The Great Deformation (87 page)

To be sure, stockholders are entitled to a share of profits, and the Fortune Top 25 did distribute $90 billion in dividends, or nearly 40 percent of net income. The distortion lies in the fact that they also spent an additional $250 billion on stock buybacks and M&A deals—or more than 165 percent of net income after dividends. So they had to borrow $100 billion to fund their massive stock buybacks and M&A deals, and that was the rub. While there is no reason to believe that dubious financial engineering projects of this scale would have passed muster on the free market, it is virtually certain that rational executives and boards would not have borrowed $100 billion to try.

Unbalanced taxation plus the Fed-enabled stock market casino and cheap debt had thus taken a profound toll. The stock averages implied that an era of unparalleled prosperity had descended on the nation, but everywhere stood signs suggesting that what had actually descended was a riot of reckless speculation on Wall Street.

GE'S ROUND TRIP TO NOWHERE ON THE WALL STREET MOMO TRAIN

One sign that the Fed's “wealth effects” levitation strategy has delivered the stock market over to marauding bands of speculators is the violent “ramp jobs” that they have done on General Electric's stock price over the last fifteen years. This roller-coaster history is totally out of character with GE's stolid corporate persona.

General Electric remains a tightly run conglomerate that spans a vast cross-section of both the domestic and global economy. Its vast earnings power together with its AAA credit rating makes it the epitome of a blue chip corporate giant, synonymous with gravity, reliability, and constancy. Yet owning GE's stock over the last two decades has been more hazardous for the average investor than dabbling in the pink sheets.

Contrary to the periodic bouts of Wall Street storytelling about GE's credentials as a “growth stock,” the astonishing reality is that it has been just the opposite: a veritable “no growth” stock. When the maestro experienced his irrational exuberance moment in December 1996, GE traded at $17 per share. At the end of 2011, it also clocked in at $17 per share.

Still, the fact of zero appreciation over fifteen years is not actually the hazardous part of the story. During its long round trip to nowhere, GE's stock resided on the Wall Street “momo train,” enduring such violent thrills and spills as would have induced vertigo in the average investor.

The first four-year ramp during the Greenspan tech bubble elevated GE's $17 stock to $60 per share by mid-2000. Traders and speculators were gifted with a “four-bagger” over four years. During the following twenty-four months, however, the stock came crashing back to earth, settling at $23 per share in early 2003. A 60 percent stock price meltdown is supposed to happen to high-flying newcomers, not hundred-year-old, well-run diversified blue chips.

The next ramp job, which coincided with the second Greenspan bubble, also took four years to unfold, and its peak $42 share price in September 2007 amounted to roughly a two-bagger. The subsequent cliff-diving phase was quicker and more violent, however. When GE's stock price reached bottom in March 2009, it was a smoldering ruin at $10 per share, meaning that it lost 75 percent of its value during the second plunge of the momo train.

Presently, the third ramp job got under way as the Fed ignited the Bernanke bubble and propped up GE's teetering finance company with a $30 billion bailout loan. This time the ramp job was even more flaccid: by the end of 2011 GE's stock price was still struggling to get back to the $17 per share threshold it had first crossed in December 1996.

This roller-coaster ride on the Wall Street momo train happened, of course, precisely because there is no honest free market in the financial system. In fact, a giant company with the underlying earnings consistency of GE would not suffer consecutive 60 percent and 75 percent stock price plunges within the span of a decade on the free market. The reason for these aberrations is that the ramp jobs preceding each plunge were artifacts of the stock market deformations fostered by the Fed.

The Greenspan-Bernanke Put has made downside insurance too cheap for the marauding gangs of professional (and some day-trading) speculators. It does not take even an amateur chart specialist to see that during the nearly uninterrupted four-year ascent of each ramp job, it would have been possible for traders using options and leverage to garner prodigious returns, even after collaring market risk with “cheap” S&P puts.

