Since October, money managers in the United States and worldwide have faced a choice: either buy the skyrocketing shares in the tech and communications services sector or risk going out of business. Every investor knows what is hot and wants to own it. As a result, many money managers have simply sold "value" (or other) stocks whose prices are related to the earnings prospects of a company and/or to interest rates and have purchased high-tech stocks whose prices are "momentum" driven. That means everyone expects the stocks to keep going up, and so wants to own them until they don’t go up any more. And when they don’t go up any more, the bubble bursts.

The Tech-Stock Craze

The momentum for "momentum stocks" has grown pretty strong. Money managers who have not traditionally been investors in equities and those who have focused on sectors of the market other than high tech have begun to violate pacts with their investors in order to buy the high-tech stocks. Though they seem unprincipled, such actions have become a matter of survival for money managers. Investors are comparing virtually every form of investment to the high-tech sector and are rushing to buy into it. They sell other investments to raise more funds to finance the purchase of high-tech stocks.

This tech-craze phase of the stock market strengthened dramatically in the last eight weeks of 1999. While U.S. interest rates have risen by more than 40 basis points across the U.S. yield curve (normally a death knell for the stock market), the S&P high-tech sector has gone from being up a healthy 20 percent on the year in October to being up 50 percent on the year late in November. Meanwhile, the NASDAQ Index, heavily weighted with high-tech stocks, has gone from being up 30 percent on the year in October to being up 80 percent on the year in late December. Furthermore, the broader S&P 500 Index has gone from being up just a few percent on the year early in October to being up about 15 percent on the year late in 1999. That move is attributable almost entirely to the high-tech sector of the S&P. Fewer than 10 percent of the stock sectors in the S&P 500 are above their forty-week moving average, though that narrow "breadth" of the stock market is at unprecedented levels. By contrast, during the second quarter of 1999, nearly 70 percent of stock sectors in the S&P were above their forty-week moving average.

Such remarkable moves of the broad indices contain some truly breathtaking increases in the component stocks of the indices. Among the hottest stocks, Qualcomm, which has risen to over 2 percent of the capital weighting in the S&P High Tech Index, is up 1,500 percent from its level early in January. The stock had risen a mere 700 percent from its January level by early November, and then redoubled the 700 percent increase during the last eight weeks of the year.

Slower-moving tech stocks like Amazon.com, Intel, and Microsoft are up between 40 and 60 percent since January, while the hotter Yahoo! has risen b y about 160 percent, with two-thirds of that increase coming since early November. Even the tech stocks are breaking down into the really hot ones, like Qualcomm (up 1,500 percent), Real Network (up 700 percent), or CMGI (up 700 percent), and the "older" hot high-tech stocks, like Amazon.com, Microsoft, Intel, and others, that have risen merely in the 50 to 100 percent range for 1999.

Is the high-tech sector in a bubble? You bet it is. At its peak in 1989, Japan’s Nikkei 225 had reached a level 700 percent above the level fourteen years earlier, when the Nikkei began its gradual ascent in 1977. In 1929, the Dow Jones Index was about 275 percent above its level fourteen years earlier. By the same yardstick, the S&P High Tech Index is up over 850 percent. The S&P high-tech sector is clearly in a bubble that is distorting both the allocation of capital and the behavior of the overall economy. Many of the high-tech companies are promising, but their prospects have not doubled or tripled during the past eight weeks, though the prices of their stocks have.

The tech-sector bubble is not confined to the United States. While Japan’s overall stock index, the Nikkei, has been about flat since October, and up about 50 percent on the year, tech stocks have performed more spectacularly. Japan’s telecommunications giant, NTT, rose by 100 percent from the beginning of the year to October. Since then, it has jumped even more sharply, to a level 350 percent above its level at the start of the year. Even hotter is Japan’s Softbank Corporation, which was up a mere 600 percent by October and since then has reached a level 1,200 percent above its level at the beginning of the year. These incredible tech-stock surges have also appeared in Hong Kong and Singapore markets--and pushed up the overall indices with incredible price moves that, in turn, increase the weighting of the rapidly rising tech stocks in the indices.

