Have you heard of the ‘Mpemba effect’? It is a an unusual phenomenon where sometimes hot water freezes faster than cold water. One can say ‘Mpemba effect’ is quite common in stock markets. Hot speculative markets tend to freeze faster than otherwise.
When confidence declines, speculation gets hit and markets freeze. This is what happened in global markets, although just for a day or two last week, following what was just a mere 15 basis points hike in interest rates to 0.25 per cent by the Bank of Japan (BOJ). All of a sudden, the fear of yen carry trade unwinding amid uncertainty on valuation for AI stocks and trend in US economy created fears of a global bubble in asset prices bursting.
Are global markets in a bubble? We leave the judgement to you. Here are insights on four super bubbles of the last 100 years for you to glean some information and make your own judgement.
The Great Crash of 1929
The decade of the 1920s was a period of great economic boom and prosperity in the US and famously referred to as the roaring 20s. A depression in 1920-21 was followed by a period of widespread economic growth, lifting the standards of living of the country’s population till it was halted by the devastating Great Depression that lasted from 1929 to 1939.
Rapid industrialisation, urbanisation and improvement in living standards, powered by innovations in electricity and automobiles, boosted the US GDP by a nearly 50 per cent in eight years, at a CAGR of 5.3 per cent between 1921 and 1929. While not high by today’s standards, it could be termed a period of boom for those times. Further, it was also accompanied by a cultural renaissance, and sense of prosperity and optimism amongst the population.
As these factors evolved over the early part of the decade, the boom in stock markets resulted in a widespread conviction amongst a section of the population that it was easy to get rich by just investing in stocks. As mentioned in the book The Great Crash by economist John Kenneth Galbraith, the American people ‘were also displaying an inordinate desire to get rich quickly with minimum of physical effort.’ The end result was an increase in speculation in stock markets to unimaginable levels by the year 1929.
The convergence of innovation, economic growth, wild speculation involving leverage against the backdrop of regulators not actively reining in speculation, resulted in the Dow Jones Industrial Average (DJIA) moving up by 377 per cent from a level of 79. 80 in end 1921 to its peak of 381.17 on September 3, 1929. Thus, while nominal GDP grew at a CAGR of 5.3 per cent, the benchmark index grew at a CAGR of a staggering 22 per cent over a period of eight years!
The PE of the DJIA had roughly increased from around 10 times in end 1921 to 20 times by September 1929. Profits of the DJIA companies, too, had roughly increased at a CAGR of 11 per cent, implying the stock boom was not just entirely speculation, but partially driven by strong earnings as well. The problem, though, was the corporate profit to GDP had risen to an unsustainable 10.4 per cent of GDP, driven by very high profit margins. A market at peak PE ratio upon peak profit margins (what value investor Jeremy Grantham terms as the Double Jeopardy) was a bubble waiting to be pricked.
This happened on what is infamously known as Black Thursday – October 24, 1929, when the DJIA opened down 11 per cent, although it recovered to close down 2 per cent EOD. Nevertheless, the confidence of investors and speculators was rattled by events of the day. Margin calls were to follow in subsequent days.
On Black Monday (October 28), DJIA closed down 13 per cent and on the next day – Black Tuesday, it fell another 12 per cent on very high volumes. Confidence was now broken. The worst bear market in human history did not just impact the investors, but dragged down the economy as well. It continued for another three years till the DJIA bottomed out at 41.22, a staggering 89 per cent below its 1929 peak. It was an excruciatingly long recovery path from there and it crossed the 1929 peak again only in November 1954!
Only nine days before the crash started, Irving Fisher, a leading economist of those times, had made a statement “stock prices have reached what looks like a permanently high plateau.” What was so amiss was that while few had warned of a big crash, most had missed not just the market collapse but also the economic decline. The US GDP fell nearly 40 per cent from 1929 to 1932!
John Kenneth Galbraith (The Great Crash) attributes this to a few factors: High income inequality resulting in very few rich driving the economy in its late stages; Bad corporate structure that incentivised high leverage and poor capital allocation and increase in corporate larceny; Bad banking structure, as result of which failure of weak banks became contagious and impacted confidence in stronger banks as well; Poor policy decisions – tighter fiscal (focus on balancing budget) and monetary policies (fear of inflation) that turned out to be counterproductive and exacerbated the decline in economy.
Japanese Asset Price Bubble (1989-90)
A generation of Japanese have experienced neither inflation nor economic growth. Inflation till last year was mostly non-existent and interest rate was increased for the first time in 17 years in March this year. This hike followed a decade of zero and negative interest rates. With regard to growth, its GDP since 1991 till date has grown a CAGR of 0.5 per cent. This is in stark contrast to the annual GDP growth ranging between mid-single to low double digits percentage in the previous 30 years. From an economic miracle, it turned into a tragedy. Many factors have been attributed, including demographics, but one significant factor is also the failure of government and regulators to control the speculative frenzy in equities and real estate to super bubble levels.
