Was the 1999-2000 tech “bubble” a bubble?

After my previous post, several commenters argued that I did not present persuasive evidence against the view that Nasdaq was in a bubble at the end of the 20th century.  They often made the following argument:

While the current level of Nasdaq is well above the 2000 peak value (of roughly 5040), the rate of return on Nasdaq has been far below the rate of return on alternative investments that are much less risky, such as T-bonds.

This is certainly a reasonable argument, but I find it unpersuasive for several reasons.  I’ll list them in order.

1.  I don’t think it’s reasonable to compare current prices to the absolute peak of the tech boom, which only lasted for a few days.  Whenever you look back on an asset price time series, the absolute peak level will usually look overpriced, in retrospect.  Importantly, that would be true even if there were no such things as bubbles. As an analogy, bubble predictions of Bitcoin have proved spectacularly wrong.  There were many people claiming that Bitcoin was a bubble at $30, then $300.  Last time I looked it was near $6000.  On the other hand, the absolute peak of Bitcoin was more like $19,000.  And yet I don’t think you could argue that Bitcoin was a bubble just because it briefly hit $19,000.  It’s pretty apparent that there is huge uncertainty as to what Bitcoin is worth.  Perhaps if it falls far below $30 then those who called Bitcoin a bubble at $30 can claim vindication.  But not at $6000.

2.  So here’s what I’d say.  There were widespread claims that Nasdaq was a bubble throughout the entire mid-1999 to mid-2000 period.  Most of the time, the market was trading in the 3000 to 4000 range.  Thus the current level of Nasdaq is roughly twice the level of the so-called bubble period.

3.  Even this, however is not enough to rebut my critics.  After all, T-bonds were yielding over 6% during the peak of the tech bubble, and they are a safer investment than tech stocks.  Here I’d point to the fact that long term bonds benefited hugely from an unexpected plunge in interest rates.  During most of the past 18 years, T-bills have yielded close to 1% (a bit above or below.)  And T-bills are an even safer investment than T-bonds.  For instance, I recall reading that long-term Treasury bonds lost 50% of their value during the Jimmy Carter years, even before inflation!  Then in 1982 their total return was over 40%, in a year of about 4% to 6% inflation (depending whether measured calendar year or year over year.).  That’s a pretty volatile asset.  Suppose you’d  bought a 30-year Treasury in 1981, yielding 15%.  Then suppose a friend had bought a stock that (ex post) yielded 11%/year over 30 years.  Would this suggest that the stock was overpriced in 1981?  No, it simply shows that the T-bond did far better than expected, in a relative sense.  After 1981, NGDP growth and inflation slowed sharply, which made T-bonds a great investment, ex post.  That inflation slowdown obviously reduced the nominal return on many alternative assets, such as stocks.

4.  Several commenters pointed to the fact that even (real) TIPS yields were pretty high in 2000, and Nasdaq has done poorly in real terms, relative to TIPS.  But the preceding argument also applies here.  Real interest rates also plunged sharply and unexpectedly during the 21st century.  Indeed they’ve often been negative.

5.  If you are having trouble with this argument questioning the relevance of bond yields, I can flip it around to make tech stocks look better.  Think about why interest rates plunged unexpectedly.  Much (not all) of the plunge was due to an equally unexpected plunge in trend NGDP growth, which has been far slower than expected during the 21st century.  If NGDP growth had been as fast as expected, fast enough to justify those 6% T-bond yields back in 2000, then Nasdaq would have also grown far faster.  In that case, Nasdaq would almost certainly be far higher today, say roughly 10,000.  Also, don’t forget that back in 2000, capital gains taxes were far lower than taxes on bond interest.  That made tech stocks especially attractive.

So here’s my argument.  Let’s go back to when Nasdaq was 3500 during the tech boom, a level certainly considered bubble by people like Robert Shiller (recall his initial bubble call was in 1996, when Nasdaq was barely over 1000).  I claim that this 3500 Nasdaq value was rational, if you assume NGDP would grow at the rate that bond market participants probably expected it to grow (say 5.5%/year).  If that growth had occurred, then Nasdaq would now be closer to 10000, and the market would have roughly tripled (plus dividends.)  Admittedly, even that sort of return would have been a bit lower than the historical average since 1926, but I believe markets have done well since the 1980s partly because of a growing realization that stocks were undervalued during most of the 20th century.  Thus a part of the 1982 to 2000 stock price boom was a sort of “catch up” as investors realized Shiller’s model was wrong, and historical valuations were too low. (Or historical rates of return were too high, given the risk involved, if you prefer to think that way.)  As an aside, I believe that’s why Shiller has done such a poor job of giving investment advice in the 21st century—not telling people to buy in 2009, and then saying stocks were overvalued a few years later, when in fact everyone should have been buying.  He has the wrong model, which undervalues stocks.

6.  Now let’s think about the justification for the bubble claims.  In 2000, people argued that all of these companies couldn’t be successful.  That’s true but not relevant; only some companies needed to hit the jackpot.  People also argued that these valuations only made sense if internet oriented companies eventually grew to utterly dominate the US economy.  Well, today the so-called FAANG stocks do dominate the stock market, with market valuations that dwarf the traditional corporate giants like GM, GE, etc.  I recall people mocking companies like Amazon, which made no profits year after year and were focused on growth.  So who’s the richest guy in the world right now?

