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EMBARGOED: DO NOT RELEASE UNTIL WEDNESDAY, JUNE 19, 2002 AT 1:00 AM PST Bubble Trouble? Bubble Trouble? Your Home Has a P/E Ratio Too Edward E. Leamer Chauncey J. Medberry Professor of Management Director, UCLA Anderson Forecast UCLA Anderson Forecast Reporti June 2002 Synopsis: The downside risks to the US economy come mostly from consumer durables and housing, which powered through 2001 completely unaffected by the business recession. Although sales of homes and cars are not likely to be as strong in the next year as they have been in the previous year, the financial conditions that historically gave rise to the extreme housing downturns are not currently present. On the contrary, the financial conditions are about as favorable for housing as they have ever been. Absent interest rate increases by the Fed which would produce a flatter yield curve, higher mortgage rates, and weaker housing appreciation, the economy is likely to grow at the moderate rate of 2.5% - 3% for the rest of the year, though GDP growth could for a couple of quarters be stronger than that because lean inventories will require some significant investments to keep inventory/sales ratios from declining to unacceptable levels. Closer to home, the p/e ratio for L.A. housing is rising but is still 17% below it’s 1989 bubble peak. The Bay Area housing p/e, however, is 6% above the 1989 peak. The LA p/e is supported by the fundamentals: appreciation of rents at the rate of 7% per year, while the high Bay Area p/e is not: rents have stabilized. Even with all the advances in the 21st Century are not buildings or equipment; the telecommunications, consumers still assets are ideas. No scarcity there. The workers are have not received the news that the not humans; the workers are microprocessors. No future isn’t what it used to be. scarcity there, either. Ideas come effortlessly and relentlessly from the minds of 20-year-old During the Internet Rush of 1998 and 1999 the Intrepeneurs, and the line of microprocessors offering High Priests of the New Economy promised a to do the work cheaper and cheaper stretches from Nirvana Economy in which scarcity would be a thing the employment window around the corner to the of the past. They promised freedom from 20th outer edges of the Universe. Century material limits on equipment, buildings and people. The assets of the Knowledge Economy of Whoops, it didn’t quite work out that way. UCLA Anderson Forecast, June 2002 Nation-1.1 EMBARGOED: DO NOT RELEASE UNTIL WEDNESDAY, JUNE 19, 2002 AT 1:00 AM PST Bubble Trouble? Businesses were the first to get the message. he-said divorce of Enron and Andersen. (By the way, Profitability, according to the National Income and that’s Andersen, not Anderson, a very important Product Accounts, stalled out in 1997. Businesses difference.) Now a new drug-testing program is responded to this bitter disappointment by feeding being put in place to assure that accountants are no steroids to their accountants to pump up reported longer taking steroids or other performance-enhancing sales and profits to keep the equity markets believing substances. Thus no more pro forma earnings, and no in the Nirvana Economy. Try “round-trip” exchanges more off-balance sheet debt to create phantom and report “pro-forma” profits. Try hiding some old earnings. Absent the steroids, these companies look merchandise in a warehouse and book it as a sale and like 100-pound weaklings. There is also an unsub- an accounts receivable. Better yet, book it as a sale stantiated rumor that the vision-enhancing psychedelic and a loan to a “partner” firm. Best of all, in the drugs that have been all the rage on Wall Street will New economy, you don’t even need the warehouse, also be subjected to new limitations. Analysts can since it is “ideas” that are sold. And while you are at still take them, and still report their fantasies to clients, it, give these gimmicks some cool New Economy but not if the firm does investment banking. names like Indian Burn and Head Noogie. Business and government have received the When accounting gimmicks lost their punch in message that the future isn’t what it used to be, but so early 2000, and equities took their first tumble, busi- far the news hasn’t reached consumers. They are nesses abandoned the New Economy religion, and cut buying homes and cars and shirts and shoes with a back heavily on spending on equipment and software religious intensity suited to a celebration of the in a desperate effort to maintain reasonable real genuine arrival of the Nirvana Economy. Even in the profitability. Bay Area