by: Issues: March / April 2000. Tags: Strategy. Categories: Strategy.

Bubbles are elastic too.

The world “bubble” sends shivers up and down investors’ spines. It conjures up images of huge, out-of-the-blue losses in 1929-like stock market crashes. Executives, workers and policymakers do not like bubbles much either. To them, it conjures up images of 1930s-like depressions that devastate jobs, living standards and business conditions, in the process ruining a lot of people, families and businesses. When executives hear informed, responsible publications and commentators musing openly and often about whether bubble conditions exist in the stock market and the economy, they should pay close attention. Their enterprises may be in jeopardy and decisive action on their part may be required. At minimum, executives should review their organizations and make sure they are managed effectively.

It is arguable that not since the 1920s has the word “bubble” been so prominent in the business press. Executives have certainly not experienced a bubble debate that remotely rivals what is happening these days. Just consider these headlines: “Bursting Mr. Greenspan’s Bubble”[The Wall Street Journal, Sep. 3 ‘99]; “Bubble Trouble” [The Economist, Sep. 4 ‘99]; “The Great Bubble Debate” [BusinessWeek, Sep. 13 ‘99]; “Trapped by the Bubble” [The Economist, Sep. 25 ‘99]; “The New Economy vs. The Bubble Economy” [Business Week, Oct. 11 ‘99]; “Bubble-Brained Fears” [Forbes, Oct. 11 ‘99]; “Will the Bubble Burst” [The Globe and Mail, Dec. 9 ‘99]; “Is This a Bubble Ready to Burst” [NBC Nightly News, Dec. 22 ‘99].

The focus of the bubble debate is the U.S. stock market and economy. Led by the technology-heavy NASDAQ index, broad U.S. stock market indices have rocketed into the stratosphere and the U.S. economy is now enjoying the longest, strongest expansion since the Civil War. Unemployment persists in the four-percent range and consumer spending is in the vicinity of double digits. Canadian economic activity has been more subdued, as has Europe’s. Asia continues to struggle. The Canadian economy is picking up steam of late as the resource and commodities cycles turn and pent-up demand kicks in. But chronically high taxes and weak relative productivity take a big toll on investor and consumer confidence and spending power.

Canada does not have a bubble issue in either its stock market or economy. However, that does not mean Canadian executives should not have the U.S. bubble debate prominently on their radar screens.

Physicists have long been fascinated by those gas-filled, thin-walled, liquid spheres called bubbles. They will tell you that bubbles have an increasing tendency to burst as they grow, and when they do, there is chaos and confusion in the atoms and molecules over a wide surrounding area.

Financial and economic bubbles are no different. When these bubbles burst, the chaos and confusion take the form of some combination of skyrocketing unemployment, interest rates, inflation and uncertainty, and collapsing confidence, living standards, growth, investment, consumption and profits. When financial and economic bubbles burst, the consequences are never pleasant; he fuller the bubble, the more likely it is to burst and the wider and worse the consequences. The physicist’s bubble is a wonderful analogy.

If the U.S. stock market and economic bubbles burst, it will be grim for the United States; it will also be grim for Canada. Free trade, strong U.S. growth and a low Canadian dollar have pushed exports to the U.S. to one-third of our economy. A huge number of Canadian workers and enterprises owe their respective jobs and profits either directly or indirectly to U.S. sales. Growing Canadian integration with the U.S. through the likes of joint computer and telecommunications systems and just-in-time inventory and production methods only add to our dependence on the United States. How the U.S. goes has more to do with how we go than any other single factor. The U.S. bubble cannot burst without bursting all over Canada.

Enter so-called bubbleologists and their science, bubbleology! So ardent are the adversaries in the bubble debate that right before our very eyes, a colourful new lexicon is being born. Bubbleologists passionately believe big trouble is right around the corner for the U.S. stock market and economy; they do not rule out collapse—the bursting bubble scenario.

