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The Story of a Bubble – and its Aftermath - Part 2

December 23, 1999


In the first part of this series we looked at factors that could contribute to a market bubble on Wall Street – if there is really one, of course. Keep in mind that about 3 out of 4 Americans believe, nay, truly know that the end of the Great Bull Market still lies many years and many thousands of Dow points into the future. The majority of market gurus regularly tell them so, which means it is true.

Investors also have faith in the ability of the Fed to manage the economy and the markets to ensure a never-ending increase in GDP and in company earnings, thus to sustain the long term bull trend in all market indices. And when things go wrong, as they did briefly in 1997 and even more so in 1998, the Fed will extend a helping hand to ensure that nobody really loses any money.

These people do not even consider the possibility of there being a market bubble. They know full well there were some doomsayers who believe so, and we all know how much money their views have made them over the past few years. This species is now practically extinct. In the words of a senior strategist at one of the large brokerages in New York, quoted in the media in mid December, "The only bears in New York are found in the zoo."

But the charts that were explored in Part 1 happen to show that levels of personal or consumer debt, expressed as a ratio of disposable income are at historical highs – at least over the past 40 years for which data is available. At the moment the ratio is substantially higher than ever before during this period. It can also be seen from the charts that whenever the relative level of debt has peaked, the high in the ratio was followed by a steep reversal in private debt relative to disposable income that lasted at least a good number of years.

It can be speculated this decline in the ratio is the reaction of people who have felt the pinch of having to service too much debt and who have taken concerted action to improve the state of household finances by reducing the gearing. Logic says that when people have expanded their relative level of debt in a climate of perceived wealth and a growing economy to where it begins to hurt, they undergo a major change in sentiment in their perception of the advantages of debt.

The current cycle of increasing consumption expenditure relative to disposable income – see Fig. 3 in Part 1 – started in March 1992. Over the 7 years to September 1999, the amount Americans had available as disposable income increased from R4.684 trillion to $6.670 trillion, for an increase of $1.986 trillion. Over the same time interval consumer expenditure rose from $4.139 trillion to $6.338 trillion – an increase of $2.199 trillion, which is greater than the increase in disposable income by $213 billion. Americans were spending substantially more than their increase in income – partly as a result of reduced savings, but also assisted by an increase in debt.

We make the assumption that America, as happened quite often in the past, is approaching a point in time where consumers begin to feel they are carrying too much debt and could soon be repeating earlier behaviour by reducing their relative exposure to debt. As discussed in Part 1, the ratio of debt to disposable income shows that there are distinct cycles in the degree of borrowing and use of credit. Whenever the load of debt becomes too great, American consumers enter a period where they reduce their relative exposure.

The actual figures show that during recent cycles when the ratio of dent to income declined, the amount of debt remained stable or even continued to increase gradually. The ratio of debt to income therefore declined because disposable income kept on increasing – a benefit of the strong GDP growth of the middle to late 90's. This is an important point to keep in mind.

Yet, even if the amount of debt merely remains stable, this would imply that funds to fuel growth in consumer expenditure will increase at a less steep rate than before. Further, if interest rates continue to increase, following the yield on the 30 year Treasury bond that is at 2-year highs, consumers might be compelled to cut back on their debt and begin to repay loans and reduce outstanding credit. If this should come to pass, the cooling effect on the strong and sustained growth in consumer spending of the past 7 years will be even more marked.

If there is a risk of reduced growth in consumer spending, the US GDP and company earnings too will suffer a reduction in the growth rate that people have become accustomed to over the past few years. How serious this cooling effect is likely to be is of course highly speculative and will be discussed later.

In this part of the series the question of market bubbles is addressed. We will try to identify certain features that could let us decide whether there really is a bubble or not. In the final parts, the overall situation of the market is evaluated to determine how robust the bull market really is and to what degree the characteristics of a bubble are present.

Finally, we will turn to the more speculative process of trying to put all the information together in an attempt to peer into the future, and thus to determine the likely aftermath of what is happening on Wall Street right now.

A market bubble? Really?

One man's bubble is another's bull market. How does one distinguish between a normal strong bull market and a developing bubble?

