Playing Bubbles 2/2

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Dennis L. Fiddle

Dec 28, 1997, 3:00:00 AM12/28/97

Q: But markets usually overshoot.
A: That is the real worry we have. This is where
the analysis of virtuous feedback becoming instead
a vicious cycle leads. We have seen it in Asia, in
other places. There are quite a lot of similarities
between the U.S. now and Japan in 1988-89. For
example, the labor market is very tight. Go back
and look at why the Bank of Japan started
tightening in 1988-89. It wasn't the asset bubble,
though they said so. In retrospect, the simple fact
was that Japan ran out of labor. Everybody sort of
writes Japan off now, but at that point, Japan was
supposedly a phenomenally innovative economy,
bringing VCRs and the Sony Walkman to a grateful

Q: Don't forget Japanese management techniques.
A: Looking back, a large part of Japan's dominance
then was based on access to cheap finance. It cost
Japanese companies virtually nothing to borrow
through the equity market. Bank lending was very
accommodative. It was the same in the Pacific Rim
recently. And as soon as you take away that cheap
finance, the rot starts and everyone suddenly is
talking about overinvestment.

Q: Are you implying the U.S. market is currently
feasting on easy money?
A: Yes. The similarities to Japan don't stop with
the labor-market tightness. There is also the
attitude toward equities, and the access to cheap
finance. In Japan, at the end of the 1980s,
everyone was in love with equities. You had the
housewives playing the market. You have the same in
the U.S. Mutual-fund cash is down to the lowest
levels since 1976, about 5.5%. You have
private-pension-fund exposure to equities at 60%,
the highest since 1972, just prior to the big bear
market. People are very fully invested, committed
to equities as an asset class.

Q: So, who's left to buy?
A: Exactly. This is what worries us: that what
could be just a fundamental correction turns into
something much more vicious. That's why we see the
Dow bottoming nearer 5000 than the 6000 we believe
would be warranted on value grounds. The rhetoric
coming out of the mutual-fund industry is extremely
misleading. They would have us believe that buying
by the retail investor turned around the U.S.
market in October. They tell us that actually there
was just less than $1 billion of equity selling on
the Friday and the Monday of that correction --
which is very low compared with the $2 trillion of
mutual-fund assets. I actually saw that statement
come across my Reuters screen! But the amount of
assets is just irrelevant. What is important is the
change in the flow. The monthly average buying in
equity mutual funds so far this year has been $19.5
billion. So, if the household sector sold $1
billion in two days -- which translates to a
monthly outflow rate of $10 billion -- that is a
massive change in the flow of funds.

Q: You mean they sold the dip?
A: No doubt about it. We've seen it time and time
again. When we have an equitymarket downturn, the
retail investor does not buy on dips. They buy when
the market begins recovering. As far as the
mutual-fund industry goes, it is a case of, "They
would say that, wouldn't they?" Nevertheless, I
don't see retail investors turning into massive

[Media]Q: Yet, you mean?
A: If you get a prolonged bear market
decline, as we expect next year when the Asian flu
takes hold and Ice Age earnings get priced in,
retail buying will dry up. And, if you go from $20
billion a month of buying to zero, that's a big
change in flow of funds. We actually think the
retail investor will turn into a marginal seller.
But that is not crucial. What is crucial is that
the mutual-fund industry has so little cash that
the funds will have to start selling stocks when
redemptions start.

Q: But what about the new era -- don't you believe
in the economic miracles?
A: Not really. We had a chap in here recently who
was making the case that the U.S. is an economic
miracle. He was quite coherent. Said it isn't that
the U.S. is losing jobs any less quickly than
Europe in the old smokestack industries. But it's
that the U.S. is actually creating employment in
new sectors. "Look at new issues on Nasdaq," he
said. "In America, whatever your race, creed,
sexual orientation, height, etc., if you have a
good idea, you can come to the market and get money
for it. And you can create jobs." Well, exactly.
What underpins that ability to access cheap finance
is the bullish attitude of the retail investor. In
Japan, it was the end of ready access to cheap
finance which partly destroyed the job-creating
ability of their corporations in the early 1990s.
You could have exactly the same thing in the U.S.
You also have, as you had in Japan in the late
1980s, very high operational gearing in companies
that have restructured to enhance profit. If
revenues were to start falling, profits would come
under unusually severe downward pressure.

