With essentially no change in the domestic economic environment or interest rates, the market seems to be marching up a wall of worry, posting new highs as political struggles wane, inflation seems tame and the air coming out of the housing market has slowed to a trickle.
So why worry about an impending precipitous decline in the stock market? Just compare the crash of 1987 and the “Bubble” of 2000 to the environment we’re in today, and the similarities are alarming.
There was no apparent change in the economic conditions between the spring of 1986 and fall of 1987, but when the bell rang on that fateful Monday in October, investors fled to the exits in droves. 1986 and 1987 were actually banner years for the stock market. Those years were an extension of an extremely powerful bull market that started in the summer of 1982. When the dust settled, that crash was the largest one-day stock market decline in history. The Dow lost 22.6% of its value, or $500 billion dollars, on October 19th, 1987.
Now rewind to the fall of 1999 and the spring of 2000. Surely, the remarkable market values assigned to Internet and related high-tech companies seemed inconsistent with rational valuation. But throughout the process of topping out, there were no visible signs of a weakening economy or storm clouds on the horizon.
From 1996 to 2000, the Nasdaq went from 600 to 5,000! By early 2000, reality started to sink in. Investors soon realized that the dot-com dream was really a “bubble”. Within months, the Nasdaq crashed from 5,000 to 2,000. Billions of dollars were lost, and panic selling ensued as investor losses went into the trillions of dollars. During this decline, the Nasdaq Composite actually lost 78% of its value as it fell from 5046.86 to 1114.11. The Dow Jones Industrial Average went from 11,800 to 7,300, losing 38 percent of its value in the process.
There is one thing that the bubble of 2000 has in common with current market conditions, and that’s the initial public offerings (IPO) market, which has seen a surge in interest by investors lately.
In the year 1999, there were 457 IPOs, most of which were Internet and technology related. Of those 457 IPOs, 117 doubled in price on the first day of trading. In 2001 the number of IPOs dwindled to 76, and none of them doubled on the first day of trading.
Ironically, the initial public offering for Chipotle Mexican Grill (CMG) in February 2007 saw their shares jump from $22.00 to $44.00 in one day, making it the first time since 2000 that a U.S. IPO of more than $10 million had doubled so quickly.
There have been over 32 offerings priced since the beginning of 2007, which is up 14% from the same time last year, making 2007 look like the busiest year for new issues since before the tech crash.
And IPOs are performing well in the aftermarket. They returned an average of 18% in 2005 and 10% so far this year, according to Renaissance Capital in Greenwich, Conn., versus returns of just 5 percent and 1 percent, respectively, for the Standard & Poor’s 500-stock index. “The market is off to a very healthy start,” says Craig Farr, co-head of U.S. equity capital markets at Citigroup.
The percentage of profitless IPO companies fell from 80% during the tech boom to 40% during the bust, and has stayed there for a while. The average age of companies going public shot up from four years in 1999 to 15 in 2002, according to research by University of Florida finance professor Jay Ritter. Investors, in other words, gave money only to companies already demonstrating that they deserve it. The average age of companies going public slipped to 11 in 2005, and it’s now heading lower.
For a variety of reasons, share prices can be very volatile as a result of irrational responses and lofty expectations surrounding the direction of interest rates, the state of the economy, and the perception of risk.
As the Federal Reserve tries to micromanage the economy and inflation, the housing market is taking it on the chin but the economy is still growing, albeit at a moderate pace. Inflation seems to be under control and the markets are putting in new all time highs. Everything on the surface seems fine, just like it did in 1987 and again in 2000.
America and consumers were different animals back in the late eighties and nineties. The U.S. was still a manufacturing power house on a global scale, and workers wages were more in lock step with the economic realties of life in America.
Now the U.S. appears to be motoring along as a service economy, surviving off consumer spending, a massive amount of debt and not manufacturing. So what happens when the consumer can’t spend and housing prices decline and their home equity piggy bank dries up?
According to Wikipedia, the free encyclopedia, a stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles.
Most market crashes are long, lasting over a year, and usually occur after a prolonged period of rising stock prices and economic optimism, a market where price to earnings ratios exceed long-term averages, and there’s extensive use of margin debt by investors. Ironically, six out of the top eleven crashes started in either September or November.
But fortunately for the buy and hold investors, stock market “bubbles” are the exception rather than the rule. Accepting inefficiencies in the markets and the “occasional mistake” is the necessary price of being involved in a flexible market system that usually does a very effective job of allocating capital to its most productive uses.
Precipitous declines in the market usually occur as natural phenomena, balancing out the irrational exuberances of investors with the realities of the fundamental values of the underlying businesses. It’s during that moment in time when the market temporarily fails in its role as an efficient allocator of capital.
Even if they all have the same tell-tale signs, stock market crashes are difficult to forecast. But if you pay attention and recognize the clues, prospering from a crash can be a realistic and rewarding proposition.
Is this market poised for a major decline in the near future? Only if history repeats itself.