The people in all kinds of markets can be loosely grouped into two categories – investors and traders, or speculators. I would suggest that a market is "normal" when there is a certain proper balance between its populations of traders and investors. What this proper balance is can vary from market to market, and the ratio is not critical – up to a point.

For as long as this balance is maintained, the market is rational, almost as if the one section of the market keeps the other "honest". When traders or speculative action pushes the market either too high or too low, or in some other fashion introduce an imbalance in the market, investors – traditionally the more "rational" section of the market – will apply the basic rules of valuation that apply to that particular market and then act to bring the market back to where it belongs.

This of course takes place within quite broad guidelines – markets are quite robust and imbalances of any kind have to tend towards an extreme before the situation becomes unstable.

One could describe an investor as someone who expects a reasonable return on his money. In other words, things being equal and with a somewhat long time horizon, an investor would rate an adequate return on the investment as of greater importance than capital gains.

An investor is different from a venture capitalist, who is prepared to take many chances of which only a small fraction really pays off, but when these do the pay-off is very large and makes the venture capitalist a lot of money – more than ample to pay for those ventures that fold or fade away without much to show for the money invested. The investor is also different from the trader who opens a position with the intention of making a capital profit over a much shorter time horizon than that of the investor.

Differences between the types of market player are blurred and not very distinct, yet as a general rule most people would not have too much difficulty to distinguish one from the other – even though there will be variation in the way borderline cases are classified by different individuals.

Investors typically desire an income that is commensurate with the risk of going into equities rather than the bond market. On occasions where the income on the investment is less than what the investor would like to see as a risk weighted return, he would expect a certain amount of capital gains to compensate for the additional risk posed by investments that have too low a direct return. However, as a matter of principle for the investor, capital gains should never take precedence over the expected yield on the investment.

Further, the typical investor has a long time horizon for his investments, a matter of many years, rather than just a year or perhaps two. Also, changing the portfolio of the investor is a gradual process, based on much study of the different opportunities presented by the market. It would not be uncommon for many months to pass without a significant change in the stocks being accumulated and perhaps years before there is a major adjustment to investment policy.

Lastly, the true investor is not geared at all. Given that he expects a risk premium for investments on the stock market, there might be a slight advantage in using borrowed capital, but typically the risk premium, as the description implies, is not certain and therefore borrowing money to invest is not sound investment practice. As a rule, investors are risk averse and using debt in an attempt to improve income increases risk by too much.

At the other end of the market spectrum one finds the traders and speculators – people who accept substantially more risk in order to earn substantially higher returns, mostly of a capital profit nature. These are the people in the venture capital market or the short term traders who typically hold on to a market position for a matter of days to a few weeks only. The latter are an important ingredient in the market, seeking out good opportunities, for example where one stock in a sector is lagging the rest for no discernible reason. Traders supply liquidity to the market and are an important force in keeping the market as a whole in step with the economy.

Investors and traders, as described here, are constituents of a normal market, both bull and bear. Because of their activities and when there is a balance between longer term and shorter term considerations, most companies listed on the exchange tend to move in the same direction as the economy. When the economy is growing at a good rate, most companies also do well, usually with a few laggards and perhaps also with a few companies that are being badly managed or that has very strong competition falling by the wayside or under-performing the market by a wide margin. Even a strong economy has its dogs that do not perform at all well despite the opportunities.

The greater the degree that a market and the people in it diverges from this description and the balance it implies, to display what Alan Greenspan called "irrational exuberance", the more the market tends to exhibit the characteristics of a bubble market.

