Average stockprices swing by 50% every year, while underlying business value is far more stable. Share turnover is enormous. The number of shares traded compared to the total shares outstanding spiked from 42% to 78% on the New York Stock Exchange between 1982 and 1999 and from 88% to 221% on the Nasdaq between 1990 and 1999. Prices on particular stocks rise sharply and fall furiously within days and weeks without any link to underlying business values.
Speculation rages, and the speed of price fluctuation has multiplied dramatically compared to previous decades. Market volatility has increased roughly in proportion to the dramatic increase in information— both real and imagined—that is readily available. Getting in before the rise and out before the fall has become the day trader’s mantra, one that reveals not only the presence of Mr. Market but the existence of his coconspirators by the thousands.
Roller coaster rides in stocklevels have been known throughout the history of organized market exchanges, but these rides took major indexes either up or down together. A quite different trail was blazed in the late 1990s and early 2000s as the Dow Jones average of leading industrial companies went one way and the Nasdaq average of more technology-oriented or younger companies went another.
Frothy new economy devotees bid up the new stocks and tech stocks to wild heights compared to their pathetic or negative earnings while eschewing the stodgy old economy stocks that continued to generate steady earnings increases. The new giddiness subsided, and the Dow surged while the Nasdaq slumped. But then one recovered while the other dropped. Topsy-turvy is the only description for this wild world.
Anyone seeking to divine some deep logic in these flip-flopping patterns, however, could stop looking on April 14, 2000, when the indexes plunged together, the Dow by 6% and the Nasdaq by 10%. Then both rebounded the next trading day, with the Dow climbing backnearly 3% and the Nasdaq moving backup 6.6% (and the day after that experiencing up pumps of nearly 2% and over 7%, respectively).
No deep logic explains these swoons or this pricing divergence, and all you can really conclude is that Mr. Market was being his (un)usual self. Staggering as these data are, consider too that in the first quarter of 2000, the Nasdaq suffered four declines of 10% or more and then in each case rebounded. In April 2000 alone it recorded two jumps that were its largest in history and three drops that were its largest in history. In the late 1990s and early 2000s, Dow busts were equally commonplace, as other drops exceeding 3% show.
The Dow busts of August 1998 were particularly potent: They wiped out all the gains the Dow had made during that year. So was the March 2000 bust: It set the Dow backto where it had been about a year earlier.
If you prefer to focus on Mr. Market’s euphoria, take the bursts in the Dow exceeding 3% that occurred in the late 1990s and early 2000s .
Apart from their magnitude, consider the proximity of these Dow busts and bursts. The charts show two back-to-back reversals: The October 27, 1997, bust of 7.18% was followed the next day by a 4.71% burst, and the August 31, 1998, bust of 6.37% was followed the next day by a 3.82% burst. The three busts of August 1998 were promptly followed by three bursts of September 1998, much the way the bust of March 7, 2000, was followed by the bursts on March 15 and 16 of that year. It is hard to believe that these successive bursts and busts are based on changes in fundamental information investors were rationally and efficiently acting on.
Beyond busts and bursts on the Dow and the Nasdaq in the late 1990s and early 2000s, recall one of the most dramatic single episodes of Mr. Market’s presence on Wall Street: the 1987 crash. The Dow vaporized by 22.6% on a single day and nearly 33% in the course of one month. The 1987 crash was not limited to the 30 common stocks on the Dow but was worldwide. The New York Stock Exchange, the London StockExchange, and the Tokyo Stock Exchange all crashed.
If stockmark et prices really obeyed the ever-popular efficient market theory (EMT) and accurately reflected information about business values, some major changes in the body of available information would be required to justify that crash. Many people tried to explain it as a rational response to a number of changes in and around mid-October 1987, including the following:
- On September 4, 1987, the Federal Reserve Board raised the discount rate.
- On October 13, 1987, the House Ways and Means Committee voted to approve income tax legislation that would disallow interest deductions on debt used to finance business acquisitions.
