Adam Hamilton December 7, 2001 5055 Words
“Gentlemen, you have come sixty days too late. The depression is over.” – Herbert Hoover, President of the United States of America, responding to a delegation requesting a public works program (stimulus) to help speed US economic recovery, June 1930
I know what you’re thinking. Hamilton has cracked. His convoluted mind was finally shattered by all that data he relentlessly pours in, kind of like the dreaded neural-creep faced by the futuristic cyborg data-couriers in the 1995 B-grade science-fiction movie Johnny Mnemonic. You are probably chuckling to yourself because the NASDAQ didn’t even exist way back in 1929!
While I certainly won’t dispute the fact that I should have been committed to a funny farm long ago, even I know that the virtual NASDAQ stock exchange wasn’t around during the notorious 1929 stock market boom, bubble, burst, and bust. Actually, the NASDAQ opened for business many decades later on February 8, 1971, was incredibly sophisticated for its time, and sparked a revolution in how we trade and invest.
The virtual NASDAQ exchange remains on the financial frontlines of the very vanguard of the mega-political revolution we fondly know as the Information Age. Since we are at most only a few decades into this fantastic new time of wondrous opportunity, I suspect that few people alive today can even begin to imagine where all our seemingly magical technology will take humanity in the coming century. The rapidly evolving Information Age will dwarf the Industrial Revolution in its importance as a force of breathtaking change in history.
Over three decades ago, the founders of NASDAQ foresaw a wired world, and thanks to their hard-work and diligence, trading has been forever altered. Every investor in the world should have tremendous respect for where the NASDAQ stock exchange has been, what it has accomplished, and where it will help lead the virtual exchanges and cyber-clearing houses in the future.
This essay, however, isn’t about the virtues of non-physical, non-geographic dependent, instant global trading. It is all about sentiment and market directions. An epic psychological war currently rages for the hearts and minds of the average American investor.
On one side looms Wall Street, stock brokerages, the US government, the mainstream media, and the vast majority of investors. These people and organizations are incredibly bullish on the US stock indices including the psychologically-crucial NASDAQ composite index. Twenty-four hours a day, seven days a week, fifty-two weeks per year, neither rain, sleet, hail, terrorism, war, fundamentals, nor economic data can halt the ubiquitous bullish propaganda cacophony calling for perpetually-rising equity markets.
On the other side stand the scarce bears. While I am a raging optimist and don’t consider myself a bear, because I have written many essays (www.ZealLLC.com) zealously trying to warn investors about the extreme dangers of supercycle bubbles and busts, most people would consider me one of the malcontent bears. Unlike the legions of bulls, the number of bears is trivial by comparison. Bears are more inquisitive than the most obnoxious house cat. Bears scour history and the information superhighways for important information that they can use to attempt to learn how markets work. Rather than accepting on pure faith alone the assertion that markets will rise in a straight-line forever, the bears seek to understand the market cycles of history and learn what really drives equity prices.
Being a bull instantly makes one part of the “in” crowd. If you go to a cocktail party and say that Intel is one of the best Information Age companies in history and will continue to change the world as we know it, and you claim that its stock price is going to rocket, you will instantly gain many friends and comrades in capital arms. Being a bull is easy, kind of like way back when you were in high school and as long as you did what the crowd did, you were accepted as one of them.
On the other hand, if folks perceive you as one of those “gloom and doomer” bears, you are “out” and will even be less popular than Osama bin Laden in New York City. If you go to a cocktail party and say that Intel is one of the best Information Age companies in history and will continue to change the world as we know it, but you express the slightest concern that it is currently trading near 79x earnings, people will scatter with extreme prejudice as if you had the dreaded smallpox.
At this peculiar crossroads in history, being a contrarian on US equities, having an opinion contrary to what the great throngs believe, means being bearish and facing the dark social stigma attached to the bloody heretics who would dare question the universal faith in perpetually rising stock markets.
On December 5, 2001, the bulls won a tremendous psychological victory in the ongoing equity wars when the NASDAQ rocketed through 2000 (again) like an intercontinental ballistic missile and the venerable blue chip Dow 30 breached the critical 10000 level (again). Before that fateful Wednesday this week, I am pretty sure that there were at least a few dozen bears left on the planet still concerned about the US equity markets’ stratospheric valuations. But judging from the number of flames and hate-mail flooding my e-mail inboxes after market close Wednesday, I suspect bears are now almost as extinct as the Mauritian dodo bird.
