The US Stock Market Bubble: 2000
Case Study: Applied Capital Flow Analysis
United States Equities: 2000
In the United States, with an abundance of statistics, the complexity and size of the market seems to confound market timing. This is where the tools of Capital Flow Analysis are useful.
In this case study, we examine how Federal Reserve flow of funds accounts gave indications of weakness in the equity markets throughout the 1990s and eventually signaled the crash of 2000.
The market crash of 2000 was the greatest curtailment of asset values in American history
The collapse in equities values over the period 1999 to 2002 amounted to a loss of $7.6 trillion dollars — the greatest curtailment of wealth in American history. In the year 2000, alone, stock values contracted by $2.3 trillion.
The ability to predict this spectacular economic event and take timely steps to protect personal savings from the storm, would have been of great advantage to a prudent investor.
We shall see in this study exactly how and when Capital Flow Analysis gave this forewarning.
The Great Stock Market Bubble in Perspective
The Federal Reserve's historical series on flow of funds for corporate equities from 1985 to 2003 provides data in table F.213 that displays the forces behind the Great Bubble.
This table paints the broad picture, highlighting major capital flows in the U.S. stock market between 1985 and 2003.
Domestic corporations and mutual funds bought, on balance, more than $300 billion in stocks in 2000, the peak year of the Great Bubble
In this table, the most important trends appear in these rows:
- [Row 2] Net Issues (Buybacks) by Non Financial Corporate Business : Annual net stock buybacks increased from $84.5 billion in 1985 to a peak of $215.5 billion in 1998, falling back to an average of $114 billion in 1999-2000, and then dropping further to $47 billion in 2001. Only in the period 1991-1993 were net domestic corporate stock issues positive.
- [Row 3] Net Issues by The Rest of the World : Annual net stock issuance by foreign corporations into the U.S. market rose from a low of $1.1 billion in 1988 to a peak of $114.3 billion in 1999, hovering at a high level over $100 billion in 2000 and 2001.
- [Row 13] Net Purchases (Sales) by The Household Sector: Individual investors were net sellers of equities in every year except 1992. Annual net sales hit highs of about $250 billion in 1997 and 1998, and then net sales zoomed to an extraordinary peak of $474 billion in the year 2000, as the market crashed.
- [Row 24] Net Purchases by Mutual Funds. Net purchases of equities by mutual funds increased throughout the period, from an annual low of $1.2 billion in 1989 to a peak of $193.1 billion in the year 2000. Only in one year, 1988, were mutual funds in net redemption.
Throughout the period, the price of equities was moving upwards, driven by stock buybacks of domestic corporations and by mutual fund purchases.
The major forces weighing against this upward buying pressure were individuals selling stocks out of portfolio and exercising options, and foreign corporations raising equity capital to finance business abroad.
Applying the Motivation Axiom
According to the Motivation Axiom, prices rise in securities markets when buyers are more motivated to buy than sellers are to sell.
From this we conclude that the primary reason for the long up trend in stock prices during the 1980s and 1990s was that domestic corporations were intent on repurchasing and canceling their own stock while open-end mutual funds were also buying equities regardless of price.
Stock purchases by mutual funds and corporations were driven by the 'Common Stock Legend', Buybacks and Options, and the Asset-Lite Movement
The motivation of these two groups have been discussed at length in the tutorials and essays. To get the most from this case, the reader may wish to review the motivation of these major players. [See the learning module: 
]
The underlying reasons for the Great Bubble were:
- The Common Stock Legend, which persuaded individuals to continued to invest in stock mutual funds for tax deferral (e.g., 401(k) and IRA plans), long after prices had passed any reasonable measure of intrinsic value;
- The Practice of Buybacks and Stock Options, which was based on the fact that most managers of domestic corporations were not controlling shareholders, but only employees who owed their positions to institutional investment managers who measured performance in terms of the short-term appreciation of prices on the stock exchange; and
- The Asset-lite Movement, which resulted in a diminished need for capital in the form of equity, while focusing executive attention on transitory financial ratios and short-term goals, discouraging long-term capital investment.
When the Great Bubble reached its peak in mid-2000, none of these motives were widely recognized by market players. Corporate managers and investors in tax-deferred mutual funds continued to act in the same way they had for years.
Even five years after the crash, in December 2005, the Common Stock Legend, Buybacks and Options, and the Asset-lite Movement still served to explain the behavior of domestic corporate executives, fund managers, and investors in mutual funds.
What caused the market crash of 2000-2001 had nothing to do with a decline in investor confidence in common stocks or an awakening among corporate executives, fund managers, or the SEC as to the unfairness of buybacks.
Price Beyond Intrinsic Value
Over many years, the price-earnings ratio of American equities had varied between ten and twenty times earnings, averaging around fifteen.
Until the 1980s, market prices were determined mainly by owner-managers of corporations who looked more favorably on selling stock to raise capital when price-earnings ratios exceeded fifteen, and by individual investors seeking high dividend yields and stocks with price-earnings ratios below fifteen.
Owner-managers and individual investors were the true 'bulls and bears' that drove traditional stock markets for 150 years.
In the 1980s, there was a true 'paradigm shift' in the market
However, in the 1980s, there was a 'paradigm shift' in the behavior of investors and issuers.
Most domestic corporations were now run by hired executives rather than owner-managers.
Furthermore, these employee-managers were beholden not to individual shareholders, but to fund managers acting as fiduciaries for increasingly unsophisticated small stockholders.
[ For a discussion of equity values, see the training module
and related essays. ]
In December 1994, the price-earnings ratio of Standard & Poor's 500 stock index reached 16.9, compared with 10.1 in 1984.
Although the price-earnings ratios did not seem excessive, dividend yields — calculated by dividing annual cash dividends by current price per share — had fallen over the decade from 4.6% to 2.9%.
Considering that over most of the history of the American capital market, especially prior to the 1960s, dividend yields were higher than bond yields and that the rate on Moody's AAA bonds averaged 8.46% in December 1994, there were clear signs that by 1995 the stock market had entered a range in which returns became increasingly speculative.
In 1995, the S&P 500 price index rose thirty-four percent, pushing price-earnings ratios to 17.5, while dividend yields fell to 2.3%.
In 1996, the bull market raged on, with the S&P 500 index increasing another twenty percent, with further erosion of fundamentals.
By 1998, price-earnings ratios exceeded 32 (a record for good times) and dividend yields had fallen to a 200-year low
The average price-earnings ratio now stood at 20.6 with dividend yields down to two percent.
At this point, Federal Reserve Chairman Alan Greenspan made his famous comment about 'irrational exuberance', suggesting that investors had thrown caution to the winds and were buying shares without adequate consideration of the merits.
Despite the warnings from those that believed that stock prices should bear a logical relationship to the economic progress of issuers, market prices continued upwards: thirty-one percent in 1997 and another twenty-six percent in 1998.
By the end of 1998, the price-earnings ratio of S&P 500 stocks was a dizzy 32.3 — a historical high for good times.
Moreover, dividend yields had fallen to 1.3%, the lowest point in two hundred years. Earnings yields had dropped to 3.1%, less than half the return on intermediate-term, investment-grade bonds.
By 1999, with prices still moving upwards, there was talk of a 'new paradigm', suggesting the rules of the game had changed.
With the advent of Internet stocks commanding prices divorced from any rational basis, it seemed that the market had indeed entered a new era.
However, data that proved that this was not the case was hiding in plain sight in the Federal Reserve flow-of-funds accounts.
