Replaying 1929

Why We Will Crash?

This greatest Bull market ever is replaying the events of 1920-1933. It's a bit longer than previous Kondratieff Long Waves because people are living - and spending - longer. But it is also, I believe, predictable in many ways.

Of course history doesn't repeat itself exactly, so anything goes. History suggests that we are tracking fairly close to the 1929 (and '87) run up-then-crash curve. Could this set up a replay of the crash of 29 for later this year? I've purchased SPBOT (S&P500 March 98 600 puts with the S&P at 914.)

At the office, I lost a $20 bet with my boss that the market would fall to 6,000 in 1997. His view - and it's the conventional wisdom on the street - is that the market is too high but that things look better than they ever have so there's no reason for the market to head south. The street logic is that the Baby Boomers are madly saving for retirements and will continue to scrimp and save - and they will have to put their money some place and that place is the market. Fortunately, the boss made another bet - that the market would not fall to 6,000 by the end of June 1998 - and I think I will win that one.

Raving of a River Boat Gambler?

If you study long wave economic theory (Kondratieff, et al), we should have had a big correction to the stock market not more than 64 years after the last crash. This means we should have seen the crash not later than 1993-4. In fact, in the Long Wave Economics discussion group (LongWaves@csf.colorado.edu) there are some adherents who hold that 1987 was the Crash which was due. But here we are, three years later than '95, and 11 years later than 87, and my predicted Crash is not here yet. So what gives?

Well, not all the historical elements were in place in 1993-94, or 1987 for that matter. Here's a list of some of the historical elements, some of which are just now falling into place:

