Case Scenario: THE ENDS OF FOUR MAJOR STOCK MARKET BOOMS
Since World War II, there have been four times when the P/E ratio for the S&P 500 rose above 20: late 1961 and early 1962, late 1972, mid-1987, and the period from mid-1997 through 2000. The P/E ratio during the peak of the market in 1929, by the way, was about 19; the collapse of the market occurred because profits disappeared during the Depression, falling from $10 billion in 1929 to -$2 billion in 1932, not because the market was so overvalued based on expected earnings. All four of these periods were followed by severe declines in stock prices ranging from 30% to 50%. What caused these bubbles, and why did they collapse? The decline in 1973 and 1974 can be explained by the normal determinants of stock prices: the inflation rate rose from 3% to 13%, bond yields rose from 7% to 9% - admittedly, not nearly as big an increase - and the economy plunged into the most severe recession of the post-WWII period. In the cases of the bear markets of 1962 and 1987, though, the economy continued to grow rapidly and the recoveries continued for several more years. The Fed tightened and bond rates rose somewhat in 1987, but not nearly enough to cause a 40% decline in the major market averages. Folklore has it that the 1962 stock market collapse occurred after President Kennedy issued his infamous dictum that ‘‘My father always told me all steelmen were sons of bitches, but I never believed it until now.''
The cause of that intemperate outburst was that Kennedy thought his Administration had arranged a noninflationary pact with the steel companies in which production workers would receive a 3% wage increase, equal to the gain in productivity, so steel prices would remain constant, in line with the government-issued wage-price ‘‘guidelines.'' After the agreement was signed, ‘‘big steel'' put through a 3% price increase, which infuriated Kennedy and the economists who advised him. Attorney General Robert Kennedy called up executives of major steel companies in the middle of the night and threatened them with the loss of Defense Department business if they did not rescind the price increase, which is indeed what happened. The entire episode was not designed to boost stock market optimism. However, before that contretemps, the P/E ratio had risen to a rarefied level of 22; five years earlier it had been at 13. Clearly, a tremendous wave of optimism had swept the investment community shortly after Kennedy had been elected, mainly on the platform to ‘‘get the economy moving again.'' It was believed that Kennedy was a probusiness Democrat who understood the stock market - after all, his father had been the first chairman of the SEC - and would boost real growth with stimulatory fiscal policy, notably reduction of high marginal tax rates, while keeping the budget balanced (which in fact occurred after his assassination). However, investors imagined unobtainable gains in profits from the Kennedy policies, so even if he had not fought that bruising battle with the steel industry, the market was clearly overvalued. Indeed, it had already fallen substantially in early 1962 before those comments were made, although they accelerated the decline.
The 1972 bubble was based on promises of false prosperity that would be generated by the Nixon wage and price controls. Looking back, it is difficult to think that normally savvy investors thought these controls were a good thing, but there was in fact a great deal of enthusiasm in the investment community. Many on Wall Street saw them as a scam whereby labor costs would be held down by the government while profits would be free to soar indefinitely. Here again, an exogenous event - the first energy crisis - intervened to dash those false hopes, but even before that occurred, inflation was rising and the market was weakening. There were no golden promises of tax cuts or restraint on wages that sparked the 1987 bubble. In fact, there had been a major tax increase in 1986, when many of the existing tax loopholes were closed in return for reducing the top marginal tax rate to 28%; at the same time, the capital gains tax differential was eliminated, so the top rate on capital gains actually rose from 20% to 28%. Nonetheless, after stuttering in late 1986, the stock market took off once again in early 1987. Perhaps some investors were encouraged by the sharp decline in oil prices from $35 to $12/bbl in 1986, even though they bounced back to $18/bbl in 1987.
Earlier in the decade, it had not been uncommon to hear scenarios from normally reasonable economists about how oil prices would soon rise to $100/bbl, hence hampering worldwide growth. Also, the return of the dollar to its equilibrium value in the 1986-8 period rescued the manufacturing sector, which was being strangled by the overvalued dollar. The main reason many people remember the Crash of 1987 was that the Dow dropped 22% on Black Monday, October 19, 1987. The major averages had already fallen about 20% from their late August highs, but a 22% decline on a single day was unprecedented even by 1929 standards. This time, however, the Fed immediately supplied the required liquidity, and while the market was extremely volatile for several weeks, it gradually moved up from those lows and rose rapidly in 1988 and 1989, in line with the decline in interest rates and the above-average growth in real GDP and corporate earnings. The exogenous shock this time may have been the news that Greenspan meant business. It is likely that some Wall Street investors thought they could intimidate the new kid on the block. Alan Greenspan formally took over from Paul Volcker on August 11, 1987, but it had been known for several months that Volcker would not be reappointed to a third term, and he was not particularly anxious to take vigorous action in his last months.
Many investors thought the new Fed Chairman would not have the guts to raise interest rates as long as inflation was stable. However, when Greenspan boosted the discount rate from 51 2% to 6% on September 4, 1987, investors suddenly realized he meant business. That may have been another reason why stock prices declined so quickly over the following six weeks. The causes of these three bubbles were quite variegated, although the one common factor was the unrealistic expectation that corporate profits could grow faster than the overall economy for many more years; except for brief periods at the start of business cycle expansions, that never happens. The exogenous factors that accelerated the downturn - the Kennedy temper tantrum, the first energy crisis, and the surprise tightening by Greenspan - were all quite different, although since the P/E ratios could not continue to rise indefinitely, the market would have eventually reversed course even if none of these events had taken place. The 1999-2000 bubble and subsequent contraction was once again built on the dreams of extraordinarily rapid profit growth indefinitely, but this time the boom was fueled primarily by high-tech stocks, and should be analyzed in somewhat different fashion, as presented in the next case study.