Are We Headed for a Third Bubble?

Published May 12, 2009

Are We Headed for a Third Bubble?

Laughter causes mirth, not the other way around, theorized psychologist William James (brother of novelist Henry) some 125 years ago. Today, practitioners of laughter therapy feign chuckling to induce happiness. Professor Charles Schaefer of Farleigh Dickinson University in Teaneck, N.J., made a study of the matter in 2002. Students he asked to “laugh hilariously for one minute” reported sharp improvements in mood, while those who smiled were less affected and those who howled like wolves were unmoved.

Could U.S. stocks be engaged in a version of laughter therapy at the moment? Monday’s decline notwithstanding, they’ve soared in recent weeks, erasing a 25% drop suffered earlier in the year, even while good news is scarce. The economy is shrinking and its number of unemployed is swelling, if at a slower pace than in prior months. Plenty of companies have beaten earnings forecasts but few have beaten on sales, suggesting slashed costs, not growth.

A bull would say stocks often rise before economic measures improve, since traders are quicker than government statisticians. A bear would point to the several false rallies of the Great Depression, when stocks rose more than 20% only to plunge afterward to new lows. But perhaps this rally is a fake one on its way to becoming real, if not enduring, growth. After all, an unwarranted rise in share prices, if it lasts long enough, puffs up investors’ buying power and sends them to stores. Companies cash in and the economy expands.

That’s arguably what happened during the bubbly stock market of the late 1990s. A slashing of core interest rates earlier in the decade produced a brief spurt of economic growth in 1994, but it subsided the following year. Then stocks turned remarkably generous. Over five years ended 1999, S&P 500 returns ranged from 21% to 38% a year. As share prices rose, growth in consumer spending and gross domestic product accelerated. Stock gains begat growth, not the other way around.

Share prices plunged over the next three years, but consumers kept shopping as house prices jumped 35%, aided by policy makers again slashing core interest rates. Stock returns turned positive again in 2003 and a second bubble ensued, this one shared by stocks and houses. Corporate profits rose from 5.4% of gross domestic income in 2003 to 7% by 2006. Rising shares helped make companies more profitable, not the other way around.

In both cases stock prices eventually collapsed, and if this rally grows into a third bubble it will surely end badly, too. If the first two bubbles were brought on by low core interest rates, conditions for a new one are ideal. The core rate is almost zero, a record. But one difference between bubbles No. 1 and 2 suggests economic growth this time will stop well short of past peaks. During the late 1990s, Americans maintained a respectable level of personal savings. In the latest bubble, savings rates turned negative. If the first time around consumers spent stock profits and the last time they had to go well beyond profits to spend debt, a third bubble might depend on the ability of banks to finance it. With losses in commercial property loans and credit cards still likely to worsen, that seems unlikely.

The recent rally has favored economically sensitive companies—ones whose profits rise quickly as the economy grows. Investors who expect the rally to fizzle ought to swap these for shares of companies whose products sell steadily no matter what. Favor modest valuations and big, safe dividends. Both are still abundant, fortunately. Also, keep ready a generous stash of cash.


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