Each time the market-wide Greenspan bubble finally collapsed under its own weight, it was the well-insured Wall Street speculators who lived for another day. The naked and the naïve, of course, got carried out on a stretcher, more often than not by way of Main Street.

Arguably, GE's first moon shot was owing in part to the solid profit performance of the Jack Welch years; but in the main it was attributable to the
wild and unsustainable expansion of market-wide PE multiples, including GE's 40X multiple, which occurred during the Greenspan stock mania of the late 1990s.

After GE's valuation multiple had been brought down to earth in 2001–2003, however, the next ramp job would never have happened on the free market. This new ramp was due to the company's unabashed and reckless financial engineering games, maneuvers which lured more and more speculators onto the momo train—some with protection, others not.

Again, the issue is not just about how much upside the 1 percenters scalped and how much downside the home gamers endured, although undoubtedly the computations would not be pretty. The problem is that, as detailed below, GE's financial engineering gambits have been so extreme and extensive during recent years that they will badly impair the company's future prospects.

The potential for significant future impairment is suggested by the magnitude of GE's financial engineering spree in 2007, a catalyst which helped goose its stock price to that year's $42 peak, which was 20X the company's trailing EPS as filed with the SEC. Even if that earnings number had been sustainable, which it wasn't, 20X was a decidedly sporty multiple for a conglomerate consisting overwhelmingly of old-line industrials like white goods, jet engines, plastics, light bulbs, generators, and locomotives, as well as the huge but potentially volatile finance business.

GE's finances, however, were not on the level. During fiscal 2007 it posted net income of $22 billion, but it actually spent the rather stupendous sum of $48 billion attempting to pump its stock price and expand its asset base. This included $25 billion for buybacks and dividends, $17 billion on M&A, and $8 billion on fixed-asset acquisition on top of recycling its depreciation charge back into capital spending.

It did not require great financial acumen to see that even an AAA company could not spend two times its net income for long. In fact, eighteen months later GE's net income had fallen by 50 percent, its stock price was below $10 per share, and its CEO had begged for and received a massive government bailout of GE Capital's wobbly finances.

GE's financial filings, in fact, screamed with warnings that its highly engineered EPS was not remotely worth $42 per share. It was easy to see in its disclosures, for example, that the huge profits of its finance company were not true earnings, but the product of a lopsided tower of financial arbitrage wherein $600 billion of risky, illiquid assets were being propped up with massive debt and cheap hot-money funding.

As it happened, GE's sustainable earnings have been barely half of the hopped-up number it reported at the Greenspan bubble peak. During the
two-year period through March 2011, for example, its EPS averaged only $1 per share, compared to the $2.20 per share in 2007.

Based on the forward-year earnings that it actually delivered, therefore, its stock price at the 2007 bubble peak was being valued at 40X. Not coincidently, at the peak of the 2000 dot-com bubble it had also traded at 40X, a valuation multiple as loony then as it was in 2007.

FINANCIAL ENGINEERING GONE WILD

As the roller-coaster ride of GE suggests, the monetary central planners were determined to get the stock averages back to year-2000 levels and to resuscitate $5 trillion of household net worth which had been vaporized by the dot-com crash. Therefore, a stock market continuously juiced by 50 percent “takeover premiums” and nonstop share repurchase campaigns suited the Fed's purpose.

As with the explosion of household mortgage debt, the Fed had no trouble remaining oblivious to the soaring business debt which underpinned these financial engineering ploys, maneuvers, and outright scams. As the latter mushroomed throughout the corporate world, the stock averages rose mightily, and that was the main thing. After all, the purpose of stock market levitation was to induce households to spend because they felt richer, whether they actually were or not.

