David Stockman, Budget Director under President Reagan, then a partner at private-equity firm Blackstone Group, and now bestselling author, graciously gave me permission to post the today particularly relevant Chapter 23 of his book, THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.
[A]s the Fed transformed Wall Street into a casino, the mechanisms and arrangements for insider speculation took on massive size. In 1990, hedge fund footings amounted to about $150 billion; by the turn of the century, they had reached $1 trillion; and by the 2007–2008 peak, they had soared to $3.0 trillion.The scale of hedge fund operations thus grew by twenty times in as many years. At the same time, the trading books of the Wall Street banks grew even more explosively, expanding by thirty times during this period to approximately $3 trillion. Together that formed the inner arena of speculative finance, the fast money complex.
Moreover, the highest-value information inside this mushrooming fast money complex was not about the corporate issuers of the securities being traded; it was about the bets being made by other traders. Likewise, the most valuable corporate information was about tradable news events: quarterly financial results and financial engineering moves, not fundamental business trends and strategies which actually drive long-term value.
Needless to say, the last thing hedge funds do is hedge, an economic service that might actually contribute some value added in a capitalist economy. What hedge funds actually do is churn, chase, pump, and dump. They play wagering games which extract economic rents but contribute little if any value added to the Main Street economy.
Wall Street is the link between financial engineering in the corporate sector and the wagering games of the hedge fund complex. Wall Street originates financial engineering transactions in its investment banking departments; it then lubricates the hedge fund complex with information and trading services out of its prime brokerage operations. What washes from one side of the Street to the other is the high-powered trading tips and gossip out of which momentum surges arise.
Thus Wall Street investment bankers advise corporate boards about the size and timing of stock buybacks. Educated guesses leak out. Significant corporate M&A transactions are only undertaken with the good- housekeeping seal of a Wall Street “league table” advisor. More hints leak out.
Leveraged buyouts are even more Wall Street centered because they encompass multiple sets of M&A advisors and also activate the vast machinery needed to underwrite and syndicate junk bonds and leveraged loan facilities. The deal process for LBOs leaks like a sieve, even before the required SEC filings are made.
Needless to say, the market-moving information which pours in from all of these sources excites small waves of buying or selling, as the case may be, among insiders in the fast money trading complex. These wavelets periodically attract reinforcements, thereby imparting momentum and more replication of the original trades.
At length, full-powered momentum trades become energized, and money piles on from the four corners of the hedge fund universe, along with that of momentum-chasing mutual fund managers, retail punters, and computerized trading algorithms. In this manner, new rips are continuously mounted and sudden wrecks are quickly abandoned.
The Chase and Crash at Crocs and Garmin
While many of the rips are so silly as to pass for financial humor, they do dramatize the extent to which the capital markets have been deformed. Left to its own devices, the free market would never deliver up the endless series of fad stocks and sectors which have flourished under the Fed’s prosperity management régime. During 2006–2007, for example, one of the more preposterous shooting stars was Crocs, a maker of brightly colored blow-molded plastic shoes that were a cross between ugly and impractical.
Nevertheless, in response to an initial fad-driven sales boom, Crocs’ stock price soared from $14 to $70 per share in only twelve months. At its peak, the stock sported a PE multiple of 40X, implying that the nation’s closets would soon be jam-packed with polypropylene.
As it happened, however, Crocs’ stock deflated back to $2 per share when the accounting illusion behind its spectacular growth became too evident to ignore. The culprit was its ballooning figures for accounts receivable and inventory, which rapidly became uglier than its shoes.
These ballooning balance sheet ratios had been reported every quarter. But only belatedly did the momentum chasers recognize their obvious meaning; namely, that Crocs had continued to produce and to ship massive volumes of inventory long after its podiatric clunkers went cold with the kids.
Since it couldn’t dispose of its towering two hundred days of inventory or collect cash from the trade “stuffed” with all this unwanted product, it was only a matter of time before the jig was up. By the same token, there was never a time when Crocs was prosecuted for fraud, and for the good reason that there wasn’t any.
In fact, the evidence that Crocs was a flash in the pan was contained in the company’s SEC reports all along, but was resolutely ignored by the stock market punters. The data they cared about could not be found in 10Ks and 10Qs anyway; it consisted exclusively of stock price momentum indicators such as twenty-, fifty- or hundred-day moving averages, and numerous like and similar charting benchmarks embedded in the stock market’s entrails.
Needless to say, Crocs was no outlier. There were hundreds of crocks just like it. During the two years prior to its October 2007 peak, for example, Garmin had been even more of a rocket ship. Its stock price had risen from $20 to $120 per share, only to crash back down to $20 a few months later. While its innovative portable GPS device for autos was actually a viable product, Garmin’s peak EPS multiple of 40X was no more plausible than that for Crocs.
Even as the momentum traders heralded its 100 percent sales growth in the year ending December 2007, it was plainly evident that the auto companies were scrambling to install navigation systems as original equipment and that demand for Garmin’s portable “aftermarket” product would dry up rapidly. In the event, its sales growth rate fell to 20 percent by June 2008 and turned negative by year end.
The fact that Garmin’s sales today are actually 40 percent lower than their 2007 peak level was predictable at the time, since the new model cars carrying their own navigation systems were already in the well-advertised automotive pipeline. As the second Greenspan bubble approached its peak, therefore, it is evident that the stock market was not discounting future corporate sales, earnings, or much of anything else except the expectation of more juice from the Eccles Building.
By the time of the 2008 bubble peak, the great financial deformation reduced the stock market to a momentum-driven gambling hall. Indeed, the senseless overvaluation that punters affixed to the likes of Crocs and Garmin was cut from the same cloth as the implausibly high valuations which had been assigned to the home builders, the mortgage brokers, Fannie and Freddie, and the Wall Street investment banks themselves.
Yet as hundreds of other highflyers like the solar energy stocks, the teen retailers, and the casino stocks took their turn in this malignant pattern of chase and crash, apologists for the status quo always had the same answer. On the occasion of these crashes they advised onlookers to move along, insisting there was nothing to see except some minor breakage attendant to animal spirits that occasionally get too rambunctious. By David Stockman, author of THE GREAT DEFORMATION: THE CORRUPTION OF CAPITALISM IN AMERICA.
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