I remember exactly the moment when I realized that the stock market was in a bubble. It was when I overheard one of the cable guys in my firm trying to persuade another installer that he should buy Cisco on a dip. "In the long run," he told his friend, "it always goes up."
Being something of a fan of John Kenneth Galbraith's work on financial panics, I knew that the long run could be very long indeed--the Dow was basically flat between the late 1960s and the early 1980s, which given the era's high inflation means investors actually lost money.
Well, it just occurred to me that it's been roughly ten years since I heard him make that claim. And at the moment, the Dow is well below its January 2000 peak of 11,722. It has gone up and down since then, but overall, we're right back where we started eight years ago. The S&P, too, is below its 2000 peak. And the NASDAQ never even came close to regaining its former value.
If I were a certain kind of partisan, this would be a good time to blame the stock market on Bush, or the bubble on Clinton, both of which plaints have equal validity. Which is to say, none.
I think its more interesting to think about what this says about our financial markets. In a world of perfect information, stock prices would never change; we'd simply discount the cash flow of a known future. In the real world, of course, they move around all the time, often in tandem. What information did we get--or rather, not get--over the last eight years that made the price of January 2000 such a good guess at the prices of September 2008?
One possibility is that prices are simply irrational; this is interesting, but not useful.
But perhaps the 1990s represented a real innovation: portfolio theory, as popularized by Jeremy Siegel, made stocks genuinely less risky, and the risk premium that buyers were demanding dropped. Though the market overshot slightly on the way down, we've basically hit a new equilibrium that has been building since the 1980s, in which prices, and P/E ratios will be permanently higher. Something like Irving Fisher's "permanently high plateau".
Which is not to say it won't, eventually, go up again. It will, probably for no very good reason that anyone can pinpoint. But that might take a very long time--it was a decade and a half the last time the market plateaued.
This means that it's actually a very good time to be investing in your 401(k). It won't do much for the next few years. But when the next boom starts, all those lovely cheap assets will pop at once.
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I remember my bubble epiphany as well. I was watching Squawk Box on CNBC during Christmas week, 1999. The guest host was touting a new, tiny company. As he spoke, the stock appeared on the ticker and went from 10 to 13. At that point, I knew investors weren't doing due diligence.
I had a similar experience / revelation during those dot com days when a plumber tried to sell me on the merits of his favorite sat telcoms. Peter Lynch actually laid out a series of timelines ranging from the point where people are sour on the markets and won't speak with him, to the point where they come to him to inquire about investments, to the point where people start suggesting investments to him ;)
"...we've basically hit a new equilibrium that has been building since the 1980s, in which prices, and P/E ratios will be permanently higher. Something like Irving Fisher's 'permanently high plateau'."
Are you summarizing Siegel's thesis, here, or subscribing to it? Because if you're buying into it, I guess you don't know much about history, and never learned the lesson of 1929, which is whenever an economist makes bold statements of certainty about economics, run like hell. Irving Fisher made that "permanently high plateau" statement just a week before the Crash of 1929.
I actually do consider the prices of most securities to be irrational. That's why I don't invest in publicly traded companies. Real estate. Small businesses. Partnerships. Yes, there's risk. But at least I can tell what exactly it is that I'm buying. Also, there is little to no risk that I'll lose $1 billion in stock value because Bloomberg runs a 6 year old story.
Stock prices are down because Obama will be elected. Now is the time to go to cash and buy things that can be safely bartered with Russian troops and Islamic Jihadis.
Also its a good time for rich people to leave the country and find safe havens. If they did anything useful they would be poor.
I was an IR consultant back in 99, and my company had a number of .com clients. At one meeting with a client, I told them that if they wanted investors to pay more attention to them, then they needed to do a better job of articulating their business plan to investors.
They responded that they didn't really have a business plan.
I knew then the game was over.
Are you forgetting to count dividends/distributions? The average dividend yield of the Dow is 3.28%, and the average dividend yield of the S&P is 2.08%. So, we're not completely flat, even considering we're down a bit from Jan. 2008. If this is a terrible stretch, it's really not too terrible.
It has already been mentioned, but you are ignoring dividends when discussing losing/making money. It may not change the fact that investors lost real funds over the 70s, but the Dow-Jones being flat for 10 years doesn't demonstrate it.
