Will 1929 Revisit Global Markets In 1999?

As Mr Yashwant Sinha prepares for his next budget, he must be crossing his fingers and hoping the global economy revives, expanding India’s export prices and volume in deep recession in East Asia is ending, and the US economy continues to roar ahead. The Dow Jones index has soared to record heights.

Yet, I have a sinking feeling that he party is about to end. The 3Com on Wall Street looks to me a bubble. If it bursts in 1999, it will spark a global recession that makes 1998 look like a picnic.

Optimists will dismiss this as alarmism. As the saying goes, economists have predicted 20 of the last three recessions. Despite many dire predictions of a downturn in 1998, the US continued into the longest post-war economic boom.

The American public feels richer and more confident than ever, and spent unprecedented trillions on Christmas shopping. Stock market values look absurdly inflated. The price-earnings ratio has doubled from the traditional level of 16 to an astonishing 32. Optimists say this is no bubble, but a transformation of market fundamentals by new factors. First, the post-industrial revolution has raised productivity dramatically in the US, and profits can rise much faster in knowledge and service industries than in manufacturing.

Second, capital from every troubled spot in the world flees to the US as a safe haven, driving down interest rates and increasing the demand for equities.

Third, the number of Americans investing in stock markets has more than doubled, and Internet trading allows individuals unprecedented access to the stock market at the lowest-ever commission rates.

Finally, President Clinton proposes to place more than a trillion dollars of Social Security budget surpluses in equities over the next 15 years. Have the fundamentals really changed? Perhaps. I do not rule out the possibility.

Yet, to me the higher demand for equities looks less a change in fundamentals than a bubble. Ultimately, stock values must reflect profitability, not the volume of money chasing equities. Ultimately, returns must equalise across different investments, and equities cannot permanently yield more than other assets.

Euphoria can run on its own momentum for some time, but must then crash. That is what happened in 1929.1 reproduce here the front page of The Washington Post’s financial section on January 1,1929.

It quoted top businessmen and financiers as saying that 1929 would be as good or better a boom year than 1928. The rest is history. Consider the facts.

  • The US stock market rose 34 per cent in 1995, 20 per cent in 1996,31 percent in 1997 and 28 percent in 1998. This far outpaced every other indicator of prosperity—income, sales, profits.
  • The household savings rate in the US has long been a low 4 to 6 per cent (India’s rate is 19 percent). But in 1998, US households actually spent more than they earned. Living beyond your means can boost demand temporarily, but not for long.
  • The stock market boom has added $ 8 trillion to the value of shares, and the “feel rich” effect has induced high spending and sustained the economic boom.

But by this token, a downward market correction will induce a “feel poor” effect that shrinks consumer spending and precipitates a recession.

  • The Economist reports that corporate profits in the six richest countries were 12 per cent lower in the third quarter of 1998 than a year earlier. Japanese performed worst, but profits were down in other big economies as well. Wall Street has blissfully ignored this.
  • Just say Internet and Wall Street skyrockets, reminding me of Harshad Mehta’s bull run Mumbai in 1992. A small US company, Biker’s Dream set up a website to sell bikes on the Internet. Its stock price jumped 167 per cent in one day, something its own owner described as “crazy”. Amazon.com is an Internet book seller of great promise, yet can you really justify its price rising from $ 9 at launch in 1997 to $ 350 today when it has yet to make an annual profit.

Now, bubbles can keep inflating for years, as Japan showed in the 1980s. So perhaps the US bubble can expand a few years more. Yet the bigger the bubble, the sharper the subsequent contraction.

Remember that the Nikkei index in Japan is today just one- third of its peak value, and its collapse ushered in eight years of stagnation. We have been warned.

What do you think?