[from The Australian Financial Review] This fragile engine By Peter Hartcher The lovers at twilight are sharing a drink on a clifftop terrace overlooking the Mediterranean. But something is deeply wrong. The camera takes us closer. She turns to him, beautiful but angry. "If you don't understand asset allocation, you don't understand me," she cries in an American accent. Frustrated beyond words, she throws her drink in her lover's face and flounces off. Too late, her darkly handsome man calls after her in a Meditteranean lilt: "But wait � I love you." It makes no difference. He watches, uncomprehending, as she leaves him forever. This advertisement for a money management firm, now showing on American network TV, captures some essential truths about the state of the union circa 2000. The stockmarket is no longer just important to the health of the US, it is central � and not just for its economy. It is also a more important personal, sociological, political and geopolitical phenomenon than at any time in at least half a century. The country's Secretary of State, Madeleine Albright, calls the US "the indispensible power". And the ineluctable foundation of the indispensible power is the stockmarket. "At no time in the post-World War II period has the economic wellbeing of the US and the rest of the world hinged so importantly on the performance of the American stockmarket," writes one of Wall Street's best-known gurus, Henry Kaufman, also known as Dr Doom, in his just-published memoirs. For the last 60 years the value of the stockmarket has averaged half the size of the national economy. Today the market has blown out so that it is worth not half but one-and-a-half times as much as the total economy. And stockmarkets are not noted for their serene stability. It is not the steadiest foundation for empire. Jim Grant, the publisher of a contrarian Wall Street newsletter, Grant's Interest Rate Observer, puts it this way: "It's like a filing cabinet suspended over our heads by a single strand of dental floss." He frets in particular over the Nasdaq index, the measure of technology company stock prices. Yet after the experience of the great bull market of the 1990s, "Americans have come to expect rising stock prices as their right. It's extraordinary. Everything is perfect and yet improving," Grants quips. The state of the market has had a powerful effect on the nation's wealth. Individual investors harvested half a trillion US dollars' worth of profits from their shareholdings last year alone, a sum equal to the size of the output of the entire Australian economy. It also has a strong influence over the national mood: "American arrogance exists in proportion to the movement of the Nasdaq index," says the author, academic and prophet Francis Fukuyama. And, as the drink-dashing heroine of the TV ad demonstrates, personal investment in stocks has become a very serious issue for the Americans who own shares � as half of them now do. This compares with just 5 per cent in the 1950s and 19 per cent in the mid-1980s. Deadly serious, in fact. An analyst who dares go public to predict a Wall Street crash can expect to receive death threats from angry investors. Alexis de Tocqueville said it more than 150 years ago. This sharp-eyed French social historian visited the US and announced: "I know of no country, indeed, where the love of money has taken stronger hold on the affections of men." It's not a new sentiment, but the stockmarket is now the main channel for indulging it. Ten years ago Americans held one dollar in every seven of their personal wealth in the form of stocks; today it is one dollar in three. It has reached the point where Americans now have more money in stocks than real estate, according to Federal Reserve data. Stock investing has spread like a fever and no corner of society has been untouched. In 1969 a group of Black Power student radicals campaigning for a black separatist state took over the Willard Straight Hall on the campus of Cornell University at gunpoint. Today their leader runs a staff stockmarket investment fund. Stock funds for children have boomed. Six years ago the Stein Roe Young Investors mutual fund had 4,000 account holders. Today it has 231,000 and the average age of investors is 11. A survey by a Boston firm, Liberty Financial, found that 55 per cent of high school students had bought stocks or bonds. The comparable figure in 1993 was 14 per cent. The stockmarket was once the preserve of the wealthy and the financially sophisticated. Now cab drivers and construction workers talk knowledgeably about their portfolios and the latest hot tip. CNBC broadcasts a TV channel dedicated wholly to the stockmarket 24 hours a day. The strength of the market has been a powerful advantage for the US economy. It has channelled savings from households to companies on an unprecedented scale. And much of these savings went to finance technology firms and new start-ups � to renovate the US industrial structure. In the last 20 years, technology companies have raised about $US400 billion ($744 billion) from