US Stock Market Bubble and Foreign Issuers
Case Study (Continued)
The Role of Foreign Issuers, Institutional Failure
No Sudden Institutional Failure
The bursting of the US stock market bubble in 2000, unlike 1929, was not triggered by sudden institutional failure (e.g., bank closures due to inappropriate lending practices) but rather by slow, gradual, and (to the general public) obscure shifts in the behavior of key groups of market participants.
The destruction of the World Trade Center and the collapse of Enron and subsequent financial scandals were still over a year away. William Jefferson Clinton, who had presided over the Great Bubble, was still president of the United States. Stock prices had started a precipitous drop in the summer of 2000, well before the presidential election.
At the peak of the Great Bubble, the news suggested that these were the best of times.
Unemployment was at 4%, the lowest rate in thirty years.
There were triggering events, but these related to unnoticed shifts in behavior of players, unheralded in the financial press.
In the first quarter of 2000, there were certain anomalies in flow-of-funds statistics on corporate equities:
- There was a drop in stock investment by managers of pension funds of state and local government employees;
- There was an increase in public offerings by foreign corporations; and
- Foreign portfolios were buying heavily into U.S. equities.
The significance of this information was not obvious.
Price Was The Trigger
Taking the long, historical view, it would have be reasonable to expect that when the S&P 500 index reached twenty-times earnings, that issuers would start taking advantage of low capital costs and would flood the market with new issues, driving down prices.
This point was reached in 1996, when Chairman Greenspan made his now-famous 'irrational exuberance' statement.
Despite low capital costs, employee-managers had incentives to continue playing the buyback-options game
However, company managers were being rewarded for short-term increases in stock prices, not for the long-term financial strength of their corporations.
Hired managers had enormous incentives to disregard low capital costs and continue to play the buyback-options game, enriching themselves at the expense of unsophisticated, long-term shareholders in tax-deferred mutual funds, while the SEC looked away.
If corporate executives, mutual fund managers, and investors in 401(k) plans were the only players in the game, the Great Bubble might have gone on indefinitely.
However, there were other issuers in the market that understood the capital-cost implications of price-earnings ratios beyond twenty, and who regarded the high price of equities as an incentive to issue stock.
They did so in amounts that eventually neutralized the upward pressure on stock prices exerted by domestic buybacks and mutual fund purchases.
The Role of Foreign Issuers
The U.S. stock market is not a closed system.
Foreign corporations can use the market to raise funds for investment abroad.
Although the legal costs and inconvenience of SEC regulations often discourage foreign issuers from raising money in the U.S. market, these barriers fade in importance when price-earnings ratios began to exceed twenty times earnings.
Foreign stock issues exceeded domestic buybacks in 1999, giving the first clear signal of the coming crash
Corporations in the rest of the world are more likely to be controlled by owner-managers that have different motivation from the hired executives that run most publicly-held U.S. companies.
These foreign owner-managers, like U.S. managers a half-century earlier, understood the wisdom of taking advantage of low capital costs.
They rushed to sell shares into the U.S. market.
In 1999, stock issues by foreign corporations exceeded net buybacks by domestic companies, giving the first clear signal that a market reversal was in the offing.
Over the three years 1999-2001, net new issues by foreign corporations exceeded net buybacks by U.S. companies by $54 billion.
The Race To Exercise Options
In the year 2000, individual investors sold an astounding $474 billion in equities. This was more than double average net sales of stocks by investors over the previous five years. It was, by far, an all time record.
Since the S&P 500 index started downwards in mid-2000, from the Motivation Axiom we may conclude that stock sales by individuals was the driving force.
Furthermore, although flow of funds accounts do not provide the breakdown, a reasonable conclusion would be that a large portion of individual stock sales was related to the exercise of stock options — the natural offset to the multi-billion dollar stock repurchases by domestic corporations.
Stock option/buyback arrangements are essentially government-approved market manipulation, insider trading schemes on a massive scale
Although there are many variations on stock option plans, a typical plan gives an executive the right to buy stocks from the company at at fixed price and to resell these stock within the next ten years, at a time of his or her choosing. There often is a three year waiting period before options may be exercised.
Executives have an incentive to accumulate options over a number of years and to sell them when it appears the market has reached a peak.
This arrangement amounts to government-approved market manipulation and insider trading on a massive scale.
Executives control the timing of stock buybacks and have privileged information regarding the current intrinsic value of company stock. Executives can use this information to time the exercising of their stock options.
Unofficial estimates from staff of the Bureau of Economic Analysis suggest that the exercise of employee stock options increased ten-fold between 1990 and 2000, accelerating after Chairman Greenspan's remarks about 'irrational exuberance' in 1996.
Stock buybacks by domestic corporations reached a peak in 1999. Problems in the economy were already noticed in the summer of 2000 — harbingers of the recession of 2001-2002. The S&P 500 index had peaked at over thirty times earnings, well beyond any logical measure of intrinsic value. Corporate insiders had reason to fear that company profits would decline in 2001, which, in fact, occurred.
The sudden increase in sales by individuals, mainly exercising stock options, crashed the market in 2000
All this added up to an enormous incentive for executives to exercise stock options at the peak of the market. The natural result of this extreme volume of sales was that prices fell and the bubble burst.
Despite the impression that Americans received from the financial press, the 1990s were not a time of wild stock buying by individuals or new issues by corporations. In fact, the opposite was true.
Corporations were buying back their own stock in huge quantities, while individuals, on balance, were selling stocks, with about two-thirds of the proceeds being directed towards money market funds, corporate bonds, and deposit accounts (See household flow analysis).
It was the sudden increase in net sales by individuals, mainly exercising stock options, at a time when buybacks by domestic companies were neutralized by new issues by foreign corporations, that popped the Great Bubble and crashed the stock market in 2000.
