The Great Deformation (90 page)

When this pell-mell acquisition spree caused Tyco's reported sales to soar from $7 billion in 1997 to $34 billion by 2001, the 50 percent per annum rate of sales growth did not signify that underperforming business assets were being recycled to better and more efficient uses. Instead, it showed that Tyco was a whirling dervish of financial engineering that had no plausible business justification.

In fact, its real purpose was providing a vehicle for absorbing the powerful waves of Wall Street speculation unleashed by the Greenspan Fed. The hapless Dennis Kozlowski didn't create Tyco International; Wall Street did, stampeded by speculators who had come to believe that the Fed would never let the party fail.

Indeed, the veritable explosion of Tyco's stock price after the mid-1990s was proof positive that the Greenspan stock market bubble was rooted in a monetary deformation. Tyco was the very embodiment of an anti-dotcom enterprise: a prosaic assemblage of old-economy businesses which on an organic basis grew at less than 3 percent per year by the company's own reckoning. Yet its stock price soared from $25 per share in early 1994 to a peak of $250 per share in January 2001.

This tech-style 10X gain in its share price was not due to a commensurate explosion of profits. What did explode was the company's valuation multiple. The latter rose from 17X EPS in 1994, which was already too generous for an industrial conglomerate, to a peak of 67X in late 1999, which was pure madness.

At that point, the stock market was obviously turning a blind eye to the warning signs emanating from virtually every pore of the company's balance sheet. Between 1994 and 2001, for example, the company's $500 million of debt soared to $43 billion, meaning that its debt burden grew ninety-fold in seven years. Not surprisingly, its goodwill zoomed from $1 billion to $40 billion, reflecting the company's chronic overpayment for
acquisitions, while its tangible shareholder equity went straight south, reaching negative $20 billion by the end of 2001.

Kozlowski ended up the chump whose visage in the pantheon of America's greatest CEOs was removed at a speed rivaling that of politburo portraits in Stalinist Russia. After a hurried do over by the financial press, Kozlowski was rechristened as the rogue CEO who stuck his shareholders with $6,000 shower curtains and a $2 million birthday party on Sardinia featuring an ice sculpture of Michelangelo's
David
urinating Stolichnaya vodka.

The true sin in the matter, however, was a financial environment that carried Tyco's market cap to $125 billion by 2001, when it was plainly a disheveled trunk of pots and pans from America's industrial pawnshop, led by a crude schemer who couldn't resist the bait. The bait, of course, was the kind of bull market hagiography which put him on the cover of
Business Week
in 2001 as America's most aggressive CEO.

Needless to say, the deflation of Tyco's wildly bloated stock value came fast and furious. By the time Kozlowski was forced out in June 2002, the company's market cap stood at only $25 billion. More than $100 billion of market cap had vaporized in less than six months.

That kind of violent repricing does not occur on the free market, and wasn't owing to the discovery that some of Kozlowski's pay and perks had not been diligently vetted by the board. Rather, Tyco was the poster boy for Greenspan's first stock market bubble and its sudden, violent demise was a wake-up call that was wholly ignored.

WHEN MOMENTUM TRADERS STRIPPED CEW FROM THE LAND

The Fed's frenetic interest rate cutting and renewed commitment to the Greenspan Put after December 2000 generated another spree of financial engineering. In all three variations, buybacks, buyouts, and M&A takeovers, the common effect was equity extraction from the business sector. However, unlike the case of mortgage equity withdrawal by households, where the cash windfall was distributed widely across the middle class, corporate equity withdrawal resulted mainly in cash distributions to the very top of the economic ladder. In generating a cornucopia of CEW, therefore, financial engineering functioned as the ATM of the prosperous classes.

That CEW went overwhelmingly to the bank accounts of the wealthy is a balance sheet given. By the end of the first Greenspan bubble, about 80 percent of financial assets were owned by the top 10 percent of households, which therefore got at least 80 percent of the cash from buyouts and buybacks. In fact, far more than a proportionate share went to the top, and
even then the windfall was not so egalitarian in the manner in which it was whacked up among the affluent classes. Among the 10 percent at the top, it was the 1 percent at the very top who got the lion's share of the CEW.

The reason for this ultra-skew to the very top lies in the subtle and convoluted manner in which monetary inflation deforms the financial markets. What happens is that cheap credit and market-pegging actions by the central bank foster an irregular and syncopated path of financial asset inflation. This bumpy rise is punctuated by sudden windfall gains in stocks and other risk assets which occur with increasing scale and frequency.

These windfalls are heavily “event” driven, as in the case of 75 percent M&A takeover premiums, corporate announcements of giant stock buyback programs, and the huge short-term price ramps that periodically occur among so-called growth stocks. By providing opportunities for outsized rewards to agile traders, as distinguished from fundamental investors, such event driven windfalls recruit more and more speculators to the craps tables.

During the first Greenspan bubble, these storied windfall events and episodes arose initially from the tech sector, such as when Cisco's stock hit its red-hot stage and witnessed a $350 billion market cap gain in just eight months. In like manner, Intel once gained $250 billion in only four months; the stock price of JDS Uniphase tripled in three months; and, of course, tech IPOs were even more spectacular. Beginning with Netscape's $14 to $78 per share ramp on August 9, 1995, these tech IPOs often produced massive gains in a single day.

Moreover, while the 10X stock price gains in deal companies like Time Warner, Lucent, and Enron required a slightly greater time frame to unfold, they, too, embodied the principle of rocket-ship gains. So the turbulent financial asset markets which were endemic to the Fed's money-printing campaigns fostered a growing posse of financial storm riders.

In the fullness of time, this posse became an enormous swarm. The Greenspan Fed thus fostered the mother of all malinvestments; namely, the massive array of hedge funds, private equity firms, highly leveraged real estate partnerships and like venues that flourished around and about Wall Street and came to constitute the fast money trading complex.

These financial vehicles were pleased to call themselves “investment” partnerships, but their game was speculative trading, frequently with leverage in all its forms. They pursued numerous strategies and techniques, but the common denominator was foraging in a financial arena that offered outsized returns based on inside information.

To be clear, the implication is not that the fast money trading complex was involved in something illegal, such as trading based on the foggy
concept of corporate inside information of the type proscribed by the SEC. Rather, the “inside information” at issue here was mainly legal; it was inside knowledge of what the Wall Street wise guys were chasing as the flavor of the week, or day, or sometimes even the hour.

Stated differently, lightning fast triple-digit stock price gains or sudden $100 billion market cap demolitions do not happen much on the free market in response to fundamental investment research. In fact, genuine value-changing information capable of causing violent price movements can only rarely be kept secret and sprung on the market without warning; it is the vast exception, not the rule.

By contrast, the stock market “rips” and “wrecks” that became chronic during the Greenspan era were signs that the financial system had been corrupted and deformed by a régime of credit inflation and easy money. After all, what causes asset prices to rise like greased lightning or plunge like a hot knife through butter is the whispered tips of speculators. And easy credit and an accommodative central bank are the mother's milk of speculation.

HEDGE FUNDS AND THE REGIME OF INSIDER TRADING

Accordingly, as 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 MOMOS AT WORK:

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.