David Stockman: The Apotheosis Of Bubble Finance

The inexorable effect of contemporary central banking is serial financial booms and busts. With that comes increasing levels of systemic financial instability and a growing dissipation of real economic resources in misallocations and malinvestment.

At length, the world becomes poorer.

Why? Because gains in real output and wealth depend upon efficient pricing of capital and savings, but the modus operandi of today’s central banking is to deliberately distort and relentlessly falsify financial prices.

As we have seen, the essence of ZIRP and NIRP is to drive interest rates below their natural market clearing levels so as to induce more borrowing and spending by business and consumers.

It’s also the inherent result of massive QE bond-buying where central banks finance their purchases with credits conjured from thin air. Consequently, the central banks’ Big Fat Thumb on the bond market’s supply/demand scale results in far higher bond prices (and lower yields) than real savers would accept in an honest free market.

The same is true of the hoary doctrine of “wealth effects” stimulus. After being initiated by Alan Greenspan 15 years ago, it has been embraced ever more eagerly by his successors at the Fed and elsewhere ever since.

Here, the monetary transmission channel is through the top 1% that own 40% of the financial assets and the top 10% that own upwards of 85%. To wit, stock prices are intentionally driven to artificially high levels by means of “financial easing”. The latter is a euphemism for cheap or even free finance for carry trade gamblers and implicitly subsidized hedging insurance for fast money speculators.

As the stock averages rise and their Fed-subsidized portfolios attain ever higher “marks”, the wealth effects operators supposedly feel, well, wealthier. They are thereby motivated to spend and invest more than otherwise, and to actually double-down on these paper wealth gains by using them as collateral to obtain even more cheap funding for even more speculations.

The trouble is, financial prices cannot be falsified indefinitely. At length, they become the subject of a pure confidence game and the risk of shocks and black swans that even the central banks are unable to off-set. Then the day of reckoning arrives in traumatic and violent aspect.

Exactly that kind of Lehman-scale crisis is now descending on global markets. In fact, it’s even worse. Speculative excesses that are even more fantastic than during the dotcom era mania have now infested the technology and social media stocks,.

So once again the end result of today’s massive central bank intrusion in financial markets will be yet another thundering crash of the high flyers and a resulting financial crisis of unprecedented extent.

 The Folly Of The FANGs

Needless to say, there have been some spectacular rocket ships in the market’s melt-up during the last several years. But if history is any guide this is exactly the kind of action that always precedes a thundering bust.

To wit, the market has narrowed down to essentially four explosively rising stocks—–the FANG quartet of Facebook, Amazon, Netflix and Google—–which are sucking up most of the oxygen left in the casino.

At the beginning of 2015, the FANG stocks had a combined market cap of $740 billion and combined 2014 earnings of $17.5 billion. So a valuation multiple of 42X might not seem entirely outlandish for this team of race horses, but what has happened since then surely is.

At the end of August 2016, the FANG stocks were valued at $1.3 trillion, meaning they have gained $570 billion of market cap or nearly 80% during the previous 19 months. Not only has their combined PE multiple escalated further to 50X, but that’s almost entirely owing to Google’s far more sober PE at 30X.

By contrast, at the end of August 2016, Netflix was valued at 300X its meager net income of $140 million, while Amazon was valued at 190X and Facebook at 60X.

In a word, the gamblers are piling on to the last trains out of the station. And that means look out below!

An old Wall Street adage holds that market tops are a process, not an event. A peak under the hood of the S&P 500 index, in fact, reveals exactly that.

On the day after Christmas 2014, the total market cap of the S&P 500 including the FANG stocks was $18.4 trillion. By contrast, it closed at $19.0 trillion in August, reflecting a tepid 4% gain during a 19 month period when the stock averages were spurting to an all-time high.

Needless to say, if you subtract the FANGs from the S&P 500 market cap total, there had been virtually no gain in value at all; it was still $17.7 trillion.

So there you have it—-a classic blow-off market top in which 100% of the gain over the last 19 months was owing to just four companies.

Actually, there is growing deterioration down below and  for good reason. Notwithstanding the FOMC’s stick save at nearly every meeting during the past two years, each near miss on a rate hike reminded even Wall Street’s most inveterate easy money crybabies that the jig is up on rates.

