The Stock Market Bubble, Take Two
By Bethany McLean

(FORTUNE Magazine) – There once was a dot-com bubble That got the whole world into trouble You'd have thought we'd have learned Having once been badly burned But scams rise up from the rubble

So goes a little ditty written by Cliff Asness, managing principal of hedge fund AQR Capital. He's one of the many skeptics who just doesn't believe that the almost indiscriminate rally in the equity markets--with stocks large and small, tech and nontech, famous and not-so-famous all soaring higher--is the end of the bad times and the beginning of a fresh bull market. Sure, the scorecard is almost irresistible: Last year the Dow returned 28%, the S&P 29%, and Nasdaq 51%; and all the indexes set new records in January. But can the three bad years--okay, three terrible years--at the beginning of the century really be enough to cleanse away the remnants of the greatest bubble in history?

Among skeptics, the problem isn't just that stocks have gone up but also the manner in which they've gone up. There's been an incredibly swift return to what looks a lot like speculation. Nanotech, anyone? How about Chinese Internet stocks? Day trading is back, margin debt is rising, and money is pouring into equity funds at the heaviest rate since March 2000. Some old uber-bulls have found new perches: Jeffrey Applegate, who was let go from Lehman in late 2002, just resurfaced as the CIO of Fiduciary Trust. And while many stocks have done well, shaky small companies have performed spectacularly. Last year, 474 stocks in the S&P 1500 were up over 50%, says Mike Weiner, a managing director at Banc One Investment Advisors. Most of them had less than $500 million in market capitalization or were priced below $5 a share at the year's beginning. "Junk pulverized quality" is the way Jeremy Grantham, chairman of Grantham Mayo Van Otterloo, puts it.

There may be an explanation for all this--but it's not particularly comforting. After the Nikkei's big fall in 1990, it rallied some 30% before sliding back to set fresh lows. The Dow had dramatic rallies both after 1929's Black Monday and after the crash of 1968--but they didn't last. It's as if the market is a bouncing ball that can't just stop, but rather bounces again, just not as high. That first post-bubble rally even has a name: It's an "echo bubble," or in more technical terms, a "B Wave."

Unfortunately, just like original bubbles, these too go splat. By spring 1938 the Dow had been cut in half again; it did not regain its 1929 peak until the 1950s. The same basic pattern held true in the 1970s.

Grantham and his team have studied every single bubble, all 27 of them, from the famous ones (obvious) to the obscure ones (the 1980s nickel bubble). In every single correction all the bubble gains were wiped out before a new bull market started; prior great stock bubbles dramatically overcorrected and stayed there for some time. This time the S&P and Nasdaq bounced back quickly (as these things go). Another way to think about it is in terms of price/earnings ratios. Historically, the market's P/E is 16 times earnings, and in every single stock market correction--again, every single one--the ratio has fallen below that before a new bull market began. Yet this time the market in its darkest hours fell only to around 19 times earnings.

Just as in 2000, there are plenty of optimists today--but they're not all wild-eyed perma-bulls who think stocks will return to their bubble heights. They sim-ply believe there are too many positives--an upturn in global growth, technological advances, and possibly good things stemming from China--for fresh lows to be necessary. John Michaelson, president of Needham Asset Management, which went bearish on tech stocks in 1999, today is more optimistic about the overall market. This market isn't an echo bubble, he says, but rather "something we haven't seen before."

Both sides do agree on one thing: There's a liquidity bubble courtesy of the Fed. If rock-bottom interest rates don't keep the economy rebounding, there's nowhere to turn. "Heightened risk doesn't mean something bad is going to happen," says longtime bear Bill Fleckenstein. "It just means that it'll be really nasty if it does." --Bethany McLean