Of course, any thinker and seeker of knowledge should rejoice when their worldview is challenged. We best grow and gain knowledge and wisdom when we are forced to question what we believe. For this reason, I have always solicited flames after my essays as through intellectual challenges I can deepen my understanding of how markets operate and what drives them. Many thanks to all the flamers who wrote telling me the bears were insane and the Great Bull is back!
Since the bulls are cackling with glee over their perceived victory, and many bears are shell-shocked and heading for the hills faster than the Taliban in retreat, I figured this week would be a great opportunity to revisit the bearish case for the NASDAQ, to attempt to determine if the bearish hypothesis still has any validity in our New Brave New Era (according to the perma-bulls, this particular one started after the September lows if you are keeping score).
As always, the keys to market behavior reside in contrarian thought. One of the core tenets of contrarian investing is that market history matters. Markets are perpetually driven by forces that ultimately change little no matter how far humanity advances.
In the short-term, market prices are driven by greed and fear. When greed reigns, markets are bid-up to silly heights of extreme valuations. Eventually, burning greed turns into black fear and markets are sold-off hard, ultimately ending in low prices and bargain valuations. Since the human heart will always be just as greedy and fearful in the present and future as in the past, contrarians believe that short-term valuation extremes are and always will be determined by popular investor psychology.
Legendary investor and mentor of Warren Buffet, Benjamin Graham, described short-term market action as if it was determined by a “voting machine”. If investors want stock prices higher, they “vote” by throwing their money at the markets and they achieve the goal they seek for a while. Conversely, when investors as a herd begin to sell and vote their dollars out of the market, stock prices plummet. Popular investor psychology is the single most important factor for short-term market performance.
Over the long-term, market prices are driven by rock-solid fundamentals, primarily earnings and cashflows. As corporate earnings generally grow at a rate slightly slower than the US economy, stock prices do inevitably gradually rise over the long-term. Benjamin Graham described long-term market action as if it was determined by a “weighing machine”. As the great ancient Israeli prophet Daniel said to Babylonian King Belshazzar in 539 BC mere hours before Persian military genius King Cyrus captured the impregnable city on the Euphrates, “You have been weighed in the balances and found wanting. Your Kingdom is divided and given to the Medes and the Persians.” (Please see the intro to our old “Writing on the Wall” essay for a description of this fascinating historical event.)
Over the long run, Graham’s “weighing machine” crushes overvalued markets (say a price earnings ratio over 20) and forces them to revert to historical mean valuations (around a 13.5 P/E). It also allows undervalued markets (a P/E of around 7) to grow and prosper, enabling them to also revert to historical mean valuations (around a 13.5 P/E). Like Daniel’s great balances on which the mighty Babylonian Kingdom was weighed and found wanting, long-term stock prices are determined by the weighing of the actual earnings and cashflows companies can spin-off for their owners, stock investors.
This crucial concept of “mean reversion”, of markets returning to average fundamental valuation ranges over the long-run as they are pushed by irresistible and unstoppable free market forces, is probably the most-well documented market truth in existence.
Investors today need to integrate these crucial historical truths into the great bull and bear debate. Has the NASDAQ currently entered a glorious new bull market like a reborn Phoenix from the fiery ashes as virtually the whole investment world seems to believe? Or is the popular index simply feigning a false new bull in a spectacular bear market rally? (Please see our “Bear Market Rallies” essay from a couple weeks ago for a deeper discussion on bear market rallies.)
Literally hundreds of billions of dollars of capital as well as the very financial futures of tens of millions of American investors ride on this all-important question!
Since both the short-term psychological winds and the long-term fundamental forces driving markets through history never change, contrarians like myself believe that the keys to unlocking the future direction of markets often lay in the past.