Q: Restructuring isn't an unalloyed blessing, then?
A: In the U.S., you have managers who've been given
lots of options. Usually it's seen as very good
because managers then address the bottom line,
controlling costs all the way through the cycle.
What people don't seem to focus on so much is the
fact that increased operational and financial
leverage can also weaken a company. If managers
leverage up a company to buy in equity, it's a very
good thing for the remaining equity investors,
including the management -- when profits are going
up. But once profits go down, they are bankrupt.

Q: So it's a bull-market phenomenon.
A: The lessons of the last recession have been
forgotten. In 1990-91, with only a mildly bumpy
landing, there were an unusually high number of
corporate bankruptcies due to excessive leverage.
The leverage isn't at mid-1980s levels now, but so
far this year, Fed data show some $75 billion of
equities have been bought in and some $200 billion
of debt issued, at an annual rate. Managements are
buying lifestyle options: "We'll leverage up the
company. In a bull market, we become millionaires.
In a profits downturn, we go bust, then move on to
the next company to do the same thing." It has
limited downside. The upside is unlimited. I'm
worried about what happens in the unforeseen
circumstance that there is a U.S. recession --
although we don't see one in the near term. There
will be one, eventually. Greenspan isn't God. This
is the man who, in July 1990, said the U.S. economy
wasn't even slowing, when it was already in
recession. If there is a U.S. recession, its high
level of operational and financial gearing means
U.S. corporate performance will be horrendous. This
is what George Soros calls reflexivity. As long as
a virtuous feedback loop is operating, things are
heading in the right direction, it looks great. You
don't even have to think of the downside. But if
you come to a fulcrum and something tips you over
the other way, it all starts unraveling.

Q: So you're telling clients to stick to cash and
A: Bonds, cash and equities last. The U.S. equity
market is every inch the bubble we thought Asia

Q: Your early -- and very much on-target -- call on
Asia didn't win you any friends in that part of the
world. Is the worst over there, at least?
A: We thought those economies would slow sooner.
When I started saying in 1995 that the Asian
"miracle" was rubbish and unsustainable, the faxes
I started getting out of the Pacific Rim verged on
hate mail. But we also said that once it started to
unravel, it would overshoot.

Q: So it's way too early to get back into that
A: Absolutely. Asia won't be like Latin America --
it will be far worse. Martin Wolf had an article in
the December 9 edition of the Financial Times,
basically saying the International Monetary Fund is
screwing it up in Asia. We agree. But clients are
saying, "Look at Mexico. The Mexican market
bottomed when the first trade surplus was announced
in February 1995 -- and never looked back."
Thailand has reported its first trade surplus in
over a decade and the South Korean current account
has just swung into surplus, but the currencies are
under pressure.

Q: What's different in Asia?
A: The IMF is making things worse. The ability for
the currency to bottom out is based on a tangled
web of interactions between the current and capital
accounts of the balance of payments The IMF is
assuming that if you move a big current-account
deficit back into surplus, all your problems are
over. But not necessarily. The IMF does not seem to
have taken into account the fact that the
composition of Asia's equity markets and of its
capital flows are very different from Latin

Q: How so?
A: Financial stocks comprise only a small share of
Latin American equity markets. Therefore, after the
peso crisis, the collapse of the Mexican banking
sector and its virtual re-nationalization did not
dominate the overall equity market. That is not the
case in Asia, where financials dominate [see
charts]. The other key difference is that capital
inflows into Latin America, private portfolio
inflows, are dominated by debt inflows, and not --
as in Asia -- equity. Therefore, during 1995, as
Latin America was forced to raise interest rates,
you had a big inflow into capital accounts. In
Asia, however, the capital accounts are dominated
by equity inflows. If you look at portfolio equity
inflows as a share of total private inflows in
1995, in South Asia they were 45%. So Asia's
capital accounts are dependent on equity inflows.
And what dominates Asian equity markets are the
financials, which are imploding, due to IMF
policies. The IMF is making a capital outflow worse
by causing a total collapse in equity-market
profits. The IMF prescription for Mexico worked to
stabilize the currency, but that won't work in
Asia. The balance of payments has continued to
deteriorate despite the collapse in the
current-account deficits.

