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. Last Updated: 07/27/2016

Stock BubbleWill Deflate, Bringing Inevitable Disaster




For the past month, as I traveled around the United States discussing the stock market, I was struck by how often I was asked the same question:


"When will the bubble burst?"


Having watched the recent market swings, like the Nasdaq's 25-percent drop during a single week in April, some investors ask: Was that "it" - was that the bubble bursting? Or does the partial rebound of the stock market since then mean that "it" isn't happening?


The questions are all wrong. The current boom in the stock market won't come to a catastrophic end. When the shift does take place, most Americans won't realize it's happening - at least not at first.


The bubble metaphor for speculative booms is unfortunate; real-world bubbles made of soap and water burst suddenly and irrevocably, and leave virtually no trace. Major speculative bubbles, on the other hand, tend to deflate over a period of years. Instead of a dramatic one-day crash, the real denouement is apparent only to those who count the days: Over an extended period of time, there will have been somewhat more down days than up days. If one looks at a chart of daily returns over these years, it is hard to see the end of the bubble. There's no one day on which investors say, "Today is the day to get out."


But all this talk about the bubble is obscuring a major, troubling shift in how people invest and why. The current boom has been bolstered greatly by our confidence in the economy and in technology. Confidence is a critical factor in any decision to invest. But that confidence is normally not so overreactive to news. We are in the longest business expansion ever, with generally good news for years about inflation and unemployment rates, and about company earnings. But the U.S. stock market has soared far more than these indicators would suggest - to truly stratospheric levels.


At some point - as it always has - confidence will falter and the air will begin to leak out of this overvalued, irrational bubble of a market. And somebody besides U.S. Federal Reserve Chairman Alan Greenspan ought to be worried about this, because there are consequences looming ahead. Overconfident individuals, companies and foundations are heavily invested in the market. Some retirees have sunk all of their savings into stocks. Investors have mortgaged houses to invest more deeply; after a major market correction, they risk losing not only their investments but their homes.


A gradual decline is a slow disaster; it can be just as devastating as a sudden shock. Either way, investors lose a lot of money. And a longtime erosion in market confidence reverberates throughout the economy. Consider the "crash" of October 1929, which - contrary to popular perception - played out for several years. After the Standard & Poor's Composite peaked on Sept. 7 of that year, there were some spectacular one-day drops, but there were also spectacular one-day increases. The drops of Oct. 28-29 are widely remembered, but these big drops were almost entirely reversed by April 10, 1930. Then the decline resumed. The S&P Composite fell 86 percent between its top on Sept. 7, 1929, and its bottom on June 1, 1932, and this cumulative decline was the result of 365 up days and 431 down days.


The current public confidence is likely to weaken considerably since, despite recent U.S. experience, history does not support the notion that stock markets will always rebound. The obvious recent example is the Japanese stock market, which is trading at about half its 1989 peak level.


Why don't people think that the Japanese example suggests that the U.S. market might also decline for a long time? The answer must lie partly in public inattention to the Japanese example, and partly in a feeling that things were "different" in the Japanese market at its peak: that the United States does not have the economic problems that Japan had, for instance, or that our monetary authority is smarter. But these theories are not strongly held by most people (because most Americans know very little about Japan) and can easily change.


Today's high investor confidence (as well as investors' willingness to act - to buy stocks) is not a natural, steady state. It is a sign that the market is likely to decline in coming years.


The signal does not identify a sudden turning point. But there may never be a better warning.


Yale economics professor Robert J. Shiller has just released a book, "Irrational Exuberance," examining the long U.S. stocks boom and public fascination with the boom. He contributed this comment to The Washington Post.