Almost every single argument used against my EMH position when I started blogging in 2009, now looks far weaker.  Both Nasdaq and US housing have at least mostly recovered, even relative to trend.  The above market returns of the Ivy League school endowments are mostly gone.  Ditto for the above market returns for the hedge funds.  Bitcoin didn’t crash when it hit $30.  The people who told me the Canadian and Australian housing bubbles would crash “any day now” are still waiting, 9 years later.  And what about the overbuilt Beijing and Shanghai property markets?  Anyone willing to sell me property at 2009 prices in those two cities, widely regarded as a “bubble” even a decade ago?

I can’t prove the tech bubble was not a bubble, just as I can’t prove that people like Warren Buffett and Cliff Asness did not become rich by finding market inefficiencies.  I’d be shocked if there wasn’t an occasional case of someone spotting a market inefficiency. Almost all social science theories are technically false, in the sense that they are not completely true.  But the EMH is far less false than most of the very useful theories we teach in economics.  It’s much easier for me to find industries that violate the laws of supply and demand (say due to market power) than it is for me to beat the stock market.  I believe that 99.9% of investors should assume the EMH is true, and thus buy and hold index funds.  I believe regulators should assume the EMH is true, and thus not try to spot and pop asset price bubbles.  I believe that academic economists should assume the EMH is true, and thus replace 20th century macro with a new macro centered around real time market forecasts of expected NGDP growth, not VAR predictions of inflation and real growth.

 


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41 Responses to “Was the 1999-2000 tech “bubble” a bubble?”

  1. Gravatar of rayward rayward
    3. July 2018 at 09:29

    Sumner’s contribution to economics is his observation that the economy needs help the most when it seems to need it the least. But this post by Sumner reveals the weakness of his understanding of reality: the boom and bust economy works for those who buy during the bust and sell during the boom. Good luck with that. In this age of (a) a high level of inequality, (b) reach for yield ((a) equals (b)), (c) reliance on asset appreciation rather than yield, and (d) the absence of any rational fiscal policy, we can expect boom and bust. Pity the poor saps who can’t adjust, and the experts who live in ivory towers.

  2. Gravatar of John Hall John Hall
    3. July 2018 at 09:35

    For your first few points, particularly, I don’t think you’re talking about investments the way that people in investment management are paid to think about investments. Your first two points are just talking about raw levels, when that’s just not how anyone thinks about these sorts of things. Consider the simple growing annuity-type model:

    P = D * (1 + g) / (r – g)

    the price depends on the dividend D (or adjusted for earnings or free cash flow, as many tech companies weren’t paying dividends), the growth rate of the dividends g, and the discount rate r. You can then use things like the dividend yield D/P as some kind of proxy for value.

    Alternately, you can solve for the discount rate. Some papers do this with multi-stage models and get the implied discount rates for stocks. If you do this using Consensus earnings expectations and incorporate the yield curve into the estimate, then you can just isolate the implied equity risk premium from the market. I would expect that you would find that the risk premium on NASDAQ stocks was very low in late 1999 and early 2000 compared to now.

    One benefit of this approach is that it would abstract away from concerns that investors were too optimistic about earnings growth. They were too optimistic, of course, but taking that as a given, by bidding up prices highly, they were willing to accept a lower equity risk premium. In other words, they willing to accept a low rate of return on the stocks. This is the rational expectations story that I would think an EMH believe would tell about bubbles.

    The trouble with relaxing the assumption on Consensus earnings it that during the late 1990s period, the earnings growth on these companies were highly uncertain. As you note, some came to dominate the economy and other disappeared. Nowadays, it is increasingly popular to value such companies like options, where the stock may be worth nothing or it may be worth a lot. I suspect this difficulty in estimating the distribution of earnings is a big driver in a lot of what people call bubbles. When dividends or coupons can be predicted reliably, bubbles are much less likely. As with any call option, when it goes up, it can go up a lot.

  3. Gravatar of ssumner ssumner
    3. July 2018 at 09:57

    Rayward, You said:

    “Sumner’s contribution to economics is his observation that the economy needs help the most when it seems to need it the least.”

    Why do you keep repeating this nonsense?

    John, I’m saying the value of Nasdaq in 2000 should have been based on what people expected Nasdaq to be worth in 2018, plus the expected flow of dividends, all adjusted for risk.

    Is that even controversial?

  4. Gravatar of John Hall John Hall
    3. July 2018 at 11:57

    It’s standard economics/finance.

    Here’s my issue: The bubble argument is that prices go temporarily beyond what fundamentals justify and must normalize. Your post starts off by saying that prices are higher now than they were then. That doesn’t even address the bubble argument because raw prices have no relation to the fundamentals. Everyone in the market would have been focusing on price to earnings/sales/cash flow/etc (which had increased significantly in the bubble period and have since come down significantly). You follow this up by talking about interest rates. But interest rates are part of the fundamentals as well. They drive the discounting of future returns. So the fact that interest rates have declined has meant that prices are higher now. It’s not a response to the bubble argument.

