The impetus for this post came from David Stockman. He has been making the rounds flogging his new book "The Great Deformation". Stockman has always been good at self promotion. So he has propelled his book, ostensibly a dry economics tome, to number 7 on the New York Times Hardcover nonfiction list as of the day I write this. Unfortunately, I am familiar with Mr. Stockman. He first came to national prominence as director of the Office of Management and Budget under President Ronald Reagan. The OMB is the font of expertise for all things budgetary in the White House.
Stockman was famous as a proponent of what came to be referred to as the "Laffer Curve". The Curve was a shorthand reference to a concept pushed by economist Arthur Laffer. The main idea was that if you reduced tax rates the economy would improve so much that tax revenues would actually go up. Most economists dismissed the idea. But it was politically convenient so it garnered a great deal of support among conservatives. If correct, the concept would result in lower tax rates and a smaller deficit at the same time. Unfortunately, supporters have only been able to find one instance where this actually happened. In the Kennedy administration tax rates were cut and the economy took off. This strong economic growth resulted in enough increased tax revenues to keep the deficit low.
Unfortunately, what happened during the Reagan years was what most people predicted. After a recession in the first couple of years (caused by a change in Fed policy) the economy recovered but not enough to cover for large increase in defense spending (and fairly modest cuts to social programs). Revenues eventually went up a little but spending went up a lot during the same period. So the federal deficit ballooned.
After he left office Stockman claimed that he had become dubious of the whole "Laffer Curve" idea early on. But he did not say anything negative publicly about Reagan fiscal policies until well after he left the administration. Later criminal and civil charges were filed against him in connection with his actions while running Collins & Aikman, a company that went bankrupt. I believe none of these charges led to a conviction. In short, Stockman's record is spotty at best.
I have not read the book. What I want to investigate is a contention he has made in several interviews he has given in the process of promoting the book. He contends that there have been three recent bubbles: the dotcom bubble, the mortgage bubble, and the financial meltdown bubble. He goes on to blame the Fed for all three bubbles (and many other sins). At this point you will be less than surprised to learn that many experts disagree with his analysis. But I am just going to stick with the "three bubbles" part. Are these three events in fact bubbles? To answer that question it is important to understand what a bubble is.
Bubbles have been around for a long time. One of the best works on the subject, "Extraordinary Popular Delusions and the Madness of Crowds" by Charles Mackay was first published in 1841. It has been in print nearly continuously since. Amazon has new copies of several versions of the book (one of which was published in 2012) for sale right now. An early bubble described by Mackay was the market for Tulip bulbs in Holland in the 1630's. Let me use this event to describe the characteristics of a bubble, or more properly a "speculative bubble".
At the time when our story starts, the Dutch has been selling Tulip bulbs for some time. As they became popular an informal market developed. For explanatory purposes I am going to arbitrarily divide market participants into "investors" and "speculators". In my explanation an investor is someone who has a stake in the underlying product. He grows Tulips, or sells Tulips at retail, or whatever. He is primarily in the market because he has a commercial interest in Tulips. A speculator, on the other hand, just wants to make a buck. He has no intrinsic interest in Tulips. They are just a means to an end. Now in the real world the situation is much more complex. There are other types of participants and a particular actor may be part investor and part speculator, even if we just look at a single transaction. But this artificial separation makes it easier to see what is going on.
I will also assume something called the "intrinsic value" of the product, in this case Tulips, exists. Determining intrinsic value is often somewhere between difficult and impossible. And experts can and will differ on what the correct intrinsic value of a specific commodity at a specific time is. But we are going to ignore all these problems and pretend there is an intrinsic value and that it is knowable. Now let's look at markets.
An investor is in a market because in some sense he has to be. There are many forces that push a price up or down. So in a normal market we can expect that the price of a product will sometimes get above its intrinsic value. In this case we can expect prices to eventually go down. Similarly, the price can get below intrinsic value and in this case we can expect the price to eventually rise. The fundamental law of speculation is "buy low - sell high". So, if a speculator can establish the intrinsic value, and if he can identify times where the price is below intrinsic value, he can buy low and expect to sell high later. Similarly, he gets out of the market when the price is above the intrinsic value and waits for the market to "return to the norm".
In this situation a speculator provides an economic benefit to the economy as a whole and specifically to investors by providing "market liquidity". An investor may need to sell when prices are low. The speculator will buy when no one else will. Similarly an investor may need to buy when prices are high. The speculator will sell when no one else will. In these kinds of situations speculators perform the service of smoothing out the market, which is usually beneficial to investors in the long run.
So we have now seen on display two of the components necessary for a speculative bubble. We have a market and we have speculators. And in this benign situation we have described so far, speculators are performing a useful function. But things can go wrong. Let's see how.
Suppose we have a market that has performed well (and in this case by "performed well" I mean gone up) for a significant period of time. For whatever reasons prices have risen steadily and apparently inexorably. This sounds like an opportunity to print money. We buy and hold. The market inexorably goes up. We sell at a profit. Any fool can make money in this market. This is the third component of a bubble. It is usually but not always present.