The seeds of the bubble were sowed in what is known as the Plaza Accord signed in September 1985. Between 1980 and 1985, the dollar had appreciated over 40 per cent against other major currencies. This had resulted in US imports surging, while American exports become uncompetitive due to the high value of its currency. The consequence was unfavourable and record trade deficits (imports-exports) for the US.
With intention to avoid protectionist measures/trade interventions to turn around this untenable scenario, the US was able to negotiate an agreement (Plaza Accord) with the four other leading economies, including Japan (all big exporters to the US) to intervene in forex markets to bring down the value of the dollar. This caused a massive 45 per cent appreciation in yen against the dollar in 1986. This caused a recession in Japan and corporates were hit badly as exports to US plummeted.
The Japanese Central Bank (BOJ) and government responded with expansionary fiscal and easy monetary policies to address the slowdown. In combination, these resulted in a lot of surplus funds in the hands of Japanese citizens. Till then, they were known for their diligent savings. But with easy monetary policies resulting in significantly lower interest rates, the surplus money started flowing into equities and real estate, and soon a speculative bubble took over. Between 1984 and 1989, the Japanese benchmark index – Nikkei 225 went up over 300 per cent after nearly doubling in the previous five years. PE ratio had crossed 60 times!
The real estate investment mania had turned into a beast of its own. Further, profits from the bubble in stock markets flowing into property too added to the fuel in property prices. At peak of the bubble, the value of property in Japan was worth four times the value of all the property in the US! The craziness of this can be understood when one realises that the land mass of the US is 26 times that of Japan!
The BOJ was too late to respond to control the speculation. It started hiking interest rates aggressively from mid-1989. From 2.5 per cent in May 1989, the rates were increased to 6 per cent by August 1990. As rates increased, the equity bubble started bursting in early 1990 and property bubble too followed.
Both individual investors and corporates partook of the bubble. Corporates had indulged in the speculation as the capital gains was boosting their profits when exports had taken a hit soon after the Plaza Accord. The bursting of two bubbles gutted the wealth and ability to spend, of many. Property prices remained underwater for decades and many home-owners became prisoners in their own home as the value of property was much lower than the loan they owed.
The Nikkei 225 lost more than 50 per cent of its value by 1992 from a peak of 38,915.87 in December 1989 . It permanently bottomed out only in 2009 at around 80 per cent down from the peak. It managed to claw back to the 1989 highs only in February 2024. Of course, after the crash in the last one month, it is trading lower than 1989 peak again. Nikkei 225 teaches a very hard lesson on why valuations matter!
The bursting of the two simultaneous bubbles has had long-lasting impact on the economy of Japan and psyche of its citizens.
The Dotcom Mania (1999-2000)
By the end of the 1990s, the competition between the Japanese and Americans was not just on who can deliver the next greatest innovation, but also on who can deliver the greatest bubble of modern times. Where the Japanese quit in early 1990s, the Americans took over.
Similar to the 1920s decade, the 1990s decade too was an era of unprecedented innovations (this time in technology) and optimism in the US. After all, they had finally won the four-decades-old cold war and were unstoppable. And the advent of the Internet gave rise to unlimited possibilities, hitherto unimaginable.
As the dotcom technology evolved at a rapid pace, investor frenzy too gained pace and the information technology and telecommunication-heavy Nasdaq Composite rallied 400 per cent in five years to a peak of 5,048 on March 10, 2000. What was absurd beyond any precedence in stock market history was its PE ratio of somewhere between 175 and 200 times at its peak.
Anything with ‘dotcom’ on it was enough to ensure a successful IPO and bumper listing. Companies with no revenues, or even worse, with just business plans got a phenomenal response in the IPO markets. This was an instance of Americans making the Japanese speculators who bought useless parcels of land at obscene prices appear rational; for, in the case of land, at least there was some physical asset! The bubble had its impact in the broader market also with the S&P 500 rising to a PE of 30 times by early 2000 as compared to a PE of 16 times five years back.
The bubble got pricked in March 2000 and the slide continued for over two years till the Nasdaq Composite bottomed out at 1,114.11 in October 2002, 78 per cent below its peak. It would manage to cross the March 2000 peak again only in April 2015. Higher interest rates at the peak of the bubble, earnings disappointment, realisation that many themes were overhyped (at least for the near term) pricked the bubble. The negative wealth effect of the bubble bursting caused a US recession in 2001. Further, September 11 attacks and the resulting impact on economy and geopolitical tension, implosion of giant corporations such as Enron and WorldCom as their accounting scandals came to light, resulted in a long downtrend in markets despite the Fed aggressively cutting interest rates.
