THE BEAR'S
LAIR Facebook - equities' death
knell By Martin Hutchinson
The Facebook initial public offering, with
its combination of management arrogance, private
equity greed and Nasdaq ineptitude, has certainly
changed the atmosphere in the United States and
global stock markets. The question is whether,
like the ill-fated AOL-Time Warner merger of 2000,
it has merely marked the peak of a temporary
bubble or the final end of the equity investing
cult among the ordinary public.
In the
stable days before 1914, retail investors bought
few stocks. Bonds represented the best means of
saving for retirement or other purposes. Because
Britain and the United States were on the gold
standard, principal on bonds of first-class
governments and major railroads and corporations
was secure against inflation and the interest
suffered either no income tax (in the United
States before 1913) or a
low rate of income tax (as in Britain from 1842 to
1914).
Thus investors in even corporate
bonds enjoyed a safe and substantial real return,
provided only that the corporation's assets had
not been "watered" by issuing more bonds and stock
than the properties were worth. (In that case,
whether for a railroad or a producer of a
commodity such as steel, the costs of servicing
the excess debt or equity made the company
potentially uncompetitive against a rival
railroad/producer whose bonds/stocks had not been
"watered.")
In Britain, the lack of equity
investment was caused by the mass of government
bonds available for investment after the
Napoleonic Wars. The merchant banking system did
not get around to carrying out share issues until
the Guinness share issue by Barings in 1886.
Instead it made its money by issuing bonds,
diversifying into foreign government bonds
initially and then reluctantly into railroad
bonds.
To get your shares listed, you had
to run the gauntlet of a terrifying set of
fly-by-night company promoters, of which Anthony
Trollope's villain, Auguste Melmotte, was
ethically at the top rather than the bottom end.
Middle-class investors like John Galsworthy's
Forsytes, to the extent they invested in shares at
all, invested primarily in the hope of a
substantial and improving dividend rather than of
capital gain. Mostly they stuck to bonds or, for
the more adventurous, rental real estate and
mortgages thereon (all those lawyers in the family
gave them access to good deals).
In the
United States, where the financial markets were
even gamier than in Britain, the public invested
in bonds, primarily of railroads and state
governments, until right at the end of the 19th
century, when equity issues sponsored by J P
Morgan gave adventurous investors some assurance
that the company in which they invested was not an
outright swindle.
That changed in the 20th
century. First, with inflation, bonds were no
longer a solid investment - Soames Forsyte's Uncle
Timothy, still in Consols at the age of 101 in
1920, was by then very eccentric and somewhat
impoverished. Closed-end mutual funds had existed
in the 19th century, but the invention of
open-ended mutual funds, in the 1920s in the
United States (Massachusetts Investors Trust,
1924) and in the more prosperous 1930s in Britain
(Municipal and General Securities: First British
Fixed Trust, 1931), allowed small investors access
to the stock market for the first time.
In
the United States, the Great Depression knocked
the markets back, as did World War II in Britain,
but persistent inflation and increasing prosperity
in the 1950s brought the cult of the equity to
both countries.
In Britain, the building
societies (which paid interest free of basic rate
income tax and whose rates floated with interest
rates generally) provided stiff competition to
equities until the period of negative real
interest rates in the 1970s.
In the United
States, savings banks and from 1974 money market
funds also remained in the game. However, from
1980 the great bull markets in both countries made
the equity markets supreme. In the 2000
presidential election, George W Bush ran
successfully on a program of investing Social
Security payments in the stock market, since it
was apparently bound to provide much higher
returns.
This all changed after 2000, as
equity markets worldwide failed to offer
reasonable returns. They had been bid up to an
inordinate extent in the late 1990s bubble caused
by Federal Reserve chairman Alan Greenspan's lax
post-1995 monetary policies. They were not allowed
to fall to a market clearing-level after 2000, as
the Fed and other central banks continued to
expand money supply excessively.
It's now
clear that certainly the 2002 stock market bottom
and probably the 2009 bottom were false; that is,
the decline was reversed by artificially pumping
money into the system before a true
market-clearing bottom had been reached.
Calculations based on nominal gross domestic
product growth since the February 1995 change in
US monetary policy suggest that a middling level,
not a bottom, for the Dow Jones index would
currently be around 8,200, so that at today's
levels the market is still 50% overvalued.
It's not surprising that investors today
find equities unattractive; they have been
subjected to 12 years of nominal returns close to
zero and negative real returns. For a "value"
investor it is very difficult to persuade oneself
that equities are currently worth buying, other
than in the commodities sector, where their value
rests on the inflated prices of the underlying
commodities.
