how the pandemic “bubble” might play out from here

“This time is different” is one of the scariest sentences any investor can utter. That’s chiefly because humans’ capacity for denying unpleasant truths is close to boundless. It’s also that this thought mostly comes up when a market is toppy and is typically a sign that a downdraft in stock prices is near.

In recent posts, I’ve written about the runups to the two big bear markets I’ve lived through that most remind me of where we are today: one was in Japan in 1989, when the Japanese government decided to end a period of wild, and increasingly damaging, speculation by raising interest rates; and the other was in the US in 2000, when demand for internet infrastructure devices and components came to a screeching halt and no Y2K computer glitches appeared. As is the case in any bear market I can think of, the trigger for each was an economic event that had important consequences for financial instruments. In Japan, rising rates; in the US, an unexpected slowdown in a key industrial area.

What’s peculiar (I didn’t say different, but it amounts to the same thing) about today’s situation is that a number of deeply adverse economic events have already occurred without the domestic stock market falling apart: several years of Trump’s growth-inhibiting economic program, the economic devastation caused by his “it’s a hoax” response to the external shock of the pandemic, his violence-laced effort at a coup to overthrow the newly elected government when voters decided to replace him, and the approval/support he continues to get from many leading lights in Congress. It’s like a super bad movie plot of racism and ineptitude–only it’s real.

Yes, the stock market declined by 30%+ last February-March. But it recovered just as quickly and ended 2020 comfortably in the black. That’s because the Fed dropped short-term borrowing rates from 1.5% to basically zero and Congress applied substantial fiscal stimulus. That combination has so far averted a deeper, longer economic and stock market downturn. More fiscal stimulus may also be on the way.

What happens from this point? My guess is that as vaccines gradually get distributed widely, the consumer economy starts to return toward normal. It seems to me there’s already some evidence of this happening in macroeconomic data, although I don’t yet see a strong reaction in the bricks-and-mortar retail part of the stock market.

Three key stock investment questions associated with potential recovery:

–how closely will the new normal resemble the old? This is about which current quarantine beneficiaries get left behind and what consumer names the market rotates into

–when does the economy become strong enough for rates to rise? Not soon, but rising rates implies PE compression

–from a longer-term, more conceptual point of view, there’s the Iraq war, the US-spawned financial crisis of 2007-09 and the damaging Trump administration. The three have conspired to give the US a considerable black eye in the rest of the world. That’s not only as a location for new plant and equipment but also as a place to visit, to research or be educated and as a country whose stocks and bonds one might want to own. One of the hallmarks of the Trump presidency has been the capital flight this has generated. Just look at the spread between NASDAQ and the Russell 2000 during 2018-20. An important long-term question, and only time will tell, is if and how this will reverse, i.e., whether the current surge in the R2000 is the beginning of a new trend or just a strong countertrend rally. Even with a pessimistic point of view, however, my thought is that relative strength of domestic-oriented names will continue throughout this year.

the US 1999-2000 internet bubble

The 1989 Japan bubble popped when that country’s central bank reversed an ultra-easy money stance by raising short-term interest rates–sharply.

In the US in 1999, the situation was considerably different from Japan ten years earlier. Interest rates were slowly rising throughout the year, as the Fed withdrew extra money put into the system in 1997-98 for two reasons:

–to smooth out ructions in smaller Pacific Basin stock markets caused by a year-long series of speculative attacks on their currencies

–the aftereffects of the collapse of Long Term Capital, a hedge fund that used enormous financial leverage to speculate in illiquid (“off the run”) Treasuries, and whose positions were so gigantic that its failure threatened the stability of the domestic bond market.

These rate increases had no visible effect on US stock market indices, however, since monetary policy was considered to be still relatively loose.

There were three big themes to US stocks in 1999:

Y2K, the idea that the date function in the oldest computer programs, which formed (and still do, I think) the guts of most commercial bank and government software, only went up to December 31, 1999. Some, spearheaded by economist Ed Yardeni, argued that one tick after midnight on New Year’s Eve, these programs–and the world financial system along with them–would stop working because of this. No bank statements, no ATMs, no trade finance, no government paychecks…and worse.