Sooner or later the Fed will just plain run out of excuses for ZIRP, and now, after 93 straight months on the zero bound, it clearly has.

And at the most inopportune time. As we demonstrated earlier, the world economy is visibly drifting into stall speed or worse, and corporate earnings are already in an undeniable downswing. As we have also indicated, reported EPS for the S&P 500 during the LTM ended in June 2016 came in at$87 per share or 18% below the $106 per share reported in September 2014.

So the truth is, the smart money has been lightening the load during much of the last two years, selling into the mini-rips while climbing on board the FANG momo train with trigger finger at the ready.

Chasing The Last Momo Stocks Standing—- An Old Wall Street Story

Needless to say, this narrowing process is an old story. It famously occurred in the bull market of 1972-1973 when the impending market collapse was obscured by the spectacular gains of the so-called “Nifty Fifty”. And it happened in spades in the spring of 2000 when the Four Horseman of Microsoft, Dell, Cisco and Intel obfuscated a cratering market under the banner of “this time is different”.

But it wasn’t. It was more like the same old delusion that trees grow to the sky. At its peak in late March 2000, for example, Cisco was valued at $540 billion, representing a $340 billion or 170% gain from prior year.

Since it had earned $2.6 billion of net income in the most recent 12 month period, its lofty market cap represented a valuation multiple of 210X. And Cisco was no rocket ship start-up at the point, either, having been public for a decade and posting $15 billion of revenue during the prior year.

Nevertheless, the bullish chorus at the time claimed that Cisco was the monster of the midway when it came to networking gear for the explosively growing internet, and that no one should be troubled by its absurdly high PE multiple.

The same story was told about the other three members of the group. During the previous 24 months, Microsoft’s market cap had exploded from $200 billion to $550 billion, where it traded at 62X reported earnings. In even less time, Intel’s market cap had soared from $200 billion to $440 billion, where it traded at 76X. Dell’s market cap had nearly tripled during this period, and it was trading at 70X.

Altogether, the Four Horseman had levitated the stock market by the stunning sum of $800 billion in the approximate 12 months before the 2000 peak.

That’s right. In a manner not dissimilar to the FANG quartet during the past year, the Four Horseman’s market cap had soared from $850 billion, where it was already generously valued, to $1.65 trillion or by 94% at the time of the bubble peak.

There was absolutely no reason for this market cap explosion except that in the final phases of the technology and dotcom bull market, speculators had piled onto the last momo trains leaving the station.

But it was a short and unpleasant ride. By September of 2002, the combined market cap of the Four Horseman had crashed to just $450 billion. Exactly $1.0 trillion of bottled air had come rushing out of the casino.

Needless to say, the absurdly inflated values of the Four Horseman in the spring of 2000 looked exactly like the FANG quartet today. The ridiculously bloated valuation multiples of Facebook, Amazon and Netflix speak for themselves, but even Google’s massive $550 billion market cap is a sign of the top.

Despite its overflowing creativity and competitive prowess, GOOG is not a technology company which has invented a rocket ship product with years yet to run. Nearly 90% of its $82 billion in LTM revenues came from advertising.

But the current $575 billion worldwide advertising spend is a 5% growth market in good times, and one which will slide back into negative territory when the next recession hits. Even the rapidly growing digital ad sub-sector is heading for single digit land; and that’s according to industry optimists whose projections assume that the business cycle and recessions have been outlawed.

The fact is, GOOG has more than half of this market already. Like the case of the Four Horseman at the turn of the century, there is no known math that will allow it to sustain double digit earnings growth for years into the future and therefore it 30X PE multiple.

Likewise, Amazon may well be effecting the greatest retail revolution in history, but its been around for 25 years and still has never posted more than pocket change in profits. More importantly, it is a monumental cash burn machine that one day will run-out of fuel.

During the LTM period ending in June 2016, for example, it generated just $6.3 billion of operating free cash flow on sales of $120 billion. So it was being valued at a preposterous 58X free cash flow.

So here’s the thing. The Four Horseman last time around were great companies that have continued to grow and thrive ever since the dotcom meltdown.  But their peak valuations were never remotely justified by any plausible earnings growth scenario.

