Bubbles and Busts:

From the 1920s to the 1990s

1999!

“History is continually repudiated.”--Glassman and Hassett

The Dow 36,000 (1999)

•What can we learn from history?•Booms and busts have common elements•Evidence weak that booms are solely fundamentals driven•Role of Federal Reserve is very limited and should not be pre-emptive

What’s a Stock Market Boom?or any “Asset” Market Boom?

• “Booms” are relatively rare long upward swings that dominate any brief retreat.

• Annual data is the most appropriate frequency to identify a boom.

• An arbitrary criterion that picks out the popularly-identified booms: three consecutive years of returns over 10 percent.

What’s a Stock Market Crash?• October 1929 and October 1987,

universally agreed to be crashes, are used as benchmarks. In both cases, the market fell over 20 percent in one and two days’ time.

• The fall in the market, or the depth, is one characteristic of a crash. There was no sudden decline for the Dot.Com crash of 2000, even though we consider it a crash. Thus, speed is another feature.

• Crashes are identified by (1) Speed (2) Depth and (3) Duration---it should last for some time.

Identifying a boom by (about) three years of annual returns over 10% with a little

generosity

1921-1928: 20, 26, 2, 23, 19, 13, 32, and 39%.

• 1942-1945: 11, 18, 15 and 30%. • 1949-1956 18, 22, 15, 13, 2, 39, 25%. • 1963-1965 17, 13, and 9%. • 1982-1986: 22, 14, 4, 19 and 26%. • 1995-1999: 27, 21, 22, 25 and 12%.

Crashes: Where the Dow Jones, S&P500 or Nasdaq decline by more than 20%

• 1903 • 1907 • 1917• 1920• 1929• 1930-1933• 1937• 1940

•1946•1962•1969-1970•1973-1974•1987•1990•2000.

Matching booms with crashes: bubbles?

• Booms:

• 1924-1929

• 1942-1945

• 1982-1987

• 1995-2000

• Crashes:

• 1929/1930-1933

• 1946

• 1987

• 2000

Recovery after 1946 was quick (duration short) so three stock market bubbles in 20th century

Boom and Bust 1920-1933

0

20

40

60

80

100

120

1920 1921 1922 1923 1924 1925 1926 1927 1928 1929 1930 1931 1932 1933

Pea

ks =

100

Dow Jones Cowles Equally Weighted

Do Booms and Busts Share Common Features?

Do Booms and Busts Share Common Features?

Boom and Bust 1980-1990

0

20

40

60

80

100

120

1980 1982 1984 1986 1988 1990

Serie

s Pe

aks

= 10

0

Dow Jones S&P500 Nasdaq

Boom and Bust 1990-2003

0

20

40

60

80

100

120

1990 1991 1992 1993 1994 1995 1986 1997 1998 1999 2000 2001 2002 2003

Ser

ies

Pea

ks =

100

Dow Jones S&P500 Nasdaq

Do Booms and Busts Share Common Features?

Table 1: Characteristics of Booms and BustsPeak Trough Drop Peak to

Trough (months)

Recovery to Peak

Date

1920s

Dow Jones Aug-29 Jun-32 -0.822 34 Nov-54

Cowles Sep-29 Jun-32 -0.849 33 Nov-53

Equally-Weighted Feb-29 May-32 -0.896 39 Sep-45

1980s

Dow Jones Aug-87 Nov-87 -0.302 3 Jul-89

S&P 500 Aug-87 Nov-87 -0.311 3 Jul-89

Nasdaq Composite Aug-87 Dec-87 -0.299 4 Jun-89

1990s

Dow Jones Dec-99 Sep-02 -0.339 34 May 2006

S&P 500 Aug-00 (1485)

Sep-02 -0.463 26 (Apr 07 -1424)

Nasdaq Composite Mar-00(4802)

Oct-02 -0.741 32 (Nov 09 1072)

What causes stock market booms and abrupt reversals?

• Probabilities of long positive runs are small– [Madoff set off alarm bells because he had

continuous positive monthly returns for years]

• Probabilities of crashes are small

• Can fundamentals really shift that fast?

• Or is the crowd just mad?

Fundamentalists and Maniacs in the 1920s• Looking back on the 1920s, Professor John B. Williams of

Harvard (1938) wrote:“Like a ghost in a haunted house, the notion of a soul possessing the market and sending it up or down with a shrewdness uncanny and superhuman, keeps ever reappearing….Let us define the investment value of a stock as the present worth of all the dividends to be paid upon it.”

• John Maynard Keynes (1936) chose to differ:“A conventional valuation which is established as the outcome of the mass psychology of a large number of ignorant individuals is liable to change violently as the result of a sudden fluctuation of opinion which do not really make much difference to the prospective yield…..the market will be subject to waves of optimistic and pessimistic sentiment, which are unreasoning.”