Way back in August 2000, when the NASDAQ was still above 4000 and very few folks would even admit that it was a bubble and even fewer that a crash had occurred, I wrote an essay called “To Crash or Not to Crash.” In that fateful essay I had the audacity to say (those darned malcontent bears!)…
“The most likely probability for NASDAQ performance in the next 18 months, weighing in at 80% in my humble opinion, is a multi-year bear market in the index. The brave tech investors (and we all know some) have more zeal and faith in their stocks and market than most religions can command. They will not give up hope easily, and are likely to slowly go down with their mortally wounded ship, the USS NASDAQ. The only likely way the backbone of irrational investor hope in companies valued at 100x to 3000x earnings will be broken is through a gut-wrenching and excruciating multi-year bear market. From a contrarian perspective, playing the market based on the human emotions of greed and fear, it is becoming increasingly evident that nothing can scare the NASDAQ disciples. They largely have no concept of critical fundamentals, exist in a blue-sky ethereal world where history is irrelevant, and invest based on hype, not cashflow prospects.”
While you can say all you want about malcontent bears and weird contrarians trading markets based on historical precedent, that call proved to be spot-on and we have been blessed with many wonderful letters from around the world thanking us for publishing that essay. It was thought-provoking enough for many who read it that they were inspired to launch their own personal due-diligence campaigns and ended up completely liquidating their NASDAQ market-darling holdings by September 2000 when the post-bubble index still hovered above 4000.
In order to more deeply explore the current great debate on the NASDAQ future direction today in early December 2001, here are a couple of the actual quaint graphs from “To Crash or Not to Crash” which led to that unpopular yet successful contrarian analysis on the mighty NASDAQ.
“To Crash or Not to Crash”, August 25, 2000, NASDAQ 4043
I remember well the day we constructed this graph. Because valuations at the time were so extreme, I was virtually certain that the NASDAQ was a mighty bubble, but I was blown away when we graphed the 1929 crash against the early 2000 NASDAQ action. Not only did the speculative mania blow-off of the NASDAQ in March 2000 near perfectly match the ominous Dow 30 action of late 1929, but the NASDAQ crash fit like a carefully crafted key in a lock!
I closed that essay with this paragraph, followed by a classic Warren Buffet quote…
“To crash or not to crash? Only God knows for sure, but the probabilities continue to increase that April was a classical index crash and a demoralizing NASDAQ bear market lies dead ahead in the fogbank right off the bow…”
The Warren Buffet quote I used is just as applicable today as it was back in August 2000. The Great Sage said, “Be brave when others are afraid, and afraid when others are brave.” Today, in early December 2001, are investors brave or afraid of the NASDAQ in general? It would serve you well to very carefully ponder Buffet’s great wisdom if you have ANY long-term capital at risk in hyper-valued NASDAQ market-darling stocks!
The following graph was also first presented in “To Crash or Not to Crash”. As mere mortals neither myself nor my partners could see the future at the time of course, but we marveled over this graph and I have to admit I lost some sleep over it. We have custom-built hundreds of unique graphs at Zeal, but I really believe that the following graph is the most important we have ever created.
“To Crash or Not to Crash”, August 25, 2000, NASDAQ 4043
Holy “déjà vu all over again” Batman! As the big red question mark above noted, the future was as uncertain in August 2000 as it is today in December 2001, but we began advising all of our private Zeal Intelligence newsletter subscribers as well as our private consulting clients to get the heck out of NASDAQ dodge based on our analysis. It was a tough and unpopular call to make, as it was just as uncomfortable and unloved to be hardcore contrarian on the NASDAQ in August 2000 as it is today in December 2001.
We felt that the chilling comparison between the infamous 1929 equity boom, bubble, burst, and bust and the fast-developing modern day 2000 equity boom, bubble, burst, and bust was so important for investors to see that we decided to prominently display the comparison on Zeal’s website. We then proceeded to diligently update the graph with current NASDAQ data week after week for well over a year. While we took a lot of flak for publicly betting against the NASDAQ, we and our clients saved much capital from being obliterated in the bust and made even more money shorting the collapsing NASDAQ bubble.
Here is the latest iteration of our popular comparison graph from last week.
www.ZealLLC.com, November 30, 2001, NASDAQ 1931
Although a little more graphically flamboyant and flippant, this graph is the very same chart that was updated from the original “To Crash or Not to Crash” essay. As you can see the NASDAQ composite appeared to track the notorious early 1930s bust quite well until the April 2001 lows, after which the NASDAQ began a long, slow bounce that did not collapse to new lows until after the radical Mohammedans made their fiery veto of US foreign policy on September 11.
