.In the past few weeks, the markets reaching highs after highs have puzzled some investors and left them worried about a major pullback due to high valuations. Many investors fear a collapse, especially now that we have Fed tapering, new COVID variants, possible interest rate hikes on the horizon, and market volatility.
There sure is a lot that reminds me of the Dotcom era in the late 1990s and preceding the Great Financial Crisis of 2007-2008 when we saw a similar phenomenon: The markets kept going up daily because of investors' euphoric attitude despite stocks hitting all-time highs, only to see a big bear market.
It is not surprising that many are worried today about the next big crash. Worse, there are always those "doom and gloom" analysts who keep predicting a severe market crash, and they have been wrong for the past several years. Could they be right this time?
In order to evaluate the current situation, let us take a look at what events triggered two of the greatest bear markets in recent history that plunged the economy into a recession. In the case of the Great Financial Crisis, it was the 2nd most severe recession in history, only exceeded by the Great Depression of the 1930s. This will help us better understand and ensure we can identify the warning signs in time.
1- The Dotcom Bubble Era
What was the Dotcom Bubble? The Dotcom Bubble was a very sharp rise in technology stocks fueled by investments in internet-based companies during the bull market in the late 1990s. The value of these stocks grew exponentially during this period. The Nasdaq technology index rose from under 1,000 to over 5,000 between 1995 and 2000 (or by 500%!).
The end of the bubble came in 2000, and the bubble burst between 2001 and 2002, with equities entering a bear market. The stock market's crash erased more than four years of gains in the tech-heavy Nasdaq composite index. By the end of the stock market downturn in 2002, the NASDAQ-100 had dropped to 1,114 points, down 78% from its peak. Even the share prices of blue-chip technology stocks like Intel (INTC), Cisco (CSCO), and Oracle (ORCL) lost more than 80% of their value.
The reasons behind the Dotcom Bubble crash:
- Investor Euphoria was extreme, whereby many investors were putting every liquid asset they owned into equities. Neighbors who had never invested before were passing around stock tips. Everyone "knew" that investing in the Internet was the best way to get rich.
- Irrationally high stock valuations were the rule, as measured by all aspects including historical valuations, price/earnings valuations or P/E ratios, and relative to interest rates. In many cases, P/E ratios were running well above 100 times for startup companies still earning negative cash flows. New metrics were invented like "eyeballs" or "mind share" to justify nosebleed valuations of unprofitable companies. Investor behavior was referred to as "irrational exuberance" at the time.
- High Interest rates: Fed fund rates (or short-term rates) ran around 5%, making margin borrowing costs excessively high. Fed Chair at the time, Allan Greenspan, later decided to tighten monetary policy in the spring of 2000 by hiking interest rates from 5% to 6.8%, but it was already too late.
- Liquidity Crunch: By the time the Fed moved to hike rates, banks and financial institutions had already used up excess liquidity in funding an expensive stock market, and liquidity was scarce both at the investor level and financial institution level. With the raise, the little excess liquidity dried up quickly. There was no more fuel to fire the bull market.
2- The Great Financial Crisis, or the 'Housing Bubble'
Now let us look at the factors that resulted in the "Great Financial Crisis" or the "housing bubble" which burst in late 2007. Both crises had some similarities, but the Great Financial Crisis was more complex. During the period preceding the crisis, the average house price from the early 1990s to 2007 rose more than 300%.
The bubble eventually burst and resulted in the second-worst economic crisis in U.S. history. Following the bubble burst, housing prices fell 33% nationally, and in many cases falling +50%. The resulting liquidity crunch hit the equity markets, with the S&P 500 falling by 57% from October 2007 to March 2009.
The downturn lasted 18 months and erased $19.2 trillion in wealth. It had its greatest impact on the bottom 50% of households, costing them as much as 42% of their net worth during the downturn. After all, for many Americans, their house is by far their largest asset. As of 2009, 18.5% of families had no liquid assets, and by 2011 this had grown to 23.4% of families.
The factors that lead to this crisis? Many claim that the main culprit was the collapse of the subprime mortgage market, but in fact, it was caused by widespread failures, including government regulation, and irresponsible behavior by Wall Street financial institutions and bankers.