Bailout Nation (14 page)

B
y 1999, stock trading had become the national pastime. People followed publicly traded companies the way they used to root for sports teams. CNBC was on in every bar, restaurant, and gym. Initial public offerings (IPOs) that merely doubled on the first day of trading were considered disappointments. Stories were rife of lawyers and dentists who gave up their practices for the more lucrative profession of day trading.

A popular discount brokerage TV advertisement of the time featured a tow-truck driver who owned his own island. He told motorists in need of aid there was no charge—he did the job only because he liked helping people.
You too, can trade your way to riches
was the not-so-subtle message.

The year 1999 began the way 1998 ended: in rally mode. The bias was to the upside, despite the fact that valuations were becoming seriously stretched. Price-earnings (P/E) ratio, a traditional measure of how expensive equities were, indicated tech stocks were wildly overvalued. The P/E of the NASDAQ was near 100, and heading higher. In the so-called new era, however, valuation mattered little. By July 1999, the Nazz was just under 2,900—up 27 percent year-to-date.

The three quick rate cuts from late 1998 were reversed. The Fed tightened a quarter point in June, in August, and again in November. But all that did was return rates to where they were in March 1997. The Wall Street warning “three hikes and a tumble”—meaning three Fed tightenings often lead to a correction—was inoperative. Markets laughed off the increases, and just powered higher.

In this environment, filled with wild speculation and overheating equities, Greenspan did
. . .
nothing. The Fed chief had any number of tools at his disposal to deal with the rapidly inflating bubble, but the most important was the ability to raise margin requirements for tech stocks. All those day-trading dentists, housewives, and tow-truck drivers were buying and selling stocks using mostly borrowed money. Constraining margin lending would have tamped down some of the mad speculation.

Transcripts of Fed meetings from the late 1990s—released years later—showed that Greenspan and his cohorts were concerned about excesses in the financial markets, and determined that raising margin requirements would help deflate the nation's newfound obsession with day trading dot-com stocks.

“I recognize there is a stock market bubble problem at this point,” Greenspan said in a September 24, 1996, Fed meeting, and declared that raising margin requirements was a solution. “I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.”
¹

But the FOMC chair chose not to do so. After the famous “irrational exuberance” speech in 1996, Greenspan thereafter remained silent about speculative excesses that, by late 1999, were terribly obvious to even casual observers.

Greenspan later claimed it was impossible to know a financial bubble of immense proportions was under way.

Actually the Fed—led, of course, by its ubiquitous chairman—did something worse than nothing. Greenspan also gave explicit, intellectual support to the equity bubble by talking enthusiastically about the tech-inspired productivity miracle. The Fed chair applauded the notion that a “new economy” had emerged. It was music to traders' ears.

M
any separate elements contributed to the boom. Cheap money was a significant factor, but it wasn't the only one. A broad economic expansion was in its sixth year, with baby boomers in the sweet spot of their earning and spending years. Inflation appeared to be modest. New technologies had captivated the American imagination, creating instant millionaires and more than a few billionaires. Internet message boards (before they were overrun by touts and spammers) helped democratize stock research. Wall Street was flush with cash. CNBC—called “bubble vision” by noted short seller Bill Fleckenstein—was a relentless cheerleader throughout this entire era.

Credit the Y2K bug for what came next.

For the prior few years, there was increasing concern over the glitch in the software code that had been given only two digits for dates. What would happen when the calendar rolled over from 1999 to 2000? There were worries that this would wreak havoc on computer systems around the world. Companies spent huge amounts of money replacing much of their tech infrastructures. The worst of the doomsayers were survivalists who seemed to be looking forward to the American version of
Mad Max
. They advised people stock up on ammo, bottled water, and canned food, along with cash and gold.

The survivalists were a fringe group, considered paranoid loons by most thinking people. Not many took them seriously, except the Federal Reserve. It did not ignore the
Apocalypse Now
crowd. It wasn't that the Fed believed this crowd; the fear was that if enough of these paranoid loners managed to somehow convince the rest of the country that all hell was going to break loose, it could conceivably cause a run on the banks.