After its late September lows, the NASDAQ began marching relentlessly northward leading us to where we sit today, snugly above the fabled 2000 level. I wrote a comprehensive essay on this latest awesome rally which we published a couple weeks ago called “Bear Market Rallies” that you may wish to skim or at least look at the graphs if you still have anything other than ultra-short-term speculative capital at risk in the collapsing NASDAQ bubble. “Bear Market Rallies” also compared the current NASDAQ action with what was observed following the 1929 crash and the classical breathtaking false rallies that followed as the DJIA plummeted.
As you may have already noticed in the previous three graphs, the original “To Crash or Not to Crash” NASDAQ 1929 graphs had dilated time scales. As I explained in the original essay, we graphed one NASDAQ 2000 trading day next to two DJIA 1929 trading days. The reason why we made this executive charting decision at the time was two-fold.
First, as the graphs above show, the correlations between the old DJIA of 1929 and a 2-to-1 time-dilated NASDAQ were absolutely amazing. When we originally constructed these graphs, we attempted several different time-scale comparisons including straight-up 1-to-1, but the 2-to-1 comparison was the most compelling at the time and most closely tracked the 1929 boom, bubble, burst, and bust.
Second, and right now I think back at this and shake my head, as all humans including me have a virtually infinite capability of rationalizing ANYTHING, we rationalized our 2-to-1 time-dilated NASDAQ 1929 graph by appealing to Information Age technology. We thought that because information flows were effectively instant in 2000 because of the Internet compared to vastly slower market news-flow velocity around 1929, that the NASDAQ 2000 bubble could unwind much faster than the DJIA 1929 bubble. And indeed for a year or so it did, although that does not necessarily excuse our rationalization at the time, even though we fully disclosed it in the essay and in all of our graphs.
Armed with this provocative data, all investors today marveling at the NASDAQ’s stunning post-September performance must do some serious soul-searching.
No one can disagree that speculative mania equity bubbles throughout history have been exceedingly dangerous. While examining history it becomes readily apparent that every 50 or 60 years or so, popular speculative manias literally explode onto the scene.
This well-known market cycle was originally discussed in the Bible almost 3,500 years ago and known as the Jubilee Year. God mandated that every 50 years all debts must be forgiven and that all the Israelis were to start-out with a clean financial slate. Since the law was well known, all commercial contracts had provisions that anticipated ending in every 50th year, so the Jubilee Year was easy to implement in the ancient business world. These Jubilee Years of debt-repudiation written into the law ensured that the natural three-generation human psychological/credit cycle would be short-circuited and it prevented too much debt and speculative excess from accumulating and causing a hyper-dangerous bubble.
Fast forward a few thousand years to last century, and this natural 50 to 60 year human psychological/market cycle became known as the Kondratieff Wave, after the Russian economic genius who studied and quantified the phenomenon in empirical terms. Here are a couple of paragraphs I wrote in our earlier “The Elusive Long-Term” essay, which describe the origin of Kondratieff Wave theory in more detail…
“Nikolai Kondratieff was a brilliant economist researching in Russia in the 1920s. He was commissioned by Marxist dictator Vladimir Lenin to produce an economic study showing how and when capitalism would inevitably fail. Naturally, dealing with command-and-control despots, Kondratieff was expected to prove a political point with real data, not conduct true open-ended research. Kind of like the Wall Street analysts today who produce perpetually bullish reports because their Wall Street employers lust after the investment banking business. Kondratieff studied commodity prices, interest rates, industrial production, and wages over hundreds of years, ultimately reaching some startling revelations.”
“Rather than telling the communist thugs what they wanted to hear, in 1926 Kondratieff arrived at the conclusion that the hated capitalist system was not destined to fail, but was self-correcting and would continue into perpetuity. Every 50 to 60 years, Kondratieff noted that capitalist economies experience huge cycles. There is a boom, followed by a bust, followed by a long, slow, choppy period of growth, which leads again to a new boom. As in the 1930s in the US, a huge bust leading to a severe deflationary depression marks the beginning of a new growth cycle. This is followed by four or five decades of debt-based growth that ultimately becomes unsustainable, and another crash and depression ensues. These cycles are also known today as K-waves or long waves. Unfortunately for our friend Kondratieff, the Soviet tyrant at the time his study was completed, Joseph Stalin, was not happy with his “anti-communist” conclusions. Kondratieff was exiled to Siberia to a dark, cold, brutal life of forced labor until he was believed to have died in the 1930s.”
