Henry **************************************************** Bubble psychology
By David Dreman
THE DOW IS HEADED for 1,000,000.
That's what investors expect,
although they probably don't
know they expect it.
Just how unreasonable are
investor expectations? Try this:
A recent survey by the Institute
of Psychology & Markets in
Jersey City, N.J. (of which I am a
director) found that the average
mutual fund investor expects an
18.1% annual return on his
capital over the next ten years.
To achieve this return, the Dow
Jones industrial average would
have to rise to 42,000 in ten
years, assuming the dividend
yield stays put at 1.7%. At the
same pace, the Dow would climb
to 1,000,000 in 31 years.
No, it's not unreasonable to
expect stocks to return 18% in
good years—that's what the
market has averaged over the
past decade—but it's folly to
assume, as so many market
newcomers assume, that this is
the norm.
The S&P 500 index is trading at
32 times trailing earnings, a
multiple that could only be
justified if earnings were to
shoot ahead at a
better-than-20% rate for years.
But rather than soaring,
earnings were flat last year and
are likely to advance, at best, 8%
in 1999. How out of kilter is the
S&P's current valuation? With
hindsight, the market was wildly
overpriced just prior to the 1929
crash, when it traded at a P/E of
22.
What you are witnessing today is
a full-scale investor mania of the
sort seen in the tulip-buying
frenzy of 1636 or the South Sea
Bubble of 1721. The bubble is
visible almost everywhere in the
market, but it is most
conspicuous in technology
stocks. Twenty-five large
technology issues accounted for
93% of the Nasdaq's sizzling
40% gain last year, and 100% of
its 5.8% gain year-to-date. By
comparison, the average Nasdaq
stock—and there are 4,460 of
them—was down 3% in 1998.
Don't worry about these
statistics, say the bulls: We are
entering "a new era"; there is a
shortage of stocks; the
enormous inflows of new money
into equities must push prices
higher. They said all of the above
prior to the 1929 and 1987
crashes.
Along with many others, I
underestimated just how
powerful the mania would
become. Buying skyrocketing
stocks has become a
self-fulfilling prophecy. Who
would have thought even a year
or two back that there would be
5 million brokerage accounts
on-line today? Individual players,
often on margin, account for
more than 50% of the volume in
most new issues and sometimes
in such established companies
as Dell Computer, Cisco
Systems, 3Com and other similar
stocks. Many of these traders
have discovered their nirvana—a
place where they will triple or
quadruple their capital in the
next several years, in a market
that can only go down for
microseconds before bouncing to
new highs.
The stunning rise in these
prices has also energized dozens
of mutual fund managers who
previously stayed aloof from the
bubble. Even stately Magellan,
the nation's largest mutual fund,
now boasts it has Lucent, as well
as other highfliers like Cisco,
Intel and America Online, in its
top ten.
What makes bubbles possible?
It's that humans are not good
statistical processors. For
example, we tend to forget that
red-hot new issues—whether
they were computer-leasing or
semiconductor stocks in the
1960s or PC companies in the
early 1980s—have provided
horrendous returns on average.
A study of new issues between
1970 and 1990 showed a median
return of minus 45% over five
years. But people ignore the
averages while focusing entirely
on the memorable exceptions,
like Microsoft.
Another cognitive error: recency.
You extrapolate the recent past
into the future. The current
bubble fits in well with this
phenomenon.
Contributing to all this is what
the experts in psychology call
contagion. In his recent book,
Thought Contagion, Aaron Lynch
explains how an epidemic of
delusion can spread. Amid
constant coverage by the TV
market channels, the press and
other media, as well as dozens of
Internet chat rooms and
billboards, the transmission rate
is startlingly high. Add to this
the profits most folks are
currently making and it's easy to
see just how powerful the forces
pulling additional investors into
the mania are. I can't say just
when it will end, only that when
it does, the losses in many
stocks will reach 80%.
"Henry C.K. Liu" wrote:
> Considering the NASDAQ comp was 500 in 1992, 1000 in 1996, 2000 in 1998,
> and paked at 2500 in 1999,
> falling to 1250 is hardly a crash.
>
> Henry C.K. Liu
>