In this regard, Cisco is the poster child for this disconnect. During the last 15 years its revenues have grown from $15 billion to nearly $50 billion, and its net income has more than tripled to nearly $10 billion per year.

Yet it’s market cap today at $150 billion is just 25% of its dotcom bubble peak. In short, its market cap was driven to the absurd height recorded in March 2000 by the final spasm of a bull market, when the punters jumped on the last momo trains out of the station.

 

This time is surely no different. The FANG quartet may live on to dominate their respective spheres for years or even decades to come. But their absurdly inflated valuations will soon be deFANGed.

 

Part 2

Indeed, the so-called social media stocks represent the very essence of the bicoastal Bubble Finance prosperity of Wall Street and Silicon Valley.

The truth is, Facebook——along with Instagram, Whatsapp, Oculus VR and the 45 other testaments to social media drivel that Mark Zuckerberg has acquired with insanely inflated Wall Street play money during the last few years——-is not simply a sinkhole of lost productivity and low-grade self-indulgent entertainment. It is also a colossal valuation hoax, and one that is heading for another “Faceplant” when the third great financial bubble of this century comes crashing down.

Why? Because at bottom, Facebook (FB ) is just an Internet billboard. It’s a place where the idle mostly idle their time, like millennials in or out of their parents’ basement. Whether they grow tired of Facebook or not remains to be seen, but one thing is certain.

To wit, FB has invented nothing, has no significant patents, delivers no products and generates no customer subscriptions or service contracts. Its purported 1.8 billion “MAUs” (monthly average users) are fiercely devoted to “free stuff” in their use of social media.

Therefore, virtually all of its revenue comes from advertising. But ads are nothing like a revolutionary new product such as Apple’s iPhone, which can generate tens of billions of sales out of nowhere.

The pool of advertising dollars, by contrast, is relatively fixed at about $175 billion in the U.S. and $575 billion worldwide. And it is subject to severe cyclical fluctuations. For instance, during the Great Recession, the U.S. advertising spend declined by 15% and the worldwide spend dropped by 11%.

And therein lies the skunk in the woodpile. Due to its sharp cyclicality, the trend growth in U.S. ad spending during the last decade has been about0.5% per annum. Likewise, the global ad spend increased from about $490 billion in 2008 to $575 billion in 2015, reflecting a growth rate of 2.3% annually.

Yes, there has been a rapid migration of dollars from TV, newspapers and other traditional media to the digital space in recent years. But the big shift there is already over.

Besides that, you can’t capitalize a one-time gain in sales of this sort with even an average market multiple. And that’s saying nothing about the fact that FB’s recent $360 billion market cap represented a preposterous multiple of 225 times its $1.6 billion of March 2016 LTM free cash flow

For the June 2016 LTM period, in fact, its multiple was infinite because its free cash flow was actually negative $1.5 billion.

In any event, the digital share of the U.S. ad pool rose from 13.5% in 2008 to an estimated 32.5% last year. But even industry optimists do not expect the digital share to gain more than a point or so per year going forward. After all, television, newspapers, magazines and radio and highway billboards are not going to disappear entirely.

Consequently, there are not remotely enough advertising dollars in the world to permit the endless gaggle of social media space entrants to earn revenue and profits commensurate with their towering valuations and the sell side’s hockey stick growth projections. In social media alone, therefore, there is more than $1 trillion of bottled air.

In fact, in a milieu built around the concept of “free stuff” the massive amount of speculative VC capital that has entered the social media space is certain to drive customer acquisition and service costs ever higher and margins to the vanishing point.

The fact is, none of the social media competitors, not even Facebook, have a permanently defensible first mover advantage. That is evident in the current tally of 140 so-called venture capital “unicorns”. Each has a private pre-IPO “valuation” of $1 billion or more, or at least did until recently when the drought of IPOs has begun to puncture the fantasy. Even then, the group is still “valued” at $500 billion in the rarified precincts of Silicon Valley.

But the unicorns are sowing forces that will eventually eviscerate FB’s massively bloated valuation.

First, they are hatching new competitors for advertising dollars like there is no tomorrow. On-line advertising revenue, in fact, is the business model of virtually the entire social media space.

Secondly, and more importantly, they are burning VC capital by the tens of billions attempting to find “users” and customers and attain business viability by buying mobile advertising from…….yes, Facebook!