    If I were you, this is my anti-bubble NASDAQ argument: In the late 1990s, investors were optimistic about the growth prospects of technology companies. They raised Consensus earnings estimates. Investors were enthusiastic and continued bidding up their stock prices to very high levels, to the point that the implied equity risk premiums in them were very low or even negative. To justify these valuations, the companies would have had to continue to grow earnings at a very fast pace. Moreover, even if they could have done this, the prices that many investors bought at would have meant that the returns to holding the stocks would not have been very strong and even they were they may not have covered the risk of investing in equities. Investors did so anyway because believed a lower equity risk premium was justifiable given the strong growth prospects of the sector. However, when the firms turned out to not be able to grow earnings as much as the market expected, then there was a revaluation and prices declined.

  5. Gravatar of ssumner ssumner
    3. July 2018 at 13:27

    John, You said:

    “Everyone in the market would have been focusing on price to earnings/sales/cash flow/etc (which had increased significantly in the bubble period and have since come down significantly).”

    Obviously not, which is precisely why people thought there was a bubble. They were focused on the expected future cash flow.

    As far as “It’s standard economics/finance.”

    No, the EMH is standard finance/economics. Any other theory is nonstandard.

  6. Gravatar of Justin Justin
    3. July 2018 at 13:38

    If people want to call it a bubble, I want to see their trading book and see that they at least made an effort to short this “bubble”. It’s just talk otherwise.

    I’ve had smug people email me boasting about how “Bitcoin was a bubble” and I think “yeah, well then you should have shorted it” These people said it was a bubble at $2k, at $5k. The same people said Amazon was a bubble. If a trader thinks an asset will fall in value, well ok, why call it a bubble though? Just place your bet and shut up.

    You’re dealing with an ever-changing probability distribution (of future price) when you’re trading assets. The mean of that distribution is shifting. Sometimes, the nature of the asset in question is so uncertain, that this shifting can be volatile (imagine a plot of market forecasts for would would win WW2 from 1939-1945).

    In 1999-2000, it was highly uncertain just how powerful and profitable the internet would be, just as the actual utility of Bitcoin has been highly uncertain. The consensus distribution changes, and the market price of the assets in question with it.

    There are two types of people in this world, those who get the EMH, and those who do not. I more or less give up on people after a certain point.

    As you’ve been saying for years Sumner, the very idea of a bubble is not useful.

  7. Gravatar of dlr dlr
    3. July 2018 at 13:49

    I think several of your arguments here are flawed.

    (1) The real CAGR of investing in the QQQ from 12/99 to 12/17 was about 1.2%. This despite suffering not just typical stock volatility but an actual drawdown of 84%. Forget the higher returns available from bonds or TIPS for the moment. Does this sound like reasonable risk-adjusted return to you or does it sound like a horrific risk-adjusted return, indicating that investors in 1999 Nasdaq stocks were extremely wrong about something.

    (2) FAANG stock do dominate the market and many people who shouted bubble back then have been proven wrong in important ways. In other ways, they haven’t. Many of the largest tech stocks, including Facebook, Google, Netflix and Nvidia were not public or did not exist at all back then and their success was not necessarily a good thing for Nasdaq 1999 investors, who owned companies subject to the creative destruction of those firms. That’s one of the reasons returns have been so anemic despite the world having been swallowed by streaming video and in-app purchases. Sure, those winners eventually made it into the indices but not before significant gains had already accrued to outside stakeholders and in many cases away from other legacy tech companies. The big-winners-make-up-for-it theory is only partially on point.

    (3) The Russell 2K generated real returns of 5.5% from December 1999 to December 2017 compared to 1.5% for the Nasdaq. This is the difference between retiring with twice the purchasing power and less interim volatility. And as you point out, we currently live in the die roll where massive FAANG tech stocks have captured our indices, half the GICS legacy industries, and our very souls. Maybe Nasdaq investors were getting a terrible price in 1999 to manage to land in such a world and STILL suffer terrible risk adjusted returns. Both the Russell 2K and the Nasdaq experienced the same NGDP environment.

    If NGDP growth had been as fast as expected, fast enough to justify those 6% T-bond yields back in 2000, then Nasdaq would have also grown far faster. In that case, Nasdaq would almost certainly be far higher today, say roughly 10,000. Also, don’t forget that back in 2000, capital gains taxes were far lower than taxes on bond interest. That made tech stocks especially attractive.

    You are allowed to say this if you want, but at least acknowledge that you have switched from showing things via a “natural experiment” to merely arguing based on a modeled relationship between NGDP and real stock prices. The Nasdaq could be sitting at 3000 today and you could also use this identical argument to claim victory and say that NGDP caused the poor risk adjusted returns. NGDP is not the only thing that happened during that time. Another thing that happened, for example, is that a hostile foreign country didn’t get the jump on quantum computing, obliterating our cryptography best practices and rendering most domestic tech stocks worthless. Lots of things happen or don’t happen. It’s either a natural experiment or it isn’t.

    if you assume NGDP would grow at the rate that bond market participants probably expected it to grow (say 5.5%/year). If that growth had occurred, then Nasdaq would now be closer to 10000, and the market would have roughly tripled (plus dividends.)

