I was recently chatting with someone about market bubbles and I recited the quip “markets can stay irrational longer than you can stay solvent”. I noted that the solvency part relates to leveraged investors – those you borrow money on margin, including those who go short. The irrational part is more interesting. In real time even if we are “pounding the tables” about a bubble we can be stunned! amazed! flummoxed! outraged! as the bubble continues not just apace, but at ever increasing speed.
Let’s revisit the Dot Com bubble as represented by the NASDAQ.
By the time of Greenspan’s famous “irrational exuberance” speech on Dec. 5, 1996 the NASDAQ was up 183% decade to date – over 16% per year.
By this point the fuddy-duddy market analysts were saying the B word and level-headed investors were feeling pretty stupid as they missed the meteoric rise. Brave souls step in to short this obviously massively overvalued market even as they see how many short were burned during the past several years. Based on history they knew their shorts would make money and soon. At the same time, the relentless market rise draws in investors who had been on the sidelines for years.
But what happens next? A sharp market correction? Well, not exactly. In just over four months – FOUR MONTHS! – the NASDAQ gains another 70%. Seventy percent. Four months. Straight up. Shorts creamed – insolvent. Panic buying.
Pause to think about (remember) how that felt. Consider the daily deluge of data, talking heads, and analysts. It’s not weeks or even months. It’s years and many of them during which the bubble grows and grows with no shortage of people to explain why it’s not a bubble and no shortage of conversations about how your friend or neighbor has made a killing.
We know how this one ended. I’ll just post the entire past 24 years:
There are a number lessons you can draw from this exercise. I’ll leave it to the reader. Be careful with the long-term chart – remember that it is not adjusted for inflation. Also consider the performance of other less risky assets during this period.
The NASDAQ is up 35% in the past year.
Note: Everything is in nominal terms here. Oftentimes it’s best to use real (inflation adjusted) dollars, but bubbles by definition involve extreme price changes over relatively brief periods. So since inflation was low using nominal dollars if fine. (The long-term chart at the end is the exception.) This post also ignores total return (dividends), but NASDAQ stocks have typically had low to no dividends. Similarly we should usually depict these data in a log-normal chart for longer period (vertical axis logarithmic) since growth is compound. However, the parabolic move of a bubble is easier to see in a normal chart and probably better communicates how it feels.