American stockmarket investors. The companies were happy and the upgrading of the US economy to a higher technological plane was under way. But the investors were even happier. Their cumulative capital profits on those $US400 billion worth of investments stood at $US3.7 trillion by the beginning of this year. How did this happen? Booms always begin with low interest rates and easy money. "The experience of the US in the 1920s and Japan in the 1980s was that if you have easy money and it's not reflected in the cost of living � that is, it doesn't cause price inflation � then it flows into asset prices," explains one of the wise heads of Wall Street, Albert Wojnilower, who started on the street as a Fed economist in 1953 and is now senior economic adviser to the Clipper Group. "We've certainly had easy money this time round, and it's flowed into asset prices, but it's been pretty much limited to stocks." By last year this enormous pool of money from US households which had poured into the stockmarket, chiefly through the funnel of mutual funds, had reached a total cumulative value of $US6 trillion. This was more than just an astonishing number, being bigger than the annual output of the Japanese economy. It was also a threshold because, for the first time, mutual funds had more assets than the US banking system, as David Hale of the Zurich Group points out. (The banks' assets stood at $US5.6 trillion). This money pursued technology stocks with mounting determination over the course of the 1990s. It was great for the technology sector, and specifically the information technology sector. And as IT spread throughout the economy, it seemed to expand the growth and productivity of the US economy endlessly. This promised to deliver ever better returns to investors. Companies exploited the allure of the market by issuing little slices of its dazzling potential in lieu of paying people cash. These slices were stock options, bits of paper that allow the holder to buy a share in a company at a future date at a fixed price. Are they a gamble? Sure, but the market has been so strong for so long � the Dow Jones average rose 11-fold between 1982 and this year, and the Nasdaq took off later but even more spectacularly � that they proved irresistible. A single company, Cisco Systems, turned 6,000 of its staff into millionaires just by issuing them options in the company. Options became America's de facto second currency. It was a kind of alchemy, turning pieces of paper into real value. Companies paid their staff with options. Start-up firms lacking the cash to pay their suppliers simply issued options instead. And it was great for the issuing companies because when they transfer options, they transfer tax liability too. That's the main reason why Microsoft paid no corporate taxes last year. In June this year, American investors had outstanding options for stock that they would be free to take up by paying $US323 billion, according to the investment bank UBS Warburg. But those investors would then be the proud owners of shares worth $US893 billion � that is, they would make a profit of $US570 billion or 76 per cent. The longer this virtuous cycle of US expansion continued, the more anxious foreigners became to join the fun. The US has long depended on foreigners to finance its growth, as it runs a chronic current account deficit. And that deficit has been quietly growing, doubling from 2 per cent of America's gross domestic product to 4 per cent in the last few years and still mounting. To finance it, foreign investors must put another $US1.5 billion into the US every working day of the year. But the US market has been so attractive for so long that foreigners have been more than happy to oblige. A leading Wall Street economist, Ed Hyman of International Strategy and Investment, puts it succinctly: "The economy is the stockmarket." In the 1980s the world came to depend on Japanese growth. Japan's financial system was so dependent on land values as the core collateral for its banks that Euromoney magazine declared that the world had moved on to a "Japanese real estate standard". Today it could be said that the world has become so reliant on US growth, and the US system so heavily dependent on the stockmarket, that the world has now moved onto a Nasdaq standard. The fusion of a strong stockmarket and a strong economy with a thriving new technology sector has had a striking effect on American society. Francis Fukuyama says: "Tom Wolfe wrote The Bonfire of the Vanities to describe the bond traders of the 1980s, and he touched a nerve because there was a really unpleasant side to the materialism and ambition. "I think it's just moved over to this other sector. It's not the bond traders now that are the masters of the universe, because the bond market has been stagnant for a decade, it's all the self-congratulatory people in the IT sector. They think they walk on water. Their arrogance is summed up in this phrase, it's one of my favourites: 'You just don't get it'." And even though he is a pro-market, pro-capital conservative, Fukuyama