Although we haven't had the sort of inflation seen in the 70's, one should also realize that although the market is roughly where it was 8 years ago, this too has been corroded by inflation.
As for forgetting dividends, one should also be comparing things to the risk-free rate. I don't know the numbers. Can someone do the average dividends minus the rate on government bonds over that same period? How about a Sharp ratio for the market over that time?
Out of curiosity, I know its just a small sample period, but who here still thinks we should have privatized social security those few years back when Bush was really pushing that?
So, all of you who "knew" the bubble was about to burst in 1999 and 2000 made a killing by shorting the market, right?
So, all of you who "knew" the bubble was about to burst in 1999 and 2000 made a killing by shorting the market, right?
Nope. I knew it was going to burst, but not when. The market kept rising at least a couple of years after I thought it was nuts. If I'd tried to short it, I'd have been wiped out ("The market can stay irrational longer....").
Megan, you forgot something very important:
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You ought to check out Vitaliy Katsenelson's thesis that we are in a secular range-bound market. I wrote a post summarizing his thesis and linking to his PDF slide show on it a few months ago. Click on my name for that post. One key point Katsenelson makes is that the economy will grow during secular range-bound markets, as will corporate profits, but multiple compression will keep the market moving mostly sideways. An example he gives from the last secular range-bound market was that the average market P/E was about 18 at the beginning of it, in the late 1960s, and had dropped to about 10 by the early 80s.
Also worth considering Jim Rogers's thesis that we are in the first half of a secular bull market in commodities (the current correction being a cyclical one) and that, historically, commodities and stocks have moved counter-cyclically. I compared his thesis to Katsenelson's here.
First, even in a world of perfect information stock prices should rise over time presuming that profits are growing. As time goes on the future high profits become closer and therefore are discounted less.
Second, and more importantly though I think convential wisdom may overestimate returns from the market. In short, the market should not return more than real economic growth plus dividend yield. That means roughly 3% real price appreciation plus 2% yeild or 5%.
(Indeed, any given investor portfolio will likely return less because of the new issues and corporate by-backs but thats a different issue)
The reasoning is simple:
If price appreciation is returning more than economic growth than either P/E is growing or earnings are outpacing economic growth.
The capital labor ratio is fairly stable and more over, in the very long run capital cannot take more than 100% and thats including returns to debt and small business.
Thus profits cannot exceed economic growth indefinately.
P/E ratio could have risen for a short period of time but over the long run I can't see any reason that P/E should trend upwards unless risk premiums and real interest rates are trending downward. It seems unreasonable that this could happen indefinately.
Thus I think equity returns are likely to hover more around 5% real in the long term.
Stocks are a speculation not an investment. The stock market is run by con men, criminals, grifters, and geeks for the benefit of insiders.
If you read the Wealth of Nations you might notice that Smith never mentions wealth being created by increasing asset values.
Any overall rise in total stock market capitalization over the inflation rate is, inflation of asset values. That doesn't increase systematic wealth, it just redistributes it.
People love the idea of getting something for nothing. Buying an asset and hoping it inflates is pretty much all that our economy is based upon. It's impossible for people to imagine that new bubbles will arise to replace the old. As in "when the next boom starts, all those lovely cheap assets will pop at once."
I happen to believe that stocks will be the best speculation long term because the modern business corporation is the dominant human organizational model now, which has captured government, so that corporations will be relative net winners going forward. As opposed citizens.
Still it's likely we are going to have a precarious drop in stocks before this cycle bottoms. And this is a big big cycle.
Edit
It's impossible for people not to imagine that new bubbles will arise to replace the old.
In January I shorted gold (GDXMX) for 870 because it smelled like a panic-fed bubble. It skyrocketed, but I held on (what else can you do?)and just sold it for $2,140. 246% profit since January.
That would have worked in commodities. You can learn a lot abot basic economics by studying relentlessy declining commodity costs.
Karl Smith is mostly correct.
Only two things matter for the general price level of the stock market:
1) the money supply
2) allocation of money ( percent of money kept in dollar bills vs savings account vs gold vs property vs stocks, etc)
I believe the great rise in stock prices from the early 80's to 2000 was caused by a massive reallocation of assets. Baby boomer pension funds, the invention of the IRA and 401k, the growth of mutual fund marketing, the stagnation of savings accounts due to inflation, etc. all caused a lot of people to move money from savings accounts into stocks. This caused a one time price run up that will never happen again.