The main effect of this worry–survivalist hoarding aside–was that the Fed kept overall policy looser than it would have and made sure plenty of cash was in circulation.

internet + cellphone infrastructure, whose buildout around the world caused a boom in most related sectors, from semiconductors to component manufacturers to contract assemblers to installing access and transmission devices to cell towers and underground/undersea cables

internet-based businesses, from AOL to to Yahoo/Google to Amazon. To my mind, Wall Street understood very little about e-anything, and so relied heavily on information from two wildly optimistic gurus, Henry Blodget of Merrill and Mary Meeker of Morgan Stanley. IPOs flew hot and heavy during the year, and, in usual form, when the supply of high-quality firms wanting to go public ran out, underwriters cheerfully offered what turned out to be total trash. Blodget later agreed to a lifetime ban from the securities business to settle SEC charges of securities fraud. The charges were based on, as I understand it, sharp differences between bullish public statements about IPO candidates and negative assessments of the same companies in his private emails

–TMT. These hot themes were clumped together as Technology-Media-Telecom, or TMT. I wasn’t so interested in media back then, so I know TMT mostly as an acronym. The crowning excess in the media area, as I recall it, was the acquisition of AOL by Time Warner for $128 billion in early 2000. It was the biggest acquisition in history at the time, and an utter failure. AOL proved to be an empty shell, with its “walled garden” version of internet access already in steep decline. Time Warner wrote off $99 billion two years later.

the collapse

Several things happened all at once in early 2000:

–there were no Y2K computer disruptions, either because of heroic reprogramming work or because there was never a problem in the first place

–internet/telecom providers’ massive infrastructure expansion plans proved way too ambitious. Researchers found that by separating a beam of light into different frequencies a ton of signals could be sent through a single strand of fiber optic cable. That made the huge cable-laying projects then underway redundant, forcing many of the firms involved–from materials to construction–into bankruptcy. Cellphone network expansion hit a wall at the same time. I don’t think there was a similar technological breakthrough, but at any rate overcapacity suddenly became a severe problem, particularly for component suppliers

–in Wile E Coyote fashion, it dawned on Wall Street that some of the latest and greatest IPOs were little more than pencil sketch musings about could-be, might-be business opportunities, not already functioning, rapidly expanding, soon-to-be-profitable enterprises. So the IPO market dried up.

two 2000 markets–ugly and uglier

the ugly

The S&P 500 peaked in December 1999, fell mildly, returned to the highs in April 2000, then fell again and regained the former highs in August. Then the world entered recession, which by September 2002 had cut the S&P in half.

the uglier

NASDAQ peaked in February 2000, fell by a quarter by May, returned to 10% below the prior peak in August and then dropped to a quarter of its peak at the bottom in September 2002.

thoughts looking back

I had a very tech-heavy portfolio in 1999. Even I, someone who isn’t good at this, saw the market top forming early in 2000. I sold 40% of the TMT I owned before prices really began to drop. I thought this was a very aggressive move, but it wasn’t anywhere near enough to keep me from underperforming the S&P 500.

The market changed direction very sharply away from TMT toward low-growth, low PE defensive areas, like utilities and consumer staples. I didn’t have enough imagination to understand that these ostensibly dead end sectors were going to be shelter-from-the-storm market stars for a period of time. I could have saved myself a lot of grief by doing a better job of identifying where to rotate my portfolio to.

At the 2002 bottom, the dividend yield on stocks in the UK market was higher than the coupon on UK government bonds.

lessons for today

I don’t think that brokerage houses and individual analysts are anywhere near as powerful today as they were back then. Given that, my hunch is that today’s SPACs are the equivalent of the late-stage no-fundamentals IPOs of late 1999.

I also think that the key to today’s market is ultra-low interest rates caused mostly by the pandemic, partly by the growth-retarding policies of the Trump administration. That’s as opposed to TMT earnings falling off a cliff. So the next trigger for market change will likely be the pandemic coming under control–something whose beginnings we could arguably see in early Spring.

more tomorrow

my take on Gamestop (GME)

the bare bones

GME is a mall-based videogame retailer. Its business has been badly hurt both by the movement of gaming online and the pandemic. This has made the company’s stock a favorite target of professional short-sellers.

In the simplest terms, these are stock market players who borrow shares of a company’s stock and sell it, hoping to make a profit by buying it back at a lower price. There are other players who also short stocks. A traditional hedge fund would have a number of short bets but would also invest the proceeds in “long” positions, stocks it thinks would go up. It makes money on the spread between the performance of its longs and its shorts. In the GME saga, though, the big forces putting downside pressure on the stock appear to be exclusively or predominantly short players.

In fact, the short GME trade has been so popular that at the end of last year many more shares of GME had been borrowed and sold short than there are available for trade (current “short interest” figures are publicly disclosed a couple of times a week). That’s because some shares have been borrowed and sold more than once.

This is an inherently unstable situation. The short-selling pros appear to have been betting that GME’s future is so bleak, and that it is therefore is so uninteresting as an investment, that there was zero chance the stock could begin to rise. They had to know that if they were wrong, someone could set off a gigantic “short squeeze.” a mad scramble to unwind the massive short positions that shortsellers had built.

Enter Reddit. It promoted, very successfully, the idea that lots of small investors buying GME at the same time, either the stock itself or call options, would have enough heft behind them to set the short squeeze in motion.


