December 9, 2005
Excerpts: The Battle For The Soul of Capitalism - Part XI
Stock Market Bubbles
This massive $2 trillion-plus transfer of wealth from public investors to corporate insiders and financial intermediaries during the late bubble years was hardly without precedent. Transfers of this nature and relative dimension happen over and over again whenever speculation takes precedence over investment. But a day of reckoning always follows. As the Roman orator Cato wrote some three thousand years ago: “There must certainly be a vast Fund of Stupidity in Human Nature, else Men would not be caught as they are, a thousand times over, by the same Snare, and while they yet remember their past Misfortunes, go on to court and encourage the Causes to which they were owing, and which will again produce them.”
While each financial bubble is different, most have been associated with the abandonment of traditional financial standards. As Edward Chancellor, author of Devil Take the Hindmost: A History of Speculation, reminds us, manias reflect the worst aspects of our system: “Speculative bubbles frequently occur during periods of financial innovation and deregulation...lax regulation is another common feature...there is a tendency for business to be managed for the immediate gratification of speculators rather than the long-term interests of investors.” What is more, bubbles often take on the attributes of castles built on sand, as sound business practices erode, integrity and ethics are compromised, and financial malfeasance creeps into the system.
One danger of such bubbles is that they undermine the notion that the stock market is an appropriate investment vehicle for long-term investors. The idea that common stocks were acceptable as investments—rather than merely speculative instruments—is said to have begun in 1925 with Edgar Lawrence Smith’s Common Stocks as Long-Term Investments. Its most recent incarnation came in 1994, in Jeremy Siegel’s Stocks for the Long Run. Both books unabashedly state the case for equities and both, arguably, helped fuel the bull markets that ensued. Both books presented compelling statistical evidence that stocks were the ideal long-term investments.
Nevertheless, based on the impressive historical data on past stock returns that the books presented, the public seized on the idea that the market was somehow a risk-free venture, and that making money was inevitable. Ironically, while both books clearly emphasized the importance of long-term investing, they seemed to mute investors’ apprehensions, inadvertently creating an atmosphere of short-term speculation. Apparently ignoring the inherent risk in stocks, investors of both eras seemed to make the implicit assumption that stock market history would repeat itself. When stocks are seen as a “sure thing” and prices are bid up to unsustainable levels, great bear markets follow. And so it was in the aftermath of the publication of both books.
Yet the only certainty about the equity returns that lie ahead is their very uncertainty, a lesson that, unfortunately, too often gets lost from one generation to the next. We simply do not know what the future holds, and we must accept the self-evident fact that historic stock market returns have absolutely nothing in common with actuarial tables (a point of view that is fully discussed in chapter five). “The past is history; the future’s a mystery.”
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