Stock Market Bubbles

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An Unreasonable Fear of Stock Market Bubbles: Why It Pays To Question Nobel Prize Winners

By Dr. Steve Sjuggerud, President, Investment U
Tuesday, November 18, 2003: Issue #290

Vernon Smith is an interesting old bird…

With his gray ponytail, his Native American jewelry and his cowboy boots, he’s not the image your brain conjures up when you hear the word “Nobel Prize-winning economist.” Yet Vernon Smith won the Nobel Prize in economics in 2002, for his work on stock market bubbles.

Smith told Forbes magazine his current thoughts on the market. You may be pleased to hear that he is not concerned about a repeat of the tech-stock frenzy leading up to 2000 – and the meltdown that soon followed. According to his Nobel Prize-winning theories, memories of 2000 are too fresh in people’s minds for investors to get out of control once again.

In order for us to worry about a new bubble, we need a new generation of investors, he reckons. In other words, it could be a long while for a bubble and a subsequent crash to develop.

Me? I’m not so sure I agree with him Specifically, I don’t agree with his premise (and many other people’s) that 2000 marked the bursting of a bubble. In fact, according to current surveys, investor optimism is higher now than at any point in 1999-2000. Along with some other factors I’ll explain below, this makes me believe that the bubble of 2000 has room to expand. And that we as investors should stick with the stock market for now, to take full advantage of the situation.

Challenging the Nobel Prize Winner

Sure he’s got his Nobel Prize in economics. But that may not necessarily mean Smith’s right about the markets

The two folks who won the Nobel Prize in economics in 1997 (Myron Scholes and Robert Merton) started a hedge fund in the late 1990s based on their Nobel Prize-winning theories. The fund went down in flames soon after, nearly bringing the entire U.S. financial system with it. (See the book When Genius Failed, by Roger Lowenstein, for the amazing story.)

Vernon Smith thinks the bubble ended in 2000. And that investor optimism faded with the crash of the dot.com stocks.

He may be right. But my take is that the bubble never ended that investors still believe in stocks, even though stocks are still more expensive than they were at the two previous bubble peaks of 1929 and the late 1960s.

I think this because I see and hear it when I talk to investors, who only want to hear about things like high-return trading services (you know the ads – “MAKE 10,000% in a YEAR!”). And you see it in the statistics Like I said, when you consider the actual surveys of investor sentiment, it turns out that investors are more optimistic today than they ever were at any point in 1999-2000.

How quickly we forget – why the China story’s nothing new

Smith claims you need a new generation of investors before you can have a new bubble. I contend that bubbles repeat all the time. China stocks (all the rage now) were previously in a bubble that peaked in 1994. Chinese stocks then fell for nearly a decade – by 90% – only bottoming early this year. And now the stories are the same today as they were in 1994, and a new bubble is forming although this is a “new generation” of China investors, which fits Smith’s theory.

So who’s right, who’s wrong and does it matter?

Vernon Smith may be right. He’s got the Nobel Prize, and has done some nifty work.

Then again, he might not

I have two simple thoughts.

The 2000 bubble never fully ended.
We have investment “bubbles” all around us because Alan Greenspan has cut interest rates so low that people have been forced to take their money out of the bank and put it to work somewhere

Regardless of which of us is right, the good news is: It looks like these “bubbles” can continue.

Good investing,

Steve

Today’s Investment U Cribsheet

Current “bubble” trends that can continue (in my opinion) include rising real estate prices and rising commodity / gold prices.
The Vernon Smith facts are from an article on him in the current issue of Forbes magazine. For more on Smith, see that issue, or try www.forbes.com. For more on the plight of Myron Scholes and Robert Merton, check out When Genius Failed, by Roger Lowenstein.