So What's Up With the Stock Market?

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The stock market seems determined to contradict all those who have predicted an imminent rebound since it first began its decline. The questions have now gone from wondering when the market will rebound to how far will it fall. To understand the real roots of the problem one has to go back a tad more than three decades but this analysis will be restricted to the last decade.

After the supposed stock market crash of 1987, which was really just a minor correction, Federal Reserve Chairman Allan Greenspan very cautiously eased the money supply. For those who don’t know what this means a brief digression into some Keynesian Economics is required.


Keynesian Theory, the prevailing economic model of our times, asserts that economic growth is the result of individuals having ready cash to spend, and that by purchasing items with this ready cash, stimulate economic growth. The Federal Reserve makes this “ready cash” available through a number of means, too numerous to mention here, but each provides an avenue to make more money available to both businesses and consumers. This is known as “increasing liquidity.” This is a fancy name for cash, as opposed to homes, automobiles, gold or any other asset that cannot be readily converted to cash. It means what you can spend now. The government controls the level of growth of the economy by controlling this liquidity. This government control is the heart of Keynesian Theory.

Greenspan’s caution was meant to prevent a singular outcome which is feared beyond all else, the great demon inflation. So the Federal Reserve monitors a plethora of indexes, from the price of bread to the price of automobiles, averages these all out, and comes up with an inflation index. What the inflation index actually measures is the loss in value of paper money, but a certain amount is thought necessary to stimulate economic growth. So the Fed very carefully expands the money supply, so that there are enough dollars out there, enough liquidity, to keep the economy humming along. At least that is the theory.

In the 1990s the gradual increase of the money supply put money in the hands of individuals as intended, and the economy began to expand. Furthermore the lowering of interest rates prompted not only individuals but businesses to borrow, thereby purchasing more equipment and expanding their operations. They then hired more workers and as these workers spent their wages the economy expanded more and more demand appeared, justifying the borrowing, purchasing and expansions. Allan Greenspan and the Fed frantically looked this way and that but saw little signs of inflation rearing its ugly head. All seemed to be well.

Into this scenario came a new kid in town, the Internet and the computer revolution. The information age had arrived. The increased liquidity and borrowing power that the easing of the money supply had wrought made it easy for the new players to get started. Start a new company, hang out your shingle on the World Wide Web and viola! You’re in business! With little capital investment, little overhead and little if any business planning almost anyone could now compete with the big guys. Almost everyone dreamed of being the next Steven Jobs and taking the world by storm. It seemed almost too good to be true.

In order to service all these new companies, and the customers they would serve, other companies sprang up to install the infrastructure necessary to support them. These companies, such as Global Crossing, borrowed huge amounts of money to invest in endless miles of fiber optic cables to service the new economy. Internet providers sprung up like weeds and people began selling everything on the Internet from books to groceries to cars. A new day had dawned and the information age had arrived.

Not everyone was thrilled though. There were economic analysts who began to question what was happening. They pointed out that many of these companies, with huge capital investments, had yet to make any profit, with no prospects they ever would. Further, though most had gone public and issued stock, those stocks were trading at levels that had never been seen before. Even more traditional companies had risen to unheard of levels as well. The traditional barometer of stock value, the price-to-earnings ratio had not only risen to the warning zone, but far surpassed it to shoot into the economic stratosphere. When these more traditional economists warned that maybe something was wrong, they were laughingly told that the business cycle had been repealed. Well, laws of economics, unlike the laws of men, cannot be repealed. What had inflated were stock prices, and such inflation is called a bubble.

The standard rule of thumb in fundamental analysis of stocks is that a rational price-to-earnings ratio is around 15, that is to say that dividing the price of common stock by earnings per share in the previous 12 months results in a ratio of about 15:1, and when it rises above 20:1 or more it is cause for alarm, the price isn’t justified by the income. Some of the high tech stocks at the height of the boom in 1999 were in the area of 135:1 or more. Even traditional stocks, carried along by the burgeoning bubble were in the area of 60:1, which is anathema to fundamentalists. That Alan Greenspan recognized that this situation was hazardous was the source of his now infamous “irrational exuberance” comment in December 1996.

In fact, the irrational exuberance that Greenspan feared was already well underway. Documents recently released from 1997 show that Greenspan wanted to begin to slow the economy then but was dissuaded by the Board of Governors. Inflation, that old bugaboo, was still within acceptable limits and there seemed to be no real reason to slow the economy down. So the growth continued apace.

The problem with all this growth was that there was nothing there for it to support. It was analogous to building a road into the wilderness and then expecting people to come build houses. The “information age” was also built upon a fallacy — people cannot just trade information with one another, information only has value when it is used to create something, to create wealth — a fact that rarely occurred to anyone. Thousands of companies had gone into debt to provide services that ultimately were not going to be in demand.

A perfect example of this is in Seattle where hundreds of miles of fiber optic cable were installed under the streets, underpinning nearly the entire metropolitan area with state of the art high speed connnectability. Yet these cables lie dark and unused because no one can afford to install the individual converters and lines that would run them the last few yards to the buildings themselves, to wire those buildings, and purchase the connections. The demand began to falter just as the final cables were being laid. This scenario was repeated all around this country and the much of the globe.

Company upon company was built upon a phantom demand that would never materialize. Equipment was purchased, people were hired, buildings were constructed all with no other product other than an Internet connection. Even companies that were created to provide a service, such as Internet-ordered groceries which were then delivered in company trucks, failed to take into account the costs of such delivery or what a minuscule percentage of people would actually change their ways in favor of such a system. Things like coordinating delivery days and times for customer convenience eventually sank such ventures.

So the stock market was confronted with a huge amount of money invested in companies that ultimately had no viability. So these companies failed and their assets were sold, sometimes for pennies on the dollar. The fact is though, this was the real valuation of what these companies were worth. This phase of liquidation to actual value is what is currently happening in the stock market, and the economy in general, world wide. Over-investment, bad investments and over priced stocks are slowly being liquidated to their real actual worth.

Now one can assess the present value of the stock market. In Andrew T. Gillies noted February 1st of this year that the price-to-earnings ratio for the S&P 500 stood at 29, when it should be 15. This gives an indication of how much further the stock market will have to fall before it reaches sensible levels. It means that on average the stock market is still over priced by about double and a tremendous amount of overvalued assets needs to be liquidated to fair market values.

The Dow Jones Industrials are currently hovering around 8,000, so surmising that its value is about double, on par with the S&P 500, then it isn’t unreasonable to assume the Dow will eventually fall to around 4000 before it rebounds. From a technical analysis point of view this would still fall within the safe range of a 2/3rds correction, measured from the beginning of the current stock market run up in the late 1980s, and not an actual depression. So the stock market will continue to fall for the foreseeable future, no matter what the economists say. The bubble is still in the process of bursting.

”’Don Newman is a freelance writer living in Waikiki and can be reached via email at”’