader of America’s largest conglomerate into Magic Jack, causing GE’s market cap to soar from $125 billion to $600 billion in the four years ending in October 2000. In truth, this massive wind-fall to shareholders was made in the Eccles Building on the Potomac, not at GE’s Six Sigma school at Croton-on-Hudson.

  Ironically, the most spectacular case of bull market mania was Microsoft. Undoubtedly one of the greatest capitalist enterprises of all time, it dominated the ecosystem of an entire industry—the personal computer—like never before in history and had the financial results to prove it. During the last twenty years its sales have risen from $2 billion to $70 billion, and its current net income of $25 billion per year represents a 17 percent compound rate of annual growth since the mid-1990s.

  But the Greenspan bull market carried Microsoft’s market cap into the realm of sheer lunacy. Valued at about thirty times its very promising earnings in 1990, its market cap of $6 billion then traced a parabolic upward curve, rising a hundredfold to $600 billion by January 2000.

  Yet this represented a wholly untenable and unsustainable windfall. Microsoft’s $600 billion market cap represented 64X its current year (FY 2000) net income, and under the circumstances was nothing less than delusional. By that point in time, Microsoft had grown to $24 billion in annual sales and recorded nearly $10 billion of net income.

  Even at an implicit PEG ration of 2.0X, its market multiple at the bubble peak implied that within a decade, that is, by fiscal 2010, Microsoft’s net income would have grown at 30 percent annually and reached $150 billion. The implied figure, alas, was larger than the global sales of the entire personal computer industry at the time.

  Needless to say, Microsoft’s income grew by 6 percent per year, not 30 percent, over the next decade to $18.5 billion; that is, its net income grew by about 2X rather than by the 15X gain that had been implicit in its valuation at the tech bubble peak. Today Microsoft is still valued at only about $200 billion, meaning that at the peak of the mania in 2000 there had been about $400 billion of bottled air in its share price.

  Nor was the Microsoft mispricing an isolated error. None of the great free market creations of the 1990s technology revolution escaped the mania. Intel’s dominance of advanced semiconductors and microprocessors stood shoulder to shoulder with Microsoft’s accomplishment in software. Intel’s powerful technology edge was reflected in the massive growth of sales and profits it recorded during the span between 1990 and 2000: annual revenues grew from $4 billion to $34 billion, and its net income climbed at a 32 percent annual rate to $10.5 billion.

  Yet the Greenspan bull market capitalized these sterling business results as if they were the financial equivalent of the second coming. Intel’s stock price rose seventy-five-fold during the course of the decade, and in no small part because its PE multiple reached 48X earnings by the time of the 2000 peak. Consequently, its market cap soared to $500 billion, compared to only $10 billion in 1990, once again showering punters with previously unimaginable windfall gains.

  Needless to say, this half-trillion-dollar gain on the stock of an already large and maturing company was unimaginable by the lights of prior history. Its 48X valuation implied that its net income would reach $100 billion by fiscal year 2010. In point of fact, Intel’s net income in fiscal year 2010 was only $11.5 billion, meaning that during the decade after 2000 its earnings grew at only a 1 percent annual rate.

  Two recessions, the rise of competition from Korea, Japan, and Taiwan, and the law of large numbers all played a role in bending Intel’s financial performance toward the flat line after the turn of the century. In the process of economic reality setting in, Intel’s $75 stock price cratered to $17 per share by the fall of 2000, thereby shrinking its market cap by about $400 billion.

  THE $2.7 TRILLION BUBBLE THE MAESTRO COULDN’T SEE

  At the time the thundering dot-com collapse was gathering momentum in April 2000, Chairman Greenspan would have none of it. Asked during a meeting of the Senate Finance Committee that month whether an interest rate increase would prick the stock market bubble, he responded: “That presupposes I know that there is a bubble … I don’t think we can know there has been a bubble until after the fact. To assume we know it currently presupposes that we have the capacity to forecast an imminent decline in [stock] prices.”

  Rarely have the words of a high official been so thoroughly mocked by the unfolding of real-world events. During the next eighteen months, the dozen highflyers of the stock market, mentioned above, experienced nearly a 75 percent average decline in shareholder value. This meant that $2.7 trillion of market cap vaporized just among these highly visible corporate majors. That staggering loss constituted the core of more than $7 trillion in market cap decline for the stock market as a whole.

  Contrary to the maestro’s Senate Finance Committee testimony, Greenspan and his monetary politburo did not need a crystal ball to spot the impending flameout. The mounting danger of a market crash was palpable, but the Fed obstinately refused to even assess the evidence that was plainly displayed in its rearview mirror.

  The explosion in the market value of the highflyers had no historic precedent, not even during the stock mania of 1929. In fact, the parabolic rise in the market value of these big companies was just plain preposterous, and meant that a meltdown of historic proportions was waiting to happen.

  Only forty months elapsed between the worried message of Greenspan’s “irrational exuberance” speech and the unaccountable bubble blindness conveyed in his April 2000 testimony. During that period, the market cap of the dozen highflyers reviewed above grew from $600 billion to $3.8 trillion. In that ascent,
the known laws of economic value creation were grossly violated.

  There is simply no plausible circumstance on the free market in which the true value of giant companies like these can increase sixfold in such a brief interval. This outbreak of irrationality, therefore, was not merely a curiosity on the margin, nor was it a flash in the pan signifying nothing of lasting import. In fact, it was decisive evidence that the financial markets had been fundamentally unhinged by the Fed’s continuous money printing and pandering.

  The maestro might have reviewed the fate of these dozen highflyers before plunging into the lunacy of 1 percent interest rates and the housing bubble which followed. Needless to say, there was no reason to believe that $2.7 trillion of equity value could have just gotten “lost” on the free market.

  The evidence as to its ultimate fate soon arrived and it was unequivocal: the big-cap highflyers at the very center of the first Greenspan stock market boom never experienced even a dead-cat bounce. Instead, they remained at their lows throughout the 2002–2006 period when the Greenspan Fed was busy transplanting bubble finance to neighborhood real estate markets throughout Main Street America.

  In fact, as of twelve years later in 2012, four of these companies have disappeared and those which remain have a combined market cap of $850 billion. In the final reckoning their share prices did not grow to the sky; the market value accruing to shareholders of this legendary dozen highflyers has actually grown at only a 2.5 percent rate over the last sixteen years.

  Neither the Greenspan Fed nor the mad money printers of the Bernanke era which followed ever leveled with the American public about the sobering truth evident in the saga of these highflyers; namely, that there is no such thing as effortless, instant riches on the free market.

  THE PERVERSE UNTRUTH OF BUBBLE FINANCE:

  HONEST SAVINGS ARE NOT NECESSARY