Before you start
What you'll be able to answer
- How far did share prices rise in the late 1990s, and how did companies raise money from it?
- When did share prices fall, and how far?
- What did the Federal Reserve do, and what happened to the economy?
Where this sits
The Dot-com Bubble ยท this module is lit
- 5 Dec 1996Alan Greenspan, chairman of the Federal Reserve, the US central bank, asks how anyone could know when "irrational exuberance" has pushed asset prices, the prices of things such as shares, too high
- 30 Jun 1999The Federal Reserve starts raising its target for the federal funds rate, the interest rate banks charge each other for overnight loans
- 22 Jul 1999Greenspan tells a committee of Congress that share prices could be driven to levels that cannot be supported
- Mar 2000Technology shares reach their monthly peak
- 16 May 2000The Federal Reserve makes the last of its six rate rises
- 3 Jan 2001The Federal Reserve changes its target rate for the first time since May 2000
- Mar 2001A recession, a broad fall in economic activity, begins, as the National Bureau of Economic Research, which dates US recessions, later finds
- Nov 2001The recession ends, on the same body's dating
- 28 Apr 2003Ten investment firms settle charges that their banking business, helping companies sell shares, swayed their analysts' research, the advice they publish on which shares to buy
A question from the Federal Reserve in December 1996
On 5 December 1996 Alan Greenspan, chairman of the Federal Reserve, the US central bank, gave an evening lecture in Washington. Low inflation, he said, meant less risk and so higher prices for shares and other assets, things people buy for the income or gain they bring. Then he asked: "how do we know when irrational exuberance has unduly escalated asset values"? Exuberance means excited high spirits. In the years that followed, American share prices, led by technology companies, rose much further.
The S&P 500 is an index, a single number that tracks the share prices of 500 large US companies. Over the five years to March 2000, roughly how much did it rise?
It tripled. The next section sets that against what the companies were earning.
American share prices tripled in the five years to March 2000
The Bank for International Settlements (BIS), a body whose members are central banks, counted a threefold rise in the S&P 500 in the five years to March 2000. The chart shows the market value of all the shares in US non-financial companies, from the Federal Reserve's accounts (non-financial companies are all firms other than banks, insurers and other financial firms): about $6.4 trillion at the end of 1995 and about $16.3 trillion at the end of March 2000.
A price/earnings ratio compares a share's price with the profit, or earnings, per share over the past year. At the March 2000 peak, the BIS found, US shares cost on average 33 times their past year's earnings, a multiple it called unprecedented. Markets abroad rose too: Stockholm's, the BIS found, rose nearly fivefold over the same five years.
Source: Federal Reserve Board, Financial Accounts of the United States (Z.1), via FRED (NCBCEL). Public domain.
Check yourself
At the March 2000 peak, on the BIS's figures, US shares cost on average 33 times a year's earnings per share. Suppose earnings then stay the same while share prices halve. What happens to that price/earnings ratio?
An initial public offering (IPO) is when a company first sells its shares to the public, at a price set beforehand. In 1999, how far above that price did IPO shares close on their first day of trading, on average?
About 70 per cent. The next section gives the exact figure and who counted it.
First-time share sales raised $319 billion from 1993 to late 2000
Companies sold shares in IPOs to raise money. The Council of Economic Advisers (CEA), the President's team of economists, counted $319 billion raised this way between 1993 and the end of November 2000, more than twice the amount raised in the 20 years before, even after allowing for inflation. Some of the largest were established firms, but IPOs were also an important source of money for new firms, particularly in information technology and biotechnology.
In 1999 the average first-day return, how far the price at the end of the first day stood above the offer price, was 69 per cent, three times higher, the CEA said, than in any other year from 1975 to 1999. It said this could come from irrational exuberance among investors, from underwriters, the banks that set the offer price and sold the shares, pricing them too low, or from both.
Check yourself
Work from the 1999 average first-day return above. A company sold its shares in a 1999 IPO at $20 each. If its first day matched the average, at roughly what price did they close?
$34
About $34: 69 per cent of $20 is $13.80, so the shares closed near $33.80.
