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News from The Globe and Mail
All bubbles eventually burst,
Madelaine Drohan says
by Madelaine Drohan - Friday, December 24, 1999
Ottawa -- Philip Strathy had it right when he said that it's
absolutely crazy the way people are spending money on
some technology stocks these days. The vice-president of
investments at Strathy Investment Management was talking
specifically of Linux mania where shares in companies with
even a remote connection to the operating system are being
snapped up without regard to underlying value.
But he could equally have been talking about the broader
phenomenon of Internet mania that has driven U.S. stock
markets to new heights and given Federal Reserve Board
chairman Alan Greenspan a bad case of the glums.
Even companies that admit they are not making a profit and
see no change in that situation for the foreseeable future are
floating shares at unbelievable prices. The fact that some
haven't lost as much as projected is enough to boost their
share price.
Look at Red Hat Inc., which packages Linux software. The
U.S. company announced earlier this week that it suffered a
$3.6-million (U.S.) loss in the third quarter. Not only that, but
it intended to issue more shares. The market responded that
day by pushing the share price UP $15.06 to $267.94 on the
Nasdaq Stock Market. Does this make sense?
No. And yet there are any number of people prepared to
defend the current situation by maintaining that we are in a
new world with technology stocks and the old rules no longer
apply.
That same argument has been made many times in the past
with disastrous results. The Mississippi Scheme in France in
the early 1700s, the South Sea Bubble in England about the
same time, Tulipmania in Amsterdam in the mid-1600s and
more recently the pyramid scheme in Albania in 1997 are all
examples.
In each case the public was willing to suspend disbelief and
ascribe a value to an object many times its actual worth. At
the height of Tulipmania, a single bulb was exchanged for
four oxen, eight swine, 12 sheep, two hogheads of wine, four
tuns of butter, four tuns of beer, one thousand pounds of
cheese, a bed, a suit of clothes and a silver drinking cup, not
to mention some quantities of wheat and rye.
Eventually the truth dawns on someone and the house of
cards crashes to the ground, bringing the local, and
sometimes even the national economy with it.
Charles Mackay, who wrote a great book on such
phenomena in 1841 called Extraordinary Popular
Delusions and the Madness of Crowds, told an age-old
truth when he said: "Men, it has been well said, think in
herds. It will be seen that they go mad in herds, while they
only recover their senses slowly, and one by one."
The madness of crowds was what Mr. Greenspan was
worrying about when he chided investors in the stock market
for their "irrational exuberance" in 1996. Three years later,
the Dow has soared 4,800 points to 11,405 at yesterday's
close. Mr. Greenspan continues to worry.
He is not alone. The Organization for Economic Co-operation
and Development put the possibility of a sharp market
correction near the top of its list of risks to the world
economy in the coming year. "Equity valuations are high in
the United States and Europe and may be vulnerable to sharp
and disruptive corrections," it warned.
Most of the danger, it has to be said, lies in the United States,
where markets have risen higher and stock ownership plays
a wider role in household wealth. The net worth of U.S.
households rose to $38-trillion from $24-trillion in the five
years ended in mid-1999. Fully $10-trillion of that is the result
of the rising stock market.
The so-called wealth effect, where people feel prosperous
because their stocks have gained in value, has propelled U.S.
consumer spending. These consumers, rather than exports,
are sustaining the U.S. economy at the moment. What
happens when the stock market drops and the reverse wealth
effect kicks in?
There is a general rule of thumb used by economists that for
every $1 change in household wealth on a permanent basis,
consumption will move by about 5 cents. Household wealth
includes equity holdings. It usually takes a while for changes
to spending patterns to kick in.
That said, economists admit that no one knows the
psychological effect a stock market drop will have today
because stock market involvement has grown so much since
the last sustained drop. In this area we really are in a new
and unpredictable world.
Figures for 1997 indicate that equity holdings as a percentage
of disposable income averaged 140 per cent in the United
States, compared with only 75 per cent in Canada. This
means a sustained stock market drop will be felt more deeply
south of our border than at home.
All that means is that we wouldn't feel the full effect of the
first shock, but we'd be helpless to avoid the secondary shock
if the first was enough to send the U.S. economy into
decline. With more than 80 per cent of Canadian exports
destined for the United States, we are inextricably tied to
their economic fortunes.
Today's technology stock investors should read the
comments U.S. financier Bernard Baruch wrote after the
stock market crash of 1929. "I have always thought," he
wrote, "that if . . . even in the presence of dizzily spiraling
(stock) prices, we had all continuously repeated 'two and two
still make four,' much of the evil might have been averted.' "
Madelaine Drohan's E-mail address is
mdrohan@xxxxxxxxxxxxxxx
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