Features that distinguish a bubble from a normal bull market include the following:

  • A reduction in the share risk premium; when earnings income on investments become negligible to the extent that capital gains become the 'only' criterion for portfolio selection by the traditional investor, the market is moving ahead too steeply and too far for its health
  • In a sound growing economy, most companies benefit from the increased spending that marks the growth in GDP. Some will do better than others, but often this changes over time again as the economy goes through certain phases, with laggards catching up on the market and early growth companies slowing down a little. Therefore, in a true bull market based on sound investment principles, prices of stocks tend to increase across the board. When the market begins to exhibit signs of a split personality, with market leaders streaking ahead to ever higher prices, while many other companies experience a decline in investor demand, then it no longer holds true that companies are evaluated in terms of their participation in the fruits of the growing economy. The greater the degree of the split in its personality, the more the market assumes the character of a bubble, where decisions to buy or sell are no longer motivated by realistic and fundamental valuations of the opportunities in that market, but by rumour or what had happened to prices yesterday. Leaders streak ahead and laggards lag even further behind.
  • As the average time that a position is held before being closed again shortens, the trend shows a change from an investor mentality to a trader mentality. When this happens to a marked degree, fundamental valuations begin to count less and less as a reason to purchase a given stock. With a shorter time horizon and expectations for capital profit typical of the trader, one does not purchase stock in a company that might be doing quite well, offering good returns, but that is also a dead duck as far as the market is concerned. The time that one has to hold on to this stock before enough people realise its value to have an effect on the price, makes the proposition impractical from a trading point of view. Rumour and the talking heads on the media and what happens on the ticker become the main criteria on what to buy and sell. For a quick profit.
  • The greater the degree that investment or rather, speculation, is funded by means of debt, the greater the degree to which the market approaches the concept of a bubble.

There are more, but these will suffice. We will now take a closer look at each of these four characteristics.

Risk premium – measured by the PE ratio

One measure of the risk premium is supplied by the PE ratio, the earnings of a company divided by the price of its stock.. In effect the PE ratio gives the number of years on has to hold on to a position until the company has earned an amount equal to the purchase price – given that earnings remain constant over this period of time. If earnings continue to increase during the years following the purchase, the PE at the time of purchase would have provided a pessimistic view of the future of the company. If the original PE had been a realistic appraisal of the past performance of that company, and there is good and consistent growth in earnings, the purchase would have been a good bargain.

On the other hand, if the PE at the time of purchase had been optimistic about the future earnings of the company and this optimism later proves to have been misplaced because subsequent earnings failed to show the anticipated growth, the investor will be stuck with a position that is very much over-priced.

The inverse of the PE ratio is the earnings yield of the company, which in a sense corresponds to the yield on bonds. The only difference is that earnings yield vary over time as company earnings change; the yield on a bond is fixed once it has been purchased until the time it is due to be repaid. The US 30 year bond has a yield of about 6,3%, which implies a PE ratio of about 15. This is the yardstick against which the risk premium of a stock is measured. (Strictly speaking the 'real' yield and 'real' earnings have to be used to calculate the risk premium, i.e. after subtracting the inflation rate, but this is disregarded here – the difference is really academic.)

Under normal circumstances, the combination of earnings and expected capital gain should offer the investor a better return than what he could obtain by investing in bonds. For much of history, actual earnings of the company tend to be greater than the capital gain, so that the latter provides the extra cream in the coffee and the final edge over bonds. Most stocks therefore tend to trade at an earnings yield that is just a little less than the yield on bonds, say at an earnings yield of as low as 5%, for a PE of perhaps 15 to 20.

The further the PE moves above say 20, the more the market is tending to disregard earnings potential, and thus realistic returns on investment, in favour of a capital profit. There are many exceptions, of course. A particular company may have the potential to sustain a much higher than usual growth rate in the earnings, which means that a higher price can be justified in order to obtain a share in the fortunes of that company. If the PE ratio is calculated using historical earnings, the PE will appear too high for comfort, yet the assumption is that earnings will keep on growing at such a rate that the apparently high PE at the current price will be substantially lower if expected earnings for subsequent accounting periods are used to calculate the ratio.

A valid argument, but only within limits. The future is uncertain and a very high PE justified by the prospect of steeply increasing earnings for too far ahead is suspect. The investor must remain aware of the fact that economies move in cycles, from periods of good growth to stagnation, when little growth is experienced. Occasionally there happens a decline in economic activity or a recession. The prudent investor, who plans with a time horizon of many years, is aware of this fact and does not invest in companies with very high PE, of say 30 or above, except on very rare occasions and under unique circumstances. And if the high PE is being justified by estimating growth in earnings more than say 2-3 years into the future, then the special circumstances to warrant an exception must really be unique and very well defined.

