0 1,000 2,000 3,000 4,000 5,000
1 4 7 10 13 16 19 22 25 28 31 34 37 40 0 2,000 4,000 6,000 8,000 10,000 12,000
Nasdaq Composite
Dow Industrials
Months Since Market Peak
Nasdaq Dow
162 Crash Profits: Make Money When Stocks SinkandSoar
Dulles turned back to Tamara and declared, “You’re an econo- mist and stock analyst. I’m a CPA. We both know that valueis what the market is ultimately all about. Plus, I’m also a psychologist by training. So I know that perception of value is equally important.
Have you taken that into consideration?”
“Yes. The Dow is now trading at 20 times earnings.”
“Isn’t that reasonable?”
Linda, remembering the 20 times earnings she had originally paid for UCBS, was about to shake her head, but she kept still.
“It depends,” said Tamara. “In great bear markets like this one, the Dow can plunge to an average of six or seven times earnings before it bottoms. That alone implies that the Dow could fall to the 2,500 level. And that’s assuming corporate earnings don’t decline any further. Yet, earnings of the Dow 30 companies aredeclining.”
“Where’s the bottom in earnings?”
Tamara’s thoughts flashed back to the bottom-fishing analysts she used to debate at Harris. “In either of my scenarios, I’m sure all of Wall Street would be asking the very same question. The fact is, there is no foolproof bottom in earnings. Even zero earnings is not a foolproof bottom. Take a look at what happened among the Nas- daq stocks!”
Tamara went back to the folders again and pulled out a chart entitled “Nasdaq Earnings Wipeout.” She showed it briefly to Linda, who nodded thankfully, and then she passed it over into Dulles’s hands. [See Figure 13.2.]
“I see, but what is that portraying?” Dulles replied.
“Point A is showing nearly seven years of accumulated profits at 4,200 Nasdaq companies—$160 billion in all. Point B is show- ing that they were completely wiped out in just 15 short months.
I’m not talking about an average, nor am I talking about just one year of profits. I’m talking about every single penny of profit that was made by every single Nasdaq company during that entire period.”
“Wait a minute,” said Dulles. “Let me see if I understand you correctly. Let’s say all these companies had socked away all their profits in one global bank account during all those years. And let’s say they never spent a penny of it. How much would they have in that account?”
“Like I said, $160 billion.”
TE AM FL Y
Team-Fly®
Hidden Risks 163
“And now you’re saying all that money was wiped out with losses?”
“Poof! Obliterated off the face of the earth! Every single penny.”
“You’re not saying this could happen to Dow stocks, are you?”
“No, but let’s consider some other factors.” Tamara picked up her Dow chart, pointing to the line labeled “Dow Today.” “What you don’t see in this chart,” she declared, “is all the things going on behind these lines, in other, related markets—like corporate bonds, for example.”
“Please explain.”
“I have the data here from Moody’s Investors Service. They say the creditworthiness of American companies is so poor that it has dropped for 18 quarters in a row. That’s four and a half yearsof sink- ing balance sheets! That means their assets are sinking, their debts are surging. And a lot of these are blue chips, Dow companies! It’s
Nasdaq Earnings Wipeout
$0
$20
$40
$60
$80
$100
$120
$140
$160
$180 (Billions)
A
B
1994 1995 1996 1997 1998 1999 2000
Figure 13.2 Nearly seven years of profits gone! Between April 1, 1994 and June 31, 2000 (point A in the chart), all of the companies listed on the Nasdaq earned a total of $159.8 billion. However, in just 15 months, between July 1, 2000 and September 31, 2001, the Nasdaq companies lost $161 billion. These losses wiped out every single penny of profits they had made in the previous seven years combined. This wipeout was due primarily to (1) accounting adjustments to correct exagger- ated earnings, (2) declining sales, and (3) deflation—declining prices for their products.
164 Crash Profits: Make Money When Stocks SinkandSoar
telling you that many of the blue chips may also be a bubble wait- ing to burst!”
“Is it really that bad?” Dulles wondered out loud.
“Look. Right here it is in black and white! In the most recent quarter, Moody’s downgraded 124 companies and upgraded just 35. That means they’ve downgraded nearly four companies for every one they’ve upgraded.”
“Junk companies or investment grade companies?”
“Both! Here’s how it’s panning out: Among the stronger com- panies, it’s going to get a lot more expensive—and a lot tougher—to raise the money they need to expand or even to stay where they are. Among the weaker companies, these repeated credit down- grades will make it nearly impossibleto borrow money, potentially threatening their very survival. When they go under, that’s when profits and stock prices really spiral downward.”
“Some people say the rating agencies are too harsh on the com- panies. What do you think?”
“Not sure. Maybe they’re just playing catch-up with past prob- lems that they previously overlooked. And in some cases, such as Enron, I happen to know they were clearly too soft. Overall, I’d have to say that the actual deterioration in balance sheets could be worsethan the ratings alone might imply.”
“Why do you say that?”
“Because companies are up to their eyeballs in debt. Because some can’t even pay current bills. Because corporate debt now totals $4.9 trillion, or 57.1 percent of corporate net worth—more than half of shareholder wealth in hock! Because of the steady drumbeat of blue-chip companies marching into bankruptcy court—Enron . . . WorldCom . . . Adelphia . . . US Airways . . . Glo- bal Crossing. But it’s not over.”
Tamara paused to glance up; then she looked back down at her materials. “Even back in 1974,” Tamara continued, “just prior to the worst recession and deepest bear market of the second half of twentieth century, the burden of private debt in this country was far, far less severe than it is now. Back then, for each dollar of GDP, there was lessthan $1 in private debts. Now, it’s close to $2.00. No wonder companies are going broke left and right! No wonder so many companies are laying workers off like crazy! No wonder peo- ple are filing for personal bankruptcy!”
Hidden Risks 165
“OK. Now I see what’s behind your Dow forecast,” Dulles said, nodding repeatedly.
But Tamara shook her head. “You keep forgetting something.”
“What’s that?”
“You never asked me for a forecast—you asked me for a worst- case scenario.”
“Sorry.” He paused, then added, “I may need to present this to some important people. If there were just one wordthat could sum up the short-but-ugly scenario, what would that word be?”
“ ‘Deflation!’ ” she shot back without a moment’s hesitation.
“But excuse me for a moment. I have to return a phone call.”
W
hile Dulles waited, he re- called an old comedy routine from decades ago.A fellow on a 1930s breadline asks his neighbor: “Which do you prefer? Inflation or deflation?” The second man responds:
“Just give me flation. Plain, unvarnished flation.”
Unfortunately, however, the public’s longing for price stability—
neither inflation nor deflation—was not satisfied in most economies of the world throughout history.
In the second half of the twentieth century, inflation was nearly everywhere. There was wage-push inflation, demand-pull infla- tion, and inflation-driven inflation. There was creeping inflation, galloping inflation, runaway inflation, and hyperinflation.
Then, as the century ended and a new one began, for the first time in more than 60 years, an old but powerful force reared its head and began to pound key regions or sectors of the world econ- omy. It was deflation—falling prices, the opposite of inflation. Ironi- cally, however, it was largely ignored. Most people were too deeply engrossed in their daily battles to sense the winds of change.
Commodity deflation had been around for a long time. But consumer price deflation, the kind that average people feel directly
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