2000 A Bubble? 2002 A Panic? Maybe Nothing!
by Professor Matthew Spiegel
December 17, 2002

Does this September New York Times headline "The Bubble Has Burst, But Strengths Remain" seem all too familiar these days? Given what we have learned over the last two years, the late 1990s presents a painful lesson. If you have learned that lesson well, then I have an easy  question for you to answer. Was the 1929 stock market peak a bubble, or was the crash that followed a panic? Now this should be easy. After all, you identified the 2000 market peak as a bubble and you only have two years of data to work with. Compared to the 73 years of information generated since 1929 that is nothing.

How about some more recent price moves? Was the 1969-1972 run up of 40% a bubble, or the subsequent 46% fall from 1972-1974 a panic? Then there was 1987. Was the price rise of 32% during the first nine months of that year a bubble, or the October crash of 26% a panic? Why does it seem so much more difficult to classify events in the "distant" past for which we know so much more, especially when compared with 2000?

Maybe the problem lies with our current shortsighted 20-20 hindsight? Typically, people think of "bubbles" as having occurred if the market goes up and then falls by a large amount. By that standard, it does appear 1929, 1972, 1987, and 2000 were bubbles. But, what about panics? A panic is generally thought to have taken place if stock prices dive and then rebound. By that standard, the crash of 1929 was a panic. An investor buying at the peak and holding until today would have earned a compounded return of about 9.7% per year. Compare this with investing in something safe like treasury bonds which to date have only returned an average of 3.5% per year. The more recent "bubbles" of 1972 and 1987 present similar problems. If you purchased stocks at the 1972 peak you earned 10.3% per annum to date, while bonds have returned only 6.4%. Even for the relatively recent crash of 1987 the score to date is stocks 8.8%, bonds 5.0% per year.

But the 2000 market peak is different. Everybody saw it coming. Professor Robert Shiller's book Irrational Exuberance made the best seller lists in 2000. Certainly many were listening. Then there were newspaper headlines like the Wall Street Journal's, "Industrials Leap 47.63 to Another High --- Three Measures Indicate Stocks Are High Priced." Money managers issued warnings too. Richard Fontaine had $400 million in assets when he stated, "We're in an extremely dangerous situation that can only be corrected in one of two ways - either by a tremendous spurt in the economy or by a big drop in stocks. And I don't see any big earnings spurt . . ." Prescient warnings to a deaf investing public? That all depends on whether you take into account that the headline comes from an April 1992 article, and the quote from early September of that year. If you ignored their counsel, purchased stocks and held them until today you earned a compounded annual return of about 8.5%. Not bad.

Still, some argue that 2000 was a bubble because valuations were so out of line with fundamentals. For example, as the Wall Street Journal warned, "By three time-tested measures -- earnings, dividends, and book value -- stocks are at optimistic, and in some cases unprecedented, valuations. . . Never before has the S&P's price/earnings ratio risen so high, not even in the great bull-market peaks of 1929 or 1987." Trouble is, the warning came in April of 1992. Not to be outdone, in 1993 the Economist quoted Professor Josef Lakonishok (who now co-owns LSV Asset Management with $8 billion under management) whose study  ". . . found that total returns (capital growth plus dividends) were low after months in which p/e ratios were high." No doubt, in 2000 price-earnings ratios did reach an all time high. However, as the 1992 quote shows that is not at all unusual.

One reason price-earnings ratios say so little is that they have been drifting up over time. For example, investing in the market only when its P/E ratio lies below its historical mean keeps your money out of stocks since the beginning of 1986. On a longer scale, this same investment rule only has you in the stock market during 19 of the last 77 years. But are those the "right" 19 years? Not at all. Since 1925 your compounded annual return has come to only 3.3%. Other "reasonable" strategies that revolve around the P/E ratio produce similar results. For example, if you only invested when the P/E ratio was below its 10-year moving average you would have a compounded return of only 4.2% to date. The problem is that the P/E ratio looks at historical earnings, and the market is not about the past, but the future.

The difficulty with declarations claiming that large stock price moves are "bubbles" or "panics" is that they rely on perfect hindsight, typically generated only a few months or a year following the event. But investors do not have that luxury. They must price securities based on the information they have at the time they make their decisions. If we all knew the market was overvalued in 2000 it would have never reached its peak levels. The fact is there were reasonable arguments to justify the index levels, just as there were good arguments for their levels in 1992, 1993, and 1994. Back then, there was talk about how the Federal Reserve had become so adept at managing the economy that what had previously seemed like unsustainable growth rates might become the norm. As recently as 1986 Professor Lawrence Summers (now president of Harvard) talked about unemployment rates of 6% or higher as being "normal" for the economy and difficult to reduce below that level without sparking inflation. Today editors bemoan the currently unacceptably high unemployment rate of 5.6%. It is a new world. Just one thing. But who knows how new, and for how long.

So, was 2000 a bubble? The fact is we will not know for quite some time. Back then, companies were continuing a decade-plus-long expansion. Profits were rising at an incredible clip, and had been doing so for an unprecedented length of time. Earlier, some pundits had declared prices "unsustainable" in 1992, 1993, 1994, and on and on. Evan at today's levels, all but those crying out after 1997 have yet to be proven right. At the moment the economy is quite different and it is not at all clear what the future holds. If you want to know at what level the market "should" trade at in 2002, you will either need a time machine or a bit of patience.

Matthew Spiegel is Professor of Finance at the Yale School of Management