Q: Now what?
A: The Asian markets could perform more like Japan
than Mexico, because they are dominated by banks
and property developers. So we still would avoid
Asia. But this is not an Asian problem, or even
just an emerging-markets problem. This is a problem
that arises from managing excess capital inflows
under a fixed-exchange-rate regime: If the money is
pouring in, you will overheat massively, get a
property boom, and a massive current-account
deficit. That is exactly what happened to the U.K.
in 1988. Even [former Prime Minister Margaret]
Thatcher, one of the shock troops of far-right
capitalism, managed to screw that up totally, and
we had the biggest recession here since the war.
The only difference between Thailand now and the
U.K. then is that Thailand has lots of
foreign-denominated debt.

Q: You're saying that Asia's woes --
A: Are just part of the natural boom-bust cycle.
Excesses burst. It happened in the U.S. property
cycle in the 1980s. It has happened in the U.K. It
has happened everywhere. So people shouldn't be put
off Asia forever.

Q: Let's talk about Europe -- where your outlook
isn't so gloomy.
A: Looking to Europe actually fits nicely into our
global scenario, where Ice Age earnings are
becoming more and more of a reality. The coming of
the European Monetary Union means that parts of
Europe offer an unusual equity investment
opportunity to lever up and capture some very rapid
top-line growth. We call this "the Euro-Bubble."

Q: Some good will come of EMU?
A: If you know what to look for. In a
single-currency zone, like the U.S., you always get
some parts of the country that grow more quickly
than others. It's natural. What happens in the U.S.
is that as wage inflation picks up in a
faster-growing region, you have a lot of labor
mobility and people are sucked into that region.
Ultimately, if there's a lot of wage inflation,
capital might migrate to a lower-cost area. What
will happen in Europe under EMU is similar. A
single interest rate will not be appropriate for
all countries. It will be too high for some, too
low for others. That is natural. From next May,
when they announce who is going to participate in
EMU and at what exchange rate, short-term interest
rates will begin to converge very rapidly on German
levels. The Asian crisis means that this level
could even be below 4%. So interest rates will
collapse in places like Italy, Spain and Ireland,
stimulating a major credit boom.

Q: So happy days are there again?
A: Exactly. Ultimately, wage inflation in the
Euro-Bubbles will pick up, even more than it does
in the U.S., because these countries lack
U.S.-style labor mobility to help even out
divergences in regional growth.


Q: Which is one reason some doubt that the EMU will
A: It could all end very quickly, but I doubt it.
If it does proceed, then inflation is an
inevitability. You have some countries overheating
already. Ireland is growing at 8%. Dublin house
prices have doubled in the last three years -- with
6.5% interest rates. Their rates are going to 4%!
Some of the Euro-Bubbles -- Holland, Finland and
Ireland, for example -- have no spare capacity left
at all. When you go to Holland and ask clients how
the authorities are going to deal with this, they
shrug their shoulders. Italy and Spain have much
more spare capacity, so inflation is not such an
immediate problem. But ultimately wage and
consumer-price inflation will pick up strongly
there, too.

Q: Tell us again where there's opportunity in this.
A: In the first place, in a more inflationary
environment in these countries, as long as you are
not producing anything tradable, you can pass on
the wage inflation in output prices and maintain
your margins. Especially if you are in the
property-related area. Now, two things are unusual
here. It's difficult to exploit regional revenue
bubbles in the U.S. or the U.K., where companies
tend to operate at least nationally, if not
internationally. But that is not the case in
Europe, where what will be currency regions are
also countries. The national stock markets are full
up with stocks in which you can isolate these
regional booms. So, for instance, basically
three-quarters of the Italian and Spanish markets
are domestic stocks and a large proportion of
those, non-tradables. There is no shortage of
investment vehicles.

