It's been a long, long time

I remember exactly the moment when I realized that the stock market was in a bubble.  It was when I overheard one of the cable guys in my firm trying to persuade another installer that he should buy Cisco on a dip.  "In the long run," he told his friend, "it always goes up."

Being something of a fan of John Kenneth Galbraith's work on financial panics, I knew that the long run could be very long indeed--the Dow was basically flat between the late 1960s and the early 1980s, which given the era's high inflation means investors actually lost money.

Well, it just occurred to me that it's been roughly ten years since I heard him make that claim.  And at the moment, the Dow is well below its January 2000 peak of 11,722.  It has gone up and down since then, but overall, we're right back where we started eight years ago. The S&P, too, is below its 2000 peak.  And the NASDAQ never even came close to regaining its former value.

If I were a certain kind of partisan, this would be a good time to blame the stock market on Bush, or the bubble on Clinton, both of which plaints have equal validity.  Which is to say, none. 

I think its more interesting to think about what this says about our financial markets.  In a world of perfect information, stock prices would never change; we'd simply discount the cash flow of a known future.  In the real world, of course, they move around all the time, often in tandem.  What information did we get--or rather, not get--over the last eight years that made the price of January 2000 such a good guess at the prices of September 2008?

One possibility is that prices are simply irrational; this is interesting, but not useful.

But perhaps the 1990s represented a real innovation:  portfolio theory, as popularized by Jeremy Siegel, made stocks genuinely less risky, and the risk premium that buyers were demanding dropped.  Though the market overshot slightly on the way down, we've basically hit a new equilibrium that has been building since the 1980s, in which prices, and P/E ratios will be permanently higher.  Something like Irving Fisher's "permanently high plateau". 

Which is not to say it won't, eventually, go up again.  It will, probably for no very good reason that anyone can pinpoint.  But that might take a very long time--it was a decade and a half the last time the market plateaued. 

This means that it's actually a very good time to be investing in your 401(k).  It won't do much for the next few years.  But when the next boom starts, all those lovely cheap assets will pop at once.