Not surprisingly, financial TV happily parroted the Wall Street shibboleth that massive corporate spending for buybacks and M&A on the floor of the New York Stock Exchange proved American business leaders were bullish on the future. What it actually proved, however, was that runaway financial engineering was generating unheard of levels of Wall Street profitability from speculative trading and transaction fees and finance. In 2007, for example, global M&A fees alone reached $50 billion, compared to an average of $20 billion per year during 2002–2004. And this was a tiny tip of the iceberg.

Not surprisingly, the Fed's meeting minutes from 2007 do not evince even a hint of worry that the surging stock market averages were being “bought” by means of massive cash and equity extraction from the balance sheets of American business. Nor was there any recognition that the deluge of financial engineering transactions was reaching a truly freakish extreme.

For example, as recently as 2005, M&A deals in the United States had totaled about $1 trillion and at that point represented an all-time record. Yet during the second quarter of 2007, the annualized run rate of M&A deals hit nearly $3 trillion. At the same time, prices paid for new deals were soaring.

Takeover premiums thus reached an all-time high of 60 percent compared to a traditional norm of 25–30 percent, while purchase multiples literally
flew off the charts. Compared to a traditional ratio of total enterprise value to EBITDA of five to six times, the average purchase multiple during the mid-2007 deal frenzy exceeded eleven times EBITDA.

During the same quarter, new LBOs clocked in at an $800 billion run rate, four times higher than a few years earlier. And in the third quarter of 2007, stock buybacks shot the moon, hitting a run rate of $1 trillion annualized. That compared to $300 billion per year as recently as 2004, which at the time was considered robust.

These trends in the aggregate volume of financial engineering transactions were truly an aberration. Yet they did not trouble the nation's monetary central planners because all three variations were rationalized as representing the free will of the free market.

This proposition had been stoutly embraced by the supreme voice of monetary authority, Chairman Greenspan, and had become catechism in the Eccles Building. Indeed, over the years the maestro had continuously lent his imprimatur to this deal mania, praising it as evidence of a robust market for corporate control.

Buyouts, buybacks, and takeovers, Greenspan explained, all embodied the free market at work, recycling capital and other business resources to higher and better uses. In so doing, he claimed, this energetic market for corporate control endowed the US economy with unparalleled flexibility and capacity for self-renewal, a dynamism largely unavailable to its competitors elsewhere in the developed world.

As in so much else, Greenspan was right in theory but failed to recognize that free markets go haywire when inundated with unsound money and central bank manipulation of key financial prices, like interest rates and stock indices. Accordingly, the idealized financial market which Greenspan envisioned may have existed once upon a time, but had long since disappeared. Its demise was owing to the post-1971 rise of printing-press money and, especially, the Wall Street–coddling version of monetary central planning that, ironically, the maestro had himself fashioned during his long tenure as chairman of the Fed.

PROOF OF DEFORMATION:

GENERAL ELECTRIC'S AAA TOWER OF DEBT

The evidence that Greenspan's idealized markets were actually vast financial deformations was in plain sight in the case of General Electric, whose CEO sat on the prestigious advisory board of the New York Fed in good crony capitalist fashion. Had CEO Jeff Immelt only been asked to describe GE's financial engineering binge, it might have given pause even to the money printers.

For much of his nineteen years at the helm, Jack Welch had conned Wall Street into embracing the financially impossible; namely, that GE's mammoth, highly cyclical, globe-spanning businesses could generate clocklike growth of “operating profit,” hitting the company's guidance to the penny.

These monotonously (and comically) reliable gains came straight from the accounting cookie jar, but at least under Welch they were profits that GE had earned the old-fashioned way: out of fanatical cost discipline, product innovation, and aggressive marketing. The cookie jar didn't invent profits, it just shuffled and smoothed them among the quarters, as needed.

But after Welch's retirement, General Electric had gone all-in for financial engineering of a less innocent type. Between early 2000 and early 2008, its total debt doubled from $400 billion to $800 billion, and most of this had gone into stock buybacks, M&A deals, and purchase of both operating and financial assets at rates which were self-evidently unsustainable.