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Book Excerpt

The dangerous market bubble Add to ...

This is an excerpt from The Fearful Rise of Markets: Global Bubbles, Synchronized Meltdowns, and How To Prevent Them in the Future , by John Authers.

The 2009 rally was the most impressive in a century, but the signs of perverse synchronization were alarming-forex, equity, credit, and commodity markets moved in alignment, forcing some countries to try to push their currencies down, and leading to record gold prices. Many feared an incipient bubble.

The global stock market rally that started in March 2009 was the most impressive in more than a century. At its nadir, the S&P 500 hit the ominous level of 666, no higher than it had been in August 1996. From there, it gained 63.5 percent, getting back to 1120, and regaining in eight months exactly half its losses of the previous sixteen months. A "relief rally" is to be expected after a big sell-off, but after nine months, this rally was still greater than the rallies after the great bear markets of 1932, 1974, and 1982.

There was fuel for a rally because the global economy was recovering after its post-Lehman seizure and profits were stronger than expected, in large part because the downturn made it easier to cut costs by firing workers. Vocabulary shifted subtly. Pundits started talking about the "Great Panic" rather than the "Great Crash"-implying that the horrors of October 2008 were merely the result of a panic, rather than a reaction to fundamentals. If this were true, the market could indeed rebound as quickly as it had fallen, once investors got over their overwrought fears.

But it appears that the rally rested on exactly the same pathologies of herding behavior, moral hazard, and a simplistic faith in models, combined with synchronized and self-reinforcing trading, that created the super-bubble in the first place. And investors got over their panic only after truly extraordinary interventions by the U.S. and Chinese governments that must, at some point, be paid for. Rather than dismissing the entire correlated crash as a Great Panic, a more alarming and perhaps more persuasive interpretation is that the super-bubble never fully deflated before the behavior that inflated it the first time began to inflate it again.

Got a question for John Authers? Send it in. He'll be online for a reader discussion at 3 p.m. (ET) on Monday, May 17th.

History's great bull markets start when prices are irrationally cheap. Despite the fall that preceded it, it is hard to say that this was true in March 2009. Surveys of investors did show exceptional pessimism in March 2009, thanks to worries about a populist backlash against the bail-outs, or a choking off of free trade, and the arrival of the untried President Obama.

But stocks were much cheaper, and the economy in even greater trouble, before history's other great rallies began. A reliable long-term measure is the cyclically adjusted price/earnings ratio, first conceived by Ben Graham and more recently championed by Robert Shiller of Yale University. This metric compares share prices to average earnings over the previous ten years, and correctly identifies 1929 and 2000 as the two historical points when the U.S. stock market was most crazily overvalued. It also spots market lows. The cyclically adjusted price/earnings ratio fell to 5.5 before markets recovered in 1932, and almost fell to 7 before the rally of 1982.

Fund managers who do not want to look stupid and lose assets should rationally stay invested in the market, as the rally will continue until the bond market loses faith in the U.S. government's creditworthiness and forces up interest rates.

In 2009, the cyclically adjusted price/earnings ratio never fell below 13, suggesting stocks needed to be far cheaper before they presented a truly compelling buying opportunity; and by the end of the year it was back above 20, well above the historic average and almost identical to its level on the eve of the Lehman debacle (although, it must be stressed, still well below the levels that marked previous bubbles). That in turn implies that the desperate measures to save the banking system lifted the stock market before speculative excess had been squeezed out. And that is easy to believe. It is, after all, exactly what happened in 2003, when cheap money from the Fed arrested the decline in stocks and ignited the credit bubble, before the effects of the dot-com bubble had been squeezed from the system. The 2003 rebound came, otherwise incomprehensibly, when stocks were still historically expensive.

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