What Next for Markets? Psychology Holds Key
Many times in recent months, Federal Reserve Chairman Alan Greenspan has been asked if the U.S. stock market was a dangerous “bubble” at ever greater risk of bursting.
His reply has been consistent: “I don’t think we can know if there is a bubble . . . until after the fact,” he repeated to a Senate panel last Thursday.
But amid the worst market decline since the 1987 crash, many Wall Street analysts, and individual investors, would argue that Greenspan was characteristically understating how he truly felt.
Indeed, the spectacular run-up in the “new economy” sector of the market--primarily technology stocks--between October and early March looked like most of history’s other great bubbles, all of which ended in terrible carnage and massive investment losses.
It wasn’t that the classic symptoms of a mania were missing; it was simply a case of both veteran and novice investors winking and nodding at those symptoms--and believing that either this time was different or that they could make it to the market’s exit door quickly enough if the boom was about to bust.
As Wall Street trading opens today after the 25.3% plunge last week in the tech-stock-dominated Nasdaq composite index, the question on most investors’ minds is, “Where will it end?”
But just as the winter run-up in hundreds of technology stocks took prices to heights few expected, the downside risk is equally unpredictable.
It depends less on thoughtful investment discipline than on basic human psychology--when the fear now driving markets subsides enough for the opposite investing emotion, greed, to take over again.
Greed, however cloaked in more polite terminology, is the driving force of every mania. As investors see others winning in the stock market or at some other game, the desire to get in becomes overwhelming.
Stock valuation rules people held dear just months earlier--how much a company should be worth in the market, for example--can quickly become compromised, or rationalized away.
As Charles P. Kindleberger wrote in his 1978 book “Manias, Panics and Crashes: A History of Financial Crises,” “As a boom progresses and greed mounts, excuses become thinner.”
In the Nasdaq market run-up that accelerated beginning in October, investors literally bid the prices of some unprofitable technology companies’ shares from the mid-teens to $200, $300, even $400.
Incyte Pharmaceuticals, a Palo Alto-based firm that provides services to biotechnology companies engaged in research into the human genetic code, saw its shares rocket from $19 in October to a peak of nearly $290 in February.
There was, of course, some basis for optimism about the company’s prospects, as excitement over human genome research was building among scientists and the public.
Wall Street brokerage analysts, who generally are expected by their firms to present a bullish case for the companies they follow (or why bother following them?), helped stoke the market’s fires by frequently raising their “price targets” for tech stocks as the shares surged. If the stock was at $100, an analyst might well present a case for $150 within, say, six to 12 months.
But as shares of Incyte and many other tech firms rose ever higher, many of the investors behind that rise probably knew few facts about the companies’ businesses, or how much the firms might eventually earn in bottom-line profit for the products and services they sell.
Instead, Incyte, and so many other technology and “new economy” stocks, became “momentum” stocks: They were going up simply because they were going up.
More troubling was that the purchases of many technology stocks in recent months were made with borrowed money, as investors, quite legally, took out a record sum in loans from their brokerages to buy as much stock as they could.
Stock bought on credit will, of course, exaggerate an investor’s gains as long as the share price continues to rise.
But if the stock price begins to fall, the investor’s losses likewise become exaggerated.
What happened to Incyte’s shares has happened many times before to stocks, or sectors of stocks, in the United States and abroad. Usually, there is a fundamental optimism about the industry underpinning the shares. But as buyers pour in, the stock’s rise takes on a life of its own:
* In the early 1960s a similar boom occurred with, of all things, bowling equipment stocks.
* In the late 1960s, many of the technology stocks of that era--names like Teledyne, Control Data and Optical Scanning--rocketed in what became known as the “go-go” era on Wall Street.
* In Japan in 1988 and ‘89, that country’s blue-chip stocks were viewed in a like vein: too exciting not to buy, no matter how high-priced they appeared relative to their earnings or growth prospects.
Each of those stock booms ended the same way: with a terrible bust.
Share prices of Teledyne, Control Data and Optical Scanning all declined more than 80% from their peaks in 1968 to their lows in 1970.
Japan’s Nikkei stock index today still is 50% below its all-time high reached in 1989.
Already, many of the red-hot technology stocks that paced Nasdaq’s winter surge have fallen far more than the Nasdaq market on average.
As of Friday, Incyte traded at about $75 a share, a 74% decline from its peak.
But whether that is the bottom--or whether Incyte returns to being a $19 stock--is now anyone’s guess.
More important than the direction of individual stocks, of course, is whether the market dive overall, if it continues, is capable of inflicting unexpected damage on the economy at large.
U.S. Treasury Secretary Lawrence Summers on Sunday suggested that investors, as they ponder what to do with their stocks or with their cash, should remember that the economy still appears to be robust.
And certainly, the mania that gripped technology stocks in winter did not affect the vast majority of other U.S. stocks--many of which, in fact, have languished at prices that Wall Street pros have argued make them bargains.
But bubbles, as they burst, have a way of causing damage far beyond their own shadows.