People may mischaracterize the actual history of a market so that it seems like it always goes up. And probability tells us that if we monitor a lot of markets, and each market has a certain amount of random price fluctuation, then eventually some of these markets will show a pattern where prices seem to always (well, for a "long" time, whatever that is) go up. Now the speculators we talked about before had a level of expertise. They were able to determine the intrinsic value of the product. But in a foolproof market that expertise is no longer necessary. The market always goes up. And we now have the fourth component of our bubble, the "quick buck artists". These are people who have little or no expertise in the particular market.
This set of circumstances moves us into the inflation phase. Prices quickly and inexorably go up. In our Tulip example this happened when French speculators started moving in in 1634. Prices started accelerating and by 1636 they were zooming up. Nothing about the underlying Tulip market had changed. But now trading was dominated by speculators. It is also when investors and the early more experienced speculators started becoming concerned that prices had gotten out of control. Now we move into the "greater fool" phase.
Knowledgeable people conclude that prices are at foolish heights. But it appears that there is always a greater fool who will pay even higher prices so they stay in the market well past when they normally would. Then we finally come to the last phase. At some point the market runs out of greater fools. At this point prices start to weaken and perhaps fall slightly. Knowledgeable people now start to sell aggressively before prices fall even further. The market crashes (i.e. the bubble bursts) and prices drop, frequently to well below intrinsic levels.
To summarize, we need a market and the market needs to be open to speculators. We need (not always but usually) a period where the market goes up apparently inexorably. Then more speculators jump in and prices start rising rapidly. We then have the "greater fool" period, followed by the peak and then the crash. This pattern has been well known for hundreds of years now. When the Tulip bubble happened no one had seen anything like it before. But it certainly wasn't the last bubble. Mackay documents a number of other bubbles like the "South Sea Bubble" that are now known only to historians of the subject. At some point it dawned on some speculators that it was possible to manufacture bubbles.
By the late 1800's "stock operators" were routinely trying to create and profit from bubbles in the price of various individual stocks. The 1923 novel "Reminiscences of a Stock Operator" by Edwin Lefevre documents many of the popular schemes of the time. I bring this up because I want to differentiate between the "natural" speculative bubble, which arises naturally and is then taken advantage of, and the "artificial" bubble, which is created as a scam from the start. With all this out of the way let me now take up the three bubbles that attracted Mr. Stockman's attention.
The dotcom bubble is accurately characterized as a classic natural bubble. Also referred to as the "tech bubble" it started gathering steam in the 1980's. The Apple II (introduced in 1977) and shortly thereafter the IBM PC (introduced in 1981) made home computers practical. Many people who had heretofore not thought of themselves as tech-savvy got computers and fell in love with them. They imputed their feelings to the market as a whole and started looking for stocks they could invest in. An early example was Netscape. Netscape brought the browser to the masses. When Netscape stock went on the market it was immediately snapped up to the surprise of Wall Street experts.
In the beginning Netscape had a reasonable business model. They were going to license their product for $25 a pop. Then Bill Gates came along and gave Internet Explorer away for free. Netscape soon abandoned their licensing model. This destroyed their business model but the public continued to support the stock anyhow. Eventually, Netscape was sold to AOL in a deal initially valued at $4.2 billion (and later at much more). So the faith of the general public in Netscape as an investment was eventually vindicated. It would not be the first time.
Bill Gates was of course famous for creating Microsoft. Microsoft also went off for crazy prices. But, unlike Netscape, Gates turned out to be a savvy businessman. Microsoft turned in spectacular earnings and profit figures year after year. So Microsoft stock zoomed into the stratosphere. Apple had a much bumpier ride, at least at the beginning. The Apple II was a big success. But follow on products (does anyone remember the Apple III) were less so. After a string of duds Apple introduced the Macintosh in 1984. But it too was not a commercial success. It only garnered significant sales after Steve Jobs left the company. Apple then got into so much trouble that Jobs was brought back to rescue the company. The company was rescued and went on to a run of spectacular success. But this mostly happened after the dotcom bubble exploded in 2000.
Microsoft stands out as the great success of the dotcom era. Mostly we have companies with track records like Netscape (never made any real profit but was eventually sold for megabucks) and Apple (up then down and eventually back up but only after the bubble burst). Nevertheless the public was fascinated with these stocks and would buy them at nearly any price. This was in spite of the fact that in most cases no one could figure out how the companies would ever make money.
So in the early days you had a number of these new style tech stocks. And many had a record of inexorably rising in spite of the fact that they never made any money and it didn't look like they would make money any time soon. The most common tool Wall Street uses to calculate the intrinsic value of a stock is PE or the price/earnings ratio. If the price of a stock is $20 and its earnings for the year are $1 per share its PE is 20. Historically, a PE of 15 is considered standard. Anything between 12 and 18 considered within the normal range. There are many reasons why the PE of a stock should be below 12 or above 18 but those are special circumstances. Generally, in the absence of special circumstances, a stock is considered cheap if the PE is below 12 and expensive if the PE is above 18. Many of these tech stocks had no earnings, no "E". So their PE was off the chart on the high side.