  • Kondratieff and the long wave theorists speak of "peak" and "trough" wars. In other words, wars tend to break out following economic peaks and following economic valleys. If you look at the long wave of history, you'll see wars (or war substitutes*) occurring roughly every 50-60 years. The Civil War and W.W.I were Peak Wars. So was the war of 1812. If you have peace, you have a chance of economic panic. If you have war, everyone closes ranks and pulls together.
  • Given that wars tend to occur at or following the peaks and valleys of an economy, you then should look at the timing of past depressions and panics. These tend to cluster in the window from 10-15 years after the end of a Peak War. Historical evidence: The panics of 1832, 1873 and 1929-30 all fit this mold.
  • What's the Peak War that has recently ended? The Cold War between the US and Soviet Union and the subsequent dissolving of the Soviet State into the CIS. Although it was not a "shooting war" with a lot of physical casualties, it was actually a pretty good war in terms of meeting the economic objectives of war - namely to waste at least 10% of the GDP of participating countries over some period of time. [See: "A Report from Iron Mountain on the Accessibility and Desirability of Peace", Leonard Lewin, 1967, Dial Press] The book was later to be shown a construction of anti-war activists, but the conclusions worth reading anyway.
  • People are living longer. The economic and cultural memories of our grand parents (and parents) tend to keep the next generation from repeating follies which beset the previous two generations. In other words, if Mom & Dad lived through the Depression, they will train you not to repeat the mistakes they made. The traditional brake on excess is being released as the number of people who remember the Depression decreases.
  • Depressions tend to occur about 40 years after a key technology begins to permeate society. For instance, the precursor technology to the 1873 panic was the railroad expansion in America in the 1830-50's. The Railroad Barons were the singular titans of industry. Then automobile technology, which evolved in the 1890's, hit 40 and the mid-technology depression of the 29-33 resulted. Will the 40-year figure hit again? I'm afraid it may. The computer is now turning 40. Remember, you didn't need the transistor for computers to evolve. Certainly, silicon has helped. But Brainiac, Eniac and Univac were vacuum tube technology computers. Von Neumann's math doesn't require SMT or Alpha chips or Windows™.
  • Is there a correlation between singular titans of industry? If you look at the premier technologist of the 1920's (Henry Ford) and extrapolate what his personal fortune was in 1929 you come up with something in the neighborhood of what Bill Gates is pulling down in the computer business. The guys with all the marbles in the 1873 panic were the railroad barons. One man or a very few men always seem to end up with the reigns of a dominant new technology as it turns age 40.
  • Lots of social patterns of the 1929 Depression are setting up to be replayed.  This may seem a little like seeing pictures in clouds, but consider some of the social parallels: Coffeehouse society of the 20's has been rebuilt by Starbucks. The Lost Generation of the 20's is our own Gen-X. White opals, and other semi-precious stones, are again being touted - just as they were in 1928. Kids in school in high school in the '20 were trying to act tough, like the "gangsters" of the day: Alfonse Capone and Dutch Schultz had a certain panache which kids admired. Today, even in the upper middle class 'burbs, the kids are cloning gang clothing and speech. Kids in the late '20's wanted a Tommy Gun. Today, in the words of rap singer(?) Rappin' Fortay, "rat-tah-tat-tat, 'cuz you gotta Gat. You like it like that..." Different market? Well, different guns: Gats & Glocks. Many of the people who would have gone to a speak easy in the 20's are doing the recreational drug scene today. What will happen when our overstressed country gets off Prozac? Does the optimism bubble pop?
  • Housing has become unaffordable for an increasing portion of the population. As good housing becomes less attainable, upward pressure on housing prices eases. Seeing the value escalation slow, people are likely to wake up one morning and in large numbers say, "Hey, time to get out of this big house and into something a little more affordable".
  • Of course, personal debt has continued to climb, too. Personal bankruptcies will top 1.3 million this year - up from last year's record. (See #22 &23 below)
  • There's the problem of war, which is coming. Depressions happen 8-12 years after the end of a war. 1873's depression followed the end of the Civil War, the '29 crash followed the end of WW1 and we're now 8 years after the fall of the Berlin Wall (1989). 10 years after the de facto end of the Cold War. The week ending 7/18/97 saw more than 3000 rounds (including mortar fire), exchanged between N and S Korean troops along the DMZ. It was underplayed by mainstream media, but the peninsula could flare up any time.
  • If this is the late 1920's all over again, who will play the role of the Weimar Republic? The remnants of the Soviet Empire. Just like Germany was "shredded" after WW1, so too the Soviet Union has been shredded. The danger I see 5 years from now (or sooner) is that we'll see a replay of the Weimar Republic complete with a Hitler-like beer hall uprising. Look for the emergence of a supernationalist in the CIS who will rearm Russia. Does it have to happen? No. Is it likely to happen? From the historical perspective, yes. Expect to see pictures of Russians with wheelbarrows full of money to buy a loaf of bread with the Russian government inflates to pay workers - and turns on the printing presses of money creation.
  • The historical Price/Earnings ratio of stocks is something on the order of 12 - 14 times earnings. In other words, a stock which earns $1.00 per year (in growth of sales) would be fairly priced at about $12-$14 per share. Lately the ratio has been much higher. Coca Cola is up around 43 times earnings. In other words, people are buying Coke stock thinking it will go up from here! Go look up something called the "bigger fool theory" of markets.
  • The valuation of all stocks has historically been about 48% of the US GDP (Gross Domestic Product). In other words, the value of all companies on listed exchanges has been about 1/2 of 1 year's economic output of the country. Today stocks are priced at 118% of GDP (Thanks to USA Today for the stats). The last time we had a BIG Crash ('29) stocks were priced at 77% or GDP and dropped to 33% of GDP. In 1987 stocks were priced at 64% of GDP and fell into the 40's.
