August 9, 2001
Most economists now agree that an investment "bubble" existed about eighteen months ago and that it has now burst. I have always argued that the first rule of forecasting is to know where you are. Then you can better determine what path may be taken next.
If we are getting showered with the debris from a burst investment bubble, that means something different for the economy and for future investments than if we are confronting a typical inventory adjustment.
How do we know that a bubble existed and that it has now burst?
Bubbles are caused by distortions in the allocation of resources. In the pristine economic world of rational decision making and independence of transactions, such distortions should not occur.
If someone is foolish enough to accept a trade at other than the market clearing price, then a capital gain and a capital loss are incurred. While this may be unfortunate for one of the parties to the transaction, the economy still has generated the same purchasing power.
However, if the winner is encouraged to seek similar transactions for similar results, then too many transactions will be done at other than market clearing prices in one area of the economy. If the winner is further encouraged by access to credit, then distorted price transactions will multiply.
Indeed, most historical bubbles not only generate serious price distortions (the bubble sector experiencing price changes that have no relationship to market clearing values), but also resource distortions. Investment capital is being diverted from more efficient resource utilization to support the bubble economy.
We should have known that an investment bubble was brewing in the second half of 1999. Not only did technology prices lose all relationship to previous valuation models, but only a third of all stocks were rising in value. Those not in the bubble are starved for resources.
Indeed, most bubbles burst because capital becomes too expensive for those not in the distorted sector and they must contract. When the bubble finally bursts, we are left with an enervated economy.
Fortunately, the Federal Reserve restricted capital under the guise of fighting inflationary risks. While this undermined the entire economy, it allowed the Fed to pump liquidity back into the system once the bubble burst.
Can we now be assured that the distortions are totally gone?
A healthy sign is that almost two thirds of all stocks have increased in value during the past twelve months although the indices have not. The injection of liquidity has pumped up the enervated investments. This is why small value stocks excluding technology are far outperforming other investments after several years of under-performance.
Unfortunately, technology stocks still are not down to acceptable values. Some of this is the result of companies that were formed when capital was pouring into the sector. The ratio of prices to earnings for all technology stocks is a stunning 75, but it falls to 32 when companies with negative profits are excluded.
Some investors still hope that those absurd stock values at the height of the value distortions will reappear. They are gone forever.
Furthermore, the stock distortions led to serious excess capacity in some technology areas (especially communications and server farms). As a result, the capacity for growth in these sectors was overstated. Lower prices to earnings must become the norm in those areas when earnings reappear.
Finally, capital distortions during the bubble create problems for those providing the capital. Normally, this leads to a period of under-allocation even to the sectors that were starved for capital during the bubble. Japan is a classic example of the aftermath of a bubble economy.
In the United States, the distortions were supported by capital from the venture community. New enterprises that were never a part of the bubble now are at risk of being under-funded. While this will harm the economy's capacity to grow, it will not have a serious impact upon the ability of the economy to return to health.