In this extract from his thought-provoking book on the history of bubbles, Jim Mellon sees signs of trouble brewing on the stockmarket. Should we be preparing for tough times ahead?
Guess what? The old saying that a fool and his money are easily parted' is true. And fools keep on lining up to lose more as bubble follows bubble.
Bubbles in the financial world reoccur time after time for one simple reason greed. Throughout history, entire populations have taken leave of their senses to join bandwagons promising, but seldom delivering, expanded wealth.
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Bubbles have occurred in all sorts of investments, from tulips in Holland in the 1630s to the first property bubble that's thought to have taken place in Athens as far back as 333 BC. Charles Mackay, in his book Extraordinary Popular Delusions and the Madness of Crowds (1841), depicts specific manias such as the South Sea Bubble in England (17111720).
Equally celebrated bubbles occurred in the US in the 1920s, in Japan in the 1980s and most recently, of course, there was the internet bubble, which ran from the summer of 1998 to March 2000. When it collapsed, it wiped out hundreds of billions of dollars of savings.
Investment bubbles seem to follow a pattern: reasonable growth in share prices or other asset prices, followed by a dramatic acceleration, leading to perverse valuations. Sensible investors who typically stay clear of bubbles are quite often the ones sucked into them in their end stages. The biggest losers in the Great Depression were those who thought share prices were attractive because they had already fallen by 20%, 30%, or even 50% and so bought, only to see them fall even further. When prices of financial and real assets really go down they collapse and then continue falling, in a slow, grinding spiral that squeezes the last optimists into capitulation.
So what starts a speculative bubble? In the past, they have usually been related to the introduction of a new technology with apparently unlimited potential. Then, and only then, is it time to buy.
Thus the opening up of US territory by the building of railroads in the 19th century set the scene for vast speculation. The 1920s saw the same pattern in the US, with the introduction of gas and electricity utilities.
But our most recent bubble, the internet bubble, is possibly the one in which the most absurd overvaluations ever occurred. At its peak in 2000, Yahoo, the internet portal, was valued at just under $145bn despite the fact that a rival could have replicated what Yahoo had achieved for a fraction of its market value. So why was Yahoo supposedly worth' $145bn in the stockmarket? The madness of crowds!
Today, in the US and in several other countries, another mania has surfaced: that of real estate. The US real-estate market has been very robust in the past few years, along with that of the UK. In both markets, equity release' (where mortgages are increased by homeowners to provide debt secured against rising house values) has been a key driver of consumption.
Recent (albeit modest) rises in interest rates are a strong signal to all speculators in property that they should get out now. Real estate is shaping up to be yet another bubble primed for bursting and the fallout from its demise will be painful, especially in the US and UK, where house prices have sky-rocketed in recent years. The ratio of mortgage repayments to salaries is unprecedented; the relative pricing of property (ie, real estate as compared to other assets) has become ludicrous; and the fact that mortgages are being refinanced to serve as a kind of cash machine by many people to provide fuel for personal consumption is hardly sustainable either.
But what of the stockmarket? Might there be trouble brewing there again too? Perhaps. Remember 1987? The October crash back then was the worst in US history and wiped 23% off the Dow Jones Industrial Average in one day. And all the same factors occurring just before it are present today (think of the deteriorating US current-account deficit; the very low dividend yields on stocks; the very high price/earnings ratios; the weakening US dollar; rising US interest rates; and finally, rising gold prices). By any reckoning, US stocks cannot be considered to be anything other than expensive.
None of these factors bode well for the stockmarket, and we maintain the view that any rallies that occur in the US stockmarket are likely to be shortlived blips in what will be a very protracted bear market. After the crash of 1987, losses were relatively quickly recovered. But that may not be the case this time: most economic indicators are less positive and the outlook for corporate profits is much less secure.
Bear in mind that the Dow Jones in September 1929 peaked at 381.2, and then finally reached a low of 41.2 in July 1932. The modern Dow's highest close was on 14 January 2000 at 11,723. Since 2003, the Dow has been in the 10,000 to 11,000 range, which is not far off its all-time high. If an equivalent fall were to occur (which we are not actually forecasting, but which is certainly possible), then the Dow would fall to 1,267! Food for thought.
Jim Mellon is chairman of Regent Pacific. Wake Up! is published by Capstone Publishing, £12.99