- On October 18, 1987, Treasury Secretary James Baker publicly announced an intention to reduce the value of the dollar.
- Market prices were already high by historical standards.
Some experts attributed the 1987 crash to various institutional factors, including program trading and portfolio insurance that were set to sell off big chunks of the portfolios of large investors as prices fell. When prices fell, these program sales pushed them down even harder. Other experts pointed to derivative securities, often exotic instruments whose value fluctuates with changes in the value of benchmarks such as interest and exchange rates. These derivatives are usually intended to reduce riskand volatility in such benchmarks, though if poorly designed can exacerbate the volatility in stockmark et pricing.
But given the international nature of the crash and its depth, hardly anyone accepts these explanations. Most people also agree that it is impossible to explain rationally the radical price changes that have occurred at other times—whether the 1929 crash, the 1989 break, or the general 1990s and 2000s volatility. Market frenzy simply cannot be explained using EMT but is a product of a complex of forces in addition to actual changes in information about fundamental business values.
Market frenzies like these are not isolated and certainly not unique episodes in financial history. On the contrary, market bubbles— situations in which prices are way higher than values—happen all too often. There was a technology stockbubble from 1959 to 1961; a bubble in the so-called ‘Nifty Fifty’ stocks in the late 1960s and early 1970s; a gambling stockbubble in 1978; a bubble in oil and energy stocks in the late 1970s; a home shopping bubble in 1986 and 1987; and a biotechnology bubble in the early 1990s (with a resurgence in the early 2000s), and all of these resemble the Internet or dot-com bubble of the late 1990s and early 2000s.
The market capitalization (price times shares outstanding) of the Internet sector was about $1 trillion at the beginning of 2000, with sales of $30 billion and losses of $3 billion.5 In 1999, scores of initial public offerings (IPOs) of Internet stocks were launched, many in the same industry where it is going to be impossible to have more than a handful of profitable companies. Deals included, for example, 17 health-care related companies, seven business-to-business e-commerce companies, six music distribution companies, five employee recruiters, and three travel agencies. It starts to sound like the “Twelve Days of Christmas.”
Driving this funding is the fascination with technological innovation, a fascination that characterized previous market bubbles as well. The 1960s technology bubble arose from innovations such as color television and commercial jet aviation. It spawned an IPO boom in electronics and other businesses whose names ended with “tron” or “onics” not unlike that of 1999’s dot-com boom.6 Takeovers surged in both periods, fueled by high-priced stockthat built many corporate empires. All the talkwas of a new history-defying era— called a “new paradigm” in the 1960s and the “new economy” in the late 1990s and early 2000s. But as Warren Buffett quotes Herb Stein as saying, “If something can’t go on forever, it will end.”
The Internet bubble may not end as abruptly as the 1960s electronics bubble did. It may instead follow the path of the stockmark et bubble in Japan in the 1980s, which ended in a gradual and total erosion of stock prices in the Nikkei average throughout the decade of the 1990s. One thing the two periods have in common—and one of the most striking common features of speculative bubbles generally— is the emergence of “new” ways to defend the high prices.
In 1980s Japan the fuel was stockprices based not on the earnings or cash that can be generated by a business, but on underlying asset values the businesses owned, which themselves had been rising to the stratosphere as a result of aggressive real estate speculation. We’ll soon see that the same alchemy plagues the turn of the twentyfirst- century United States.
These examples merely manifest in U.S. stockmark ets the emotional drives inherent in human market making, exemplified more generally not only by the 1980s Japanese experience but by classic episodes of bipolar disorder such as the Dutch tulip bulb mania of the 1630s and the British South Sea exuberance just prior to 1720.
In each of those cases—as in most others—the initial reason to buy may have been sound. Rare tulip bulbs in Holland were valuable because the novelty of that flower in Holland turned it into a status symbol. Shares of Britain’s South Sea Company were valuable when it began to exercise its royal grant of monopoly trade with Spain.
Read More : Swings ,Bubbles, And Crashes