    Maybe, but ideal NGDP growth is not the only variable in the soup. Let’s assume that right now we are growing at a “normal” rate in that most of the world is not substantially affected by a demand-side recession. Despite this, real interest rates are incredibly low. Much lower than what was implied by the forward curve in 1999. 10 Year real rates in the US are 70 bps compare to 4.5% in 1999. 10 year real rates in Germany are negative. And risk spreads are also low. In 1999, option adjusted high yield spreads were substantially higher, roughly 5% for most of 1999. Today they have been hanging around the 3s. This is true (in direction) around the globe. Today’s low, real rates aren’t about problematic NGDP growth. They are a dramatic change versus what markets expected in 1999 in either real growth or required returns or both. You know, the kind of stuff you bet on implicitly when you buy tech indices at 50X earnings.

    One way to interpret this is as a big positive shock for asset prices, irrespective of the last 18 years of NGDP. Forward markets in 1999 gave no indication that the real cost of issuing a junk bond 18 years hernce would be only 1% in Germany or 4% in the US or Australia. They thought it would continue to be 10%ish. So maybe what really happened is that Nasdaq investors got incredibly lucky to have terrible risk adjusted returns, bolstered by shifting global time preference and risk aversion that declined even in the face of a crazy president and a giant interim NGDP shock. They took over the entire world and watched the real cost of capital fade away and all they gotten was a lousy stinking 1%!

  8. Gravatar of rwperu34 rwperu34
    3. July 2018 at 15:05

    re #3: I’d argue that stocks benefited from an unexpected plunge in long term interest rates as well. The slowing NGDP may have slowed revenue growth, but the gain in PE ratio more than compensated.

  9. Gravatar of bill bill
    3. July 2018 at 15:21

    All bubble predictions should come with a prediction for when and how much the price will fall. Otherwise they are just laughable. ie, they are all laughable. People don’t remember the tulip bubble because investors earned a little less than Treasuries or inflation.

  10. Gravatar of artifex artifex
    3. July 2018 at 15:50

    If you are reasonably certain that a tradable financial contract will be priced less at some point in the next thirty years than it is now, there is in principle no reason a broker would not allow you or at least some other investor with sufficiently low credit risk to borrow a share, sell it now, and give them a share back at any point the price has gone down, even if you don’t know in advance when that will happen. If brokers don’t have enough shares, they can make arrangements with brokers who do. Because of this, it is nearly impossible for the EMH, in weak and semi-strong forms, not to be true in an unregulated financial market.

    This practice of borrowing a share, selling it now and only delivering a share when the price comes lower is naked short selling. The SEC adopted Regulation SHO on January 3, 2005 which banned “abusive” naked short selling by limiting the time brokers can permit failures to deliver. And in 2008 and 2009 the SEC called naked short selling a “fraud” (never mind the fact that neither the investors nor the brokers nor the market makers minded it, making it hard to understand who exactly was being defrauded) and took coordinated actions “to strengthen investor protections” against naked short selling, “[making] it crystal clear that the SEC has zero tolerance for abusive naked short selling”.

    Naked short selling has been claimed in 2005 to have “cost investors $100 billion and driven 1,000 companies into the ground” (never mind the fact that the capital and therefore the resources that were allocated to the shorted companies were not destroyed but instead allocated to other companies that may have been able to make better use of them). It has been blamed for the financial crisis. It has been blamed for the failure of financial firms. It has been used as a scapegoat by many corporate officials to explain why their company had fallen in value. It is banned on most of the large stock exchanges (though I could not find that it is banned on the London Stock Exchange or the Toronto Stock Exchange).

    So if bubbles do exist now, the people shouting “bubble!” should at least blame regulators for regulating financial markets too much instead of blaming them for not regulating them enough. In doing this the regulators prevent the bubble identifiers from exploiting their knowledge to make money while correcting the price error.

  11. Gravatar of Benjamin Cole Benjamin Cole
    3. July 2018 at 16:17

    Why no fame for those who predict a reverse bubble?

    If you believe in bubbles, then you must also believe in reverse bubbles (that is, a period of unwarranted gloom).

    Obviously, 2009 represented a reverse bubble in house prices.

  12. Gravatar of Michael Sandifer Michael Sandifer
    3. July 2018 at 17:11

    Interestingly, the correlation between the Nasdaq and GDP is .905 since 1971. But from 1995 through 2003 it was less than .35. From 1971 through 1994 the correlation was .93, and from 2004 to present, it’s .95. I just ran these numbers using FRED data.

    I often make the argument that bubbles in the S&P 500 don’t exist, due to the .97 correlation between GDP and the S&P 500 since 1950, again using FRED data. So, what am I to make of the above observations about the Nasdaq? Well, the S&P 500 crashed with the Nasdaq, so how does that square with a pure tech bubble story?

    I think it was reasonable for Nasdaq to have a high valuation circa 2000, given the uncertainty related to the birth of new industries and the fact that the winners, while very difficult to predict, would more than make up for the losers in a diversified portfolio.

    I think about the early American car industry and how there were hundreds, if not thousands of American car companies in the early 20th century, with gasoline engines competing with steam and electric alternatives. Only 3 car companies survived, and only gasoline engines, for decades. Just buying and holding Amazon or Google would have made up for many, many losers.

    I further think that, generally, it’s easy to argue that NGDP shocks should be the null hypotheis for the cause of stock crashes in the US. From this perspective, I’m a stronger EMH advocate than Scott, as I think the 1987 stock crash represented an averted recession.