This might be ok if there was reason to believe that earnings would skyrocket in a couple of years. If we were certain that three years from now the stock would be earning $5 per share then the "forward" PE would be 10 if the price of the stock is currently $50. This forward PE of 10 might justify buying the stock now. This kind of logic is risky but not insane. The problem with many of these stocks is that no one could figure out how they could earn say $5 per share 3, 5, or even 15 years out. So purchasing these stocks appeared to be completely insane to Wall Street analysts. But the public bought them anyhow. Enter the greater fool.
From start to finish the dotcom bubble took about 15 years. That is an extremely long time period by Wall Street standards. And Wall Street's approach to stocks that eventually became part of the tech bubble went through three stages. Wall Street had been investing in "tech" for a long time. GE dates back to the 1800's. IBM was a Wall Street darling in the '60s and the '70s. But these were big well known companies. They were thought of more as "industrials" than as some weird subspecies. These new companies were an entirely different kettle of fish. By this time Hewlett Packard was a substantial company. But it wasn't a giant. And it had taken decades to grow to its current (as of say 1980) medium size. The idea that a company could go from "startup" to "largest market cap in the world" as Microsoft did was literally unimaginable. So these tech companies started off as a side business. Wall Street could make a couple of bucks off them by managing their IPOs (Initial Public Offering of the sale of the stock) but that was just a nice but small sideline business for a Wall Street firm.
But the public's appetite for the stock of these companies seemed to be insatiable. So Wall Street came to see them as a serious line of business that could generate substantial profits. And the public continued to be happy to shoulder responsibility for being the greater fool. So Wall Street got serious about the business of shearing the sheep.
Wall Street stock brokers like Merrill Lynch maintain a group of people called "stock analysts". They are supposed to provide informed and unbiased research on stocks. By this third stage all the stock analysts had nothing but praise for these companies as sound investments. Why, since the characteristics of the underlying companies had not changed? They still had no earnings and little to no prospects for earnings in many cases. The answer is that the same company has a retail business, servicing individual investors. But it also has a corporate business where they do IPOs, float bond issues, advise corporations on various financial matters, etc. It was easier to get the "corporate side" business of a particular company if the analyst was saying nice things to retail customers. So analysts were given their marching orders to come up with reasons why these companies were good investments. This required a great amount of skill at creative writing. But those analysts that prospered turned out to be very good at it.
Cooking analyst's reports is a bad thing and I believe it is illegal. But I don't think it contributed much to the dotcom bubble. A large segment of the public had started buying these stocks long before this bad behavior became wide spread. Were some people who might have otherwise dodged the bullet enticed into purchases they would not otherwise have made by these reports? No doubt the answer is yes. And I am sure that a number of pension funds and other large investors ended up putting more money into these stocks than they otherwise would have. But the dotcom bubble was of long duration. And it was recognized as a bubble for longer and by more people than any other bubble in history.
The stock market tends to go in one direction for three to five years, or so the experts believe. Then it changes course, at least for a while. The market started up from a bottom in 1982 and climbed more or less continuously until 2000, People started saying "it's time for a correction" by about 1986 or 1987. By the early '90s there was a "when's the correction going to start" cottage industry among investors. But the market continued on its upward course. There were corrections (like Black Monday, October 19, 1987) but they tended to not last more than a few months. Then the upward trend would resume. I was introduced to both of the books mentioned above during this period.
By the late '90s jokes about the bubble were common. I remember a fund manager that I respected saying "I don't understand it but I have to be in these stocks to make money" during this period. But the market kept going up even though "everybody" knew it was too high and that prices couldn't be sustained indefinitely. Over and over in this period the "sensible people" kept being made to look like fools while the "greater fools" made bales of money. What finally happened to derail the gravy train?
The overall economy took a slight dip. This put some people in a modest financial squeeze. So they sold some of the stock they had made so much money on so that they could meet their other financial obligations. This drove the price of some tech stocks down. Much of this stock had been bought on margin (with borrowed money). When the stock price goes down, even a little, margin investors have to either put in more money or sell the stock. A significant number of people, either because they wanted to or because they had to, sold the stock. This drove prices down further. This resulted in more margin calls, etc., a classic example of a vicious cycle. At first only a few stocks went down. But this caused enough investors to decide it was time to sell other tech stocks too, "just to be safe". So the decline in tech stocks spread and soon took the whole category down. The category of speculative tech stocks went down 90% almost over night.
The tech sector has never recovered completely. The NASDAQ is tech heavy. Recently both the Dow Jones Industrial Average and the Standard & Poor "500" have each hit new "all time high" records. The record high for the NASDAQ is 5048.62. It is currently at about the 3000 level.
(to be continued)
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