Grow Up To 1,000% Richer In The Great Stock Panic Of 2002

Chapter 3

Why I Expect Dow 5000

Let's get one thing straight from the outset: This is not an unreasonable forecast. In fact, it represents a 55% decline from peak to trough.

The Nasdaq Composite, including the very cream of America's know-how and ingenuity, has already fallen by over 65% in just the first 21 months of the new millennium.

The Nikkei, representing nearly ALL of the big blue chips of Japan (the second largest economy in the world), has fallen by 75% from peak to trough.

In the mid-1970s, the Dow fell nearly in half, and in the 1929-31 debacle, by almost 90%.

These declines caused intense losses and serious pain. But they did not bring on the end of civilization or the destruction of the planet. The world continued; and despite the hardship, we went on to bigger and better days. The same is true today, even in the face of the new terrorist threats.

So I hope this dissolves any notion of incredulity, and puts my forecast in the proper context. I am not forecasting the end of the world as we know it � just a very severe and intense decline in the stock market and the world economy. It's happened before. And now, it will happen again.

Has the bear market
already begun?

Sounds like a simple question, doesn't it? But it's not.

Cover one eye and look strictly at the Dow Industrials. You'll see a bull market that still appears to be largely intact, and that is far closer to its all-time highs than its 1990s lows. (As I write this, it's still not far from its peak. But by the time you read this, it could be lower.)

Then, cover your other eye and look strictly at the new-economy Nasdaq companies.

You'll see one of the worst bear markets in history � the 65% plunge from its peaks, the massive $5 trillion in wealth destroyed, and a Spring rally that barely made a dent in those losses.

So, what's the reality? The apparently bullish image represented by the Dow? Or the obviously bearish picture portrayed by the Nasdaq?

To find the answer, just uncover both your eyes and let your brain merge the two images into one. If you do, here's what you will see ...

This chart, comprising the trends in both the Dow AND the Nasdaq, is evidence that the bear market is already well under way, and it's for real.

It's telling us that the rally of Spring 2001 is nothing more than a normal and temporary reaction to the decline.

A True Picture of the U.S. Stock Markets
(Dow Industrials and Nasdaq Composite Combined)
(Index: Level at beginning of 1998 set tp 100)

Moreover, it's clear that, even if the rally continues a while longer, it will still not change the major trend � down, down, down.

I see this decline unfolding in three phases:

Phase 1 struck down the tech stocks and is now mostly history. This is not to say that the tech stocks won't fall a lot further. They will.

But in Phase 2, the center stage will shift to a rout in the old economy stocks � giant manufacturing and service companies. In other words, the bear market will spread from tech to non-tech, from the Nasdaq to the Dow and the big blue chips in the S&P.

And as typically occurs in major bear markets, Phase 2 will bring the largest and broadest decline of all, driving down the Dow and the S&P; by 50% or more from current levels. This is the core of the Great Stock Panic. (Important note: Phase 2 had already begun BEFORE the September 11 attacks on New York and Washington.)

Phase 3 will bring the major economic impacts of the Great Stock Panic. This is when you will see the bulk of the decline in world economies ... the majority of weak debts going into default ... the preponderance of vulnerable banks, insurers, and brokers brought to their knees. And it's at the tail end of this phase that you'll also see the world's financial system brought to the brink of paralysis.

Indeed, at that point in the crisis, it will no longer be limited to a Great Stock Panic. It will have expanded in scope far beyond the stock market � to the economy, the bond markets, money markets, and derivatives markets. It will become a Great Money Panic.

Where are we now?

As I put the finishing touches on this book, it's mid-September 2001.

We are in the early part of Phase 2. That means that the bulk of the decline is yet to come, and it's still not too late to sell.

Quite the contrary, if you have a good mix of both tech and non-tech stocks in your portfolio, by selling now, you can still protect the bulk of your net worth.

If you're holding solid stocks, selling at a reasonable valuation (say, 15 times earnings or less) and boasting strong balance sheets, the decline ahead may be less than 50%.

If you're holding shaky stocks, selling at 20, 30, 50 times their earnings, and/or with weak balance sheets, the decline could be well over 50% � 70%, 80%, even 90%.

Either way, the time to sell is right now. You should sell whether the stock is still relatively near its recent peak, or making brand new lows. You should sell whether you bought the stock a long time ago when it was still very cheap ... or more recently, when the Wall Street hype machine was in overdrive.

Why Are Stocks Falling?

I've already told you about Reason #1 � probably the least understood reason of all. It is the great stock market scam I detailed in Chapter 1. Stop and think for a moment about how key aspects of the great scam impact stock prices ...

Earnings manipulations: If a company reports earnings of $2 per share and the stock is selling at $100, it appears to be selling for 50 times earnings, right? That's already darn high and requires a big extra measure of hype and hope regarding future earnings growth to justify owning its shares.