As we learned from the dotcom bust, when freshly minted companies start taking in each other’s laundry in Silicon Valley things get way out of whack. Capital morphs into revenue and “burn babies” temporarily and deceptively appear to be a booming new customer base.

That is, until the bubble implodes, new capital flows dry up, start-ups disappear en masse and revenue from their purchases of equipment, services (e.g. Amazon’s cloud services) and advertising vanishes.

And that get us to the ludicrous hockey sticks on which FB’s current valuation is based—even as the end-of-bubble handwriting is already on the wall.

Start-up company space , for example, is being vacated all over the place in San Francisco and real world consumer products companies like the mighty Proctor & Gamble have already decided to stop paying exorbitant rates for Facebook’s ineffective targeted mobile advertising.

Nevertheless, Merrill Lynch is currently projecting that Facebook’s $16.6 billion of ad revenue in 2015 will grow by 84% to $30.5 billion by 2017.

But what would happen if it turns out that the central banks have not abolished the business cycle after all? Assume that the growing signs of global recession materialize in a downturn between now and then, and that results in a advertising reduction of about half as severe as the Great Recession.

Accordingly, this time the world ad spend would drop by only 5%, not 10-15%, to about $545 billion. Furthermore, assume optimistically that the digital ad share gains another 2 points per year, rising from 26% of the global add spend last year to 30% by 2017.

Under those perfectly sober assumptions, digital spending would rise by about $15 billion over the next two years from the $150 billion level achieved in 2015. And the non-search share of that gain where FB competes—that is, the portion outside of Google’s near monopoly— would be about $7.5 billion.

In short, the Wall Street hockey brigade is essentially projecting that FB will pick up 200% of the available new ad dollars that would likely materialize under an even moderate global recession scenario.

But that isn’t even the half of it. Even a hint of recession would knock the props right out from under the monumentally bullish financial market bubble that has been fueled by the Fed and other central banks since the 2008 crisis.

History leaves little doubt about what happens then. The massive amount of venture capital pouring into Silicon Valley and the social media space would dry up in no time; and the “burn baby” advertising spend by the unicorns and other start-ups would quickly vanish.

So instead of growing at 40% per year, there is a very distinct possibility that FB’s sales will slump to the single digit range not too many quarters down the road.

Stated differently, Facebook is a valuation train wreck waiting to happen. It is spending tens of billions on acquisitions of companies that do not even have revenues and ramping up its internal operating costs at staggering rates of gain.

This means that when ad spending hits the recessionary skids in the months ahead——look out below. Its stock price will crater.

In short, Bubble Finance hype is the sum and substance of Facebook’s crazy valuation and its modus operandi. But its founder, controlling shareholder and CEO, the brash young Mark Zuckerberg, is no Bill Gates. Not by a long shot.

Gates was a true business genius who created an essential component—desk top operating systems—- of the internet age. By contrast, Zuckerberg happened to be hanging around a Harvard dorm room just as the central bankers of the world were cranking up their printing presses to warp speed.

The hallucinatory sense of grandeur that accompanied Facebook’s IPO eight years later in May 2012 has been on display ever since. But Zuckerberg’s madcap M&A frenzy—culminating in the insane Whatsapp deal——may well become the defining moment for the third and final bubble of this century.

To wit, Zuckerberg paid the stunning sum of $22 billion for a social media outfit that had just $10.2 million of revenue. The purchase price thus amounted to 2,150X sales.

And while you are at it, just forget about the fact that Whatsapp actually lost one-half billion dollars during the year prior to the deal’s close in October 2014.

Then again, the way you lose such staggering amounts of money on virtually no sales is quite simple. That is, you adopt a business model that even the most intellectually challenged hot dog stand operator would not have contemplated before the age of Bubble Finance.

Namely, plow headlong into a huge business operated by the biggest telecom companies in the world. In this case, one which generates $20 billion in annual billings for the wireless carriers. And the key to grabbing market share in that brutal neighborhood: offer your service for free!

That’s right. Whatsapp is just a text messaging service that challenged the paid SMS services of AT&T, Sprint, Verizon etc. by reducing the transmission charge from $10-20 per month to, well, nothing.