Greenspan's nightmare scenario was 24/7 news media coverage of long bank lines around the country, as a panicked populace withdrew their money in preparation for the end of the world.

The mad ravings of maniacs aside, the Fed figured better safe than sorry. To stave off any Y2K-related bank runs, the Federal Reserve held a bigger cash reserve than it ordinarily did. It also created a way for banks that needed any extra cash to borrow some—creating (I kid you not) the “Century Date Change Special Liquidity Facility.”

But most important, the Federal Reserve injected an extra $50 billion in currency into the banking system. It's readily visible as a giant spike on a chart of U.S. currency (M1) (see
Figure 7.2
).

The effects of all of this extra fuel on an already “bubblicious” environment lit the market's afterburners. Stocks went from red-hot to white-hot, as all of this money found its way to the most speculatively traded issues. The NASDAQ exploded upward, despite having a P/E that was approaching 200 (a P/E of 15 is considered reasonable). For the calendar year 1999, the index gained 85.6 percent (see
Figure 7.3
). From the liquidity injection in late October to just six months later, the NASDAQ almost doubled, rising from 2,600 to over 5,100. It was a nearly 100 percent gain in only half a year. There simply was no precedent for anything like this in stock market history.

Figure 7.2
U.S. Currency (M1)

SOURCE: Board of Governors of the Federal Reserve, 2008 Federal Reserve Bank of St. Louis,
http://research.stlouisfed.org
.

It was the perfect setup what came next.

The final up leg of a bull market often takes the form of a blow-off top. This occurs when the merely absurd becomes the utterly ridiculous. Blow-off tops happen when stocks (or indexes) make all-time highs, sucking in the last of those spectators who had been sitting idly on the sidelines.

In 2007, for example, China's Shanghai Stock Exchange (SSE) index had a blow-off top, rocketing from 1,200 in 2006 up to 6,400 by October 2007. The SSE had gained an unsustainable 100 percent plus year-to-date. A year later, it was back at 1,800, a tumble of 71 percent.

Figure 7.3
NASDAQ, 1999

In 2008, crude oil had a similar blow-off top. During the summer, crude peaked at over $147 per barrel. Before year's end, it had plummeted more than $100 a barrel, falling 69 percent to $46. Such is the nature of speculative tops.

Y2K came and went. The clocks rolled over on December 31, 1999, to January 1, 2000, virtually without incident.

Markets pulled in a bit in January—likely tax selling—then made new highs. After some backing and filling, the NASDAQ resumed its record-breaking pace in February. Thus 2000 looked to be yet another good year. From 3,600, the index gained another 35 percent over the next six weeks, breaking over 5,100.

But there were some residual effects of the Y2K bug that would soon be felt. Corporate America had just completed a massive technology upgrade. Companies had essentially rebuilt their entire information technology (IT) infrastructures over the past year or so. Hence, there was very little need to do much spending on hardware or software. The Y2K upgrades and preparation had pulled much of the year 2000's tech spending into the 1999 fiscal year.

Preannouncement season is that period each quarter just before earnings get released. Also called “confessional season,” it is when any company whose profits are below previously given public guidance to the press, investors, and analysts must fess up.

Preannouncement season was when the wheels started to come off the technology bus.

The first quarter of 2000 brought a series of warnings from Qualcomm, Intel, Dell, EMC Corporation, and a host of other stalwarts of the so-called New Economy. With stocks up enormously and valuations incredibly rich, it was sell first, ask questions later.

There is an old traders' expression:
Markets eat like a bird, but shit like a bear.
Gains accumulated over time can disappear very quickly. Momentum is a double-edged sword, and the excitement that had driven stocks higher over the prior five years quickly reversed to the downside. Barely a month after hitting its all-time peak, the NASDAQ had plummeted 37 percent, to near 3,200.

Soon after, bargain hunters appeared. The current crop of traders' only frame of reference was up, up, up! They had known nothing but a rampaging bull market, and their muscle memory had been trained to buy on the dips. This led to a reflexive bounce to 4,000, followed by another sell-off back down to 3,000.