To the bubbleologist, the U.S. stock market has nothing more supporting it than hype, hot air and poorly informed investors willing to pay ever more to be in the market. Take away those investors willing to pay ever more and that is the end of the stock market’s seemingly unstoppable momentum and the beginning of a major downward correction or worse. From there, it is a few short steps to recession, maybe even depression: Rapidly falling stock prices devastate perceptions of personal wealth, which in turn shatter the confidence to spend on things that create economic activity, growth, jobs and profits.

Bubbleologists are not exactly sure just what will cause to dry up the supply of investors willing to pay ever more, but they are adamant that it will happen sooner or later. Sooner is regarded as a much better bet than later; there is considerable astonishment that it has not happened already. Possibilities about what might abruptly send investors to the exits and, in the process, prick the bubble in the U.S. stock market and economy are numerous.

First, investors may come to their senses on their own. After all, the spectacular arithmetic of the U.S. stock market’s height relative to historical norms is no secret. Suffice it to say that investors have seen nothing like the aggregate price-to-earnings and dividend-to-price ratios of late. The catalyst for the end of one of the great bull markets of U.S. history may be nothing more than investors acting on the age-old maxim that, “What goes up, must go down.” Unfortunately, the history of investors abruptly coming to their senses in a greatly overvalued market is more one of the stampeding herd than the orderly retreat.

Second, the U.S central bank, the Federal Reserve, manipulates monetary policy and interest rates with the goal of maintaining stable financial and economic conditions. With the stock market so strong and the economy so hot, the chances for a serious Federal Reserve blunder that spooks investors rise accordingly. The history of central bank-orchestrated soft landings from the stock market and economic levels of late is not at all encouraging (for example, 1929 and 1988 in the U.S. and Japan, respectively). Federal Reserve chairman Allan Greenspan posed the key question on Dec. 5, 1996 in a quote that made Newsweek’s people of the century issue [Dec. 20 ‘99]: “How do we know when irrational exuberance has unduly escalated asset values?” We all have a big stake in the ability of this recently re-appointed 73 year-old to answer that question effectively.

Third, the Federal Reserve is not the only institution with the clout to make an error that could really upset the apple cart. The newly formed European Central Bank is charged with managing the monetary and interest-rate affairs of the 11 EU countries that use the euro. A poorly managed crisis in the euro could send shock waves through the U.S. stock market and economy. No list of institutions capable of quickly doing serious damage would be complete without the International Monetary Fund and the World Trade Organization.

Fourth, buoyed by low interest rates, a booming economy, brimming confidence and stock market-based feelings of newfound richness, the U.S. has gone on a borrowing binge. The heavier the debt load, the harder the stock market and the economy will fall if there is a glitch. The heavily over-borrowed investor and consumer usually have no choice but to abruptly sell and cut back; that can quickly turn a downturn into a rout.

Fifth, the U.S. current-account deficit is horrific. It is getting worse and there is no particular reason for optimism. Current account deficits can trigger exchange rate crises, which in turn can send both the stock market and economy tumbling.

Finally, there are always surprises. Who would have thought that a currency devaluation in Thailand in the summer of 1997 would trigger massive recession in Asia and so disrupt our financial markets? The Long Term Capital Management fiasco imperilled debt markets in 1998, but who had heard of them before the fact? Who thought Russia would default on its treasury debt in 1998? Surprises that could roil the U.S. that might be out there include a sharp jump in the inflation rate, a Chinese currency devaluation, the failure of a major world financial institution and a serious accident in the derivatives market. Derivatives provide a marvellous capacity to transfer risk and lever markets, but a number of billion-dollar-plus losses suggest that not all users know exactly what they are doing and how they are exposed. It takes two sides to make a debate. The other side of the bubble debate dismisses the bubbleologists as a bunch of nervous ninnies, worrywarts and chicken littles; as for the science of bubbleology, quackery fits. The case that the U.S. good times will keep rolling is powerful. Readers are especially referred to Dow 36,000 by James K. Glassman and Kevin A. Hassett [1999] and “The New Economy is Stronger Than You Think” [Harvard Business Review, Nov./Dec/ 1999].