But now, let's say the company has been manipulating its earnings reports and was really earning no more than $1 per share. Suddenly, its stock isn't just selling for 50 times earnings; it's selling for 100 times earnings.

Moreover, this revelation will almost invariably come as a shock to investors, driving the shares into a tailspin. That's often why you've seen so many shares crash and burn, sometimes losing up to 50% of their value in a matter of hours!

Deceitful ratings: The inflated ratings drove investors to buy stocks en masse, driving prices into the stratosphere. Now, as the deceitful nature of the ratings is revealed � in Congress, by the SEC, by the NASD, and even the popular press � those same buyers will turn sellers, driving the stock prices back down.

In short, the great stock market scam contributed some of the primary ingredients of a great stock market bubble ... and now this bubble is being burst by one, very old but powerful force: the truth.

But there are other, equally powerful reasons the stock market is going to continue to fall ...

Reason #2. Corporate
Earnings are Plunging

Corporate earnings are the single most important force driving US stock values, the key that can make or break the entire US economy. And right now in August 2001, as I finalize this book, corporate profits are plunging!

Just a few months ago, in early 2001, analysts expected profits to rise 9% for the year. Then, before the terrorist attacks, they said profits would drop 8% for the year. Even the New York Times called this "a reversal that has stunned Wall Street." Now, due to the shock of the terrorist attacks, they are saying the profit decline will be close to 20%. And even that doesn't give you the real picture for three reasons:

First, it's just an average. The actual results for most individual companies is far worse. EMC � down 68%. Intel � down 75%. Advanced Micro Devices � down 92%!

Second, it doesn't include billions of dollars in losses relegated to so-called "special charges." These are the some of the adjustments companies are finally being forced to make to compensate for the earnings exaggerations and manipulations I told you about in Chapter 1. But so far, only a small minority of companies has recognized their past errors. And among these, many have only fessed up to a fraction of the exaggerations.

Ironically, the companies do not include these special charges and losses in their reports of operating earnings. Their excuse: They are just "one-time charges that do not reflect the actual operations of the company."

Oh really? Then why did they include these same factors to help bloat up operating earnings reported in previous years? Besides, who decides when a loss is a "one-time event" or a recurring item? The company, of course � the same company that manipulated its earnings consistently in previous years.

Bottom line: Most of those losses are going to appear again and again in future reports; and they're going to be bigger, not smaller. Moreover, these companies will soon discover a Lincolnian truth � although they were able to fool nearly all investors when the stock market was going up, they are not going to be able to fool more than a handful as the market falls.

Reason #3. Corporate
Investments are Plunging

Corporate investment is the turbo-engine that has been driving the US economy for a decade.

From 1991 through 2000, corporations had been investing more and more every single quarter, non-stop. Now look ...

This force is more powerful than government spending, even more important than consumer spending. And it's plunging.

It means that every corporation in the US � and the world � that has anything whatsoever to do with supplying equipment of any kind is losing sales at a rapid pace. It implies huge layoffs as these companies are forced to take drastic steps to cut costs. And it's a force that inevitably feeds on itself: The more a corporate customer cuts spending, the more the corporate supplier has to cut its spending, forcing its suppliers to make similar cuts ... and on down the business "food chain."

Reason #4. The Big Merger
Boom of the Late 1990s
Will Be the Great Merger
Bust of 2002

The other key aspect of the stock market bubble that's about to come unglued is the merger-mania of the 1990s.

Indeed, in the later half of the 1990s, behind Wall Street's fa�ade of glamour and glory, millions of unsuspecting investors were swept up in the wildest and most dangerous merger mania of all time.

In 1999 alone, 8,840 merger and acquisition deals were announced or completed in the US ... scooping together more than $1.3 trillion in assets ... bloating the bubble beyond belief and entrapping millions of investors.

What's ironic is that the most frenetic feeding frenzy took place in precisely those industries where shares were already grossly overpriced � telecommunications (249 deals involving $667 billion in assets) ... computer hardware and software (288 deals, $104 billion) ... Internet (51 deals, $26 billion) ... and financial services (359 deals, $106 billion).

Flurries of buying � by acquiring companies or investors � naturally drove up the shares of the target companies. But this buying was primarily based on greed for profits and lust for market share � not fundamental earnings or growth prospects. So it merely added more fluff and hype to an already hyped-up market. Some examples:

An inflated currency: The acquiring corporations often paid a large chunk of the purchase price with their own shares; and these shares replaced cash as the new "currency" of the merger-mania. Indeed, as recently as 1988, fewer than 2% of the large merger deals were paid for entirely in stock. In 2000, more than 18% of all mergers used stocks exclusively in the purchase; and virtually all mergers used stock shares as some portion of the package.

