Looking For Signs of A Bubble

August 7, 2000 – Every once in a while a bubble is created in a market. Bubbles can occur in any market, whether stocks, commodities, real estate or whatever. As an example of a bubble’s capacity to strike anywhere, even old baseball cards – considered by some to be a worthwhile collectible – experienced a bubble not too many years ago.

Bubbles in markets are, as the name implies, unsustainable. They are manifested by inflated prices that go up and up to achieve unthinkable levels for awhile – and in some cases, for a very long while. But inevitably, the bubble pops, with the unfailing result that prices soon thereafter drop back to earth.

Thus, like their soap-bubble counterparts, bubbles in markets clearly lack durability. But market bubbles lack something even more fundamentally important – they lack reality.

In essence, bubbles are nothing more than a bald system that jacks prices ever higher to previously unheard of levels, until the market attains a shocking level of overvaluation. To achieve this outrageous fiction about prices in relation to value, almost invariably a bubble involves the general and wide-ranging acceptance of some delusive idea or scheme.

Some times the ideas/schemes are very obvious. When John Law proposed his so-called ‘funding system’ in 1716 he needed a grand scheme. The virgin lands surrounding the Mississippi River provided the means by which he developed the ruse to swindle the French nation, in a game plan that even without the benefit of hindsight was obviously flawed to anyone willing to ask the right questions. Yes, those were indeed virgin lands in the Mississippi basin, but they were also undeveloped lands, even unexplored lands, so the prices paid for the stock of Law’s company far exceeded their real value. The Mississippi Bubble has forever been offered as the apotheosis of market bubbles.

In contrast to John Law’s Mississippi Company, sometimes the delusive idea/scheme that fuels the bubble and propels prices higher is not so obvious. Many people believe that the US stock market is in a bubble. There is a lot of collected evidence to suggest that anyone who believes that stocks are in a bubble may be on to something – this evidence includes sky-high P/E ratios, minuscule dividend yields, etc.

All of these time tested measures of value are at levels never before seen, so stock prices are valuing underlying assets outrageously, at least based on what have heretofore been reliable historical criteria. But if there is a bubble in the US stock market, what is the delusive scheme driving stock prices higher?

About four years ago I read what I believed to be the answer to this question. British economist and market strategist Andrew Smithers published a very thoughtful report analyzing the impact on stock prices from employee stock option plans. I thought then, and I still think now, that he hit the nail on the head. In other words, stock options would in time prove to be the delusive scheme of the US stock market bubble.

Employee stock options have become a constant that everyone accepts without questioning any underlying premise, such as how these option schemes work, how they affect a company’s financial position, and most importantly, how they affect a company’s stock price. But as with most things in life, timing is everything. Mr. Smithers was early. He got little publicity for his thoughtful research, and much of it was derisive as the stock market continued to soar. But things are changing.

The stock market has stopped soaring. And employee stock options are receiving unprecedented attention, and importantly, publicity. One recent noteworthy media report was a Wall Street Journal article on July 28th entitled ominously for the bulls, “Tidal Wave of Stock Options Paid to Employees Could Swamp Investors, Drain Firms’ Resources”.

Here’s how employee stock options work. Rather than giving an employee a fair cash salary, compensation is instead a combination of cash and stock options. As the stock price climbs, the options become valuable, so the company issues new stock to the employee in exchange for the option, and this stock is then often/usually sold so that the employee ends up with cash.

The delusive part of this scheme occurs because this compensation ‘paid’ to employees is not a bookkeeping expense of the company. Therefore, earnings are not reduced by the cost of compensation paid to employees as stock options. The result is that company earnings do not truly reflect all operating costs.

Some companies have managed to prevent the dilution that occurs by using available cash to buy back their company’s stock. But this ploy diverts cash from other more important uses that would help build the company and make it stronger in the long run. And in any case, the sheer magnitude of employee stock options outstanding compared to available cash-on-hand make this task impossible for most every firm in the long run.