  • The fair value of the Dow is about 3,200 based on earnings, and dividends.
  • Every time traders have said "This time it's different..." the crap hits the fan. What's "different" this time is "growth" stocks. The buzzword is "growth". But it's another way to say "a stock, which can't pay a dividend". The same great sales organizations which mislead the American Public on inflation ("Prices go up" instead of "The value of your money is going down") are now touting Growth instead of yield.
  • Many high tech "growth" stocks are sort of like a Ponzi Scheme. If you were building a Ponzi Scheme, at a high tech company, here's how you would do it: You'd pay the chairman his compensation as a bunch of stock. The chairman would then turn around and sell the stock on the market and pocket the cash. Next, the company goes to the open market and buys the stock back, which the chairman just sold. The amount of stock doesn't go up, but demand is flamed and the Chairman makes all the money. Interestingly, it doesn't matter much to the chairman if the stock price goes up or falls, as long as he can keep the scheme going. Why should a dividend be paid, when the chairman can make all the money in the world simply getting and reselling the same stock over and over again?
  • Homework assignment: Explain how this is different from what Microsoft does.
  • Dividends on many common stocks are disappearing. It used to be that when you bought a piece of a company you would be paid interest on your investment on a quarterly or annual basis through a dividend. Any appreciation in the underlying stock price was a nice bonus...but the game was total yield: dividend plus growth in the underlying company which enhanced its value. Now, none of that matters. I strongly suggest to you that times have not changed. Good companies still have cash left over which can be used to pay dividends. Growth companies are generally cash strapped. My view is pretty simple: If a company doesn't pay a dividend, don't invest in it. Oft quoted Professor Irving Fisher of the prestigious Harvard Business School was busy telling people in August 1929 "We have reached a new plateau" and the rules have changed. Sure. You'll hear "new plateau" statements everywhere today.
  • Commodities are all over the place. When commodities fall, markets follow - in time. When they go up too fast, same problem. There are some great, but rather short term profits...but eventually as goes the farmers (and General Motors!), so goes the economy. This is something you can track all the way back to Tulipmania in 1634-1637 when the Dutch ran up the price of tulip bulbs to incredible prices. There's the South Sea Company bubble.
  • The Mutual funds of today are the bubble. More people are selling funds than at any time since the '20's. Oh, excuse me. In the '20's they were called Trusts. The name was changed in the Depression to protect the guilty. Trusts were closed end mutuals. A few survived. The "new" name for Trusts is Mutual Funds and they are predominately open end in structure. There are more "trusts"...er...mutual funds...than there are major stocks to invest in!
  • Have you noticed the recent epidemic in third world currency devaluations? The Philippine peso follows Thailand, Malaysia and others. This sets up a foreign debt collapse that could also be a trigger event. Don't forget that loans to South America were popular in the '20s and contributed to the liquidity crisis after the Crash in '29. Watch the Brazilian stock bubble collapse. It has not spread to a lot of neighboring countries (yet), but Brazil is in a heap of trouble.
  • We're in another mass migration of the population. Not only from East to West but from the BIG mega-cities to the smaller cities of 50-100,000. This is why small towns like Boise Idaho are going gangbusters and LA is stagnant. California's future growth, for example, is more likely in San Luis Obispo than in San Francisco.
  • A lot of my friends, including my boss, tell me a Crash can't happen again because we don't have 5% margin buying of stocks like we did in '29. Well, that's true, and but also not true. We have margin buying, all right, but the margin is distributed through the ownership of a security at different levels. Take investor who is buying what he (or she) thinks is a "growth multi-fund". You know the end is near, by the way, when the banks and financial institutions start buying up mutual fund companies... The layers are: The investor buys on 100% margin with a bank card advance, the multi-fund buys on 50% margin and the individual funds may buy on 50% margin. In other words, ownership by the funds can be on margin equal to 50% of 50% of 50% which is 13.5% margin while the consumer has only signed a name and paid for a cash advance! But it gets worse. The fund company may show assets which aren't really liquid, things like "letter stock" and so forth. If, or more likely when, a melt down comes, the only way to protect yourself will be to have acted NOW to get into funds which either invest only in securities which are backed by the US Government (Benham Capital Preservation Fund, is an interesting money market, for example), or make sure the funds you do own do not have the "redemption in kind" provision so common among funds.
  • Go look at the margin requirements on other markets. To trade on the TSE (Tokyo Stock Exchange) you start to play on 30% margin, but can go as low as 20% before your positions are liquidated. Who said margin had been eliminated from the system?
  • People today are not just buying stocks on margin. They have in many cases purchased their whole lifestyle on margin. The house is only 5% owned (after being refinanced to take money out to pay bills, the car is not owned at all being leased, and most folks have a mountain of bank card debt. The number of people who are living on 1% margin or who have a negative net worth (meaning if they sold everything, they would still be in debt) is tremendous. Worse than the 20's and 30's.
  • The year 2000 is upon us. Even though most of the world's computer systems are adapted, there's still a chance of a glitch. How will people react in the summer and fall of 1999 when they get reminded by their banks and credit card companies to hold on to their receipts and cancelled checks to prove their position? Wouldn't that cause you to lose a little faith in the system?
  • The Elliott Wave Theorist, Bob Prechter's excellent subscription service (see www.elliottwave.com) noted that tattoos and body piercing are at the highest level since 1929. I have been trying to ignore that social trend. Why the denial on my part? It's odd that one of my daughters has a tattoo and my son wears an earring... The only tattoo I find amusing is the one that says "Dah plane, dah plane..." on Fantasy Island reruns.