Fundamentalists and Maniacs in the 1990s• On the threshold of the great bull market, Robert Shiller

(1991) observed:“I present here evidence that while some of the implications of the efficient markets hypothesis are substantiated by data, investor attitudes are of great importance in determining the course of prices of speculative assets. Prices change in substantial measure because the investing public en masse capriciously changes its mind.”

• In contrast, John Cochrane (1991) expounded:“We can still argue over what name to attach to residual discount-rate movement. Is it variation in real investment opportunities not captured by current discount model? Or is it “fads?” I argue that residual discount-rate variation is small (in a precise sense), and tantalizingly suggestive of economic explanation. I argue that “fads are just a catchy name for the residual.”

Fundamentals•Fundamentals require that stock prices equal the present discounted value of expected future dividends. •P = Dt+1/(1+r)1 + Dt+2/(1+r)2 + Dt+3/(1+r)3 +…….. •If all dividends are equal and certain then•P = D/r •If all earnings paid out then same as P=E/r or P/E = 1/r, if an acceptable return is 6% on stocks, then P/E is 16.7 •If allow for some growth--the Gordon growth model—where D grows at a constant rate g and investors command a constant return of r, composed of a risk free rate and an equity premium. • P = (1+g)D/(r-g)Has almost all elements any analyst uses today!!!Prices rise because dividends are growing, the risk free rate is down or the equity premium has fallen…

The Gordon model captures all explanations for asset price movements, including booms and busts:

(a) *Technological change increasing productivity and leading to higher dividend growth

(b) Changes in the risk free rate

(c) *Changes in the equity premium

Frustrating!•Explaining actual stock price movements with fundamentals has proved frustratingly difficult.

•If expectations are rational, stock prices should embody the realized dividends in the future appropriately discounted.

•In a classic article, Shiller (1981) found that stock prices moved far more than was warranted by the movement in dividends, where the ex post rational price was equal to the discounted value of the future stream of realized dividends.

•Even if there were deviations in was expected from what was realized, the fit should have been good over 1871-1979, yet the variation of prices exceeded the variation in fundamental prices violating any reasonable test.

Background of Two Booms1920s v. 1990s

• Zero inflation, 4% unemployment, balanced budget

• Real Earnings jump• Real Dividends jump• Soaring Prices• Collapse in D/P and E/P

• Low inflation, low unemployment, balanced budget

• Real Earnings jump • Real Dividends don’t• Soaring Prices• Collapse in D/P and E/P

Explanation: Technological Change or the “New Economy”

• In the 1920s and 1990s bull markets, technological innovations were viewed as improving the marginal product of capital, increasing earnings and hence dividend growth.

•A wave of innovations, sometimes characterized as a new “general purpose technology” was believed to have placed the economy on a higher growth path.

The New Economy of the 1920s• Irving Fisher: the stock market boom

justified by the rise in earnings, driven by the systematic application of science and invention in industry and the acceptance of the new industrial management methods.

• High Tech Industries: Automobiles, Radio, Aircraft, Movies, Electric Utilities, Finance

• But some executives (A.P. Giannini of Bank of Italy) feel prices are too high and say they will not pay higher dividends.

The New Economy of the 1990s• General purpose technology of 1990s greater

impact than in 1920s—computers, the internet, biotech!!!

• “Moore’s Law” number of transistors per integrated circuit doubles every 18 months, helps drive price declines.

• Estimated average annual price declines for electricity and automobiles: 2%, but computer prices collapsed at a rate of 24%.

• Faster rate of change and price decline in the 1990s, promised higher levels of growth and consumption.

• IS THIS THE EXPLANATION?

Ummmmm…..Productivity Growth• 1870-1891: 0.39% • 1890-1913: 1.14%. • 1913-1928: 1.42% • 1928-1950: 1.90% Golden Age of GP Tech• 1950-1964: 1.47% • 1964-1972: 0.89%• 1972-1979: 0.16%• 1979-1988: 0.59%• 1988-1996: 0.79% • 1995-2000: 1.35% .

1920s and 1990s Fundamentals? • Apply a Gordon model to S&P500 data and

calculate the growth rates that would be needed to justify the peak P/D (similar to P/E)

• P = (1+g)D/(r-g), • For 20th century, average P/D was 28 and real g

was 1.4%, implying an r of 5%.• To match 1929 high ratio of 38 with r of 5%

would require g of 2.3%. (7% implies g=4.3%)[1] • To match 1998 high ratio of 48 with r of 5%

would require g of 2.9% (7% implies g=4.8%)• Huge historical leaps--a doubling of productivity

growth

Explanation 1?For both the 1920s, the conclusion for the 1990s is fairly clear: expected dividend growth was not a major factor driving the boom. The surge in earnings was part of a robust business cycle but did not have a sufficient permanent component to raise stock prices

Explanation: Changes in the Discount Rate

• The return required or stock yield (r) has become the favored factor behind stock market booms.

