ANATOMY OF A BUBBLE: WHERE IT ALL WENT WRONG

decisionpoint.com ^ | 7/5/02 | Carl Swenlin

[Soren]

ANATOMY OF A BUBBLE: WHERE IT ALL WENT WRONG The charts on this page show the S&P 500 (black line) in relation to its normal P/E range. The lines composing the channel show where the S&P 500 would be if it were overvalued (red line), undervalued (green line), and fairly valued (blue line). The three charts below show that the S&P rarely moves outside that range. When it does, it signals extraordinary risk (higher than the channel) or extraordinary value (lower than the channel. Also, the direction in which the channel is moving tells us whether earnings are expanding or contracting.

The top chart shows the period of the largest valuation bubble in the history of the U.S. stock market. In the early 1990s prices rose, pushing the top of the envelope higher, correctly anticipating earnings growth. In 1997 earnings peaked, but prices experienced a reality disconnect and kept rising with no regard to earnings.

Complete article and charts are here.

[Soren]

Thanks to GaltMeister for pointing this out to me.

[Soren]

ping. rohry this might be of interest to the Market Wrapup group. Not sure how to ping that entire list.

[Soren]

ping

[jwh_Denver]

S&P has broken Major trendline.

http://www.therhodesreport.com/TAC/

[Gritty]

Excellent chart!

If the author is correct and S&P "fair value" is 371, we have an awfully long way yet to fall!

[Ken H]

Here is a useful calculator for figuring out annualized rate of return. For example, you can calculate the annualized rate of return for the Dow from its low of about 600 in 1974 to its 1987 peak of about 2700. http://www.1728.com/compint.htm

[RightWhale]

Was the lowering of the prime rate in response to the high P/E ratio? No doubt lowering the prime rate took the steam out of the bubble, but it seems that a high P/E ratio indicates a low return, low interest rate for lenders and bond buyers.

[Starwind]

Very interesting chart.

Fit's a personal theory of mine, that the Fed inadvertently overstimulated investments when it pumped liquiidty into the system in '99 to keep the system and banks solvent in event of Y2K-related runs and shortages.

I've read the Fed did make this liquidity available, but oddly didn't prevent banks from loaning it out, and so it found it's way into the markets.

IT capital spending was huge in '99 to upgrade to Y2K compliant products.

IT spending, extra liquidity, dot.com's all pushed the markets unrealistically higher in 99. No one wanted to sell because of tax hits so everyone margined and bought more. Equity traders laddering new issues further exacerbated the 'boom'.

Then when the Fed felt it had to combat inflation from the 'irrational exuberance' it had helped spwan, the only hammer it had was interest rates and the Fed hammered the golden goose in 2000, by raising interest rates so high that capital intensive industries (like telecom and computers, chips, etc) pulled back and we had a business-lead recession.

Thoughts?

[Freee-dame]

wow!

[Moonman62]

I've read the Fed did make this liquidity available, but oddly didn't prevent banks from loaning it out, and so it found it's way into the markets.

In October of 1999 the Federal Reserve announced a Special Liquidity Facility that would loan money at a higer rate than the discount window and entailed some bothersome paperwork that was setup to discourage its use except in an emergency. A report that came out in 2001 said the facility had hardly been used.

The Federal Reserve also announced that it would possibly buy stocks and corporate bonds if Y2K really turned out to be a disaster. I suspect that a lot of the huge increase in stocks between 10/99 and 02/00 was due to foreign capital finding its way into our markets as a safe haven. I've read more than one columnist claim that the Fed added a large amount of high powered liquidity at that time, but I've never been able to find any evidence of it other than what I've mentioned and I've never seen anyone offer evidence.

[Soren]

Greenspan's MO is to inject liquidity at the first sign of trouble. In 97 it was the Asia flu, in 98 it was LTCM, in 99 it was Y2K, in 01 it was 9/11. People criticize him a lot for raising interest rates, but in my view, by that point in time the damage was already done (i.e. there was a bubble that had to deflate eventually).

[equus]

Completely agree. In fact don't think it's a personal theory as I've heard that said many many times. You can't really fault Greenspan for injecting the liquidity at that time--if there had been a y2k disaster, it would have been enormous. But it did do the damage as you point out. And then later he kept slamming the markets with interest rate hikes, not waiting for them to work their way through the system--he loosened too much in the Asia crisis, then tightened too much post y2k--the fed always creates recessions.

[equus]

P.S. What he should have done, rather than punish business by hiking rates so many time, was rein in the average invesgtor and all investors by making it harder to buy on margin.

[David]

You guys ought to repost this article again tomorrow and maybe every day next week to be sure everybody sees it--It is the most articulate succient description of what is transpiring in the stock markets that I have seen.

His last paragraph, the point that his epa are the currently stated core business earnings is also important because if you restated the published core earnings from the last five or eight years you would have the effect of moving the red, blue and green (solid) lines down as well as the dotted red, blue and black channels--so the real conclusion is that however bad correction to reality might be based on the chart depiction to 400, the real correction should be lower--I have said 100; maybe the actual bottom is somewhat higher.

[rohry]

Good charts, but I thought every serious market watcher already knew this...

[David]

"Good charts, but I thought every serious market watcher already knew this..."

Ought to. But if you look at the daily run of posts about the market, you will conclude that there are a lot of people here who don't understand this.

[RightOnTheLeftCoast]

More charts and analysis here.

[fogarty]

And actually, the Fed started goosing the liquidity and flooding the market with easy money long before Y2K. When LTCM buckled in 98 he goosed the market big time, injecting billions into a hedge fund which should have rightfully collapsed. If he had let LTCM collapse, and let the markets go down with it, then we would have been much healthier than we are today.

Even now we are only starting the unraveling of the trillions of dollars in derivatives and leveraged investments made by banks, funds, and speculators. It is going to get worse before it gets better - and some bigger names and companies will go down before this market hits the bottom.

[Soren]

Presentation counts for a lot when trying to convey a message. I've experienced this in the consulting that I do. You can tell someone the facts straight out, like the S&P 500 P/E is 34, but sometimes it doesn't hit people until you package it a certain way. I think these charts are the best I've seen in conveying the message about the current market valuation relative to historical levels.

[razorback-bert]

The BTU to GNP was the most interesting thing, will search for more data.