Our prudent investor knows that before the high and sustained growth in earnings over a number of years as implied by the PE ratio can be realised, the economy could falter and bring the company's performance back to earth. Or new competition for that company may materialize and suddenly its price adjusts downwards to reflect the changed fortunes due to reduced market share – a risk that is the greater if barriers to entry for new start-ups in that market are relatively low.

For a prudent investor, the future for almost any company with a too high PE, say more than twice the PE of long bonds as a rule of thumb, is simply too uncertain – which for the investor equates to too much risk – for it to be considered as an investment. And good risk management is a key component of successful investing over the longer term.

Japan offers an example of what happens when PE ratios become too high. In years when the growth in the Japanese economy averaged 9%, the PE ratios on the Tokyo stock exchange hovered above 60. These extremely high values, implying earnings gains of about 1.5% were justified partly by relatively low interest rates, which, sets the benchmark against which the expected return from an investment in equities is measured.

However, during the 70's and 80's the main theme of the supporters of the high PE ratios was that the Japanese economy was structurally different from other economies – and also from what it had been in the past. It was widely believed Japan had achieved a built-in growth factor all of its own and it would last indefinitely. When the economy eventually did slow down, this fact was not translated into lower prices on the stock market, to bring PE's in line with lower expected earnings. Oh no, that would be far too rational an action. By then the market had come to believe its own hype about "a new paradigm" and that "Japanese were not interested in dividends, only in capital gains". So prices remained high, with PE's rising to above 80 as company performance slowed.

Until, of course, the time came for reality to re-assert itself, as always happens.

At the end of 1989 the Nikkei index topped out and plummeted by more than 60% in just 30 months to signal the start of a decade of deflation and economic contraction.

Market breadth

Market breadth is the term used to describe the consistency of a market trend. It is a comparison on a day by day basis of the number of gainers and the number of losers and is typically applied to a bull market. If breadth is strong, with prices of the broad market all moving in the same direction, rising or at worst remaining constant, the bull trend is said to be well established. If breadth is weak, with losers about equal in number to or, even worse, substantially more than the number of gainers, breadth is said to be weak.

A good way of examining market breadth is to look at a chart of the Advance-Decline line. The AD-line is generated by keeping a running total of the net difference between gainers and losers on each trading day. If gainers consistently outnumber losers, the AD-line will exhibit a rising trend. The greater the day to day difference between the gainers and losers over a period of time, the steeper the trend will be. On the other hand, if losers outnumber winners on most days, the AD-line will be in a descending trend, and again the steepness of the trend will signal die disparity between the average number of gainers and losers over a given period.

Intuitively one would expect that during a bull market the AD-line would be in a rising trend, just as the market indices will be. And intuition is correct in most cases. As discussed above, if the economy exhibits good growth and the majority of companies share in the good times, they should mostly be reporting increasing earnings and thus be able to command better prices.

The exception, where intuition fails, is when a bubble market begins to develop. Under bubble conditions the decision making of many market players is no longer fully rational, based on factors such as economic outlook for the sector, the nature of management and of competition and the company's expected earnings. When traditional means of valuation are discarded, decision making swings more and more to what the price has been doing in recent weeks and days and to what the latest news have to say about hot performers in the market.

This implies that during a bubble market there is a tendency for losers to continue to lose and for gainers to continue as winners. It also means that stock picking becomes largely divorced from fundamental considerations; buyers' decisions are now influenced by a combination of very recent performance, market rumours and media tips – joined in recent years by what is said in the internet chat rooms. The end result is an ever thinner wedge of rising stocks as losers are continuously weeded out to join the ranks of the also rans. The AD-line slips into an ever steeper descent until a point is reached where not even funds being withdrawn from market losers and pumped with ever greater abandon into a chase of the decreasing number of winners can sustain the trend.