The WSJ article says that it would cost Cisco, Microsoft and four other heavy practitioners of employee stock options 15-times 1999 earnings to buy back enough stock to offset the dilution from new stock that will need to be issued for their option schemes. Clearly it is an impossible task to prevent this dilution, so stock prices must keep heading higher or… I’d rather not think about the alternative given the grim fact that this country is up to its neck in stock, much of which is financed by debt.

Another noteworthy report about employee stock options appears in today’s Barron’s. The impact of these reports so far has been slight, but they could be the thin edge of a wedge creating doubts by investors about the durability of stock prices.

If so, the leveraged impact that employee stock options have on stock prices on the way up could be reversed, with the same leveraged impact on the way down. Two highly visible and vulnerable companies are Cisco Systems and Microsoft, the darlings of the 1990’s bull market. Both companies have market caps around 20-times revenue, huge numbers of shares outstanding, and huge employee stock options.

Ever wonder why Cisco and Microsoft haven’t been paying any federal corporate income tax? Employee stock options are the answer.

There is one very strange thing about bubbles. Even though prices are out-of-line with value based on any prudent historical measure, people don’t react as one would logically think. Instead of recognizing a bubble for what it is, people instead tend to rationalize why prices are so high. They try to explain to themselves why prices are supposedly reasonable.

This attempt to rationalize what is illogical and abnormal is a unique characteristic of bubbles. But it is not too difficult to see why this foolhardy thinking happens.

When you are living in a bubble, it is very hard to accept the fact that you are indeed in the middle of a bubble. The reason for this inability to perceive foolhardy thinking is that most everyone acts as if there were no bubble. Everybody is saying, doing and thinking the same things. This mutual and identical action reinforces one’s view to mistakenly believe that what they are thinking is correct and normal instead of what it really is, namely, the illogical and abnormal pervasive thinking that is found in a bubble.

In effect, the rationalization explains that stocks can’t possibly be overvalued because [….]. Go ahead. Fill in the blank. We’ve all heard all of the reasons – new economy, advances in technology, increasing productivity, inflation is under control, etc.

In short, it’s different this time, but the reality is that it is never different. While technology and other circumstances are indeed constantly changing, the common denominator is that human nature never changes, so bubbles are possible because people are always willing to believe the unbelievable, such as the delusive accounting of employee stock options.

Only when the bubble pops does the bubble become obvious.

It is only then that the realization dawns on people that they had been living in a bubble. Only then do the serious questions get asked. How could I have bought Amazon when it was overloaded with debt, had no book value, earnings or near-term prospects for turning a profit? Or to the case in point, how could I have bought Cisco when it had a market cap more than twenty times annual sales and no earnings when the impact of employee stock options is being accounted for properly? Hindsight is always 20/20.

Law’s scheme was based on the false premise that the lands of Mississippi were worth far more than they really were worth, but because this premise became widely accepted, it inflated the stock price of his Mississippi Company. Price far exceeded value. It was much like another bubble closer to our time – the Florida real estate bubble of the 1920’s. Property prices on Florida property were outrageous. Prices far exceeded value.

This observation about prices and value describes the most basic element of bubbles – outrageously high prices overvalue the basic good being traded in the market in which the bubble is created. Eventually, everyone recognizes this basic fact, but not until the bubble has popped. So the basic unanswered question now given the fact that the US stock market bubble has not yet popped is this: Are Cisco and Microsoft over-priced and therefore over-valued?

When the current stock market bubble eventually pops, it seems likely to me that employee stock options will be looked at differently. Instead of being seen as a means to retain talented personnel, employee stock options will be seen for what they really are under current methods of accounting – a scheme with two outcomes. It is first a scheme by which a company’s stock gets propelled higher and way beyond any prudent value when the bubble is inflating, but after the bubble pops. it will be seen for what it really is, a spurious and deceptive accounting practice. In time employee stock options will be shown to be the delusive idea that created this stock market bubble.