    That said, while I think the EMH applies more consistently than Scott does, I don’t think it’s as strong as he seems to think it is. If there weren’t opportunities for smarter investors to arbitrage, then there would be no incentives to make markets efficient. I think it is possible to consistently beat markets, beyond chance, but a precious few investors manage to do it. This is similar to the tiny percentage of athletes who are able to compete professionally. Looking at the aggregate statistics, one would say to any athlete< "Why bother?", but then there are certainly professional atheletes.

    I think the Fama and French 3- and 5-factor models apply, because the primary tradeoff for investors involves tolerance for liquidity risk. Fama argues that growth and value stocks are riskier than blue chip stocks, due largely to higher costs of capital. But, Fama agrees with Shiller that holding such stocks is a way to "beat" the market in the long run. In Fama's view, the market isn't being beaten in risk-adjusted terms.

    Yes, some of Shillers ideas about stock investing are awful, like how he misuses his CAPE, but he generally agrees with the philosophy of Dimensional Funds, with which Fama's been associated for a long time.

  13. Gravatar of Lorenzo from Oz Lorenzo from Oz
    3. July 2018 at 18:19

    There is an argument that the uncertainty of new tech naturally leads to boom and bust patterns …
    https://www.philadelphiafed.org/-/media/research-and-data/publications/business-review/2011/q4/brq411_theory-of-asset-price-booms-and-busts.pdf

  14. Gravatar of bill bill
    4. July 2018 at 05:19

    @Benjamin Cole,
    The reverse bubble is a great comment. It’s the great tell. Without checking, my guess is that NASDAQ at 1200 produced returns thru today further from “the norm” than NASDAQ at 5000. Yet the media at the time was calling for further falls, not saying “look at this crazy reverse bubble”.

  15. Gravatar of Ryan Turner Ryan Turner
    4. July 2018 at 06:16

    I think the underlying problem is that Summer’s definition of a bubble is more precise than most.

    I view bubbles as an emotional phenomenon, and if you are participating in the markets I think bubbles, much like porn, are easy to identify.

    When the dominant motivation to invest is a fear of missing out, and absolute confidence that someone will be willing to pay a higher price next week, you are in a bubble.

  16. Gravatar of Todd Ramsey Todd Ramsey
    4. July 2018 at 07:35

    EMH predicts that all available information is quickly included in asset prices.

    Scott, do you understand that EMH also includes the sum of all EMOTION into asset prices?

    People are greedy and fearful. The vast majority are prone to herd instinct. Therefore asset prices sometimes move disproportionately to purely informational changes.

    Buffett exploits changes in aggregate emotion, and he consequently beat the broader market over a 50 year period.

    EMH proponents might believe efficient markets will eventually anticipate and internalize those emotions to mitigate those price swings. Perhaps someday that will happen. However, human emotions are deep-seated and difficult to view within oneself. As recently as the crash of 2008, emotion was clearly still playing a huge role in market movements.

    I believe in EMH, but only with the understanding that the market prices in not only information, but also emotion.

  17. Gravatar of Scott H. Scott H.
    4. July 2018 at 08:16

    Arguing against EMH is kind of like arguing against science. As soon as you formulate a completely compelling attack on a scientific theory you’ve defacto changed the science. The same would be true for EMH — beating the market means changing the market. Look a Warren Buffet’s performance vs. market return over time.

    Markets and science aren’t static. They seemlessly incorporate reasoned analysis. Would be attackers are constantly going against an evolving target.

  18. Gravatar of Michael Sandifer Michael Sandifer
    4. July 2018 at 08:57

    Ryan Turner and Todd Ramsey,

    Emotions, and individual psychology in general, are irrelevant regarding EMH. Every over-emotional investment decision increases the incentive for a rational decision. For every panicking fool in a crisis, there are cool-headed Warren Buffetts happy to buy.

    Bad investment decisions increase arbitrage opportunities for good investors. There’s no way around it. It’s only the aggregate decisions that matter. You guys are falling victim to fallacies of composition.

  19. Gravatar of rayward rayward
    4. July 2018 at 09:28

    Rayward, You said:

    “Sumner’s contribution to economics is his observation that the economy needs help the most when it seems to need it the least.”

    Why do you keep repeating this nonsense?

    Could it be because Sumner has written that contractionary/deflationary policies leading up to the 1929 crash and the 2008 crash contributed to them, and made them far worse? Stated another way, the obsession with inflation leads policy makers to adopt policies that produce the worst possible outcome. It’s unlikely that Sumner has listened to Summers’ Okun Lecture as the 2008 crisis was happening, but Summers blamed policy makers’ (i.e., the Fed) for failure to see “inflation” lurking in the background. Inflation! I’m always impressed with how unaware of themselves economists are, even when they are right (as with Sumner).

  20. Gravatar of rayward rayward
    4. July 2018 at 09:44

    To be clear, I’m not being critical of Sumner. Indeed, I sympathize with him. After all, he has to pretend that he agrees with the depression economics promoted by his Austrian friends. That’s what friends are for. Now, if Sumner were to offer some good suggestions for an alternative to the bubble approach to economic growth (i.e., rising asset prices), I would strongly encourage him.

  21. Gravatar of H_WASSHOI (Maekawa Miku-nyan lover) H_WASSHOI (Maekawa Miku-nyan lover)
    4. July 2018 at 14:20

    It is okay for me to increasing numbers of people who believe EMH and are buying the mostly cap-weighted portfolio.