At that point in time, market indices that have been rising consistently on a decreasing number of high cap stocks, succumb to the last bout of profit taking and the holders of the stocks at that time suddenly find that the many keen buyers who used to begin their pursuit of the "flavour of the day stocks" each morning are absent the market.

What happens then is described later.

Stock retention

Under normal conditions, a market is divided between investors who hold a share for years and traders who have a time horizon of days to weeks. Some statistics that were bandied about on the internet not long ago said that the "float" – that part of the issue of a company's shares that are not held firmly by the direct owners and management – of even some of the major Nasdaq companies were turning over in a matter of weeks, not in many months to a year or two, as used to be the case before the stock market boom that had started in the mid 90's. This applies not only to smaller cap companies, but even to major issues such as those of the top internet stocks.

An illustration of what could happen under these circumstances follows: Not long ago, as reported in the NY Times, an announcement about some positive developments at a quite small internet hardware company caught the attention of the day traders. This happened quite some time after the initial announcement was made, but this at first only attracted some attention within the trade.

The big news hit the internet the Tuesday before Thanksgiving after market close. Within a day and a half of hectic trading over that period the price of the stock went form a previous close of about $3,50 to $37 – after briefly touching $57. That price action may seem quite impressive, but is nevertheless not in the same league as the turnover figures. With less than 10 million shares issued and an estimated float of say 5 million shares, the total turnover on the Wednesday before Thanksgiving and the half day of trading on the Friday was well above 100 million shares.

This implies that positions were held for less than 30 minutes, on average, before being closed.

Obviously this is an exception, since very few stocks indeed attract this kind of sudden and over the top attention which offers an illustration of the power of the internet to marshal many buyers into a feeding frenzy. While perhaps exceptional in its intensity, it is clearly not an isolated event, but illustrates the kind of mentality that is taking over the propulsive forces of the market.

Under these conditions fears of interest hikes recede into background noise. Who cares when the Fed raises rates again, or by how much? Provided it does not happen during the next 30 minutes everything is fine and I can pocket my profit.

Funding "investment" by means of debt

The fourth of the factors that were mentioned above as barometers of a bubble market is the use of debt to fund positions in the equity market. In Part 1 we have looked at consumer credit and debt in relation to disposable income. A problem of course is that there is no information on how much of that debt found its way onto Wall Street. There is however one measure that can be used to estimate the degree to which debt is being used to fund speculation – surely one can no longer speak of "investment", not even within quotes – on Wall Street, to which the statistics given below apply. The situation on Nasdaq, with its day-traders and extreme speculation may well be much worse.

This measure is margin debt – credit advanced by stockbrokers so that punters can buy into a position in the market.

Margin debt is said to be one of the reasons why the 1929 market bubble developed as it did and later popped. At that time, one could open a position with a 10% deposit and the rest on margin. After the collapse of the market in 1929, a low margin requirement was seen as one of the major causes of the speculative bubble that created such havoc when it was finally pricked. To forestall similar problems later, the margin requirement was raised to 50% of the value of the position.

In 1993 the total amount of margin debt on the NYSE exceeded $50 billion for the first time, after reaching just short of $50 billion shortly before the October 1987 Crash and then declining to about $25 billion in 1991. In August this year the amount of margin debt reached above $175 billion, or 3.5 times the amount in 1993 and almost 4 times the peak in 1987.

The problem with margin debt is that if prices decline, the broker's exposure to risk exceed 50% of the new ruling price. This results in a margin call to the market player who then has to add to his deposit to make good the "paper loss" suffered by the broker Under this kind of pressure, people exposed to margin calls often decide to sell, rather than to add more money to a losing position.

If one assumes an average price of $25 for stocks traded on the NYSE then a turnover of 1 billion shares imply a daily turnover value for Wall Street of $25 billion. Since the total amount of margin debt could be 50% of the total volume of margin purchases, the margin-funded position could be as high as $350 billion. This implies if a significant and lasting correction should occur on Wall Street, as much as 14 trading days of average daily turnover might come onto the market as urgent selling by speculators feeling the pinch of margin calls.