Speaking of Fantasy Island, can it happen again? In the fantasy of Wall Street, no. Out here in the Asian banks going broke real world, sure. It's only a matter of timing. Read Davidson & Mogg-Rees "The Great Reckoning", and their follow on book, the "Sovereign Individual", for some of the global implications of deficit spending, the high cost of peace, and the ramifications of the information age on conventional power structures of Western democracies. (Although I think they underestimate the power of the labor movement, which is reasserting itself, in case you haven't noticed.)

It's reasonable to expect that this crash will play out differently. Margin won't be blamed. Options and derivatives may be, but more likely is the huge mountain of government and personal debt, especially the runaway inflation of real estate prices fueled not so much by demand, as the availability of easy money. Second and third mortgages, wraps and other creative financial schemes have run up the price of housing. Over a long period of history, you could only afford a house priced at twice the income of the primary breadwinner. Today, both breadwinners' incomes are counted and then it's 4-10 times annual income. That's a sure formula for disaster because when financial markets melt down, liquidity is what saves the day. The wealth of most Americans is neither accessible nor real, as they will likely soon find out in painful, personal terms.

Fueling the real estate bubble has been the explosion in personal real estate contracts. This type of money creation is totally out of control of the Fed. It's one reason why M1 is up slightly but M3 is up dramatically. (It's going up at an annual rate of 10%. That not only suggests but requires inflation to follow!) When you create a personal real estate contract, you're creating money. Just as the barter economy is beyond federal control, so too, real estate contracts.

This time, instead of margin calls, look for layoffs in key industries - starting later this year perhaps in computers and autos. You may not see these layoffs at first because they will happen in "soft jobs". There are two kinds of "soft jobs": Large airlines, like Delta and others, now use temporary workers to answer phones. Why? In the event of a slowdown they are not "employees" - they can be instantly trimmed with no revenue liability. Other declines will occur as businesses realize that "information systems" departments and other non-essential staff jobs can be eliminated because the difference in typing speed between Word 2.0 and next week's version of Word is zero.

As these instantly downsized millions of highly leveraged homeowners discover they're out of a job, they will flock to dump securities and mutual funds to keep their bellies full and a roof over their heads, tax consequences be damned. No, it won't be the same as margin calls, but the effect will be the same. Banks will likely end up with big stocks of property which they will sell at deep discounts, providing large losses for them on paper, but making lower priced housing available within a few years for today's young people. We may not have a run on banks: we may have cash machine networks shut down. American consumers are a sadly gullible lot. Where else in the world would people tolerate paying a fee to get their money out of a bank as many do when they use an ATM machine? I'm not sure how close we'll follow the chart. But watch the stock market closely and listen for the first person to yell "FIRE!" in this very crowded theatre. Many financial academics insist that markets operate efficiently and are rational. But the people who panic in the crowded theatre looked pretty rational too when they neatly lined up, and sat in assigned seats. Markets and crowds are bimodal - rational most times but easily stampeded.

P.S. Japan is in a depression, so is most of South Asia - Just like the (then) Dutch East Indies in the 1927-1929 period.

The Absolute Clincher:

If you have gotten this far and still don't believe we're in a replay of 1929, let me give you one more point to consider - and this one ought to make a believer out of you:
In 1925 and in a second session in 1926, names & numbers were assigned to most of the federal interstate highway system, principally east-west routes, by the way, the north-south routes were detailed in 1963. Now, what new form of commerce has been routed (and is still being built) and numbered even as you read this? Hint: This highway system has road signs like "http://" and "ftp://". One more thing to consider: The similarities in market position of R.C.A. in 1925 through 1929 and the position of Microsoft here in the 90's and into the new millenium.

If history teaches us anything about how to place bets, I would have to place one in favor of of JAVA emerging as a dominant language fin the not to distant  future, a scenaro with negative connotations for Microsoft.  The Microsoft effort to contain JAVA seems destined to failure.  Along the same lines, line, Linux poses another long term threat to Microsoft's core position.  Certainly not now, or in the next year, but over time, the high ground in technology battles shifts around.  Ask any AM radio station owner what FM did to them in the 70's. Rotation among technologies is constant, victory fleeting, both repeating.

Thanks:

...to the the newsgroup LongWaves@csf.colorado.edu a fine discussion group who have contributed to (and critiqued some of these ideas. ...

..to Dr. Charlie Dalton at California Pacific University for concurrence and encouragement.

Readings:

"Crashes, Manias, and Panics", Charles Kindelberger, MIT Press 1991

"Acceleration of Technological Change in the Great Depression", Doctoral Thesis of Joseph Waters, 1971 Ayers

"Memoirs of Popular Delusions of Crowds", Charles McKay in the public domain at www.gutenberg.org

"How to Survive the Coming Mutual Fund Crash", Don Christensen 1994

"Penturbia: the fifth migration" Jack Kennedy (about 1992 or so)

"The Great American Deception" Dr. Ravi Batra see: http://www.bookpage.com/9609bp/readersguide/business/greatamericandeception.html

"The Sovereign Individual" Davidson and Mogg-Rees (see Amazon and Barnes & Noble)   Back to home page