Yes, Virginia, There Is A Speculative Bubble

Is the long-awaited stock market correction at hand, or is this the bull market that refuses to die? Lately, a lot of smart people have concluded that the market has peaked. Yet in the first quarter, investors put a record $120 billion into equity funds, most of it into aggressive, high-growth funds. When exuberance is truly irrational, it tends to be impervious to evidence.

PaineWebber Inc. recently ran a full-page ad warning investors to be prudent. "We have said it countless times before," the ad declared, "and we will say it again: In the long run, only two things determine stock prices--earnings and p-e. Yet many of these `new new industrials' have no earnings." Robert J. Shiller's new book, Irrational Exuberance, cites a 1999 Barron's poll, which asked money managers: "Is the stock market a speculative bubble?" Amazingly, 72% answered yes. Even the bullish Abby Joseph Cohen of Goldman, Sachs & Co. recently announced that she has pared her exposure to stocks.

But investors don't want to believe the party is over. At first, they fled "old economy" stocks for the technology sector. They fled Internet retailers for high-tech business-to-business companies. Then they fled back into traditional blue chips. (Did somebody say "herd behavior"?) What they have not done yet, despite five interest rate hikes, is to flee stocks for money-market instruments.

NEW FAITH. Optimists insist that the New Economy really is so new that historically outlandish valuations are justified. They cite three key factors. The Internet economy portends a new era of permanently higher productivity growth, higher economic growth, and higher profits. The baby-boomer money pouring into the stock market will keep share values up. The new faith in "stocks for the long run" will prevent panic selling.

The pessimists, led by Shiller, suggest that the present level of share prices is a classic bubble. He likens the market to a "naturally occurring Ponzi scheme," a self-deception by giddy investors who assume unsustainable returns, on the premise that other investors will be even giddier.

At some point, however, a stock price has to reflect earnings. And earnings plainly cannot possibly justify present multiples. Shiller cites one company, eToys Inc., established in 1997 to sell toys over the Internet. Its stock value soon soared to $8 billion, higher than industry leader Toys `R' Us--even though Toys `R' Us had 400 times its sales and ran a healthy profit of $376 million in fiscal year 1998, while eToys ran a loss. The price-earnings ratio of the market as a whole is now far in excess of 1929 levels.

Enthusiasts of Internet retailing mistakenly assume that each new company will enjoy monopoly profits. But regulatory policy and the laws of economics are necessarily constraining that euphoria. The Securities & Exchange Commission has been jawboning accounting firms to take their jobs seriously. As a consequence, a growing number of dot-coms are reporting lower actual revenues and poorer prospects for future earnings. The Justice Dept. is also insisting that antitrust rules be applied to the New Economy. And the patent laws are requiring that generic innovations such as video streaming be made widely available rather than hoarded. While some innovators such as Inc., with its patented "one-click" checkout system, have managed to defend unique business methods, these monopolies are being challenged as well. The Internet invites price comparison, which shaves profits.

This market has been cruising for a major correction. One trigger could be the Microsoft case and the implication that monopoly profits are not an inevitable aspect of the Internet economy.

As I write these words, I am preparing remarks for the White House Conference on the New Economy. What is surely new about the New Economy is higher levels of productivity growth, made possible by information technology. This is no small achievement. It means that we can enjoy near full employment with low levels of inflation and steadily rising real living standards.

But the Internet economy has not repealed the timeless rule that the worth of an enterprise must reflect its earnings capacity. It would be better for the real economy if some air came out of the stock market slowly. Alas, that is not the nature of bubbles--particularly when all that's sustaining the equity markets is the prospect of even higher share prices and not dividends. When the herd decides that the bubble can expand no more, the herd psychology is to cash out fast. In the long run, of course, the market comes back. But try telling that to a stampede.

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