• R = risk free rate and an equity premium. It is believed to be moved primarily by the latter, as the risk free rate is held to be relatively constant.

• The equity premium is then calculated as the difference between the stock yield and a measure of the risk free rate.

The Equity Premium• For 20th century:

stock yield= dividend yield and growth

D/P = 4.5% Real growth = 1.7%

Real 10 year bond yield = 3.2%

Equity premium = 6.2% – 3.2% = 3.0%

Booms: Below 2% 1929, near zero 1990s

But is this warranted, aren’t stocks really “risky”

Bullish on the Equity Premium• “A Paradigm Shift” Glassman and Hassett, The Dow

36,000 (1999) diversified portfolio of stocks no more risky than U.S. government bonds

• “Stocks should be priced two to four times higher---today. But it is impossible to predict how long it will take for the market to recognize that Dow 36,000 is perfectly reasonable. It could take ten years or ten weeks. Our own guess is somewhere between three and five years, which means that returns will continue to average about 25% p.a.

• Rationale: premium can fall from 2.8 to 0.8%: real long term bond rate of 2% and g = 2.3% permits a D/P of 1.5% to fall to 0.8% with a tripling of P.

• P/D = 41 rising to 127

Bottom Line on Bubbles

• Huge swings in stock markets are impossible to justify by real factors.

• Dividends, Earnings, Interest Rates and the Equity Premium don’t move as much as prices.

• Prices tend to follow these fundamentals but not always

Is there a bubble out there? How to measure????

• Evidence in the market for brokers’ loans that lenders were very skeptical of the height that the market had attained in late 1929.

• Extraordinary interest premia

• Margin demanded rises from 25% to 50% lenders felt they needed this protection against a potentially huge decline in the market.

Costs of a Bubble: Distorted Decisions• Keynes (1936): “Speculators may do no harm on a

steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”

• A bubble will (1) raise household wealth causing higher than optimal consumption, (2) produce overinvestment it will raise market value to book value in Tobin’s q, and (3) induce more firms to borrow because of higher value of collateral and firms switch to equity finance if there is a lower equity premium. Crash will create credit crunch.

Should the Fed intervene? Should it pop a bubble?

What’s the optimal policy• NO INTERVENTION IN THE BUBBLE:

Powerful traditional lesson---drawn from experience of 1928-1933---is keep monetary policy focused on inflation and growth, not the stock market.

• BUT STEP IN TO PREVENT A PANIC: Intervention is appropriate for a central bank as lender of last resort to intervene temporarily in a payments crisis or financial intermediation crisis and then withdraw injected liquidity (as in 1929 and 1987).

Remember the Backdrop to the Boom

• 1920s: long post-World War I economic boom, preceded by high inflation, hard recession and many bank failures.

• 1922-1929, GNP grew at 4.7%, unemployment averaged 3.7%. (2 brief recessions), and no trend inflation

• Fed accommodated seasonal demands for credit and countercyclical policy, 1914-1929

The Fed and the Boom• Beginning in 1928, the Fed becomes obsessed

with the rapidly rising stock market. Fears that there is “non-productive” investment---speculation may lead to inflation.

• In February 1929, Board chairman Young spoke out against excessive speculation. “Direct pressure” on member banks to limit "speculative loans.“ NY Fed opposes and wants to raise rates

• August 1929 when the discount rate raised from 5 to 6%, just as the economy reaches its cyclical peak.

• Crash October 1929—2 days market falls 20%

Intervention in a Crash?• NY Fed injects liquidity (easy loans to banks) into

market in response to crash of October 1929• Stressed brokers and customers need credit as margin

calls are made. • Danger of collapse of securities firms and clearing

and settlements system.• Interest rate spreads widen then close as crisis abates. • FR Board criticizes NY Fed for saving speculators• Credit tightened again even though country sliding

into recession.• Continued worry over stock market leads to

excessively tight policy after stock market crash when still worried about speculative excess.

• Helps to start the Great Depression----lesson learned in 1987---Fed moves with unanimity to prevent panic after crash, economy quickly recovers.

Conclusion

• Measures of stock market boom fundamental and bubble components are fragile at best.

• Although there may be a bubble in the market, central banks should not intervene but focus on inflation and growth

• Central banks proper role is as a lender of last resort if a stock market crash threatens the payment system or intermediation.