Tuesday, September 15, 2009

Irrational Markets, Irrational Investors, Irrational Exuberance

"How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?" - Fed Chairman, Alan Greenspan, 1996

Is the stock market really an accurate measure of the health and strength of the economy? Or is the stock market average often misleading? Might it simply be reflective of irrational bubble economics?

The fact is, the majority of Americans don’t have any direct investments in the stock market.

In its 2002 study, the Mutual Fund Industry group, Investment Company Institute, found that only 21 million households (less than 20%) owned individual stocks outside an employee sponsored retirement plan. Employees in such plans are typically invested in mutual funds that give them no voting control.

In 2004, the Economic Policy Institute reported that the percentage of American households invested in the stock market in any form — either directly or indirectly through mutual funds or 401(k)s — was 48.6 percent.

However, the percentage of households with more than $5,000 in stock was just 34.9 percent.

So Wall St. is not a true reflection of how the average American worker, or the average family, is faring.

In reality, Wall Street is a pretty poor barometer of the economy’s performance since it is simply a bet on the future performances of a select group of companies listed on a few stock exchanges.

Regardless of the health or profitability of various companies, many investors will still buy.

During the tech run-up, people bought stock in unprofitable hi-tech companies with the belief that those companies would one day be quite valuable.

And people futilely bought the doomed stock of Enron and WorldCom, believing they were buying into solid, profitable companies that would continue to deliver great returns.

What about the stock market boom of this decade, you may ask? Much of it was an illusion created by the financial sector, which doesn't actually produce anything — except debt.

From 1948 to 1985, the financial sector accounted for around 12 percent of American corporate profits, never reaching 20 percent nor dipping below 5 percent. After 1985, however, the profits of the sector rose dramatically, going from 19 percent in 1986 to 41 percent in 2000.

That meant that more than 40 cents out of every corporate dollar of profit was paper profit, not created by actual wealth-generating activity, but by corporate gambling and debt creation.

The truth is, the stock market is highly irrational. The buying and selling reactions to quarterly reports are understandable. But there are continual up and down movements between these reports that seem to be tethered to nothing.

The daily fluctuations in the market are not linked to fundamentals, but rather to fear, greed, Wall St. hype, and a herd mentality marked by ignorance and unfounded optimism.

Noted economist Robert Shiller came to the rather obvious conclusion that stock markets jump around a lot more than corporate fundamentals do. He’s considered a genius for his uncanny ability to grasp the obvious.

And renowned MIT economist Paul Samuelson promoted the absurd notion that a rational market is a random one. He’s also considered a genius for advocating this blatant oxymoron.

However, things that happen randomly are by their very nature irrational. And investors can be equally irrational.

Investors often behave like sheep, following the herd, as well as the money. Whereas ideas and investments traditionally chase money, right now, as in most of this decade, money is chasing ideas and investments. That’s a bad development, and a dangerous sign.

Over the past 10 years, stock returns are negative 5.4%. Adjusted for inflation, $1 invested in stocks in March 2000 is now worth just 60 cents.

Despite this, the US stock market is still over-inflated and built on speculation, not fundamentals. As of June, stocks were still selling at more than 20 times their expected earnings for 2009.

Can you say, “bad investment”?

This rampant speculation has led to highly inflated bubbles that have burst one-by-one.

The mainstream media machine — exemplified by CNBC and Fox Business Channel — is a big part of the problem. It helped perpetuate Wall Street's smoke and mirrors act.

The financial news media have served as nothing more than cheerleaders for Wall St. and corporate America. They are the insiders who seek to curry favor with, and access to, the powerful. Far too often, they have fallen short in their role of objective, skeptical, inquisitive outsiders. The media has continually neglected its duty as stewards of the public trust, failing to serve as a genuine, trusted, check and balance on power.

No one in the mainstream media ever seemed to doubt Wall St. or its inflated numbers, the housing bubble, stated-income loans, no-money-down loans, interest only loans, negative amortization loans, adjustable-rate loans, and all of the other collective madness.

As the stock market was continually pumped up with new money this decade, everyday investors were being conned and duped by Wall St. and its financial media cronies.

The stock market is simply a type of Ponzi scheme that relies on constantly luring new investors to inflate the market, not on sales and profits. These new investors pump up the market by continually infusing it with new money, giving it the the false appearance of growth built on fundamentals.

Savvy, professional investors — the biggest market movers — know this and use it to their advantage, taking profits when the market advances. Who would sell their positions in an allegedly strong, profitable company? Only an experienced investor who knows that it's all just the smoke and mirrors of a market being influenced by Wall St. and the herd mentality.

By issuing stock, the nation's biggest corporations are essentially able to print their own money. And they also sell bonds (or debt) to raise additional money. In this sense, Wall St. issues its own fiat currency. Like the dollar, common stock has no physical backing. It's just pure, unadulterated risk.

Many average investors didn't learn a thing from the collapse of the tech bubble, or from the corporate scandals at Enron, WorldCom, Arthur Andersen, Haliburton, Tyco etc. Instead, they just went headlong into the irrational market surge that followed later this decade.

What should have been learned is that corporate America—particularly Wall St.—is perversely corrupt and contemptible.

All confidence seemed to have been lost by March of this year, when the Dow surrendered its euphoric 14,000-point highs of 2007. Stunningly, the market was more than halved, dropping back down to around 6500.

At that point, no one trusted Wall St., government regulators such as the SEC, or the credit-rating agencies.

Market confidence has been ruined because we now know that credit-rating agencies like Moody’s and Standard & Poor’s were in cahoots with Wall Street. Instead of assigning credible, independent grades to securities that are now known as "toxic assets," the agencies were hopelessly compromised by the fees that the securities issuers paid them to issue ratings.

Here’s an actual e-mail exchange between two analysts at S&P about a deal they were examining:

“Btw - that deal is ridiculous. We should not be rating it.”

“We rate every deal. It could be structured by cows and we would rate it.”

The assorted corporate scandals of the past decade, as well as the accounting scandals, had taken their toll; investors couldn't even trust the bookkeepers. Accountants at Arthur Andersen had been paid off to keep quiet and look the other way, or worse, to participate in the massive scams at Enron.

One has to ask, how pervasive is this behavior?

The entire system is based on confidence. So it was little wonder that investors sold off their holdings and stopped putting money in a market they simply didn’t, and couldn’t, trust.

And yet, sensing an opportunity for riches, bottom feeders have swept in and pumped up the market again by purchasing millions upon millions of corporate shares. But none of the fundamentals have changed. American businesses are still struggling and consumers are not spending. And the financial sector is still teetering, despite their recent glowing reports.

Sure, some corporations are becoming more profitable right now by laying off American workers. But is that worth celebrating, or investing in?

Corporations won't solve their problems by dumping human capital. The market is over-inflated and set for another tumble. The fundamentals haven't changed at all. There will be another correction, and millions of investors will be crushed once again.

But the savvy, veteran investors see the writing on the wall, and they will exit quickly, with their portfolios largely intact. That will start the next selloff, and the herd will follow.

But it will too late for most, and their fall will be very painful. Some people just don't learn.

"What we've got here is... failure to communicate. Some men you just can't reach. So you get what we had here last week, which is the way he wants it... well, he gets it. I don't like it any more than you men." — Cool Hand Luke, 1967

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