Out of the Magnificent Seven stocks of 2000 (largest by market cap) — Microsoft, Intel, Cisco, Qualcomm, Oracle, JDS Uniphase and Sun Microsystems — only Microsoft has managed to create value for shareholders from those bubble levels. Oracle and Qualcomm, while trading above 2000 levels today, have underperformed the S&P 500/Nasdaq significantly. Cisco and Intel investors have seen high wealth erosion, while JDS Uniphase and Sun Microsystem shareholders saw wealth destruction of over 95 per cent.
The Housing Bubble (2007-08)
A cure becomes the cause for another disease and sometimes much more severe! That is the story of the housing bubble of between 2002 and 2008 in the US, that brought the global financial system to its knees in September 2008. How did things reach such a dire state? The reasons can be broadly classified under three factors – loose monetary policy, poor regulations/deregulations and outright frauds.
In response to the 2001 recession, the US Fed followed a policy of low interest rates to help the economy heal from the wealth destruction that followed the Dotcom Mania. Gradually this money started flowing into the US housing market. Loose monetary policy from the US Fed apart, this was also due to pressure from the government to keep interest rates low and stimulus given to enable maximum number of Americans realise their dream of owning a home.
Amid this backdrop, there was also support for deregulation and not stifling financial innovations that benefit the economy, totally ignoring the other side in terms of consequences. Poor regulation also resulted in weak oversight of banks and how they deployed their capital. Such was the zeal for deregulation that In the famed Jackson Hole conference in 2005, when Raghuram Rajan highlighted how the incentives in financial system were aligned with excessive risk to the detriment of long-term shareholder interest and the broader financial system, his view was much ignored and economist Larry Summers termed him a ‘Luddite‘.
The combination of the above two factors also created a breeding ground for rampant frauds in mis-selling of loans, including what is infamously known as NINJA loans. These were housing loans extended to people with no income and no jobs, with poor credit history. Their ability to repay didn’t matter. Money was flowing easily, and they could borrow and buy homes. The fraud allegedly extended to the big banks at top level as well, wherein these loans were repackaged and sold to other institutions, with top ratings from the rating agencies, despite knowing they were of poor quality.
And it was not just this. Poor regulations also allowed for rampant risk taking of bank capital in speculating on the default probability of housing loans. Confident that the overall housing market will not decline much based on historical data, many banks staked big sums of capital in providing insurance in the form of credit default swaps. These were transactions in which buyer of the swap would be paid money by the seller of swaps (mostly big banks, hedge funds and insurance companies), if certain loans defaulted. The interesting thing to note here is that as explained by author Michael Lewis, this was like a speculative transaction between A and B on whether C’s home will catch fire! Trillions of dollars, multiple times the actual value of outstanding bonds, were at stake in such transactions.
So, the housing bubble had layers of bubble built upon each. First was the bubble in overall housing prices that increased 90 per cent (as measured by the Case-Shiller index) between 2000 and Q2 of 2006 (peak). As home prices started declining in H2 of 2006 and interest rates too were increased, the defaults on home loans started increasing. The subprime mortgage crisis was in full steam in 2007. Yet, many were oblivious to impending broader crisis including the US Fed.
Atop this housing bubble was the economic bubble. The boom in home prices had uplifted the domestic economy as well, which resulted in earnings bubble for banks and overall S&P as well. Think of this – the S&P 500 was trading at an inexpensive PE of 16 times in end-2007. Yet, it fell a massive 57 per cent from peak in 2007 to bottom in March 2009. The bubble was in the earnings and not in the valuation!
Then, there was the speculative bubble involving credit default swaps. As loans went bad, many big banks that had sold these swaps had to book losses. By September 2008, the entire net worth of the US banking sector was more or less eroded, which resulted in large-scale bailouts by the government. The extremity in speculation can be understood from one single fact – AIG, which was one of the world’s oldest and largest Insurance companies, was bankrupted by a small team that aggressively sold the swaps. Its failure was the tipping point that froze the global financial system in 2008.
Can there be a triple jeopardy?
Today, global stock markets are trading at near-peak valuations, upon peak profit margins, upon peak leverage. Since the financial crisis of 2008, while private balance sheets have mended, government and central bank balance sheets have become bloated. This can be inferred from the increase in global debt to GDP which as per IMF data has increased from 195 per cent in 2007 to 238 per cent as of end 2022. The cure by central banks and governments to heal the wounds of the financial crisis may have consequently created another disease of unsustainable debt to GDP levels. In recent years, high interest rates on such high debt, after a decade of zero-low interest rates is complicating this further. How this unwinds and whether it will have painful economic implications is anyone’s guess. Nevertheless, Indian investors need to be on the watch.
Across the bubbles discussed above, one common factor was the proliferation in credit and speculation. To that extent, it is a welcome move that the regulators in India – RBI and SEBI — have been proactively addressing the surge in loan growth and F&O speculation. While investors may balk at it now, in the long term these may look as moves that shielded us to an extent like in 2008.