The Federal Reserve raised its interest rate six times
The Federal Reserve's rate-setting committee, the Federal Open Market Committee, sets a target for the federal funds rate, the interest rate banks charge each other for overnight loans. On 30 June 1999 it raised the target from 4.75 to 5 per cent. Five more rises followed, the last on 16 May 2000, which took it to 6.5 per cent.
In May 2000 the committee gave its reason in terms of the whole economy: demand was still growing faster than the economy's capacity to supply, even with that capacity rising fast, and this could push up inflation, the general rise in prices. Its statement did not mention share prices.
The Nasdaq Composite is an index of more than 4,000 shares, which the CEA used to measure technology share prices. From its monthly peak in March 2000 to October 2001, how much of its value did it lose?
About two-thirds. The next section compares that with another index of US shares.
Technology shares peaked in March 2000
Internet companies had risen fastest of all. On the CEA's count, the market value of the companies in a Wilshire index of internet businesses rose from $145 billion in December 1997 to $1.6 trillion in December 1999, about 23 per cent of the rise in all stock market wealth over those two years.
Technology share prices reached their monthly peak in March 2000 and then fell. On the CEA's figures the Nasdaq Composite fell 67 per cent from that peak to its monthly low in October 2001, back to where it had been in early 1998. Over the same months another index of US shares, the Wilshire 5000, fell 32 per cent.
The same pattern appeared in other countries. The BIS found that the share markets that had risen most tended to fall furthest, and technology shares most of all.
Check yourself
Work from the Nasdaq figure above. Someone held $10,000 of shares that moved exactly with the Nasdaq Composite from its March 2000 monthly peak. Roughly what were they worth in October 2001?
$3300
About $3,300: a 67 per cent fall leaves 33 per cent of the starting value, and 33 per cent of $10,000 is $3,300.
A recession began in March 2001
A recession is a broad fall in economic activity, across many industries, that lasts more than a few months. In the United States its dates are set by the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), a research organisation. In November 2001 the committee found that a recession had begun in March 2001. It ended an expansion, a period of growth, that had started in March 1991 and lasted exactly ten years, "the longest in the NBER's chronology".
Industrial production, a measure of the output of factories and other industry, had peaked late in 2000. Employment across the whole economy kept growing until March 2001. In July 2003 the committee dated the end of the recession to November 2001, eight months after it began.
Check yourself
Industrial production peaked late in 2000, but employment across the whole economy went on growing until March 2001. What does the gap between the two suggest?
The CEA counted the loss across the whole market
Share prices went on falling well after the recession ended. On the chart, the value of non-financial companies' shares reached its low, about $8.7 trillion, at the end of September 2002, a little over half its March 2000 level. The CEA counted something different: the loss to everyone holding US shares. On its count, from the first quarter of 2000 to the fourth quarter of 2002, shareholders lost nearly $7 trillion. The two figures cover different shares and different dates, so one cannot be worked out from the other.
Why had prices risen so far, and what followed when they fell? The next module takes it up.
Check yourself
The key questions
How far did share prices rise in the late 1990s, and how did companies raise money from it?
Far ahead of earnings: the S&P 500 tripled in the five years to March 2000, and at the peak US shares were priced at a multiple of earnings the BIS called unprecedented. Companies, many of them young, sold shares to the public in IPOs, which often closed far above the offer price on their first day.
When did share prices fall, and how far?
Technology shares peaked in March 2000; by October 2001 the Nasdaq Composite had lost two-thirds of its value, against about a third for the Wilshire 5000. The fall spread across the market and ran on until late 2002.
What did the Federal Reserve do, and what happened to the economy?
It raised its target interest rate six times, to 6.5 per cent in May 2000, citing the risk of inflation. A recession began in March 2001, ending a ten-year expansion, and lasted until November 2001 on the NBER's dating.
The numbers
Check yourself
Two figures from the boom: at the March 2000 peak US shares cost on average 33 times a year's earnings, on the BIS's figures, and in 1999 new shares closed their first day 69 per cent above the offer price on average, on the CEA's. What do the two suggest together?
Check yourself
From March 2000 one investor held only technology shares, and another held shares that moved with the Wilshire 5000 index. Which describes what happened to them?
Check yourself
Someone says the Federal Reserve raised its rate in 1999 and 2000 because the economy was already shrinking. Which answer fits this module?