The "Bubble" in the Stock Market
Jude Wanniski
January 11, 2000


To: Rich Karlgaard, publisher of Forbes
From: Jude Wanniski
Subject: Beating the Dart Throwers.

I thoroughly enjoyed your January 24 column, "Sorry I Stank," about how the Wall Street professionals once again failed to beat the stock indices in 1999. As you put it: "We're not talking the high bar of the NASDAQ 100, either. No, your average Wall Street pro hasn't beat a dart tossed by a drunk in a bus depot since 1994." In 1999, even Warren Buffett was bopped down 20%. As you correctly note, the general excuse of the losers is that "the public is incredibly stupid." In other words, they say, the unwashed masses who are picking stocks and winning have propped up the stock market, but any day now the bubble will burst.

I don't know if you caught NBC-TV's The McLaughlin Group on Sunday, but host McLaughlin once again predicted the bulls would get their comeuppance in 2000 and the Dow Jones Industrials would finish the year almost 3000 points lower than it began. Of course, he could turn out to be right, but his reasoning was so fallacious that you could see why he has been wrong so consistently over the last several years in predicting a major correction. He thinks that excess liquidity created by the Federal Reserve has pushed up Wall Street equity prices. It struck me that John's cash-flow hypothesis of how the stock market works is one of the common mistakes made by professional money managers. It is a mistake not made by ordinary investors, who do not bother thinking about such things and thus have no extraneous impediments.

Cash-flow analysis is a mistake I made 30 years ago when I began to study economics, finance and price theory, not in the classroom, but from Robert Mundell and Art Laffer. It was Laffer, I think who told me that Johnny Carson -- the Tonight show host back in those years -- once asked "Where does the money go when the stock market crashes?" The answer is that it doesn't go anywhere and it didn't come from anywhere. When you buy $1000 worth of stock, you get a piece of paper, and someone else has the $1000. The price may be higher or lower than it was yesterday, but that "price" is based on the market's estimate of what it is worth. Laffer went further by telling me prices can change without there being any transactions. In other words, without any money changing hands at all, prices can go up or down. Suppose, he said, you live in an upscale development where the average house is $400,000 and some are up for sale at that price. Then suppose the government announces that the development was built atop a waste treatment site that contains carcinogens. The value of every home will crash and so will the price. Confirmation of that fact will come when the first house is sold.

The kind of cash-flow analysis prevalent among professionals seems like common sense, but it is not even mechanically correct in the way John McLaughlin put it. If there is "surplus" liquidity in the banking system as a result of Fed actions, it does not "go into" the stock market. It goes first into the price of gold, then spreads to other commodities, eventually lifting the general price level. Stock prices will tend to rise during this chain reaction as the value of assets owned by a corporation follow the inflation. Years ago, the public was taught that "stocks are a good hedge against inflation." This is because real assets underpin equities and these real assets increase in price during a general inflation. Bonds are not a "good hedge against inflation," because there is nothing real underpinning a bond. In an inflation, a bond loses value because it is being serviced by interest and principal payments that will have less purchasing power than they did when the bond was issued.

The "liquidity" that McLaughlin mentioned is NON-INTEREST-BEARING DEBT OF THE GOVERNMENT, i.e., "monetized debt." It comes into the possession of banks as the Fed buys bonds with printing-press money. If there is more liquidity than the banks want -- given the availability of secure borrowers -- there is no way it can "get into" the stock market. Why does it "go into" gold? It is because gold is close to being a pure monetary commodity. Its value will remain constant in an inflation where a bond will lose value. When the central bank "monetizes debt," taking interest-bearing bonds out of the system and replacing them with unwanted cash that pays no interest, the market will prefer gold that pays no interest to cash that pays no interest. The price of gold will rise as the spread between the offering price and the selling price changes. At the margin, someone holding gold will be reluctant to sell at yesterday's price and someone wishing gold in exchange for the surplus liquidity will find none is available at yesterday's price. The spread widens until the holder of gold is willing to part with it at the higher bid price.

When the stock market crashed in 1929, it was not because there was too much liquidity in the system -- thereby bursting the speculative bubble. Nor was it because there was too little liquidity in the system -- thereby bursting the bubble. Monetarists and Keynesians, and even many Austrian economists, still make the mistake of thinking of money as a commodity, when it is really only a promise. And promises become worth much less when the means to deliver on those promises crash in value -- which is what the sudden increase in the U.S. tariff wall did. The market saw the Smoot-Hawley Tariff Act looming as a cancer under the foundation of global commerce. There were a great many transactions reported as stock prices collapsed, but there did not have to be any transactions. If the New York Stock Exchange had simply closed for a few weeks and then opened, the bid and asked spreads would have changed in the interim, in the minds of all the buyers and all the sellers.

Those professional asset managers who understand this are liberated from false theory and are then free to build their decision-making mechanisms around models that work. Over the years, the asset managers who have been clients of Polyconomics have done much better than the dart throwers and the indices for precisely that reason.