The stock market bubble

By C. Rammanohar Reddy

IN 1920, a Charles Ponzi in the United States was able to convince investors that there was money to be made in buying international postal coupons in Europe cheap and selling them dear in the U.S. The first round of investors who received large returns convinced a second group to put their money with Ponzi. The success this group too had drew in yet another set of investors and so on. So persuasive was Ponzi with his `business model' that within seven months he had collected $ 15 million from 30,000 investors. Then the Ponzi fund collapsed. There had never been any arbitrage opportunities in postal coupons. The scheme had been thriving because the funds from each successive wave of investors was used to pay high returns to the previous one. When the inflow of fresh funds dried up, there was no money to repay any deposits - leave alone returns on investment.

Such schemes did not end with Ponzi. His lasting contribution was to give what are otherwise called pyramid schemes a special name. More recently, a huge Ponzi scheme in Russia in the mid-1990s consumed the funds of hundreds of thousands of gullible investors. At home, the `blade companies' of Kerala and the deposit companies of Karnataka, both with promises of returns of more than 25 per cent a year, did much the same thing in the 1980s. Many of the NBFCs in the 1990s too functioned in a similar way, though poor investment decisions also contributed to their downfall.

All Ponzi schemes involve fraud. The promoters either deliberately cheat the investors or ride on the hope that they will eventually find a way to usefully deploy the funds they collect. But it is an intriguing thought that there can be `naturally occurring' Ponzis, in other words market schemes that do not deliberately fool investors but fool them nevertheless. In a new book titled ``Irrational Exuberance'' (Princeton University Press 2000) the Yale University economist, Robert J. Shiller, convincingly demonstrates that the boom in the U.S. stock market since 1992 is a speculative bubble being driven by a `feedback mechanism' through which wave after wave of investors are being drawn into the stock market on the promise of ever-increasing returns. Drawing not just on economics but also on sociology, demography, media studies and `behavioural finance', Shiller tells a compelling story of why and how the eight-year- long boom in the U.S. markets has little basis in `fundamentals'. The analysis has much relevance for India, not just because the market often tries to `mirror' the U.S. market (especially the prices on the NASDAQ) but also because the factors that have contributed to the `irrational exuberance' in the U.S. are in evidence at home as well.

An important element of analysis in ``Irrational Exuberance'' (the title of course taken from a 1996 speech by Dr. Alan Greenspan, Chairman of the U.S. Federal Reserve, to describe the market boom at that time) is how share prices have moved in the U.S. since the late-19th century and what link they have had with corporate earnings, dividends and (capital and income) returns on equity. First, in the 129 years (1871-2000) for which data is available at no point have real share prices reached such heights as they have between 1992 and 2000. Second, the 1990s share boom has had little correspondence with the movement in real earnings of firms. Corporate earnings did double between 1992 and 1997, but the jump was on a low-base occasioned by the recession of the early 1990s. Moreover there have been such increases in the past as well (after the 1890s, the Depression of the 1930s and World War II) without a similar movement in share prices. Third, in the years after market peaks in the past (1901, 1929 and 1966), investors have suffered very poor returns. For example, investors suffered a negative return of 2.6 per cent a year in the five years after 1966 and a negative 1.8 per cent for the next 10 years. The signs for investors in the current boom could not be more ominous.

Fourth, the analysis over 119 years of the connection between price-earnings (P-E) ratios and subsequent real returns (dividend plus capital) reveals that in general long-term investors did well when they bought at low levels of P-E ratios and poorly when they bought at high levels. This is yet another danger flag for investors in the current U.S. market in which P-E ratios have gone through the roof.

``Irrational Exuberance'' does not offer a single or simplistic understanding of what has taken the U.S. market (and with it many in the rest of the world) to dizzying heights. The operation of a `confluence' of economic social and cultural factors other than the fundamentals is instead the proffered explanation. These include factors that have favoured business success in U.S. society, a mood of triumphalism that economic rivals (the former Soviet Union, Japan, west Europe and east Asian countries) have been vanquished, the arrival of the Internet that prompted a false boom in even non-IT stocks, changes in tax laws, self- serving optimism of equity analysts, the introduction of 24-hour trading and more. In addition, three social and cultural factors need special mention if only because similar processes have been in operation in India.

The first naturally is the influence that the `new era' or the `new economy' has had on share prices in the 1990s. But as Shiller points out in his survey of share price movements over 100 years, we may think we are the first ones to be living in a new era but there have been `pioneers' in the past as well. The three earlier peaks (1901, 1929 and 1966) in share prices have all been associated with contemporary feelings of living on the verge of a new age. The Yale University economist sights accounts from 1901 (when Marconi had made his first trans-Atlantic transmission) suggesting that ``the high-tech age, the computer age and the space age seemed just round the corner in 1901''. The 1920s were when the automobile and electricity spread far and wide in the western world, prompting John Moody (of the rating agency fame) to write in 1928 that ``this modern mechanistic civilisation in which we live is now in the process of perfecting itself''. Of course what followed in the 1930s and 1940s was the biggest economic depression of the 20th century and the biggest social and political threat to western society.

A second factor that needs mention is the blame Shiller places on the news media for being ``fundamental propagators of speculative price movements''. While some of the arguments are extreme, there is more than a point in the analysis which shows that in the constant search for interesting stories the media has hit on the market because it gives a constant stream of news (the minute by minute changes in share prices), and it offers `star quality' (the making or breaking of wealth and reputations). An additional argument is that media reporting on individuals firms is now oriented towards giving investment tips leading to a greater demand for stocks - similar to the effect of advertising on consumer sales. An interesting observation is that in this respect the only competitor to the stock market is sports and that it is no accident that in the U.S., the sports and financial news together make up half of the editorial content of the U.S. newspapers.

Then there is the spread of gambling. Beginning in the 1980s, the legalisation of many gambling activities in the U.S. apparently led to an explosion of betting opportunities in racetracks, casinos, lotteries and slot machines, so much so that in 1998 almost the entire adult population in the U.S. (125 million) is said to have gambled. And once they form a habit of gambling, the `upscale' speculation in securities beckons. In a curious reversal of roles, a huge hoarding in the U.S. for racetrack betting read ``Like the Stock Market, Only Faster''.

Much of all this is, however, after the event. The damage was already done in the late 1990s. One must now wait for the fallout. People's memories are of spectacular crashes on a single day. But as Shiller points out, one-day events are important only as symbols of the malaise. When the decline comes it takes place in the U.S. over a protracted period lasting years and recovery takes even longer. And now more than ever before when the U.S. sneezes, the rest of the world catches a cold.

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