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By Todd Switzer

Todd Switzer writes for Tulips and Bears. Tulips and Bears-Stock market newsletter provides contrary investing opinion for thinking traders. Global stocks and markets are covered with stock, sector, and country timing picks from both the long and shortside. Tulips and Bears uses a proprietary method that combines technical analysis, investor psychology, and value investing to identify profitable investing opportunities. You may visit the Tulips and Bears web site at: http://www.tulipsandbears.com/

January 23, 1998

The de facto devaluation of the Brazilian Real should have come as no
surprise to observers of the recent ineffectiveness of IMF policy
implementation. Likewise, the resulting sharp sell off in the U.S.
stock market came as no surprise to participants who were looking for
any excuse to take profits after the market's 3-month 2000 plus point
rally. Similarly, students of market psychology were not surprised by
the sound of eternally bullish money managers producing such
soundbytes for the ratings hungry financial press as "We expect
the market to sell off for a few days in reaction to Brazil
before beginning a new move up, but ultimately Brazil will have little
effect on the U.S. The U.S. economy is strong and the consumer is
driving its growth." What may come as a surprise to many, however, is
that ultimately those who think Brazil will have little effect on the
U.S. economy are right. These analysts are right not in their
simplistic reasoning that "Brazil is a fundamental nonevent", but
rather they are right in the sense that in comparison to the other
problems facing the American economy, Brazil is a minor blip on the
radar screen.

Granted, a further deterioration of the situation in Brazil, or an
outright collapse, would have devastating effects on Latin American
economies and heavily exposed major U.S. money center banks. It would
also have a serious effect on economic growth in the U.S. The damage
that a Brazilian collapse poses are small, however, in comparison to
the underlying systematic damage that has already been done to the
U.S. economy by a combination of unsupervised thrill-seeking amateurs,
irresponsible policy makers, and shortsighted executives who have
unwittingly built the greatest economic pyramid scheme since the late
1920's.

The Fed's expansive monetary policy during the last 5 years, and the
resulting flow of dollars flooding into U.S. equity markets, have
driven equity markets above the high end of their historical valuation
range extremes . As the liquidity driven bull market has gathered
steam, the public, sensing a sure fire money maker, has stampeded into
its midst. The resulting inflows of individual investor's money have
served to drive the market ever higher. With each surge in equity
prices the individual has grown more confident that investing in the
stock market is the path to riches. Emboldened by the rise in their
portfolio values, the consumer has gone on a spending spree thus
pumping more money into the economy which ultimately finds its way back
to the stock market. The combination of an overly expansive monetary
policy, a rising stock market, and increased consumer spending have
created a self feeding economic boom that relies on one hand to feed
the other. It is the economic equivalent of a ponzi scheme, in which
each person who joins the party adds more cash to the game thus
creating the illusion of a growing, healthy economy. Like a pyramid
scheme, the "recession proof,new economy" relies on the entrance of new
participants to sustain its growth. This artificially created
expansion has instilled in the public a false sense that "this time it
is different", "recessions are a thing of the past".

With each 1000 point rise in the Dow, the ranks of individual investors
participating in the stock market have increased. In scenes
reminiscent of the height of stock market fever in mid 1990's Singapore
and Malaysia, shopkeepers and hairdressers now bark out orders to their
brokers from cell phones. "Playing" the stock market has replaced
baseball as the public's sport of choice. Internet based stock picking
contests have helped create a carnival atmosphere about the market.
The contest winners boast of their stock picking prowess in the 1990's
equivalents of the 1920's speakeasy: the chat rooms and message boards
of Silicon Investor and Yahoo Finance. The confidence of the individual
has grown with each upward leap in asset values. Every doorman and cab
driver in New York is now an expert stock picker. Fundamentals and
lessons from the past no longer matter to this new breed of investor
who believes that 20% annual gains are a given and an internet stock is
the ticket to wealth.