Yesterday a number of brokers–Merrill, TD Ameritrade, Interactive Brokers and Robinhood are the ones I’m aware of–announced they would not take buy orders for GME and similar stocks, although they would take sells. Some basically said they would no longer recognize GME et. al. as collateral for margin borrowings, potentially forcing account holders to put more assets into their accounts to keep them above water.

The results were what you would have expected–panic selling and a collapse in the GME stock price.

my take

–I think the crowdsourcing of investment ideas, long or short, through Reddit or other forums is going to be a big deal and eventually a serious threat to the research departments of establishment brokers. There may be questions about whether in this instance the Reddit movement has 100% complied with securities laws (the SEC is now investigating). But I think this is something that can be easily fixed.

–I was shocked by yesterday’s brokerage house bans on purchases of Reddit stocks. I can’t remember anything like this happening before in any world stock market during my working career. My hunch is that this, too, will be investigated by the SEC.

My Wall Street experience is that firms rarely, if ever, do stuff like this for the greater good. My cynical guess is that the brokers who placed the bans will turn out to have proprietary trading desks that had very heavily shorted GME and similar stocks and were losing their shirts. It could also be that their stock lending operations (whose job is to put stock lenders and borrowers together) were unable for some reason to unwind the deals they’d put in place.

the Japan bubble, 1989

This is my highly simplified account–although as an active investor in Japan for much of the 1980s I did live through this one in a way most American investors didn’t.

The point of what follows, which I’m not sure I’ve made clear, is that what popped this bubble, which is the closest I’ve experience to what’s going on in the US today, was seeing interest rates begin to rise.

general background

Japan decided to rebuild itself after being devastated in WWII by concentrating on export-oriented manufacturing. The US was the only developed country whose industrial base remained standing after the war, so it was the target destination for Japan’s exports. To make sure Tokyo’s plans weren’t upended by unfavorable currency movements, it tied the yen to the dollar. (The most important firms in this rebuild were the industrial conglomerates founded by nineteenth-century samurai stationed in Tokyo and with too much time on their hands. These zaibatsu were the driving force behind Japan’s twentieth-century militarism. They were outlawed by US occupying forces but basically just renamed themselves keiretsu and carried on. As I see it, even today they remain the dominant political force in Japan.)

Japan was so successful it became the model for other developing countries. It was so successful, in fact, that in the 1970s the US forced Japan to reset the peg from 360 yen = 1 dollar to 308. In the Plaza Accord of 1985, the US forced a second revaluation of the yen from 250 yen = 1 dollar to 160.

the 1985 endaka (“high yen”)

After the Plaza Accord, all at once every Toyota, Nissan or Honda exported to the US became 50+% more expensive. It didn’t help matters, either, that the yen strengthened further to 120 yen = 1 dollar in short order, mostly because of trade and government spending problems in the US that hurt the value of the greenback.

Tokyo’s response to the doubling in dollar value of its currency was to lower short-term interest rates from 5% to 2.5% in several steps. This was both to stop the yen from strengthening further and to help the keiretsu to finance automating their manufacturing operations.

the Tokyo stock market

Given that much food and fuel in Japan is imported, suddenly Japanese consumers had a lot more discretionary income. And interest rates were cut in half. So there was an explosion in the stock market. More than that, interest shifted away from export-oriented names to domestic demand beneficiaries, from retail to utilities to property developers. By 1989, things had gotten pretty wacky (see my posts on tobashi, for example). Real estate speculation was rampant. Trading on margin was through the roof.

popping the bubble

Then Yasushi Mieno became the head of the Bank of Japan in mid-1989. To end the market craziness he began to raise rates late that year, boosting them to 6% over the following eight months.

The Topix index was cut in half.

Mieno announced his plans in advance but the index didn’t peak until he actually began.

why I think this is important

Late 1980s Japan is the closest period I can think of to what is happening in the US today. I don’t think speculation here is anywhere near as intense as it was in Japan back then. But then–as now, I think–many market participants, even professionals, don’t seem to grasp the essential relationship between stocks and interest rates, in two respects:

–one reason, maybe the reason, stock prices are so high is that interest rates are so low; and

–as/when the world begins to recover from the pandemic, interest rates will begin to rise. That will compress PE multiples.

To my mind, the scariest thing about the comparison is not irate Japanese brokerage customers disemboweling their brokers with samurai swords. It’s the thirty years of economic stagnation that followed the bubble bursting, due to a set of preserve-the-keiretsu-status-quo economic policies that are essentially the Trump economic platform.

There’s a practical issue here that I don’t know the answer to. How quickly, if at all, can Biden undo the severe economic damage Trump has caused over the past four years? This has a bearing on how soon and how high interest rates will rise.