(This is Part 2 in a series. Go back to Part 1.)
Our fourth example is the Great Financial Bubble that is occurring right now.
By some measures it began at the financial and economic bottom that occurred in 1932-33. By others measures it began in the financial/economic bottom that occurred in 1974-75. But whenever it began, for a long while the expansion of credit was relatively mild. Correspondingly, stocks and housing rose, but at a measured pace.
For instance, the Dow Jones Industrial Average (DJIA) entered the decade of the 1990's at about 2500 and by 1995 had reached 4000, a relatively normal rise of about 10% per year. (Stocks over a 200-year period have risen about 9% a year.)
But in the mid-1990's the process began to take on a feverish pace. In just 5 years, from 1995 to 2000, the DJIA rose from 4000 to 11,750, a rise of 194%.
But wait, it gets better. From 1990 to 1995 the Nasdaq, a measure of technology stocks, rose from about 325 to about 800, a very substantial rise of 146%. But then over the next 5 years the Nasdaq leaped 538%.
It was a time when internet companies with no sales and no earnings could raise tens of millions of dollars; a time when a year-old company could be worth billions; a time when telecom stocks could have price/earnings multiples of a hundred or more.
During those last five years, credit—the fundamental force feeding the stock market—also rose at a blistering pace. By March of 2000, as mentioned earlier, the ratio of Total Credit to GDP was at 300%, the highest in history.
Meanwhile, the dividend yield on the S&P 500 was below 2%, the lowest in history. And countless other indicators, from P/E's to price-to-book, were at all-time levels. The credit and stock markets had entered a parabolic blow-off stage, which is a reasonably good definition of a "bubble."
But all bubbles eventually go bust. They break down precisely because they went to an extreme, like stretching a balloon to its limits.
More precisely, money and credit—the energy source of bubbles—begins to outrun itself and reach a point in time where leverage, financial imprudence, mal-investment and distortions to the system are so great that the system itself begins to implode.
When the Great Stock Market Bubble broke, the Nasdaq fell 70% in 2 1/2 years and the S&P fell 50%. A jobless recession set in.
In response, the Federal Government enacted the greatest fiscal stimulus package since the 1930's, and the Federal Reserve Board aggressively lowered short-term interest rates, cutting the Discount Rate a total of 11 times down to a 45-year low of just 1%.
But that artificially low rate, along with its accompanying environment of EZ credit to everyone everywhere at all times, has created severe repercussions—repercussions that are taking place mostly beneath the surface for now but which will sooner or later exact a momentous toll.
(This is the end of Part 2. Go to Part 3.)
—jim sloman, 3.27.04 for Feb 1
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