It can also be assumed that funding a position by means of margin debt is a bit more expensive than, say, increasing the mortgage on the house or taking a loan from a bank. The steep increase in margin debt then indicates that a substantial number of Americans have exhausted other sources of loans and are now turning increasingly to margin. They are not averse to using risky and expensive margin to fund a position because they believe that the risk is minimal and that the market will continue to perform well enough to ensure a good return on their debt funded position.


It is suggested here that the presence of a market bubble can be identified at the hand of a number of factors that change quite dramatically during the transition from a normal bull market to one that at first approaches and eventually becomes a full blown bubble.

In effect the bubble results when the balance between investors – in the traditional sense – and traders or speculators is disturbed by the fact that more and more investors are beginning to act as traders. The focus of the investor community changes from a longer term time horizon and a proper valuation of a company in terms of its potential to deliver sufficient earnings to justify the price paid, to a much shorter time horizon and the potential for a capital profit, rather than earnings funded dividends within a meaningful time frame.

The greater the degree to which this metamorphosis of investors into traders has developed, the more difficult it becomes to distinguish between what used to be investors and the dyed in the blue speculators. And the more committed the market has become to a pure bubble mentality.

Which brings one to the following questions – is a bubble destined to collapse and if so, how long can it last and how far can it run.

How long can a bubble last and how far can it run?

One problem with market bubbles is that it is practically impossible to forecast when they will end. And since prices turn almost vertical during the blow-off, there is no saying how high they will reach before the end finally comes. As it must.

Bubble markets require quite a shock of some kind before they collapse, since people have to be shaken out of their firm belief that the bull is here to stay. And sufficiently large shocks do not come on demand – they are unexpected, by definition, and this too makes it difficult to predict the end of the bubble.

One other factor can mean the end if the bubble, though. Like a blaze that dies down when all the fuel has been consumed, a bubble too can run out of steam when there is no longer any funds available to keep on feeding it. Even if funds released by a trader selling shares are plowed back into the market, the constantly rising prices set an important constraint. Either the trader must add funds from an outside source or the market must scavenge funds from one part in order to keep an ever decreasing number of stocks on the boil.

This is easy to illustrate.

If a market consists of only one stock, then the price can only rise if new funds flow into the market. If someone sells a 1000 shares at $10 and later wants to re-enter the market when the price has gone up to $12, he either has to add $200 to his stake or settle for fewer shares than the 1000 he had sold. If he settles for the second option, and so does everyone else in that market, demand will begin to lag behind supply and sooner or later the price will top out.

Now consider a market that consists of two stocks, A and B, both at $10 per share. A trader, X, sells 1000 of each to trader Y and has a kitty of $2000. He watches the market and then buys 1000 shares of A at $12 each and bids for 1000 shares of company B at $8, which he soon gets. In both cases trader Y was the seller and he now has a kitty of $2000.

Much later, trader X again closes both positions by selling to trader Y. Company A is traded at $14, for a profit of $2/share, but in order to get rid of his holding in company B trader X has to drop his price to $6/share as that is the extent of Y's funds. If we assume that there are only 1000 shares in issue for both companies, the capitalisation of the market is still only $2000, with ownership of the market oscillating between A and Y.

However, if the index used for this market consisted only of company A, at 10 index points/dollar the index would have shown an increase from 100 points to 140 for a gain of 40%, without any new funds flowing into the market. The price of company A reaches new highs all the time and the price of company B hits new lows all the time.

If now more funds can flow into the market and the losers have reached a level where the prices no longer have any downside potential, the mechanisms that feed the bubble have dried up. Then it is merely a matter of time before even a minor nudge causes the whole edifice to collapse upon itself.

The fact that funding of new positions by debt might be nearing an end – particularly under threat of higher rates – means that within the foreseeable future only internal scavenging can keep the market bubbling along. That it is already happening is evident from the following statistics:

For the week ending December 17th, when the main indices ended about square or had relatively small gains, there were a full 180 new highs out of the about 3700 stocks quoted on the NYSE. New yearly lows were achieved – if that is the right term – by more than 1100 stocks.

Further evidence of the current state of the market in the light of the preceding discussion on the characteristics of a bubble market, is provided and evaluated in the third part of this series.

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