Keynes and Fundamentals
THE RUN-UPS IN housing, equity, and other asset markets and the subsequent sharp reversals that were among the proximate causes of the financial crisis that began in 2007 solidified the belief that asset-price swings are largely unrelated to fundamental considerations. Instead, price bubbles supposedly form and collapse as a result of the trading decisions of market participants who are irrational, prone to emotions and other psychological factors, or engage in momentum trading.
Many observers point to the long upswing in U.S. equity prices during the 1990s as a prime example of such behavior and widely refer to this upswing as the “dot.com or internet bubble.” During this period, there was indeed much confidence, optimism, and even a sense of euphoria about internet stocks, with initial public offerings for many companies witnessing remarkable price increases. Globe.com and eToys, just to name two, saw price rises on the first day of trading of 606% and 280%, respectively. During October 1999, the six largest technology-related companies— Microsoft, Intel, IBM, Cisco, Lucent, and Dell—had a combined market value of $1.65 trillion, or nearly 20% of U.S. gross domestic product. At its height in August 2000, the broader S&P 500 price index had climbed to roughly 43 times its underlying earnings (Figure 7.1).1 This number eclipsed the market’s valuation in Octo-
1The use of a 10-year trailing moving average to construct the priceearnings ratio in the figure addresses the problems that the current level of re