    Well,even if EMH is not true,the fact “cap-weighted portfolio is the equivalent to aggregate rival’s portfolio” still holds.So maybe,not so much bad choice.maybe.

  22. Gravatar of Matthew Waters Matthew Waters
    4. July 2018 at 14:33

    The 1981 T-bond example compares simple and compound interest. The 1981 T-bond, in the last year, yielded much less than 15% of the principal and accumulated interest. An apples-to-apples comparison requires reinvestment of interest at lower interest rates.

  23. Gravatar of ssumner ssumner
    4. July 2018 at 14:53

    dlr, What was the real return on T-bills from late 2007 to late 2016? I’d guess the nominal return averaged about 0.3%, while inflation averaged close to 1.8%. How about the entire 18 year period? I’d guess the real return was roughly zero. Is it any surprise that ex post real returns on riskier assets were disappointing during that stretch of time?

    More broadly, I don’t like to even look at real rates, because I view inflation as a meaningless variable. The point is that nominal rates are much lower today because NGDP growth has been and likely will be in the future much lower than expected in 2000.

    Rwperu34, You said:

    “I’d argue that stocks benefited from an unexpected plunge in long term interest rates as well. The slowing NGDP may have slowed revenue growth, but the gain in PE ratio more than compensated.”

    No. You are mixing up two distinct issues. One is the low rate of NGDP growth from 2000 to 2018, which has no impact on current interest rates, and the other is the lower expected NGDP growth rate going forward, which depresses current nominal rates. So I stand by my argument, that the NASDAQ would be around 10,000 if NGDP had grown at rates bond holders expected, even if interest rates were 5% today. If rates today were 5% you’d be discounting future profits at a higher rate, but expected future profits would be that much higher.

    Rayward, We most need contractionary policies during hyperinflation and we most need expansionary policies during depressions. I agree with the consensus. Please stop.

    You said:

    “After all, he has to pretend that he agrees with the depression economics promoted by his Austrian friends.”

    More stupidity on your part. I don’t agree with Austrians on depression econ, and I have no Austrian friends.

  24. Gravatar of Matthew Waters Matthew Waters
    4. July 2018 at 15:16

    “For every panicking fool in a crisis, there are cool-headed Warren Buffetts happy to buy.”

    There is no evidence of this. Low P/E or P/B portfolios have better long-term performance in studies. This is across different time periods and different countries.

    Most funds are deployed through intermediaries. Intermediaries generally have incentives out of line with long-term performance of their managed funds. Most fees are based on capital managed rather than performance. Even if fees match performance, portfolio managers personally have an extremely asymmetric incentive. If capital flees due to short-term underperformance, the portfolio managers are out of a job.

    For his part, Buffett 1965-1971 set up a very good position for himself. As part of a spate with Berkshire’s manager, he bought most of Berkshire stock with his partnership funds. Then he ended the partnership and returned capital. Managing Berkshire insulated himself much more than typical money managers. A proxy contest is infinitely more difficult than investors withdrawing money.

    Other value investors with hedge funds or mutual funds needed particularly patient investors. For example, Julian Robertson closed down his fund in 2000, after refusing to invest in Tech stocks.

    More importantly, shorting is always much more difficult than long investing. Shorting a stock requires 50% margin posted and paying interest on the stock you borrow. The lender can recall their stock immediately. Due to short squeezes, the short investor may need 2x, 4x or more of the stock price ready to meet margin calls. The posted margin is cash, earning zero returns. Even with an infinite source of money, shorting an overvalued stock will generally lose money versus alternative investments.

    As a caveat, I don’t think regulators should try to call bubbles or anything like that. Regulators will have same behavioral issues as general investing public.

  25. Gravatar of artifex artifex
    4. July 2018 at 15:52

    Matthew Waters, portfolios with low price-to-earnings or price-to-book ratios having better long-term returns would not be evidence against the EMH. It would be evidence that these portfolios have higher undiversifiable risk.

  26. Gravatar of dlr dlr
    4. July 2018 at 16:38

    dlr, What was the real return on T-bills from late 2007 to late 2016? I’d guess the nominal return averaged about 0.3%, while inflation averaged close to 1.8%. How about the entire 18 year period?… Is it any surprise that ex post real returns on riskier assets were disappointing during that stretch of time?

    For the 18-year period 90 day T-bills averaged just over 1.6% and the real return was around -0.4% or -0.5%, which is rather close to the slightly negative real returns from T-bills from 1940-2017. What’s more, and as I mentioned, the Russell 2K and the equal weight wilshire 5000 had returns from 2000-2017 that were perfectly in line with historically equity premia despite an identical NGDP and real/nominal rate environment.

    And, in fact, during the great T-bill drought of -1.5% from Dec 2007-2017 the QQQ produced outstanding real annual returns of 11.3%. More than 100 percent of its terrible risk adjusted performance came during the period when real risk free returns were actually well above normal. So I guess according to yoru question above you should be shocked that the QQQ generated an amazing negative 9% annualized real returns from the eight years of December 1999 to December 2007 despite higher than average risk free returns and fairly normal NGDP growth.

