In a book store near Wall Street the other day I picked up Irrational Markets, a treatise by investment adviser Don DeVitto on the prospect of a stock market crash. It is part of an increasingly popular body of literature that reflects a ghoulish fascination with past financial disasters, and it makes sober reading after 10 years of economic expansion in the US. Investors desperately want to know if another crash is coming, and how long will it take for stocks to recover.
This month especially, one year after the 57 per cent slide in technology stocks from a peak in March 2000 that wiped out $3 trillion (#3.22 trillion) in investor wealth, comparisons are being drawn with other stock market failures. Analysts recall the Dutch tulip mania of the 17th century, the South Sea Bubble of the 18th century, the US railroad stock tumble of 1837, the Wall Street crash of 1929 and the Japanese collapse of 1989.
Pessimists point out that the 1929 crash like today's Nasdaq fall followed a period of red-hot technology advances (air travel, electricity, radios, assembly-line cars).
Players on Wall Street have taken to sending each other charts overlaying an index of the Nasdaq against graphs showing the Dow Jones Industrial Average around 1929 and the Nikkei Average of 1989. One conclusion, the Wall Street Journal said, is that it takes longer to repair the damage than people expect.
The damage is already severe. Holders of stock in the Internet company, Yahoo, for example have seen it fall 90 per cent in 12 months, just as shares in Radio Corporation of America, the equivalent high-tech bubble stock of its day, tumbled from $500 to a few dollars in 1929. The bad news for those seeking historical precedents is that it took 30 years for Radio Corp shares to recover. Even the optimists believe it could take three to five years for new technology stocks to regain their highs.
There are, of course, significant differences from the past. The life-cycle of new technology is shortening thus stimulating demand for new manufacturing equipment, tax cuts are on the way, and chairman of the Federal Reserve, Alan Greenspan, who cut interest rates in January, is likely to take them down further soon, though rate cuts after 1989 in Japan were unable to stimulate demand, and only pumped air into the bubble.
Which brings me back to Irrational Markets, written by Mr DeVitto just as stocks began to go west. Americans were living in an economic dreamland and were in for a rude awakening, he argued. The economy was sitting on a mountain of consumer debt, encouraged by years of easy money and virtually non-existent credit standards.
Price earnings ratios, which fluctuate between lows of six/seven times earnings when interest rates are high to 20-25 times earnings when stocks are popular, reached 200 times earnings on the Nasdaq. Valuations relative to earnings remained far above historic norms. The long bull market propelled share prices to dizzying heights and led investors to expect returns of 20-30 per cent a year. Everybody wanted in.
One factor distinguishing the 1990s market from the 1920s was the degree of public participation, with stock ownership more widespread in mutual funds and retirement accounts. From 1987 the number of mutual funds in the US had grown from 431 to more than 10,000.
The stock market share of household wealth had grown from under 10 per cent to more than 35 per cent. However savings had fallen to zero. The consumer would therefore feel more acutely the financial impact of a stock market downturn than in the last recession in 1987. It was the optimism of the American consumer which held together the world economy, and sooner or later it would erode, Mr DeVitto said.
In 1929 over-leveraged investors were forced to sell as the market dropped. Could this happen again? One of the main worries of the Federal Reserve is that the slump could cause investors in mutual funds to head for the exits and force fund managers to start selling massive amounts of stock to pay off investors. The funds are cash rich but - a straw in the wind - an estimated $13.4 billion was pulled out of stock funds in February, the first month of redemptions for three years, and US money-market funds received $103 billion in January, compared with just $25 billion flowing into stock funds.
Perhaps it will be different this time, Mr DeVitto suggested, and the market will snap back, but Americans were still witnessing the most extreme bull/bear cycle of the century. "The bear stage is coming and it promises to be one of the most dangerous in history," he concluded. When I reached the book store checkout I noticed his slim volume would leverage $40 (#43) from my earnings. Whatever about his predictions, his book has a very high p/e ratio and he at least has figured out how to profit from doom.
