Market Meltdown – I Warned in 2002

I ran across one of my Market Updates from May, 2002 this morning, and it struck me how easy it was to see the future. I even warned about the trillions of dollars of derivatives being purchased by the banks.

The depressing thing about this is that I worry that my current predictions of America’s future might come true as well. While I still think that American technology, capital and freedom will keep our nation solid, I fear that we are moving rapidly to a high-debt, socialistic state that will decrease the standard of living for us all. We will still have great lives, but it will become harder and harder for our children and grandchildren to keep this balloon afloat.

Blame for the mortgage meltdown can be spread everywhere, to conservatives to liberals to greedy capitalists and toothless regulators. Obama, individually, had little to do with the problem. The biggest blame must go to Wall Street for excessive greed, to Congress on both sides of the aisle, to fraud at Fannie Mae, to Alan Greenspan for fueling the fire, to George Bush for not crying loud enough and to Bill Clinton for trying to end “corporate greed” (by eliminating the tax deduction for salaries over $1 million, which triggered the big wave of stock options and a short term business focus.).

I have tried to go easy on our new administration. Lord knows, George Bush disappointed most of us, on both sides of the political aisle. Mr. Obama was elected and he deserves the opportunity to attempt to implement his agenda. However, I am continually amazed at how flat-out naive he can be. Whether it is arrogance, ignorance, or poll-driven politics, Obama is walking us down dangerous paths that even the intrepid should fear to tread. Iran may go unchecked until they nuke someone, hopefully not New York. Our national debt will rise to a point where we’ll be crippled by debt payments. Business will suffer because capital is being taxed away from the people that create jobs.

I understand that this is all being done with the objective of “fairness.” That still doesn’t change the fact that these policies come with a very steep price that most of us do not understand, especially politicians.

I will attempt to keep my criticism of Washington to a minimum, while I pick at the edges of social trends. I do believe in the U.S. Constitution and the right of the victor to get his/her chance to implement legislation. Our nation was founded on the belief that conflict is healthy and necessary to govern in a way that is best for all. While I celebrate Obama’s ascension to the political throne, I also celebrate my liberty to assert my contrary opinions.
Here is what I wrote:

Market Update – May 10, 2002

Big Asset Class Disparity

Here is what I see happening in the financial marketplace.

Some of you may have received my market analysis on January 26, 2000 that warned of the coming collapse of the tech stocks. Those of you fortunate enough to listen to me allocated a good portion of your growth assets to the small value sector. During the past two years, the small value sector is up more than 35%, while the growth sector is down more than 20%.

I see the same huge market disparity today as I did back then. The market sector where I see the greatest opportunity is in Emerging Markets. Traditionally, emerging market stocks act like a yo-yo. They can be up or down 50% or more in any give year. Emerging market stocks represent one of the highest risk categories of stock investments, and potentially the one of the highest returns as well.

I believe that a portfolio should always be well diversified across many asset classes. Yet, sometimes it makes sense to do a little strategic tinkering with the overall mix. That time is now. Let me explain.

Of 192 emerging market funds I analyzed, the average Price to Earnings Ratio was 18.6. (The average share is trading at 18 times earnings per share.) The average U.S. growth mutual fund (of 3,345 analyzed) holds stocks that are selling at an average of 31.9 times earnings. The expectation inherent in a P/E ratio is that stocks with a high P/E ratio are expected to grow more rapidly than those with a lower P/E. Stocks with a high P/E can also fall farther and more rapidly than lower P/E shares if earnings growth slows.

The Price to Book ratio for emerging shares is a much more conservative 3.2 versus 4.9 for U.S. growth stocks. May we be so bold as to see emerging market stocks as value shares? They are priced that way.

Now let’s look at trailing earnings growth. The earnings growth of our emerging company shares have grown at an average of 28.9% (through April 30, 2002) for the past three years. Our U.S. counterpart shares have earnings growth of just 14.9%. Get the picture? Emerging shares have twice the earnings growth, and are selling at half the P/E. This is a highly unusual disparity.

For those investors with a long-term perspective, who don’t mind taking some risk, emerging markets might represent a huge buying opportunity. Would I place a big, big bet here? No. I don’t recommend big bets in any asset class. However, for investors with excess assets over and above their needs, a 10% to 15% holding of emerging market funds might pay off handsomely.
I must warn you that investment returns are not guaranteed and all stock investments involve risk—so invest with care.


Those of you who know me know that I am bullish on America, and bullish on the long-term prospects of the U.S stock market. I expect that the S & P 500 will average slightly below normal for the next decade, but not as anemic as the 1970s. Moreover, I think investment managers who do the bottoms-up research will outperform the averages.

I don’t want to alarm anyone, however, but if you have an investment horizon of less than 10 years, you ought to take heed of these next few paragraphs. Even if you have a long-term investment horizon, you should at least be aware of the potential risks during the next few years.

