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the stock market

``` [I've enclosed a letter I received from a friend in San Francisco who is trying to start a company. He says he can't, though, because there literally aren't enough lawyers...]

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Date: Mon, 10 Jun 1996 10:00:18 -0700 From: <>

You have probably read, since it was reported everywhere in sight, that during the first four months of this year net $100 billion flowed into stock mutual funds, and that this dwarfs the rate in 1995, which was $125 billion for the whole year, which in turn dwarfed the previous record. You may not have thought to do the following simple calculation, which I have not read anywhere (despite following the financial markets fairly closely). There's ~150 million workers in the country, so that means that on average each worker put ~$700 into stock funds. That works out to an annual rate of ~$2000 per worker. I forget what annual per-worker wages are in this country, but I think $25,000 is not wildly wrong. (If anyone knows offhand what the actual numbers are, I'd like to hear.) That implies that 8% of pre-tax income is currently going into stock market mutual funds. Historically, the savings rate has run around 4%, and only around 25% of that (or 1% total) has gone into stock holdings of all sorts, and only about half of that into mutual funds. So we've all read that there's a buying panic going on, but this gives a sense of its magnitude.

Now, where's the money coming from? Consumer spending is also growing smartly. So it's not coming out of consumption. The answer, as far as I can guess, is supplied by the observation that credit card debt is skyrocketing. Everyone is dutifully putting 8% of income into stock mutual funds, because that is what all the popular financial pundits are telling them to do, and they are funding current consumption with credit cards. This has been possible because banks are in a lending panic, extending huge credit lines to absolutely everyone. It's working great for the banks so far, because with the economy doing OK everyone is managing to pay their 18% interest. No one seems to notice that this is adding up to an enormous margin loan, at usurious rates (you'd only pay ~9% on a real margin loan), and with an unspecified leverage ratio.

Maybe this will somehow work out OK, but it could get very, very ugly. Someone should at least figure out what the effective leverage ratio is. Unfortunately, I don't have the necessary numbers to do this quantitatively.

The wrong way to do this calculation would be to look at the ratio of outstanding credit card debt to total household assets. That ratio is small. The problem with that calculation is that almost all of total household assets are held by the wealthiest 20% of the population, and those people (among whom I'm lucky enough to count myself) probably mostly don't roll over credit card balances.

Credit card debt expansion is dramatic among the bottom half of the population. These are the people who have been suddenly snookered into playing mutual funds by a fashion change, over the last five years, in the professional investment advice industry. In this half of the population, almost all of assets are in one of two illiquid forms: retirement plans and homes. I would guess that for this half, liquid assets are much smaller than credit card debt, so if we count only those, the leverage ratio may be as high as the 10:1 that caused the '29 crash. In case of a ``margin call'', retirement assets and home equity would be seen as collateral by credit card issuers (and bankruptcy courts), and many people could lose theirs.

Second observation. Rationally, when stock prices are high, a company's treasurer should sell equity (which is overvalued relative to the company's worth); when they are low, the company should buy the equity back, at a discount to its value. Some cynics have been predicting for some time now that the market's current wild overvaluation would soon end because Wall Street could easily generate supply to meet the public's demand for stocks, by issuing IPOs. And, of course, the volume of IPOs is exceeding all records. (A personal barometer: I've recently started a tiny high-tech company, which means I need to procure legal services. I'm literally unable to do so -- which is significantly hampering my ability to do business -- because every competent corporate lawyer in the Bay Area is up to his or her eyeballs in IPOs.) Despite this, the volume of shares out there is actually decreasing. Corporate stock buy-backs are significantly exceeding the IPO volume.

If you believe that companies are managed to maximize profit (or intrinsic value), this is insane; corporations are in an even more extreme buying panic than the public, at a time when by several measures stock prices are higher than in September 1929. By standard economic theory, and by common business sense also, buying one's own stock at a premium to its value is no more rational than buying any other stock at a premium to its value.

(Parenthesis: there's a frequently-cited explanation of this effect, that corporations have figured out that dividends are taxed twice, once at the corporate rate of 35-39%, and then again at the owner's ordinary income rate, whereas stock buy-backs are effectively only taxed once, and at the usually-lower capital gains rate. Thus stock buy-backs are a more tax-efficient use of free cash flow, so companies don't pay dividends anymore. This argument is very true, ceteris paribus. However, the tax efficiency has to be traded off against the intrinsic value premium; the argument is completely spurious if the stock is trading at a 100% premium, which most now are.)

So why are corporations acting in an apparently irrational way? The answer is in Jackall's book: companies are managed to advance the careers of managers, not to maximize profit. [He is referring to Robert Jackall's "Moral Mazes: The World of Corporate Managers", which I've recommended here many times. Terrific book.] There has been a tremendous shift just in the past five to ten years to paying CEOs mainly in performance bonuses, rather than salaries. This is actually a sensible move, I think. However, the bonuses are almost always based on share prices, rather than intrinsic value. CEOs have figured out that they can best drive up share prices by using stock buy-backs, and they are enthusiastically doing so, and in the process driving a feeding frenzy -- and producing obscene bonuses for themselves.

This has gone on FAR longer, and to a FAR greater degree, than I thought possible. (Or than anyone else did. The Silly Valley money people I talk to are all in a panic to get EVERYTHING to an IPO as soon as possible, before it all unravels.) I don't think it's going to go on long enough for my company to cash in on this cycle. ```