How I Called the NASDAQ Jude Wanniski April 19, 2000

Once I sent out my client brief last Friday after the stock market had closed with a crash, my wife Patricia and I went out and celebrated, despite the fact that our net worth had declined during the day by more than I had made as president of Polyconomics during the last three years. It was an odd feeling -- the pleasure of being right in my profession trumping the pain of financial loss. It might have seemed a reckless gamble to assure you that it was safe to jump into the market on Monday. There are those on my staff who might have believed I was gambling the company on one roll of the dice. All the other elements I had considered and discarded as the reason for the carnage on the NASDAQ in general and the dot.coms in particular left only tax-selling. If the market had not collapsed on Friday -- the last realistic day to sell in order to have funds for the IRS by Monday midnight -- I would have had to admit I was wrong. With the selloff, I had a pat hand, as I learned in the four years (1961-65) I lived in Las Vegas as a young card-playing newspaperman. The reason I write this as a client letter is my belief it will help all of you deal with the New Economy/Old Economy tensions that will exist well into the future.

The most important element in the call was my basic assumption that there is no such thing as a financial “bubble.” It was that assumption that led me to my 1977 discovery of the cause of the Crash of 1929, as well as the Crash of 1987, Japan’s Nikkei crash of 1990-91, and the Asian crisis of 1997-98. I’d been persuaded by Art Laffer that the market is rational and efficient in assessing risks and opportunities, based on the information available to it. If this were not true, the market could not set prices on goods and services through the law of supply and demand, nor on the underlying shares of corporations producing them. Capital could not be allocated effectively by the market, which would mean that market capitalism could not compete against wise men who could do it more effectively in government planning boards. It was the belief that the 1929 Crash was such a “bubble” that led to the New Deal government planners and the end of experiments in market socialism in the USSR.

Bubble theories are not only the province of communists or socialists or liberals in general. Milton Friedman believes in financial bubbles, as does Alan (“irrational exuberance”) Greenspan. This is because their economic models of the way the world works are fundamentally flawed -- and thus cannot effectively forecast market behavior. Once they set the assumptions that underpin their demand theories -- whether Keynesian or monetarist -- the logic that flows from them should lead to ballpark forecasts that turn out to at least get the direction right, up or down. When their forecasts are wrong more often than right, they must assure the students in the economic schools they lead that they would have been right if not for the irrationality of the market. “Bubbles” close the logical loops. Our forecasts at Polyconomics have not always been directionally right, but when they are off, we re-examine our assumptions and look for information that had been available to the market that we had overlooked. We have amended our analytical model many times in minor ways during these 22 years and in 1989 amended it in a major way, appending the risk model developed by Reuven Brenner of McGill University in Montreal. Because the world changes constantly in ways never previously experienced, there can be no constant template. As Aristotle observed 2500 years ago, there is one constant, which is the superior wisdom of the organic mass of people to that of the individuals who comprise it. In financial markets or political markets, there is a regression to the mean. In other words, the opinion of every individual who is in the market or thinking of getting out or getting in is of importance, as illogical or as irrational as they may seem to others. When they are added up and netted out, though, they come close to perfection in setting the direction of the market’s total capitalization.

The metaphor I personally use is a tug of war, with 20 men on one side pulling as bears and 20 men on the other side, pulling as bulls. As an observer trying to get it right for you, my clients, I have to listen to all the opinions of which man on which side is pulling his weight or slacking off. That’s because when you see the line move in one direction or another, it is not obvious which “reason” has caused the movement. In the several weeks that encompassed the NASDAQ’s sell off, the most popular reasons given were that (1) the dot.coms were overpriced because investors were irrational, (2) the Microsoft antitrust problem was a threat to the high-tech industry, and (3) the Federal Reserve would raise interest rates again and again until it weakened the economy, dragging the Internet stocks with them. I rejected the Microsoft argument out of hand because it had not been clear to me whether it is bullish or bearish for the future of the New Economy to have Microsoft’s wings clipped. The Fed argument makes more sense because Greenspan clearly is pulling on the bear side of the tug-of-war. But he has not been pulling any harder lately than he has for the last two years, and the inversion of the yield curve tells me the market has figured out how to get around his threat. He no longer frightens the market that much.

In past history, there have been similar periods of dramatic change from Old to New. In 1900, the buggywhip companies had their highest earnings in the history of the horse-and-buggy industry while the nascent auto industry was in hock up to its ears in debt and equity. The same in the 1920s when the telegraph industry was giving way to wireless and radio. The old guard has an advantage because of its cash and political power in slowing the transition to the new. It was successful in 1929 -- the Old Guard being on the side of Smoot-Hawley and the protection of obsolete capital. The cost was high, though: Depression and WWII. These threats are coming at the dot.coms through potential taxation and shaving of patent protection for infant ideas. They added to the pulling on both ends of the rope these last several weeks, but on balance, we could not attribute the slide to any special advantage to one side or the other. It is something we watch on a daily basis in our Washington office for just such news.

I’d come to the tax-selling conclusion for two specific reasons. First, I joined the Amerindo Tech Fund three years ago so I could be in direct touch with the New Economy. When Alberto Vilar began accumulating cash in the fund early last year, he did so on the idea that prices were getting too high. He would wait for a correction. The correction came at April 15, and because I do not believe in bubbles, it stuck in my mind that something else was going on. In late March of this year, I made the connection, when I realized my three children would have big tax bills because of their dramatic 1999 portfolio gains under the guidance of David Howe of Gilder, Gagnon & Howe, whose clients were up more than 600% for the year. My daughter’s tax bill would be three times the size of her schoolteacher salary, and she had put off her trip to the tax accountant to learn about this until the last minute. I realized she only could meet her IRS obligations by selling her Internet stocks, which is all she had in running up those gains. The successful day traders, who only had short-term capgains, were in an even bigger pickle. As March gave way to April and the slide steepened, it was clear to me this was the key to the bear slide -- and that it would end on the last trading day before the April 15 weekend.