Is bubble ready to burst soon?

The Economy

November 28, 1999|By William Patalon III

IT'S A PERPLEXING period for finance guru Burton G. Malkiel.

A Princeton University professor, Malkiel is the author of "A Random Walk Down Wall Street," an investment classic now in its seventh edition.

On one hand, as espoused in his book, Malkiel believes that securities markets are efficient, meaning stocks are very nearly always accurately priced. On the other hand, with the technology-focused Nasdaq composite index hitting record high after high, and with profitless high-tech firms valued at billions, Malkiel says he's certain as can be that the stock market is out-of-whack: We're in the midst of a stock-market bubble -- a speculative financial frenzy that's destined to burst because share prices are way too high.

"This is a classic bubble," Malkiel insists.

Others will disagree, contending that we're in a new era of prosperity.

The debate is more than academic. In January, the U.S. economy is expected to achieve its longest stretch of unbroken growth ever -- helped by a stock market that's made most of us wealthier, allowed us to spend more, and enabled us to carry heavier debt loads.

A stock market collapse would be a rude end to this economic bliss.

Yet there's a risk for those who opt to watch from the sidelines.

What if the "New Economy" is real?

New Economy companies would be more valuable, justifying current stock-price levels. Then there's our aging population, with the heightened need to save for retirement that's made easier by the proliferation of 401(k) retirement plans. That flood of cash could continue to push share prices higher than conventional wisdom might allow, some market watchers contend.

If this all adds up to a fundamental change in our economy, the nation may have entered a period of long-running prosperity, meaning those who decide not to participate will be left behind.

In Malkiel's view, that's not a concern: Even the New Economy doesn't mean we can dispense with the old rules -- immutable laws of financial physics that determine what firms are worth. As proof that a bubble exists, he says, just look at technology stocks -- specifically, the shares of Internet companies, many of which have no prospects for profits and yet are valued at double or even triple the worth of their profitable counterparts in the offline world.

New-era naysayers like to compare Amazon.com, the Internet retailer, and Sears, Roebuck & Co., the venerable department store chain. Amazon is boosting sales at a blistering clip, while Sears seems to have fallen into a funk. But analysts predict that Sears will earn $1.4 billion next year, and say Amazon won't turn a profit for years -- if ever.

Yet Amazon is valued at nearly $30 billion, and Sears at less than $12 billion.

Such disparities are not rational, and will be corrected -- possibly unpleasantly, Malkiel says. But he can't predict how long that could take and, for now, says it's suicide to invest against such a powerful bubble.

"In every crazy market, eventually, everything comes down to earnings," Malkiel says. "I just don't know when."

That's the trouble with bubbles: They are labeled as such only in hindsight. Bubbles exert a hypnotic draw on investors, even those vowing to stay away. You watch as your friend, co-worker and next-door neighbor pull down huge profits. You know it's not rational. But the fatter your co-worker's coffers become, the more your resolve ebbs. Ultimately, you succumb. Others follow and the bubble expands.

History has seen many bubbles. The first well-recorded one was "Tulip Mania" of 1630s Holland, where a speculative frenzy over -- of all things -- tulip bulbs imploded, smashing the Dutch economy, which at the time was a world leader. Others included the "South Sea Bubble" of 1700s Great Britain, the Great Crash of 1929, and the collapse of Japan's stock- and real-estate markets in the early 1990s, which left that "invincible" economy in shambles.

The ingredients of a bubble are about the same each time -- disconcerting when viewed from the vantage point of today's U.S. economy. Bubbles arise during periods of prosperity, and usually when an economy is seen as new: With the South Sea Bubble, serious global exploration was under way, and Great Britain was chartering public companies to exploit new lands. The frenzy to profit spawned dozens of start-up "bubble" companies -- many with no real business. Sound familiar?

During each bubble, there's a deep belief prosperity has become perpetual, and that "things are different this time." For example, at an Oct. 15, 1929, luncheon, two weeks before America's notorious Great Crash, respected Yale Professor Irving Fisher told executives that "stock prices have reached what looks like a permanently high plateau." Accounts of the time show us many felt that way.

Bubbles burst for many reasons, a key one being that credit gets tight -- bothersome since the Federal Reserve has raised interest rates three times since June.

Besides, even in a New Economy, bubbles are fueled by old truisms: human nature, greed and mass hysteria.

Consider all this when your friend tells you to buy shares in a profitless Internet start-up with a vague mandate.

"If you go back in time, to the original auto companies, you'll find there were hundreds," says Malkiel. "We have three auto companies today. There were literally hundreds at one time that you never hear of today."

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