The CEO of a competitor succinctly explained why this tactic works,

It always comes down to the economics,” said Greg Woock, the chief executive of Pinger. “Free is a compelling price point.”

Yes, it is. Not surprisingly, Whatsapp free messaging service had gone from a standing start in 2009 to 400 million users by 2014. Now that’s the kind of “growth” that social media bubble riders can get giddy about.

But it amounted to this: Facebook paid $55 per user for a business that had 13 cents per user of revenue.

But never mind. Having virtually his own legal printing press—–FB issued $17 billion of freshly minted stock to pay for most of the deal—-Zuckerberg explained it this way:

‘Our strategy is to grow and connect people. Once we get to 2-3 billion people there are ways we can monetize’.

In fact, Whatsapp now has nearly 1 billion users, but still no revenue and has actually eliminated a minor annual user charge.

If this sounds vaguely like the dotcom mania in early 2000, it is and then some.

Part 3

Nearly everywhere on the planet the giant financial bubbles created by the central banks during the last two decades are fracturing. If this is beginning to sound like August 2007 that’s because it is. And the denials from the casino operators are coming in just as thick and fast.

Back then, the perma-bulls were out in full force peddling what can be called the “one-off” bromide. That is, evidence of a brewing storm was spun as just a few isolated mistakes that had no bearing on the broad market trends because the “goldilocks” economy was purportedly rock solid.

Thus, the unexpected collapse of Countrywide Financial was blamed on the empire building excesses of the Orange Man (Angelo Mozillo)  and the collapse of the Bear Stearns mortgage funds was purportedly owing to a lapse in supervision.

So it boiled down to an injunction of “nothing to see here”. Just move along and keep buying.

In fact, after reaching a peak of 1550 on July 18, 2007, the S&P 500 stumbled by about 9% during the August crisis, but the dip-buyers kept coming back in force on the one-off assurances of the sell-side “experts”. By October 9 the index was back up to the pre-crisis peak at 1565 and then drifted lower in sideways fashion until September 2008.

The bromides were false, of  course. Upon the Lehman event the fractures exploded, and the hammer dropped on the stock market in violent fashion .During the next 160 days, the S&P 500 plunged by another 50%.

^SPX Chart

The supreme irony of the present moment is that the perma-bulls insist that there is no lesson to be learned from the Great Financial Crisis. That’s because the single greatest risk asset liquidation of modern times, it turns out, was also, purportedly, a one-off event.

It can’t happen again, we are assured. After all, the major causes have been rectified and 100-year floods don’t recur, anyway.

In that vein it is insisted that U.S. banks have all been fixed and now have “fortress” balance sheets. Likewise, the housing market has staged a healthy recovery, but remains lukewarm and stable without any signs of bubble excesses. And stock market PE multiples are purportedly within their historic range and fully warranted by current ultra-low interest rates

This is complete day traders’ nonsense, of course. During the past year, for example, the core CPI has increased by 2.20% while the 10-year treasury this morning penetrated its all-time low of 1.38%.  The real yield is effectively negative 1%, and that’s ignoring taxes on interest payments.

The claim that you can capitalize the stock market at an unusually high PE multiple owing to low interest rates, therefore, implies that deep negative real rates are a permanent condition, and that governments will be able to destroy savers until the end of time.

The truth of the matter is that interest rates have nowhere to go in the longer-run except up, meaning that the current cap rates are just plain absurd. Indeed, at the end of last summer’s melt-up rally, as we indicated earlier, the S&P 500 was trading at 25X LTM reported earnings

Moreover, the $87 per share reported for the period ending in June 2016 was actually down by 18% from the $106 per share peak recorded in September 2014. So in the face of falling earnings and inexorably rising interest rates, the casino punters were being urged to close their eyes and buy the dip one more time.

And that’s not the half of it. This time is actually different, but not in a good way. Last time around the post-August 2007 dead-cat bounce was against $85 per share of S&P LTM earnings, meaning that on the eve of the 2008 crash the trailing multiple was only 18.4X.

That’s right. After the near-death experience of 2008-2009 and a recovery so halting and tepid as to literally scream-out that the main street economy is impaired and broken, the casino gamblers have dramatically upped the valuation ante yet again.

There is a reason for such reckless obduracy, however, that goes well beyond the propensity of Wall Street punters and robo-traders to stay at the tables until they see blood on the floor.