The world economy walks on a financial razor’s edge. U.S. corporate debt is now in excess of $5 trillion. Company debt has been growing at a much faster rate than our Gross Domestic Product (GDP). This kind of leverage can magnify risk and return.

Companies like Nextel, PSINet, Xerox and 7-Eleven have incurred huge amounts of debt, particularly when measured against their cash positions. A number of such companies will fail during the next few years.

The recent stock market downturn has erased a huge portion Americans’ life savings, perhaps by as much as half. At the same time, consumers have been refinancing their homes at a record pace (due to the dramatic fall in interest rates) and have been spending this equity just as fast. This trend has kept the country from entering a significant recession, but it has dramatically eroded personal wealth. Not good.

A downturn in real estate prices, coupled with a leveling of interest rates will dramatically reduce consumer spending and could create a drag on economic growth.

The telecommunications industry is swimming in debt. Global Crossing defaulted on tens of billions of dollars of debt. This may be only the beginning. We may see company defaults exceed a hundred billion dollars. This too will keep the economy sluggish.

There is $400 billion in venture capital loans outstanding, and a big portion of that could be headed toward default.

Banks are holding huge amounts of hedge securities, or “derivatives.” Derivatives are volatile and can be quite risky. U.S. banks hold trillions of dollars in derivative securities that could turn south.

Japan, the world’s second largest economy, is now mired in debt. Japanese banks hold more than $1 trillion in debt, much of it non-performing. As a nation, Japan has wrung up national debt at a staggering rate. Until recently, the Japanese government has allowed its banks (by funding them) to continue operating, despite the fact that many of them are technically bankrupt. There are signs that Japan may stop this policy, something that will force Japanese banks to unload huge amounts of U.S. stocks and bonds.

China is an awakening financial giant. In the 1960s, 70s and 80s Japan flooded the U.S. market with cheap goods. Over time, Japanese quality improved to exceed that of equivalent American goods. This one-two punch was harmful to the American economy, as our domestic imports increased and our balance of payments deficit ballooned precipitately. The technology revolution put an end to Japanese dominance, since their culture of cooperation versus innovation could not cope with the new style of business. Not so with China.

The Chinese people are extraordinarily capitalistic. As the shackles of Communism are slowly removed, China will become a powerful economic rival to the U.S. Unburdened by concerns over pollution and human rights, China will continue to produce goods and services for a small fraction of the cost to their U.S. counterparts. Look for the Chinese stock market to fare well in the upcoming years. Then look for Chinese economy to give us a serious run for our money by the end of the next decade.

Finally, there is oil. There are no signs that the Middle East tensions will ease anytime soon. The war on terrorism will go on, as it should. This puts us over an economic barrel when it comes to oil. If OPEC decides to raise prices or drop the production of oil as a show of Arab solidarity, and this continues for months, this will cause a spike in prices and a dramatic slowdown in the economy.

The U.S. has the domestic oil reserves to be energy self-sufficient. Much of this can only be recovered at higher prices, and a lot of it is under protected lands in Alaska and the Gulf Coast. We need not worry about our long-term energy needs, but we should be aware that we are dangerously vulnerable to a sort-term oil crisis.


Now that you know the downside, let’s talk about the upside.

Productivity American companies continue to enjoy historically high productivity increases. While some experts disagree, I expect this trend to continue strongly for the foreseeable future, as technology advances continue to allow employees and businesses to operate more efficiently.


Because of our individualistic culture, our system of higher education, and our capitalistic economy, the U.S. continues to dominate world technology. The global marketplace is driven by technology. Twenty years ago it was possible for the Japanese to copy an American product, and then build it for less. Today, product cycles last just a few months. It is impossible to copy and reproduce. This gives America a strategic advantage that is virtually impossible to overcome. This translates into profits.

Within the next few years, hopefully, we will be driving SUVs that get 40 miles per gallon. New cars will be equipped with a new power system that utilizes fuel at twice the efficiency. This will help keep oil prices down, continuing the long-term trend of oil price growth that is significantly under the long-term rate of inflation.


There is a great pool of investment capital in this country—far more than any other. Money makes money. It always will. Money will continue to find its way to new, innovative business ideas that will drive our economy forward.

Social Structure

The European companies and governments have been giving workers more and more entitlements like guaranteed health care, shorter working hours, etc. This has put a drag on the ability for European businesses to compete in the world arena. European taxes have increased as well. This hampers the source of new investment capital for business growth. The same has occurred in Canada. This has allowed U.S. companies to maintain a competitive advantage over our competition, which will continue for the foreseeable future.

Medical Breakthroughs

Get ready for medical advances that will dramatically reduce the costs to society. Genetic technology will bring about cures for many diseases that will reduce human tragedy and bring about economic opportunity. People will live far longer. There will be economic costs brought about by our aging population, but the costs will be outweighed by benefits of medical advances. A cure for cancer would bring about an economic renaissance like nothing we have ever seen, and can barely imagine.

Speak Your Mind