First, and perhaps most important, a spectacular array of workplace and product technological advances have boosted U.S. productivity to levels heretofore thought impossible. Microelectronics and telecommunications are the drivers, and not only has productivity exploded but whole new industries have been created. E-commerce and e-finance are just two examples. The argument is straightforward: Rising productivity boosts profits and accordingly justifies higher share values; the investment required to make the new economy a reality pushes growth and job creation; stock market paper wealth gives people the confidence to keep spending.

Second, most stock market and economic booms meet their demise in rising inflation. But rising productivity should combine with rising competition in goods and services markets to keep a lid on prices. Pressures on competition include globalization, more open world trade and accelerating technological change.

Third, if inflation stays low, there is no need for interest rate increases that could snuff out the U.S. bull market and economic boom. Low inflation gives the Federal Reserve the reason it must have to run the kind of policies needed to keep things going.

Fourth, the chances for a major policy blunder at the Federal Reserve or elsewhere are low. Early warning systems that would signal a blunder abound. Abrupt policy reversal is possible, since more is known every day about how the financial and economic systems work. The Federal Reserve has the worldwide credibility, the wisdom to do its job effectively and the resources to back up its policies. Then there is the trump card: Allan Greenspan is a financial god. Senator Phil Gramm calls him “the greatest central banker in the history of the world” [The Economist, Jan. 18 ‘00].

Fifth, we often underestimate our capacity to respond and adjust. For example, Thailand’s devaluation and the accompanying Asian meltdown did not lead to the catastrophe many hypothesized. Neither did the Russian default or the Y2K computer problem.

What should Canadian executives make of all this? For openers, the cases for and against a U.S. bubble about to burst both have merit. No one knows for sure what will happen, as, in the end, stock markets and economies always have a mind of their own. Only time, therefore, will tell.

I am personally optimistic—certainly not a bubbleologist—but that said, the fuller the U.S. balloon, the greater the jeopardy here. The U.S. bubble debate might best be viewed by Canadian executives as a wake-up call to assure they are doing everything they can to mitigate the effects on their enterprises of trouble in the United States. What Canadian executives should specifically do is make sure their enterprises are well managed. After blind luck, good management is always the best defence against an increasingly risky business environment.

No checklist on management practice is complete without satisfactory answers to the following question: Does the enterprise understand its customers and how their expectations are changing? Does the enterprise understand who the competition is and who it is likely to be in the future? Is the product at the cutting edge of quality? Are costs among the lowest in the industry? Is the enterprise flexible, adaptable and responsive? Is the balance sheet seriously mismatched, making the enterprise vulnerable to rapidly rising interest rates? Does the investment community have confidence in the enterprise’s prospects and management? Are financial controls adequate? Is management deep enough to withstand a number of unexpected departures? Is there a good succession plan? Is the enterprise properly governed at the board level? Are there serious ethical issues involving the likes of the environment, the treatment of people and financial practices? Is senior management told about problems in a timely fashion? Is the enterprise investing enough and in the right places to assure its future? Are staff motivation, morale and effort up to the tasks and challenges ahead? Does the enterprise understand its technological environment? Is the enterprise properly diversified? If the only thing the U.S. bubble debate does is make Canadian executives aware of just how dependent they are on the U.S., then that in itself is something.

The U.S. stock market and economy will go where they go. Canadian executives have no control over them, nor do they have any special skills in forecasting them. What Canadian executives do have control over is how well their enterprises are managed. The bubble debate in the U.S. gives Canadian executives one more reason to make sure their enterprises are well managed. Whatever happens in the United States, the Canadian enterprises that do best will be the ones that are managed well. Executives can never spend too much time making sure their management practices are effective.

About the Author

John S. McCallum is Professor of Finance at the I. H. Asper School of Business, University of Manitoba, and former Chairman of Manitoba Hydro. Contact John.McCallum@umanitoba.ca.