In the long run, if people don't allocate any more of their savings into the stock market, the price of stocks will only rise with inflation (money supply growth). The only way to actually make money from investing is from dividends. Of course, if people start reallocating away from the stock market, or if pension funds start selling off to support retired baby boomers, there could a massive, long run decline in the stock market ... Past performance is not an accurate prediction of the future.
The terrifying thing about the current stock market is the low the dividend ratio. We've had 10 years of stagnation, yet the dividend ratio is still way below even what it was in 1929. There is no difference between a stock that never pays dividends and a baseball card. A non-dividend stock is only valuable because everybody else thinks its valuable. ( And yes, I know corporations have been choosing to buy back stock instead of pay dividends. But this only helps the current shareholder if the buyback reduces the total amount of shares outstanding. If the buyback is counteracted by dilution and grants to employees, then there is no net benefit to the shareholders. And that's exactly what is happening.)
There has been way too much dumb money entering the market ( regulated funds, people investing based on tv ads). When dumb money owns the shares, corporate governance deteriorates. This allows the company to reallocate all the company's profits back to its employees, rather than to investors. This type of break down is unprecedented, and is very scary.
For further reading, I highly recommend Mark Cuban's recent posts on the stock market. He's made a boat load of money from playing Wall St. and he knows his stuff.
Karl Smith IS correct
companies earn money faster than the risk-neutral rate: with perfect information we discount at the risk neutral rate, anything else would be crazy
people often ask how is that stock prices usually beat inflation and bonds. Suffice it to say that when markets work correctly, only those companies that - on average - earn more than the rate of inflation are listed. Those that earn higher returns take over those that earn lower returns. Makes sense, no?
and no Devin, it is not all about the money supply, it's about the real economy and real productivity
You've been reading too much Galbraith!
You don't have to be an 'Austrian' to think the Fed policy might have had something to do with the boom-bust cycle of recent years. I've never found these wholly endogenous accounts of financial markets at all compelling - animal spirits, bubbles driven by manias? Perhaps.
But the institution that decides monetary policy must have some effect, no?
Josef-
Real productivity is very important. But it only matters to the investor if it results in earnings growth that will eventually, some day, result in dividends. You could have all the productivity growth in the world, but if the stock doesn't pay dividends, you might as well be investing in baseball cards.
Second, in the very long run, it's impossible for the price of stocks to grow at a higher rate than the growth in the money supply. It's a logical impossibility. Productivity growth translates into cheaper goods, not into general stock price appreciation. The only way that productivity growth causes stock prices to increase, is that productivity growth allows the Fed to allow money supply growth without eroding people's standard of living. It's that money supply growth that translates into higher stock prices.
I had two advantages in realizing just how overheated the market had become. One, I was teaching MBA students. Just listening to how they reasoned made it pretty clear that we were well into bubble territory. My favorite semester was spring, 2000, just watching the changes in their degree of certainty from January to May.
Two, I had just come back from Hong Kong. When I first moved to Hong Kong, the Hang Seng Index was below 6,000. I saw it climb, and can remember the speculation about whether it could possibly cross 10,000, then saw how, when it finally closed above 10,000, people just shrugged and asked when it would hit 11,000. The Hang Seng went above 15,000 in the 6 years I lived in Hong Kong. When I left, it was back down to about 7,000 again (maybe 7,500, but only half of the fairly recent peak).
After the bubble in the US in the 1980s, there was the bubble in Japan (which I experienced only through the Hawaiian real estate market), then the bubble in Southeast Asia, and then I came back to the US to see the internet bubble, and it was deja vu all over again.
But no, Creech, I didn't make much money from my conviction that it was a bubble, since I got out of the stock market (on the long side) in the summer of 1999, and the market kept climbing. I did some shorting in early 2000 (how the MBA students gasped when they heard I was shorting Best Buy), but it takes deep pockets to hold shorts for very long in a bubble.
Wouldn't this be a good time to take a loan against your 401(k)?
