I’ve been meaning to follow up on a terrific article from the WSJ last week, titled Why Analysts Aren’t Sure The Bubble Has Fully Burst. The “Three Bubbles” graphic accompanying the article is simply a gorgeous instrument of communication (its here Three Bubbles PDF).
E.S. Browning does an admirable job soliciting a variety of viewpoints from different theorists. They discuss several perspectives regarding whether the excess of the greatest investment frenzy in history has been fully wrung out of the system or not:
“After a huge stock-bubble burst, the stock market historically has pursued a painful and predictable path. This time, it hasn’t quite followed the script, and that is making some stock analysts nervous.
“I ask myself about this every night before I go to sleep, and I have to say that, sometimes, I don’t get to sleep,” says Peter Bernstein, a longtime investor, consultant to investment institutions and author on market history.
The problem, in a nutshell, is that after the 1990s bull market peaked four years ago, in the first quarter of 2000, the stock market fell for 2½ years, until October 2002. And yet, by classic measures of stock value, stocks never reached the depths hit in other collapses, such as in the 1930s or the 1970s.
By these measures, which compare stock prices with corporate earnings, the gains of the late 1990s had been greater than those of any previous bull markets. The price of the Standard & Poor’s 500-stock index rose to more than 40 times its companies’ earnings, twice as high as in 1929. When stocks fell, the price-to-earnings ratio also fell, but it never returned even to the average of the preceding 80 years, which is about 16. By traditional measures, stocks never hit the bargain basement. They never fell below the historical average, and the worriers say that stock values can’t remain above average forever.
“Typically, after a bubble, the market falls back below fair value and breaks everyone’s heart,” says Jeremy Grantham, a founder of Boston money-manager Grantham, Mayo, Van Otterloo, who has studied past bubbles in a variety of stocks and commodities. “That hasn’t happened.”
click for larger chart
I believe the valuation issue is only part of the problem; Its really a matter of time to work off all the excess capacity created by overinvestment. As we’ve discussed previously, market bubbles and their subsequent crashes do not simply go away after 3 or 4 years.
Here’s an additional excerpt:
Most of the experts do agree on two things. First: Stocks don’t look poised for a big drop any time soon. But second: Even many of those who think the market will avoid a sharp decline worry that overall stock performance could prove lackluster for years.
“Based on history, you shouldn’t expect the market to do that well for a number of years ahead,” says Richard Sylla, professor of economics and financial history at New York University’s Stern School of Business.
“Returns are going to be disappointing for most people,” adds Francois Trahan, chief investment strategist at New York brokerage firm Bear Stearns. “The good times are behind us.”
At a time when people have again begun expecting double-digit percentage gains in major stock indexes, Mr. Trahan says, the market is poised for single-digit gains. For the rest of this year, he forecasts a rise of less than 1.4% in the broad market. And yet, he and Prof. Sylla both dispute the idea that a repeat of the wrenching 2½-year decline is somehow in the cards.
As Twain said, “History does not repeat but it rhymes.” So anyone expecting an exactly parallel course is likely to be dissappointed. The question I wrestle with is this: How much has the structural underpinnings of the market changed — the answer is alot — relative to changes in Human Nature, which is what drives market activity.
Of course, Human Nature hasn’t changed for millions of years:
The heart of the current debate is whether stocks are doomed to repeat the past or whether history is in fact a movable feast, whose patterns aren’t always close copies. In the latter case, any declines could be more moderate . . . “When you look at historical cycles, you see how the market changes with time,” Mr. Birinyi says. “These rules are written in water, not in stone. This has all the characteristics of a new bull market, and we expect it to continue.”
One reason that stocks fell more heavily in the 1930s and the 1970s than they did this time, says Prof. Sylla of NYU, is that policy makers made huge errors in those eras — raising interest rates too high and putting up trade barriers in the 1930s, and allowing runaway inflation in the 1970s.
“The world may have changed,” Prof. Sylla says. “The real difference is the macroeconomic stabilization we have been having, with [President] Bush spending money right and left and [Federal Reserve Chairman] Alan Greenspan keeping interest rates on the floor.” In addition, investors seem more comfortable owning stocks today than they were in the 1930s and 1970s, when many saw the stock market as the province of speculators and schemers. If investor attitudes have changed, Prof. Sylla says, perhaps investors can return lastingly to stocks before the market falls off a cliff.
Mr. Trahan of Bear Stearns says postbubble market behavior has less to do with the economy than with investor psychology, but he reaches a similar conclusion. “The typical bubble takes 2½ years to deflate, and during that period you usually see three countertrend rallies,” which is what happened in the Nasdaq, he says. “Normally after 2½ years you find a footing and then the market rallies very strongly for 15 or 16 months, and then it has a major correction. Now we are in a period where the market should be correcting and I would argue that it is.”
Mr. Grantham, the Boston money manager, says he fears that this kind of analysis will prove too optimistic.
Terrific stuff. Go check out the full piece.
Ah, the 1990s: Why Analysts Aren’t Sure The Bubble Has Fully Burst
By E.S. Browning
The Wall Street Journal, February 23, 2004 9:31 a.m. EST