These ultra important three-generation market cycles are, once again, driven by the human heart, pure psychology!
For example, the generation that suffered through the 1930s as adults was exceedingly frugal and prudent after the debacle. They saved money, abhorred debt, and were terrified of speculation since they saw so many people lose everything after the disastrous 1929 speculative mania.
This “depression” generation has kids, and the kids are a little less conservative than their parents. They start dabbling in debt in seemingly innocuous ways, including “buying” homes on time instead of saving money and writing a check, “buying” cars and appliances with installment debt, etc. These second generation kids are also much more aggressive in investing and speculation and demand far higher returns and therefore accept more risk than their parents.
Then comes the third generation, the kids of the kids. Unlike their ultra-conservative depression-era grandparents, these hip kids come to fully accept and embrace debt-based financing of consumer goods and debt-based financing of risky speculations (margin). Rather than seeing debt as a dangerous enemy of future prosperity, its true nature, they see debt as a friend. These kids are very aggressive financially because they have never seen the bottom of a K-wave cycle, and they inevitably think they are in a Brave New Era driven by wondrous technologies. Their collective gambling psychology ultimately gels into a spectacular speculative mania that propels equity valuations to fantastic heights that soon collapse into a bust, and the three-generational psychological market cycle begins all over again.
NASDAQ 2000, the Dow 30 in 1929, the Railroad Mania in England in the mid-19th century, the parallel bubbles of the Mississippi Scheme in France and the South Sea Bubble in England in the early 18th century, the infamous Tulipomania of Holland in the early 17th century, and the list of devastating bubbles goes on and on. These are all textbook examples of popular speculative manias occurring during times at least third-generation removed from previous such episodes.
Like a case of anthrax, bubbles can be lethal for investors unless they recognize the symptoms early and immediately take protective action to preserve their capital through the inevitable consequences. No great historical bubble ever fell-apart gently, and the following busts were always brutal and of comparable magnitude to the preceding boom as the gross speculative excesses of the bubble were painfully unwound.
There is no question that bubbles are always bad news for conventional investors (buy-and-hold philosophical perma-bulls) and that they always have very serious consequences.
To help understand the current NASDAQ situation on top of this awesome rally in early December 2001, an important question needs to be addressed. Was or was not the NASDAQ 2000 blow-off peak a classic speculative mania bubble?
“The Elusive NASDAQ Bottom”, October 12, 2001, NASDAQ 1703
In this graph lifted from our recent “The Elusive NASDAQ Bottom” essay, many clues are offered that suggest that NASDAQ 2000 was indeed a classic speculative mania bubble.
First, note the parabolic ascent in the blow-off speculative mania stage that rocketed the NASDAQ to its all-time peak of 5049 on March 10, 2000. This is the ultimate classic bubble signature for a speculative mania! Second, note the crash in March/April 2000 that Wall Street still won’t admit was a classic crash (because they know that means a bust will follow), and note the sharp decline since then that is symmetrical with the parabolic terminal ascent. If it looks like a bubble, smells like a bubble, feels like a bubble, and quacks like a bubble, then the probability nears certainty that it was indeed a bubble!
Finally, note the yellow line in the graph, which is the NASDAQ hypothetically conforming to the standard 100-year average US equity return of 7.5%, the inverse of the 100-year average US equity P/E ratio of 13.5. It begins from an arbitrary starting point of the first trading day of 1990 and shows a normal non-bubble progression curve for an equity market. As the yellow number indicates, “fair value” for the NASDAQ in terms of these historic norms was only 1115 in mid-October 2001.
If tell-tale bubble signatures are observable in history, if bubbles always have dire consequences, and if the NASDAQ 2000 valuations were far into classical speculative-mania bubble territory, than perhaps it would behoove investors to study the NASDAQ post-bubble bust thus far in terms of past bubble busts.