is troubled by the influence of the new prosperity. "There are all these things going on in the class structure now that people are only dimly comprehending. One of the more revealing ones was a story in The New York Times about a year ago about a butler school in Colorado . . . because so many Americans are wealthy enough to have servants now. You see all these people who got rich on the stockmarket building these enormous houses with 10 bedrooms and 11 bathrooms. It's disgusting. "All I can say is, it's not the America I thought I understood. I read about these kids at Palo Alto high school. One of them is driving a Mercedes and another one is in a Lexus and they have an accident in the school parking lot. But when it gets to court their parents are too busy making money in their dot com start-ups to make an appearance for their kids." While all this is going on, many social problems remain unsolved. While millions of children play the market, one in five American children lives in poverty. Inequalities have become aggravated, and affluence is not necessarily a matter of deserved personal reward. Hubris is invariably followed by nemesis. And upturn must eventually yield to downturn. The virtuous circle that has generated America's great boom is susceptible to reversal. There are several key vulnerabilities. The US has actually produced very few companies that have generated consistently stellar earnings performances. Of the 10,000 publicly traded companies in the US, the number that have produced growth in earnings per share of 20 per cent or higher in each of the last five years is exactly 11 (this is not a misprint), according to the Bank Credit Analyst research group. Many stock prices have performed as well or better than this, but only because of the volumes of money bidding their prices up, not because it accurately reflected their underlying earnings. So the market's stunning performance has more to do with easy money and liquidity, rather than actual corporate earnings. This means that the market is keenly vulnerable to changes in monetary conditions. And as we know, the Federal Reserve's chairman, Alan Greenspan, has started to tighten monetary conditions for fear of inflation, and the ready flows of money into mutual funds have started to falter. As a result, the Dow Jones and Nasdaq are both down so far this year. Further inflationary threats are possible, the oil price foremost among them. If they are realised then further monetary tightenings beckon, and a more emphatic stockmarket downturn is in prospect. Many investors have put their faith in the power of technology to ward off financial distress. They may need their faith because the technology will not suffice to save them. The internet and IT revolutions are important, but they can no more immunise the stockmarket against downturn than the �hot' technologies of 1929, the automobile and the wireless, could prevent the Great Crash. Historically, the internet is actually rather ordinary as technological revolutions go. The US National Academy of Engineering recently asked its members to rank the greatest technological innovations of the 20th century, and they ranked the internet in 13th place after electrification, the automobile, the aeroplane, water supply, electronics, farm mechanisation and refrigeration, among others. A productivity expert and internet sceptic, Professor Bob Gordon of Northwestern University in Chicago, was slightly more generous. He ranked the internet 11th in his list of the century's most important enhancers of productivity. And of course, once a stockmarket downturn takes hold, the virtuous circle can go into reverse. Stock options are no longer attractive. Employees will want cash, and suppliers too. Companies, no longer able to transfer the tax liability with the options, will face bigger tax bills. The de facto second currency is suddenly valueless. And if the fat returns are no longer so fat, foreigners will be less inclined to supply the daily $US1.5 billion to finance the US current account deficit. This could lead to a further unravelling as the US dollar weakens, in turn exerting an inflationary impulse on US prices and inviting Greenspan to increase interest rates again. Indeed, the World Bank's president, Jim Wolfensohn, who hosts his old friend Alan Greenspan at his Jackson Hole ranch every year for the big central bankers' conference, gave us an insight into this last week. He said that the Fed's chairman, in private while staying with him on the ranch a few weeks ago, had been preoccupied with the problem of the ever-increasing current account deficit. Both mighty and fragile, the stockmarket, like the empire it supports, is in desperate need of the gentlest of soft landings. But as Albert Wojnilower says: "I've never been through a soft landing that felt soft while I was going through it." _______________________________________________ Crashlist resources: http://website.lineone.net/~resource_base To change your options or unsubscribe go to: http://lists.wwpublish.com/mailman/listinfo/crashlist