Namely, their failure to understand that the current central banking regime of Bubble Finance inherently and inexorably generates financial boom and bust cycles that must, and always do, end in spectacular crashes.

The Baleful Legacy Of Bubbles Alan Greenspan

And that brings us back to the father of Bubble Finance, former Fed Chairman Alan Greenspan. In a word, he systematically misused the power of the Fed to short-circuit every single attempt at old-fashion financial market corrections and bubble liquidations during his entire 19-year tenure in the Eccles Building.

That includes his inaugural panic in October 1987 when he flooded the market with liquidity after Black Monday. Worse still, he also sent the monetary gendarmes of the New York Fed out to demand that Wall Street houses trade with parties they knew to be insolvent and to prop up stock prices and other financial valuations that were wholly unwarranted by the fundamentals.

Greenspan went on to make a career of countermanding market forces and destroying the process of honest price discovery in the capital and money markets. Certainty, that’s what he did when he slashed interest rates in 1989-1990, and when he crushed the justified revolt of the bond vigilantes in 1994 with a renewed burst of money printing.

The same was true when he bailed out Long-Term capital and goosed the stock market in the fall of 1998—-a maneuver that generated the speculator dotcom bubble and subsequent collapse.

And then he applied the coup de grace to what remained of honest price discovery on Wall Street. During the 30 months after December 2000, he slashed interest rates from 6.25% to 1.0% in a relentless flood of liquidity. The latter, in turn, ignited the most insane housing market bubble the world had ever seen.

During the second quarter of 2003, for example, as rates were brought down to a previously unheard of 1.0%, the financial system generated mortgage financings at upwards of a $5 trillion annual rate. Even a few years earlier, a $1 trillion rate of mortgage financing had been on the high side.

Needless to say, housing prices and housing finance costs were systematically and radically distorted. The crash of 2008-2009 was but the inexorable outcome of Greenspan’s policy of financial asset price falsification—–a policy that his successor, Bubbles Ben, doubled down upon when the brown stuff hit the fan.

So as we sit on the cusp of the third Bubble Finance crash of this century, now comes Alan Greenspan to explain once again that he knows nothing about financial bubbles at all.  According to the unrepentant ex-Maestro, it’s all due to the irrationalities of “human nature”.

Why, central banks have nothing to do with it at all!

“The 2000 bubble collapsed. We barely could see a change in economic activity. On October 19, 1987, the Dow Jones went down 23% in one day. You will not find the slightest indication of that collapse of that bubble in the GDP number – or in industrial production or anything else.

 So I think that you have to basically decide what is causing what. I think the major issue in the financial models has got to be to capture the bubble effect. Bubbles are essentially part of the fact that human nature is not wholly rational. And you can see it in the data very clearly.”

No you can’t.  As the astute student of 30 years of Bubble Finance, Doug Noland, recently observed:

 Had the Greenspan Fed not backstopped the markets and flooded the system with liquidity post the ’87 Crash, Credit would have tightened and bursting Bubble effects would have been readily apparent throughout the data. Instead, late-eighties (“decade of greed”) excess ensured spectacular Bubbles in junk debt, M&A and coastal real estate. It’s been serial Bubbles ever since.

Noland is completely correct. During the early part of the Bubble Finance era, the main street economy was goosed time and again by cheap credit, which induced household and business spending from the proceeds of steadily higher leverage.

But now the households of Flyover America are stranded at Peak Debt. Yet the Fed keeps hammering their real incomes via its specious 2% inflation target and their savings by its lunatic adherence to ZIRP.

Accordingly, and as we have previously demonstrated, the massive liquidity emissions of the Fed and other central banks never get beyond the canyons of Wall Street—– where they fuel ever more incendiary financial excesses and ever more traumatic crashes.

Now comes another.

Source: http://davidstockmanscontracorner.com/the-apotheosis-of-bubble-finance-part-1/

Source: http://davidstockmanscontracorner.com/the-apotheosis-of-bubble-finance-the-once-and-future-faceplant-part-2/

Source: http://davidstockmanscontracorner.com/the-apotheosis-of-bubble-finance-august-2007-redux-part-3/

 

1 Comment

Comments are closed.