Our final graph is based on the original NASDAQ 1929 graph that we have long-featured on our website to warn others of what is happening, but in this latest iteration we trash the 2-to-1 time-dilation and put the comparison on a 1-to-1 scale. One trading day of NASDAQ 2000 action is graphed next to one trading day of DJIA 1929 action. As always, the vertical axes are zeroed in order to provide an accurate and non-misleading perspective of the crucial bubble-to-bubble comparison.
www.ZealLLC.com, December 4, 2001, NASDAQ 1963
Ouch! While the 2-to-1 comparison was very helpful and saved countless investors’ hard-earned capital, this straight-up 1-to-1 comparison, with the respective bubble peaks of DJIA 381.2 on September 3, 1929 and NASDAQ 5048.62 on March 10, 2000 exactly matched, is downright scary. If this ominous comparison does not shake the faith of the NASDAQ zealots championing the “glorious new bull market” hypothesis based on this latest rally, nothing will!
Note that the NASDAQ terminal blow-off stage (in red) was far more extreme than the sobering example of the DJIA in 1929. While the NASDAQ did not fall as far in its initial crash (see “Bear Market Rallies”), it more than made up for lost time in its gut-wrenching plunge ending in January 2001 when Alan Greenspan desperately began manipulating short-term interest rates in full-blown panic mode to attempt and save his disgraceful mega-inflationist legacy (“Greenspan’s Fine Mess”).
Even after the current rate-slashing extravaganza began in earnest, the NASDAQ continued plummeting further, with a squishy dead-cat bounce in April and what is almost certain to be yet another brutal feline splattering on concrete beginning in late September. (Sorry, I offer no apologies to all you cat fans out there. You are all far crazier than me if you like those filthy opinionated furballs!)
This essay was originally going to be titled “The Changing of the Guard”, noting that the new NASDAQ 1929 graph shown above will become our standard homepage graph at www.ZealLLC.com, updated at least once a week with current data. Since few would have been perplexed or offended enough to click on an essay with that benign title and read it, we changed it to the far more provocative “NASDAQ 1929” in the hopes of offending everyone and stirring-up some controversy.
The bottom line, dear friends, is that even though everyone and their filthy opinionated furball is now bullish and believes the bottom has already been seen in the NASDAQ, history suggests otherwise. Our graphs above offer ample technical evidence suggesting that the NASDAQ perma-bulls have not yet seen their coveted and fabled turning point to a glorious new bull market.
In the current December issue of Zeal Intelligence just published this week for our highly-valued private newsletter subscribers, we discuss fundamental reasons why all the US equity markets remain vastly overvalued from the long-term fundamental standpoint we briefly mentioned above in this essay. In addition, we noted some dire current US economic statistics that are now the worst seen since the Great Depression of the 1930s! Today’s stellar valuations of the NASDAQ along with hyper-bullish popular market sentiment are simply mind-blowing and are outlined in detail in our latest newsletter for our clients. The ominous technicals shown in the graphs above are confirmed in spades by the horribly frightening fundamentals we outlined in the latest issue of Zeal Intelligence.
As contrarians deeply respect the timeless lessons of history, I would like to close with an ancient parable.
As Jesus Christ wrapped-up his breathtaking and immortal Sermon on the Mount near Galilee almost two millennia ago, the greatest sermon in world history, he wisely pointed-out that a house built on a foundation of sand is doomed. In the closing parable of his great sermon, talking of the wise and foolish builders, Jesus rightfully taught that faith built on a foundation of sand is worthless and will be washed away in a storm.
Although Jesus certainly wasn’t teaching about the NASDAQ or even investing, the current zealous NASDAQ perma-bull faithful would do well to heed his timeless lessons and apply them to the present NASDAQ situation. They have foolishly placed their faith in the market on a foundation of sand, Wall Street mania propaganda, rather than building an unassailable foundation on the solid rock of market history. Will the sandy foundations of the New Era hype hold fast, or will they be blown away in future market storms?
While the NASDAQ future may appear murky at this moment in time, in another six or twelve months we will all probably know for sure whether the embattled index will miraculously prove to be the first true New Era in history and burst free from the iron bonds of fundamentals, or whether it will continue its death-spiral down and destroy hundreds of billions of dollars of more capital before this third generation of investors learns the hard lessons their grandparents had to learn in the 1930s.
“While the crash only took place six months ago, I am convinced we have now passed through the worst, and with continued unity of effort we shall rapidly recover. There has been no significant bank or industrial failure. That danger too is safely behind us.” – Herbert Hoover, President of the United States of America, May 1, 1930
Adam Hamilton, CPA December 7, 2001 Subscribe at www.zealllc.com/subscribe.htm