From the day Greenspan took the Chairmanship till the day he left M3 rose at a 9.7% annual rate. During that exact same period the S&P 500 average rose, you guessed it, hopefully, at 9.7% annual rate.
Correlation is not causation. Perfect correlation suggests an significant causal relationship. logic does too but there isn't room here.
During the stock boom the trope that stocks rose 10% per year became gospel. The first problem was the major stock index averages were always used to prove it. The thing is that the components of the indexes are ever changing. The second problem is that half of the historic total return on stocks was dividends yet during the bull that started in 82 divdends fell and fell and fell.
Dividends are real wealth, mostly. (FRE was paying one till last week so there are exceptions) But divedends are sooooooooo booooooooooooring. 2%! That's for sissys and old ladies. Never mind that the old benchmark 3% dividend benchmark was half of the more honest 6% long term hisoric average return on stocks.
The Real Estate bubble was brought to you by the same people. Everyone was going to get rich on housing inflation. So now 80% of Americans have an IRA worth less than $18K and a house that is worth if they are lucky what they paid for it and deeply in debt. In other words a negative net worth.
Which was always the goal. I know most can't believe that the goal was to make Americans debt slaves with no economic security but let the results speak for themselves. Every suit in Washington and Wall Street still says the economy is fundamentally sound.
I guess that McArdle is calling the trough (as it were) a bit early; but "Buy before the trough, sell before the peak" remains sound investment practice.
rapier-
You're overselling the case. In the long run stock prices are bounded by money supply growth, but in the short run the correlation will depend on other factors ( how newly created money enters the market, asset allocation decisions, hype cycles, etc.) M3 grew enormously in the 1970's yet stock prices stagnated. Also, M3 is fairly arbitrarily defined number, so there's no reason why it in particular would track exactly with stock price growth.
You folks ought to check out the first 31 slides of this PDF by Vitaliy Kastenelson, the fellow I mentioned earlier. Lots of pictures and charts, quick reading.
Consider also Jim Rogers's explanation for why stocks and commodities tend to move counter-cyclically. When commodities are cheap and plentiful, companies that don't produce commodities have lower input costs and higher profits. These companies grow and attract capital -- e.g., in the late 1990s, a lot of folks were interested in investing in tech companies, but no one was excited about digging a new copper mine. Eventually, demand for commodities grows as current sources deplete. At that point, commodity prices rise, spurring investment in new mines, wells, etc. Those higher commodity costs are a drag on companies that require those commodities as inputs. Capital starts to flow toward commodity-producing companies. Those companies enjoy a secular bull market in commodity prices because of the lag times before investment in new mines, etc. leads to significant new supply.
Eventually, the new supply overtakes demand, and commodity prices decline. The low commodity prices fuel profit growth in non-commodity producing companies, and the cycle turns again.
Devin Finbarr,
Thanks for the link to Mark Cuban's blog. Interesting stuff. I just posted a couple of excerpts from it on my site.
But when the next boom starts, all those lovely cheap assets will pop at once.
I basically agree and am putting money into mutual funds right now, but...how are people who went long on the stock market in Japan in 1998 doing these days? Maybe they're doing okay, I don't know -- I'm genuinely wondering.
In a world of perfect information, stock prices would never change; we'd simply discount the cash flow of a known future.
That may be one of the dumbest things ever written. To give a fairly obvious example of why, when Company XYZ announces that they have built a better mousetrap, and the world is beating a path to their door, do you really think that this will not affect the price AT ALL?
Really?
Of course, this is all based on the premise that markets are rational, and that the amount and clarity of information is perfect . . .
On the actual planet Earth, markets are composed of people, and people are not rational. It is not even intuitive to think they are. Market actions, including stock prices - where's the accounting for inflation in this argument? - move with the herd. And why are we reading stories about Lehman and AIG? The market moved with the herd to asset-backed securities, not because that was the rational thing to do, but because everyone else was doing it. The people who were supposed to be rational and work with information, the people running Bear and Lehman and Merrill and AIG, weren't so at all. Only in theory could they be expected to be rational, but here on planet Earth, they saw the hot thing and hopped on it. People are trendy, and putting on a suit and reading Ayn Rand doesn't cure them from this - in fact, reading Ayn Rand and cleaving to an ideology to explain the world is just another trend.