Q: What other opportunity is there?
A: It is the opportunity for equity managers to
invest in inflation at no risk. In a
single-currency zone like the U.S., you don't care
about the regional inflation rate. So, too, in the
Euro-Bubble. The example we are using is this:
Suppose Spanish wage inflation picks up to 10% and
Spanish consumer-price inflation is 10%. It won't
get to that, but suppose. In nominal terms, a
Spanish company will have a 10% profits gain. In
Spanish Euro terms, it will be a zero real return.
You won't be able to buy more with those profits in
Spain. But for a German investor, that will
represent a 10% real gain. We equate this to going
into the Hong Kong equity market to purchase
property price inflation: Whether you are buying
the developers themselves or the banks who are
lending to the developers, the key is that the
inflation is there, and you're banking on there not
being a currency adjustment down. So it's a
perfectly natural investment opportunity. What we
are saying is that in the Euro-Bubbles, inflation
will flare up, potentially quite a lot. And it
represents an opportunity. Ultimately, of course,
after a period of years, the bubbles will deflate
as the tradable-goods sectors in the Euro-Bubble
countries become totally uncompetitive. A country
like Holland, a very open economy, will slow down
quite quickly as its tradable-goods sector is wiped
out. But in countries like Italy and Spain, which
aren't so open, anything tradable has basically had
it. The Irish technology sector is finished because
of wage inflation. Seagate's recent exit will be
the first of many. Meanwhile, Germany and France
will benefit as exporters of tradable goods to
these countries. Ultimately, Germany will dominate
the tradable-goods side. But for two, three, four
years, this thing will bubble away and look great.

Q: You said the EMU could meet a quick end.
A: One big uncertainty is what will the European
Central Bank do as Euro-Bubble inflation rises
sharply. The Maastricht Treaty is not explicit. The
ECB is charged with targeting Europe-wide price
stability, but it isn't accountable to anyone.
Which is quite frightening, really. One thing they
will have to focus on is that German and French
growth looks vulnerable as export-led growth is
impacted by the Asia crisis. This is in addition to
the economic headwinds of restructuring. So is the
European Central Bank going to raise rates because
Italian inflation is picking up, when France is
still only growing at 2%? It will be a real
dilemma. One thing is certain. France is not
joining EMU to go back into recession. So if the
European Central Bank does address rising Spanish
or Italian inflation, EMU will be finished within
two years. The problem is that the Maastricht
Treaty does not have provision for countries to
leave EMU once they have joined. It's interesting
to note that about 18 months ago, when there was a
dust-up over France Telecom fudging some numbers,
Helmut Kohl gave a little-noted speech in which he
said, "The alternative to EMU is war." I wrote a
piece at the time saying that if the alternative is
war, fudging the numbers is quite a palatable
alternative. There are quite clear examples in
history of people trying to leave other currency
unions which did lead to civil war. If it goes
wrong, it could turn ugly. Anyway, that's why we
think the European Central Bank won't address
Italian inflation or Dutch inflation. Real politick
means the ECB will have to allow inflation to flare
up in Italy, Spain and to a lesser extent Holland,
of the big countries. In Ireland, Portugal and
Finland, among the smaller ones. In a world where
inflation has disappeared, we will see it suddenly
flare up in the Euro-Bubbles.

Q: We dimly recall that inflation isn't great for
A: Inflation is usually a dirty word for equity
investors, because higher inflation means higher
bond yields, which is bad news for equities. In
EMU, bond spreads will not widen as inflation
diverges vis-a-vis Germany. As with corporate
bonds, the spread is determined by default risk,
which in EMU is the risk of leaving the currencies
zone. For Spain, with its booming economy, the risk
of leaving EMU is zero. Nevertheless, people will
be very nervous about higher inflation. But don't
think of it as "inflation, that dirty word." Think
of it as pricing power, a far more equity-friendly

Q: What are you buying?
A: As we wrote in a recent strategy piece, "In a
gale, even turkeys fly. Buy Italian turkeys."
Brokers so often say, "Buy the blue chips." But
what we are saying is to buy the most leveraged
rubbish you can find in these countries. The banks,
which are full of bad debt, basically will float
off the rocks. As Malaysian Prime Minister Mahathir
said, "Strong growth covers a multitude of sins."
Bad debts disappear. Plus, you get very strong
revenue potential. As in Asia and the Dow, riding a
bubble can be extremely profitable -- while it
lasts. You just have to know when to get off.

Q: Thanks, Albert.

Copyright © 1997 Dow Jones & Company, Inc. All Rights

-- (Dennis L. Fiddle)
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