Is the Stock Market a Bubble?

I can’t speak for everyone in the bubble camp (all five of us), but I am not sick about the strong stock market; nor am I mad that the economy has done well. I was very bullish on the economy from the 1991 lows until Asia fell apart in late 1997. I am, however, very concerned about what happens when the bubble bursts.

We agree that bubbles are rare. There have only been two large bubbles this century: the late ‘20s in America and the late ‘80s in Tokyo. Were they not rare, they would be more easily recognized and prevented before they became large and destabilizing. In my opinion, this bull market started to become a bubble in 1995, after the Fed and Treasury bailed out Wall Street by bailing out Mexico. The liquidity burst and the moral hazard created at the time–which caused investors and speculators to believe that they would always be bailed out–has continued to this day after we saw the same sort of process at work with Russia, Brazil, et al.

There are differences between Japan’s bubble and the bubble of the ‘20s that we had in this country. Japan’s bubble primarily was a real estate bubble, and that was the epicenter of the speculation. What was interesting is that few transactions took place. Recently a prominent Japanese department store sold off some land underneath their building. It was the first real estate transaction to have occurred in downtown Tokyo in almost 50 years. The prices that Japanese real estate “soared to” were based on projections related to the government land tax. Real estate was borrowed against and stocks were speculated on in the Tokyo market, and that was used to speculate on more real estate and more securities.

So the mechanisms don’t have to be exactly the same. The claim has been made that our valuations aren’t as crazy as Japan’s were, but that isn’t true. The Nikkei traded to around 70 times or 80 times earnings. The top 10 tech stocks have a valuation of about $1.2 trillion, which is about 50 percent of the valuations of all Japanese equities. The Nasdaq itself trades over 90 times earnings. Our stock market capitalization is $14 trillion, and it’s 140 percent or 150 percent of GDP. The peak in Japan was 120 percent. The peak in 1929 was 80 percent. So the bubbles are not going to be created exactly the same, end in the same way, or have precisely the same aftermath. But what we can see is that the aftermath is horrendous.

Look at the problems Japan has now. Economists who are big on revisionist history blame the policies post-bubble for the problem, just like people blame the policies of the ‘30s for the Depression. But the problems were the excess capacity and the speculation that went on beforehand, not the policy that went on afterward. I would like to quote from a very credible source about what the period was like in the ‘20s. His name is Benjamin M. Anderson, who from 1920 to 1937 wrote the Chase Economic Bulletin and was the bank’s chief economist. He was a contemporary critic of the monetary authorities, as he understood at the time that the policies were reckless and would lead to disaster.

In a book titled Economics and the Public Welfare: 1914-1946, published in 1948, he wrote, “Those who see history only from the outside easily convince themselves that impersonal social forces are overwhelming, and that the individual men in strategic places make little difference. But that is not true. The handling of Federal Reserve policy by Strong and Krissinger in the years 1924-27 led to ghastly consequences from which we have not yet recovered. And courageous men occupying their positions would have avoided the mistakes these men made.”

So in essence, three years of irresponsible monetary policy set off a chain reaction of trouble that lasted for 20 years. Tokyo’s floundering now, 10 years and counting, after the end of its bubble and can’t seem to solve the problems. So my complaint about the bubble has to do with the aftermath and what I fear it could be if, in fact, this is a bubble. It’s also a problem for everyone. For instance, if I choose to stay out of what I perceive to be a bubble, and I miss out by being wrong, tough luck for me. But if by being irresponsible the authorities allow a bubble to take place, everybody has to pay in the aftermath. That isn’t right.

Now people who think that it’s not a bubble are fond of making the case that the economy’s strong and there’s no inflation. I agree that the economy has clicked along; I don’t happen to believe the government statistics, but let’s talk about what’s supposed to power stocks. It’s not the economy–it’s supposed to be earnings. In our president’s language it would be, “It’s the earnings, stupid.” And yet the earnings growth isn’t there. Since the end of 1996, the S&P 500 has risen 70 percent. The S&P earnings growth has risen only 2 percent, from $38.73 to an estimate this year of $39.50. From the end of 1994 to present, the S&P is up 177 percent, with earnings growth growing only 29 percent. And this is with all the accounting gimmickry we use these days in terms of trying to make earnings look better with the write-offs and paying employees with stock options. So as far as inflation, the absence of CPI inflation does not mean that we cannot have serious trouble. In fact, the absence of CPI inflation is a prerequisite for keeping the monetary floodgates open too long. The resultant asset inflation that has occurred now and in previous bubbles is the real danger and what causes the bust.

So what I call the mania phase of this bull market has not been accompanied by earnings growth; it’s been accompanied by mass speculation. It’s not a solid foundation at all. Stocks are going up because they’re going up. According to Forbes, we now have 5 million day-traders. And take a look at the last couple of weeks. We had this wild orgy for stock splits. Why? Because companies were splitting their pieces of paper. Microsoft added nearly $50 billion in the five days after its stock split. Now stock splits have become the raison d’être. Adding a dot.com makes stocks go up. It’s not about earnings growth; it’s about speculative frenzy.

There’s one thing that people seem to forget and I’m surprised it’s been forgotten so quickly. Dave made the case that the Japanese never came close to possessing a very large, very dominant economy. In fact they are the world’s second largest economy and in the late ‘80s here in America and around the world people were terrified that the Japanese were going to own the world. They bought Rockefeller Center, they bought Pebble Beach, they and their management techniques were the envy of the world. We Americans were stupid and they were the geniuses. And in fact, they do have a lot of world-class companies and they dominate a lot of industries. They don’t look so dominant now because they are in a sinkhole. But we can’t forget about Sony and Nissan and Toyota and Fuji Film and Hitachi and Toshiba. When they are in a business they oftentimes dominate it. So they were every bit as powerful relative to the world in terms of perceived dominance then as we are now. And they had a much more powerful argument in the fact that they were a nation of savers and they always took a long-term view.

That has not typically been our pattern and in fact the latest statistics show we are not saving, we’re consuming more. Now I think that might be because people generally believe they are saving since their stocks are going up. But we also know that these tremendous stock market gains are fueling consumer spending and keeping the economy alive. So I continue to believe this is a bubble and that the stock market participants are acting in a way that is not reminiscent of sane investing but of rank speculation.

Presently we’ve got a $14 trillion stock market and in terms of participants, it’s not knowable, but we can certainly guess that a huge percentage of the population is speculating in stocks. So in terms of size, this is far bigger than Tokyo. (Real estate plus equities combined only reached approximately $6 trillion in Tokyo; granted, that is a higher multiple of GDP than we now face, but in terms of sheer dollars we have a big bubble.) The earnings growth that’s supposed to be there along with a strong economy isn’t there. I wouldn’t care if it were a bubble and people were out there having a good time, except for the horrific ramifications of what comes next if it turns out that is the case.

One of the definitions of a mania, or a bubble, is that people are buying stocks simply because they are going up. It’s no different than in a chain letter or in a Ponzi scheme. And what started out as a great idea–investing in the long term for equities–has morphed into a wild, speculative frenzy.