where unemployment rates skyrocketed in 2001, home sales are up and home prices are on the Governments were the next to get the message, rise again. though not until just two months ago, in April of 2002. In 2000 and 2001, capital gains and stock-option These consumers are making me really angry. income continued to swell the government coffers, They are wrecking the accuracy of my bearish and politicians did what they do best: they spent this forecasts, which call for growth rates in the 2.5-3% revenue, not on temporary one-time expenditures or range throughout the year. Stop it, you crazy spend- temporary tax cuts but on long-term continuing ers. commitments, as if that burst of revenue would continue forever. A not-so-confidential e-mail was To make the point rhetorically, my March 2002 sent to every politician by the equity markets in 2000: report was titled “This is our first business cycle” tax receipts from capital gains would soon dry up. which was my elliptical way of saying that the cycles This was the first great telecom failure – the politi- since 1950 have all been “consumer cycles” with cians didn’t get the message. It wasn’t until April of reductions in spending on cars and homes leading into 2002, when the politicians went to the counting houses a recession and with businesses reacting to that drop to assess the 2001 tax receipts, that they suddenly in sales by cutting investment. The recession of 2001 realized there is a problem here. is all on the business side. It was caused by a drop in spending on equipment and software beginning in mid Next it was the accountants who got the mes- 2000, and that drop in business spending didn’t cause sage. News of the accounting gimmicks didn’t seem any reaction on the consumer side. to matter much until the messy high-profile he-said, Nation-1.2 UCLA Anderson Forecast, June 2002 EMBARGOED: DO NOT RELEASE UNTIL WEDNESDAY, JUNE 19, 2002 AT 1:00 AM PST Bubble Trouble? Just to make sure that you understand the point, These graphs dramatically reveal the cycle in the two graphs below depict real per capita spending both houses and cars. The cyclical swing in housing on consumer durables (e.g. cars) and residential has been particularly extreme. But not this time. In investment (new homes and remodeling). The ten this first “business cycle” consumers have been “official” recessions are shaded and numbered. If expressing complete and utter disinterest in the tech you look carefully, you will see that reductions in collapse. That’s good, since it has made the 2001 spending on cars and housing preceded the official downturn mild. On the other hand, we cannot count recessions and bottomed out at or near the end. on 2002 as the beginning of a normal expansion. If it Real Per Capita Consumer Durables 8000 10 4000 9 7 2000 6 8 5 2 3 4 1000 ? 1 1996$ Per Civilian Labor1996$ (log Per Civilian Force scale) 1950 1960 1970 1980 1990 2000 Real Per Capita Residential Investment 3200 2800 10 2400 2000 4 5 ? 6 7 1600 9 2 ? 3 1996$ Per Civilian Labor Force (log scale) (log Labor Force Civilian 1996$ Per 8 1200 1 1950 1960 1970 1980 1990 2000 UCLA Anderson Forecast, June 2002 Nation-1.3 EMBARGOED: DO NOT RELEASE UNTIL WEDNESDAY, JUNE 19, 2002 AT 1:00 AM PST Bubble Trouble? were a normal expansion, 2002 would be a “recov- Wall Street analysts made during the Internet Rush ery” year during which GDP growth would average when they imagined that the New Economy changed 5%. If it were a normal expansion, we should not the rules and created a fundamental disconnect expect another recession for five years at the earliest, between corporate earnings and stock prices. We or maybe ten years. But this is not a normal expan- know differently now. The markets are rudely sion. This is a completely unique event. Indeed, if reminding us that when we buy a stock (an asset), we you look at these two graphs again, you might have are buying an earnings stream. The price we pay for the impression that we are “overdue” for a consumer the stock should reflect current corporate earnings downturn. and reasonable expectations about what the future of earnings might be. A bubble is created when these Thus the title: Bubble Trouble? What has get disconnected. caused those wild swings in housing, and what is the risk of a consumer driven recession in the next year? Survivor Investing can temporarily disconnect earnings and valuations There is no housing shortage and don’t expect a phantom shortage to prevent a bubble from It is easy to lose track of the connection be- being created. tween earnings and valuations for stocks.

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