  27. Gravatar of Michael Sandifer Michael Sandifer
    4. July 2018 at 17:44

    Matthew Waters,

    In response to, “For every panicking fool in a crisis, there are cool-headed Warren Buffetts happy to buy.”, you replied:

    “There is no evidence of this.”

    No evidence? For every sale during a crash there is necessarily a purchase. There’s no way around it. Market don’t just crash uncontrollably. They crash in proportion to the real and/or nominal shock.

  28. Gravatar of Matthew Waters Matthew Waters
    4. July 2018 at 21:59

    “No evidence? For every sale during a crash there is necessarily a purchase. There’s no way around it. Market don’t just crash uncontrollably. They crash in proportion to the real and/or nominal shock.”

    Every transaction having two sides doesn’t entail “They crash in proportion to the real and/or nominal shock.” That doesn’t follow at all.

    Remember that my post was in response to this:

    “Emotions, and individual psychology in general, are irrelevant regarding EMH. Every over-emotional investment decision increases the incentive for a rational decision. For every panicking fool in a crisis, there are cool-headed Warren Buffetts happy to buy.

    Bad investment decisions increase arbitrage opportunities for good investors. There’s no way around it. It’s only the aggregate decisions that matter. You guys are falling victim to fallacies of composition.”

    I didn’t take “for every panicking fool…” sentence as saying, merely, that every buyer has a seller. I took it as the “cool-headed Warren Buffetts” having equivalent or greater access to money, generally.

    The fact that the ledgers equal out does NOT mean the two sides of the transaction RAISED equal money. They bought and sold equal money on the day of the panic. In an extreme scenario:

    1. Irrational investors raise $100 to buy 50 shares. The shares are actually worth $1, but the irrational investors pay $2.

    2. The rational investor raises $10 and just sits on it.

    3. Irrational investors panic and now want to sell at any price. The rational investor buys all 50 shares using their $10. The shares sell for $0.20 each.

  29. Gravatar of Michael Sandifer Michael Sandifer
    5. July 2018 at 03:06

    Matthew Waters,

    You don’t understand my point. The 2000 crash didn’t happen in a single day. It occurred as a trend over months. There were big up and down days, as new information emerged about future GDP growth prospects. The fact that the Fed controls NGDP entirely, but watched this happen, indicates a gradual loss in confidence in the Fed over time, which seems rational to me.

    The relative wealth or liquidity of the buyers and sellers is irrelevant. The point you can’t seem to grasp is that every irrational investment creates greater incentives for rational ones. Every liquidity constrained investment decision during a downturn does likewise. Lower prices ease liquidity constraints for those able to buy.

    There’s always been a bounce-back after crashes, so there are rational buyers on the way down. Indeed, for most long-term, non-liquidity constrained investors, selling during downturns is irrational. If they can’t time when to sell, how can they time when to buy in again? They risk realized losses, instead of mere paper losses.

    The fact is that markets are quite efficient, in a relative sense. The vast majority of investors don’t consistently beat the market above the rate of chance. If you agree markets are relatively efficient, which is what EMH claims, then you must think they’re extremely inefficient in the absolute sense. If that were true, why would we choose to organize our capital markets that way? What would be the incentive for such liquid trading, and companies wanting to raise capital that way?

  30. Gravatar of Ryan Turner Ryan Turner
    5. July 2018 at 05:41

    @Michael Sandifer

    When “Long Island Iced Tea” can quadruple their market cap by changing name to “Long Blockchain” with no change in business model, some property of the market has clearly changed.

    You can argue that the market is still obeying the EMH, as investors are (correctly) incorporating the sentiment of other participants; but the valuation process has clearly departed from the underlying economics and become a purely psychological game (that is almost certainly misallocating capital).

    I agree that no violation of EMH has occured – Long Blockchain was never an obvious short because the risk of getting squeezed was so high – but if you are unwilling to call this situation a bubble I’m not sure your definition is useful.

  31. Gravatar of Michael Sandifer Michael Sandifer
    5. July 2018 at 06:09

    Ryan Turner,

    The case of Long Island Iced Tea is not as you present it. It wasn’t just a name change, but the company also reportedly announced it was investing in Bitcoin mining.

    https://bitsonline.com/long-blockchain-corp-transitions/

  32. Gravatar of John Hall John Hall
    5. July 2018 at 09:54

    Scott, you said:

    “Obviously not, which is precisely why people thought there was a bubble. They were focused on the expected future cash flow.”

    My point was that your post focused on prices at the expense of expected future cash flows. Investors look at them together (with also with risk). I would have found your post more convincing if you made reference to ratios like P/E (preferably on a 12 month forward basis). My first comment was merely talking about a more sophisticated approach, but many investors were focused no P/E ratios at the time of the bubble. There was endless discussion of things like “is Internet Companies P/E of 100 too expensive” They never were like is a PRICE of $100 too expensive by itself. Because what matters is price relative to the expected future cash flows (and earnings are often an indicator of what future cash flows to the investor could be)

    and:

    “No, the EMH is standard finance/economics. Any other theory is nonstandard.”

    I was agreeing with you…

    That investors should discount cash flows based on their risk and time preferences is standard undergraduate finance. However, that idea is NOT the efficient market hypothesis. EMH is the idea that asset prices reflect all public available information in liquid markets. It doesn’t say anything about how investors should go about determining what the prices should be.

