Market Bubbles of the 20th Century

1. The Great Crash of 1929

The US, an erstwhile colony was a rapidly growing economy in the early part of 20^th century. The convergence of innovation, economic growth, leverage and wild speculation coupled with regulatory inaction resulted in Dow Jones Industrial Average (DJIA) moving up from 79.80 in end 1921 to 381.17 on September 3, 1929. During the period, nominal GDP growth was 5.3% CAGR (Compounded Annual Growth Rate). But the bench mark index (DJIA) recorded a staggering growth of 22% CAGR.

However, a handsome growth of 11% in the aggregate profits of the companies, seemed to justify doubling of the valuation level from a PE (Price to Earning) of 10 at the end of 1921 to 20 by September 1929. The problem though was that the ratio of corporates profits to GDP had risen to an unsustainable 10.4% of GDP driven by very high profit margins. A market at peak PE ratio coupled with peak profit margins (what Jeremy Grantham called the “double jeopardy”) was a bubble waiting to be pricked. On black Monday (October 28), DJIA closed down 13% and the next day it fell another 12% on very high volumes. Confidence was now broken. The worst bear market in human history did not just impact investors but had dragged down the economy as well which had declined by nearly 40% from 1929 to 1932. Bank failures were rampant, unemployment was high and extensive with consequent collapse of demand.  The bear phase continued for another three years during which DJIA bottomed at 41.22, a crippling fall of 89% from its peak in 1929. The recovery was long and painful. DJIA surpassed the 1929 peak only in November 1954. The reasons for the crash are many. John Kenneth Galbraith in his book The Great Crash, analyses the factors that brought about the Great Depression. Among others, he points to the extreme inequality with only a few people controlling the means of production as the prime reason for economic collapse.

2. The Japanese Asset Price Bubble (1989-90)

Supported by American aid, Japan expeditiously rebuilt its shattered economy after the II world War and was regarded as an economic miracle and export power house. But the US had emerged as the most powerful economy in the post war world and between 1980 and 1985, the dollar had appreciated over 40% against other major currencies. This resulted in the US imports surging while its exports became uncompetitive because of the high value of its currency. This led to what is known as the Plaza Accord in September 1985. Under this accord four other major trading partners, including Japan, were to intervene in the forex markets to bring down the value of the dollar. This was done to prevent the US from turning into a protectionist economy. Action under the Plaza Accord caused massive 45% appreciation in Yen vis-à-vis the dollar in 1986 and Japan went into a recession as corporates were hit badly by plummeting exports to the US. Bank of Japan (BOJ – Japanese central bank) and the Government responded in tandem with expansionary fiscal and easy monetary policies to address the slowdown. This resulted in a massive supply of cheap money and a hardworking people known for their diligent saving habits were lured into speculating in equities and real estate. Between 1984 and 1989, the Japanese benchmark index, Nikkei 225 rose by over 300% and the PE ratio had crossed 60!

The real estate mania turned into a beast of its own. The profits flowing from the bubble in the equity market further fueled the property prices. At the peak of the bubble, value of property stock in Japan was worth four times that of the US. In hindsight one can see the depth of the madness when one the realizes that the landmass of the US is 26 times that of Japan. BOJ increased the rates sharply, though belatedly, to arrest the speculation. In just one year, the rates went up from 2.5% to 6% and the equity bubble spluttered, deflating the property bubble along with it. Nikkei 225 lost more than 50% of its value by 1992 from a peak of 38996 in December 1989. It managed to claw back to the 1989 highs only in February 2024. Nikkei 225 teaches a hard lesson on why valuations matter.

3. The Dotcom Mania (1999 – 2000)

In the US the 1990s, like the 1920s was a decade of unprecedented innovation and was marked by pervasive optimism with the country coming up trumps in the four-decade old cold war. The advent of internet threw up numerous and increasing possibilities and as the “dotcom” technology evolved at a rapid pace, investor frenzy too gathered momentum. The information technology and telecommunication heavy Nasdaq Composite rallied 400% in five years to a peak of 5048 on March 10, 2000 with its PE ratio oscillating between absurd levels of 175 and 200. Anything with “dotcom” on it was enough to ensure a successful IPO and a bumper listing. Companies with no revenues or just business plans with fancy projections and favourable discounting rates for their cashflows, got phenomenal response in the IPO market. By now the debunked Japanese speculator who chased useless parcels of land at obscene prices seemed to be a trifle more rational when compared to the Americans chasing “dotcom” castles in the air!

The bubble got pricked in March 2000 and Nasdaq Composite bottomed at 1114 in October 2002, a fall of 78% from its peak. The ongoing massive wealth destruction ushered in a recession in 2001. The implosion of giant corporations such as Enron and WorldCom with their accounting scandals further deepened and extended the downtrend in the markets, despite the Fed aggressively cutting interest rates. It is a sobering fact that of the Magnificent Seven of the time – Microsoft, Intel, Cisco, Qualcomm, Oracle, JDS Uniphase and Sun Microsystems – only Microsoft has managed to create value for the shareholders from those bubble levels.

But this is not the end of the story of bubbles. In the very first decade of 21^st century the world faced yet another bubble, more devious and convoluted than any, that it prompted the Oracle of Omaha, the redoubtable Warren Buffet, to state that derivatives are weapons of mass wealth destruction! More on that in the next edition.