Analysts, market gurus, and newsletter writers have also become
believers. The percentage of advisors who are bullish is at its highest
since January 1992 (Just before the last biotech bubble burst).
Analysts have tossed aside the valuation measures of the past. A new
type of analysis has been invented to fit the new economy. Actual
earnings are no longer a concern. Celebrity analysts recommend
stocks with market caps of $12 billion and sales of $45 million as
screaming buys to their legion of followers who dutifully bid the price
up. Internet gurus, knowing a good long term investment when they see
one, recommend stocks like Broadcast.Com because it is now a value at
$150 (never mind that in the 2 prior days it had risen from the mid
80's to $270 before falling back, or that it has no earnings). Money
managers are heard to exclaim, "The type of excitement that we saw in
the internet stocks in December has spilled over to the rest of the
market. This is bullish for the market." Yes, excitement is the order
of the day.We're told that a new technological revolution is at hand
that demands new valuation measures. We're told that market history no
longer matters. Unfortunately, we've seen this saga played out many
times before. It's called a bubble, and history does repeat in the
stock market.

In a bubble, it is the individual investor who is the last to arrive and
the last to leave. Sadly, the individual investor's inexperience
with past market history and the flip side of a bull market often leaves
him unprepared for the inevitable end of the bubble and the market's
return to historical valuation norms. In previous market bubbles the
psychology of the individual investor has mirrored that displayed by
today's chat room cowboy. The current gung ho, "I've found the secret
to market riches" attitude exhibited by many inexperienced investors is
similar to that shown by many beginning futures traders who start out
their trading career with a string of wins and think, "This is easy. I'm
guaranteed 40% returns." Unfortunately these are the same individuals
who dominate the ranks of the 80% of traders who leave the futures
trading field by the end of their first year. Just as overconfidence
and excitement are an anathema to a long term career as a futures
trader, they are the fatal flaws of an individual investor at a market
top. With nearly 40% of U.S. households invested in the stock market,
and with a large percentage of them exhibiting excessive enthusiasm and
believing that 20% returns are the norm, the outlook is anything but
rosy when the current bubble bursts and reality sets in.

The belief that this time it's different has been played out during each
previous market bubble. The discarding of past valuation models in
favor of new models that are developed to accommodate the excessive
valuation levels of a new high growth industry is nothing new. The
1920's radio stock craze, the late 1960's computer industry bubble, the
early 1980's PC bubble, and the biotech stock bubble were all
accompanied by a belief that a breakthrough technology justified
new valuation methods. The belief that a new technology would change
the world is not unique to the internet, neither are the valuation
excesses and the justifications given for them, or the buying frenzies
to get in on the next sure thing. The fate of investor's who jumped on
an internet bandwagon that has already reached manic levels while
disregarding history will not be unique either.

A sudden bursting of today's stock market bubble would have disastrous
consequences for the U.S. economy. The underlying economy continues to
weaken, with pricing power nonexistent, over capacity rampant, labor
costs rising, and corporate operating earnings in decline. The
economy, which has relied on consumer spending to generate growth and
create the illusion of a healthy economy, would be thrown into a
tailspin if the consumer were suddenly forced to cut back (or if the
consumer were forced to stop spending more than he makes). With the
S&P500 trading 50% above historical norms, any break in the illusion of
endless economic growth could be disastrous for the heavily invested
investor on Main Street. If the U.S. hopes to avoid the fate of 1990's
Japan (or of a similar technology driven bubble era: the 1920's), steps
must be taken now to ensure that the air is let out of the bubble
slowly.

An effort must be made to take some of the froth out of the market. We
commend the efforts recently taken by Merrill Lynch and several other
brokerage firms to rein in their customers' internet feeding frenzy,
but much more needs to be done. Many market gurus, members of the
financial press, newsletter writers, and (dare we say) internet stock
analysts need to pick up a book on market history before continuing to
advise their faithful followers to make the same mistakes that have
doomed others during past market bubbles.

Perhaps the biggest effort of all must come from the Federal Reserve.
The Fed must not wait until after the fact to address a problem, as it
did when it cut rates in late 1998. The dangerous over use of
derivatives and inadequate risk management practices employed by many
firms were widely known and ignored for several years before the Fed
acted when ultimately faced with disaster. The Greenspan Fed has
helped to inflate the bubble, and it must take steps now to slowly let
the air out of it before it explodes. Merely voicing concern over the
extended valuations of the market is not enough to stop the bubble from
expanding. The public's feeding frenzy (not to mention its ingrained
belief in eternal 20% annual gains) has reached a level where words
of warning are no longer heard over the voices saying, "It's a sure
thing. Valuations don't matter. No price is too high." The Fed must act
now by either raising margin requirements or bumping up interest rates a
1/4% point. Acting now would produce an initial sharp correction, but
it would ensure the future health of the market. If the Fed fails to
act the U.S will be doomed to repeat history, in this case the history
of 1990's Japan.

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