The Fed's post-1995 policy
has thus been extremely damaging. First it
inflated equity values to a ludicrous extent, far
above any possible rational calculation of value.
Then, instead of allowing markets to correct to a
level that could have represented "good value" and
from which savers could have achieved a high
return with only modest risk, the Fed kept prices
artificially inflated, but subject to large
unpredictable downdrafts such as that of 2007-09.
For a thoughtful investor, equities in this
environment represent a very poor investment, and
will only represent a good one when monetary
policy has been corrected and market excesses have
finally been wrung out. Needless to say, since we
only have a finite lifespan, a period of 15 years
or more in which common stocks are a poor,
overvalued investment has been a major deterrent
to using them as the basis for our retirement and
savings planning.
Only in emerging markets
was the decade of the 2000s lucrative for equity
investors, and there for most US investors
information was scarce and the barriers to
investment high - many of them erected by the
Securities and Exchange Commission and
Sarbanes-Oxley legislation, making it hugely
expensive for foreign companies to list in the
United States, and more or less illegal for US
brokers to sell to retail investors the shares of
foreign companies that were not so listed.
It's thus not at all surprising that
investors are disillusioned with equities. The
problem is, the alternatives available to them all
have major disadvantages.
Private equity
may look logically like the alternative to stock
market investment. However overvaluations here are
even more extreme than in the public equity
market. Interest rates are at record lows,
artificially reducing the cost of leverage, while
corporate earnings are at record highs in terms of
GDP. Both factors can be expected to go into
reverse in the near future. And private equity
bears much of the blame for the Facebook bubble.
The plethora of "insiders" investing at a
US$60 billion valuation in a company whose true
value was no more than $10-15 billion (its
competitor LinkedIn is valued currently at $10
billion) drove up valuations to an absurd extent,
and their attempt to unload their holdings onto
"greater fools" in the public market at a $100
billion valuation produced the fiasco we have just
witnessed.
Compared with public equity,
private equity provides no diversification, just
an opportunity for money managers to raise their
fees to absurd levels without providing
significant additional value. And, by definition,
private equity investment is more or less
unavailable to investors who are not
multi-millionaire favorites of the major brokerage
houses.
Hedge funds are now consistently
underperforming other investments and should be
avoided at all costs. They add no economic value
and provide vastly excessive profits to their
sponsors. Institutions that invest in them are
throwing away their pensioners' and policyholders'
money; we should avoid joining them.
Debt,
whether top-quality or lower quality, is a huge
bubble waiting to burst. The fact that Vanguard
has closed its "junk bond" fund to new investors
is sufficient indication that supply of money here
hugely exceeds that of legitimate deals.
Gold, silver and other commodities are
less of a bubble, in spite of the huge increases
in their prices. The need for consumers in
high-population emerging markets to buy products
that "hurt when you drop them on your foot" is
real, and so therefore is the surge in commodities
demand.
On the other hand, natural gas has
recently shown that supply innovations can bring
down commodity prices with a bump, and this is
likely to happen elsewhere. The money-supply boost
to commodity prices is real too, but will last as
long as Fed chairman Ben Bernanke holds his job
and not a day longer.
Real estate has cost
investors their shirts in the last decade, but is
actually now a good investment. Not commercial
real estate, whose prices have been inflated by
cheap financing, nor residential real estate in
Britain, where prices are still far too high, but
in the United States, outside the major coastal
cities, home prices are now reasonable, in spite
of subsidized financing. Rentals will continue to
increase compared to sales in the
lower/middle-price brackets, so a well-located
apartment block in an area of low unemployment is
probably one of the better investments available
right now.
The better-heeled Forsytes took
advantage of these opportunities; so should we,
provided leverage is kept moderate and holdings
conservative.
Equities are never going to
regain the place in investors' affections they
held in 1995-2000 and nor should they - that was a
bubble, too. Nevertheless, with the exception of
careful, moderately leveraged investments in
residential real estate, there are no other good
alternatives.
Once Bernanke has gone, and
we have suffered through another major bear market
taking the Dow Jones Index down to 5,000 or so, we
should once again make the public equity markets,
with adequate global diversification, a
substantial part of our investment strategy.
Martin Hutchinson is the author
of Great Conservatives (Academica Press,
2005) - details can be found on the website
www.greatconservatives.com - and co-author with
Professor Kevin Dowd of Alchemists of Loss
(Wiley, 2010). Both are now available on
Amazon.com, Great Conservatives only in a
Kindle edition, Alchemists of Loss in both
Kindle and print editions.
(Republished
with permission from PrudentBear.com.
Copyright 2005-12 David W Tice &
Associates.)
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