What's worse is that just before a merger, corporations did everything in their power to goose up the share values. You might think they'd try to accomplish this by doing good things for their company � like improving sales, boosting profit margins, cutting costs. No such luck! Instead, they launched high-pitched PR campaigns designed to attract investor interest. They made deals with Wall Street investment bankers to hype up their shares. Most important, they bought back their own shares on the market in quantities that no rational business plan would justify.

Here's how it worked: The company repurchased a big chunk of its own outstanding shares. This reduced the supply of shares on the market, boosting the price. Plus, it inflated the earnings per share, which some investors misinterpreted as an actual earnings increase.

Between the two � reduced supply and a deceptive rise in earnings per share � ecstatic investors bid the share prices upward. As long as the company had � or could borrow � enough money to continue financing these stock buybacks, it could continue to fuel the stock price rise. Like a Ponzi scheme, they made early investors rich by taking more money from other investors or lenders.

Was this legal? Yes. Was it prudent? Of course not. When companies bought back their own shares in a rising market, they were defying the most fundamental rule that any beginning investor knows � buy low, sell high.

Warren Buffett will tell you the same thing: A company should only buy back its stock when the shares are cheap and it has enough cash to pay for them. In the late 1990s, too many companies were inverting BOTH of these basic principles.
  • In 1999, AT&T; began spending $4 billion to buy back its shares, sending prices initially higher. It then proceeded to make a raft of acquisitions including TeleCommunications Inc. for $52 billion, MediaOne Group Inc. for $55 billion, plus another NINETEEN different companies.

  • First Union announced a 50-million-share stock buyback, pushing its stock high enough for the bank to afford to purchase JWGensis in a $110 million deal.

  • US corporations spent $174 billion on stock buybacks in 1999 and close to $250 billion in 2000, just as markets were peaking.
Gross overpayment: Armed with a "stronger currency" (their own overvalued shares), the acquiring company is ready to go after bigger targets, bid more aggressively, and "pay" a lot more than it would under normal market conditions.

In this way, the overvaluation of the acquiring company causes a similar � or even greater � overvaluation in the target company.

And, boy, do they overpay! Worse, instead of buying hard assets like real estate, machinery and equipment, they are gobbling up intangible assets � "goodwill," "customer lists" and "employee brainpower."

CNET paid a 50% premium for archrival Ziff-Davis by shelling out close to $11 per share � $3.68 more than Ziff-Davis' going price of $7.25. InfoSpace, a Web services provider, planned to buy Go2Net for $4.01 billion in stock � 43% more than its current share price. Symantec acquired Axent Technologies for $687 million, 67% more than the stock was worth.

Huge debts: Typically, the equity of the acquiring company is placed in hock by the billions in debt needed to make the acquisition. Result: Corporate debt was 33% of GDP in 1980 ... in 2000, it was more than 44%.

Conclusion: It's safe to say that the shares of merging or merged companies are among the most vulnerable in the world today.

Nevertheless, Wall Street's cheerleaders remain undaunted and unperturbed by the inevitability of hundreds of billions � perhaps even trillions � in losses that investors will suffer as a direct result of their misguided enthusiasm. They obviously have not studied history. If they had, they'd know the truth that more than half of all mergers turn into disasters for shareholders.

In 1994, Quaker Oats bought the trendy iced tea maker Snapple for $1.7 billion. Three years later, Quaker sold the company for $300 million, less than one-fifth the purchase price.

Bank One paid $7.9 billion to acquire credit card company First USA in 1997. But since then, problems at the credit card division caused Bank One to write off over $2 billion of the investment, sending the company's share price into a freefall.

Mattel bought interactive software Learning Company for $3.5 billion. Soon Mattel was drowning in red ink, hoping to salvage $500 million for the Learning Company, just one-seventh of its original investment.

If these were the exceptions, you might chalk them up to clumsy, blunder-prone managers or to some freak accident. But the data is both unambiguous and ominous:
  • Business Week and Mercer Management studied 150 major deals from 1990 to 1995. Half lost money for their shareholders.

  • KPMG, a privately-held leading worldwide accounting and consulting firm, looked at the 700 highest priced deals between 1996 and 1998. Result: Only 17% increased shareholder value.

  • Since 1998, even while the major market averages were showing a stellar performance, the deals have been put together on a wing and a prayer ... and are the riskiest ever!
Now, as corporate earnings falls, the merger bust will add another powerful force behind the Great Stock Panic.

Despite all this � the unraveling of the great stock market scam, plunging corporate earnings, plunging business investments, the danger of a merger bust, and the new uncertainties in the wake of the terrorist attacks, economists have yet to throw in the towel. They refuse to believe the economy is headed into a severe decline. Instead, they are hoping that one sector � consumers � will save the day.

They're whistling in the dark, as you'll see in the next chapter ...

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