    My problem is that your post did not feel like it could have passed the ideological Turing test. Stuff like: “Prices were high then, but they’re higher now.” That prices were high, by themselves, does not make it a bubble!

  33. Gravatar of rayward rayward
    5. July 2018 at 10:23

    Sumner: Rayward, We most need contractionary policies during hyperinflation and we most need expansionary policies during depressions. I agree with the consensus. Please stop.

    Rayward: Then what’s the point of employing economists. I can recognize floods and droughts without the need for a weatherman, and I can recognize depressions and hyperinflation without the need for an economist.

    Sumner: You said:

    “After all, he has to pretend that he agrees with the depression economics promoted by his Austrian friends.”

    More stupidity on your part. I don’t agree with Austrians on depression econ, and I have no Austrian friends.

    Rayward: You have no friends at the Mercatus Center? I admire Peter Boettke because he actually believes the nutty things he believes. What do you believe?

    For the longest time I never understood why the commenter who called himself Ray Lopez was such a jerk.

  34. Gravatar of mpowell mpowell
    5. July 2018 at 14:31

    You keep jumping between two different arguments. One, regarding the accuracy of the EMH and a second regarding what constitutes a ‘bubble’. What is really ironic to me about your argument is that you are now proposing that stocks were undervalued for most of the 20th century as evidence that the NASDAQ wasn’t a bubble in 1999 and therefore the EMH holds!

  35. Gravatar of Todd Ramsey Todd Ramsey
    6. July 2018 at 06:00

    Michael Sandifer,

    “They crash in proportion to the real and/or nominal shock”.

    “The 2000 crash did not occur in a single day.”

    What real and/or nominal shock — large enough to erase 22% of market value — occurred between the close of the market on Friday, 10/15/87 and the open of the market on Monday, 10/19/87?

  36. Gravatar of W. Peden W. Peden
    7. July 2018 at 02:51

    Rayward,

    “Then what’s the point of employing economists?”

    In PART, because people (including bad economists) tend to think that “we need to liquidate the bad investments” during the depressions and that “the source of the inflation is rising costs due to Arabs/trade unions/American Imperialist Jackals/Jewish bankers/evil reactionary businessmen” during hyperinflations (and periods of high inflation more generally).

    It takes a lot of effort under such circumstances that the problem is almost entirely a lack/excess of nominal spending.

  37. Gravatar of Michael Sandifer Michael Sandifer
    7. July 2018 at 09:52

    Todd Ramsey,

    Greenspan was a new Fed chair and was seen as tightening policy. He was sworn in August 11 of 1987. He then announced a “pre-emptive strike” on inflation on September 9 of that year. This was also in the context of Treasury Secretary Baker threatening Germany on the value of its currency. He told them to hike it, or he’d devalue the dollar.

    So, I’d say there was at least a nominal shock, and perhaps a real shock in terms of trade, potentially as well.

    Looking at the P/E of the S&P in early September of around 20, it suggests markets were predicting a roughly 1.4% loss in GDP on black Monday.

  38. Gravatar of Todd Ramsey Todd Ramsey
    7. July 2018 at 11:26

    Michael Sandifer,

    You mention Greenspan’s comments from September 9. EMH implies the market would instantly incorporate those comments, not 40 days later.

    You offer no explanation why markets predicted a 1.4% GDP reduction and a 22% reduction in the value of equities on Monday from the previous Friday. What INFORMATION became known over that weekend not previously available to markets?

  39. Gravatar of Michael Sandifer Michael Sandifer
    7. July 2018 at 13:11

    Todd Ramsey,

    Baker spent the weekend before that Monday crash threatening Germany regarding raising their interest rates. Markets in Asia were already falling precipitously before the Monday crash in the US. So, we’re the markets in Asia wrong too?

    Again, the correlation between the S&P 500 and GDP is .97 since 1950. The value of the US stock market is only about 5% of the NPV of expected NGDP. So, GDP shocks should be the null hypothesis when it comes to potential causes of stock crashes.

  40. Gravatar of Todd Ramsey Todd Ramsey
    7. July 2018 at 13:42

    Are you really serious that Baker threatening Germany was the information that caused the markets in Asia and the U.S. to fall 22% in a single day? If so, you would need, at a minimum, to confirm that Baker never made threats at any other time.

    Your correlation statistic, combined with your Baker observation, would indicate the markets anticipated a 21% fall in GDP due to the Baker threats.

    I agree that GDP shocks should be the null hypothesis; however, on Black Monday, the cause of the market fall was not markets anticipating a 20% fall in GDP.

    You stated, “the 2000 crash did not occur in a single day”. I gave an example of a crash that did occur in a single day. That refutes your original claim.

    All I am claiming is that markets price not only information into pricing, but also emotion. Usually, emotions are calm. But there are instances where fear and greed overwhelm people’s logical mind. Black Monday appears to be one such instance.

  41. Gravatar of Michael Sandifer Michael Sandifer
    7. July 2018 at 16:00

    Todd Ramsey,

    No, the conclusion you reach about the relationship between the correlation of the S&P 500 and GDP and the scale of a crash issue relation to GDP is incorrect.

    Believe what you want. Learn to run the numbers for yourself, and then maybe you’ll learn how things work. Until then, this is a total waste of time for me.

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