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J. Bradford DeLong
The NASDAQ is now back where it was three years ago, in the spring of 1998. The S&P Composite Index is now back where it was three years ago too. In between the S&P rose to a peak some 35% above its current level. But in between the NASDAQ tripled, peaking at over 5000 in the early spring of 2000. It was a long round trip. Those who shifted their portfolios into cash in the spring and summer of 2000 are now happy, if a little shaky after their narrow escape. Those who shifted their portfolios from cash into NASDAQ stocks in the spring and summer of 2000 are now very unhappy indeed.
It was on December 5, 1996 that Alan Greenspan asked his question "How would we know if the stock market were subject to irrational exuberance?" Back then the Dow-Jones Industrial Average, the NASDAQ, and the S&P Composite were all at two-thirds of their current levels. Economists continue to dispute whether the stock market was already subject to irrational exuberance in December 1996and is thus even more subject to it today.
Those led by Yales Robert Shiller who believe that it wasand who thus implicitly believe the stock market today has a long way further to fallpoint to current average dividend yields of less than 2 percent per year. They compare these to historical average dividend yields of 4 to 5 percent. They say that stocks still have forty to sixty percent further to fall before they get back to their standard relationship to dividend and earnings fundamentals.
Those who believe that it was notand who thus implicitly believe that the stock market today is fairly valuedpoint to the extraordinary gap between inflation-adjusted returns on stocks and bonds over the past century. For most of the past century, anyone who diversified their stock holdings earned much higher returns than those investing in bonds for little extra risk. From this point of view, stocks today are fairly valued and the average return on stocks in the future will be a little bit more than the average return on bonds. It was the gap before 1995 between stock and bond returns that is hard to explain. It is not that the stock market today is irrationally exuberant. It is that the stock market of past decades was for some reason extraordinarily depressed.
One position that lacks spokesmen today is the "Dow 36000" position: the belief that stocks today are fairly valued and that investors in stocks can expect the same extra return relative to bonds seen for the past two generations. The Dow-Jones Industrial Average will reach 36000 somedaybut not this decade, and probably not until 2030 or so.
A second position that lacks spokesmen today is the position that the stocks that make up the NASDAQ were fairly valued in March 2000 when the NASDAQ kissed 5000. Ask someone today who bought the stocks that make up the tech-heavy NASDAQ index what they were thinking, and it is very hard to get a coherent answer. It is not that they were expecting internet-mediated home grocery delivery a la Webvan to be an immensely profitable business forever. After all, how could it be? Large persistent profits are found only where a company has a unique and hard to copy capability that no one else possesses. Instead, they had noted that at each stage in the past someone had made money by finding a greater fool to sell the stock to at a higher price, and they expected that this pattern would continue a while longer.
The most extraordinary moment of prices that made absolutely no sense from any fundamental point of view came in early March 2000, immediately after the initial public offering of Palm. Its parent company, 3Com, sold five percent of Palms shares at the IPO, retaining ownership of 95 percent of the company for itself. Each share of 3Com that you owned, therefore, contained within itself ownership of 1 1/2 shares of Palm. Yet on March 2, 2000, Palm closed at $95 a share and 3Com closed at $82. If you wanted to buy 3000 shares of Palm at the close on March 2, you could either buy Palm directly and spend $285,000; or you could buy 2000 shares of its parent company and spend $164,000. If you did the second, you would save $121,000 and you would have not only your (indirect) 3000 shares of Palm but also 2000 shares of the rest of 3Com. Even three months later the gap between Palm and 3Com prices could be made to make sense only if 3Coms cash on hand was valued at 50 cents on the dollar, and 3Coms businesses carried no value at all.
How does a stock market get itself wedged into a position of irrational exuberance? Economists Brad Barber and Terrance Odean point out that economists have been running classroom laboratory experiments for decades, and have come up with three factors that make classroom micro-stock-markets prone to irrational exuberancepersistent mispricing far away from fundamentals, and speculative bubbles that expand and then pop. When a large proportion of participants are new to the market, when there is great uncertainty about the true value of an asset, and when investors are flush with cash and feel that they have to spend it on somethingthen is when the stock market is likely to go awry. To these three I would add a fourth that so far it has proven impossible to test in experimental micro-markets: a long runup of prices transfers wealth from more pessimistic, cautious, and risk averse believers in fundamental values to more optimistic, aggressive, and risk-loving speculators. If you think of the market price as an average of individual investors judgments weighted by individuals wealth, then after a long bull market the average will place an especially heavy weight on the judgments of the over-optimistic and risk loving.
In retrospect we can look back and say that the NASDAQ in early 2000 was clearly subject to irrational exuberance, and in the midst of a speculative bubble. How about the broader market today? Has the 27 percent fall in the S&P Composite in the past six months purged it of speculative excess? I side with Shiller: there is still a lot of air in the broad market, and a lot of companies with stock prices that appear disconnected from their profits.
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