The process whereby the leadership in stock markets becomes narrower and narrower as a smaller and smaller subset of stocks rises faster and faster is a classic late-equity-cycle phenomenon. As the favorite stocks rise spectacularly in value by factors of 10 and 15, their weighting in the overall index becomes larger, and thereby provides support for the index. What that support conceals is an ever-weakening performance by a broader and broader sector of "unfavored" stocks within the index. The number of New York Stock Exchange stocks at new fifty-two-week lows has soared to 1,200 over the past eight weeks, which is about the level reached last autumn during the Exchange’s panic phase.

Today, investors look at their "typical" portfolios and find the values either flat or falling--even as they read newspaper headlines about the spectacular performance of tech stocks. As a result, they migrate to funds that are labeled as tech-sector mutual funds. Since the capital weighting of such mutual funds has historically been very small, the funds quickly find themselves overwhelmed with investors, and, because of constraints of management and other scale factors, some are forced to limit the flow of funds into their firms. Meanwhile, desperate managers of funds that have traditionally had nothing to do with high-tech stocks suddenly discover that tech stocks somehow match their original investor mandate and start to buy the stocks. More and more investors begin to chase fewer and fewer stocks, and the result is the spectacular increase in prices of a few favorite stocks.

The tech-stock surge has nothing to do with broader arguments about the valuation of typical stocks. My colleagues James Glassman and Kevin Hassett have argued in Dow 36,000 that stock prices relative to earnings may indeed rise, on average, to levels three times their current levels, based on an elimination of the risk premium between stocks and bonds. A lower risk premium on stocks should push up nearly all stock prices. But the average price-earnings multiple on the S&P 500 has actually dropped slightly from its high of around 34 this summer to about 29 now. That is partly because typical S&P shares have been sold to finance purchases of high-tech shares.

Nineteen ninety-nine was a year during which a strong stock market, propelled by unusually sound fundamentals like strong earnings growth and an absence of inflation pressures, was transformed into a stock market driven by a true bubble in the technology and communications sectors. With all investors eager to add to their holdings of tech stocks by selling, as necessary, less-favored sectors, serious distortions are beginning to arise. Traditional small cap stocks with price-earnings multiples below 25 are facing a higher cost of capital than the overall S&P Index with a price-earnings multiple of 29. More broadly, analysts who attempt to place a value on stocks that is conditional on earnings prospects and returns on alternative assets such as bonds have given up those criteria as a means of allocating scarce capital. Rather, the need to survive has simply driven them to purchase tech stocks irrespective of the absence of earnings or the ominous rise in interest rates in the United States and Europe.

The U.S. Economy and the Bubble

The macroeconomic consequences of the tech-stock bubble in the United States are beginning to emerge, and they are making the Federal Reserve governors distinctly uneasy. By the broadest measure, the U.S. economy, which was growing at about a 2.5 percent annual rate during the first half of the year, accelerated to a 5 percent growth rate during the second half of the year, with the rise in growth driven by stronger consumption spending. U.S. aggregate demand growth exceeded U.S. output growth during the first three quarters of 1999 and looks set to do the same during the fourth quarter.

Optimists about the U.S. economy say that there is little cause for worry, given the acceleration of U.S. growth, and suggest that neither wages nor prices are rising very rapidly. Although the rises are moderate by historical standards, inflation is, in fact, rising. The Consumer Price Index, which began 1999 rising at a year-over-year rate of 1.6 percent, hit a 2.6 percent year-over-year rate in October. Wage growth, while not torrid, is running between 3.5 and 4.5 percent, depending on which measure one chooses.

Productivity growth has blunted the inflationary pressure of higher wages. But the inflation picture will get worse. Oil at $25 a barrel will push up CPI inflation by another 0.3 of a percentage point over the next several months. Further, technical changes in the way the CPI is calculated, which have reduced measured inflation by 0.3 of a percentage point over the past year, will not be repeated. Taken together, those factors alone will add about 0.6 of a percentage point to inflation over the next several months and push the rate well above 3 percent by spring. Based on the current 4 percent level of real interest rates, which is needed to allow bonds to compete with the torrid tech sector of the stock market, long-term interest rates--the sum of real interest rates and inflation--will move to 7 percent once the reality of 3 percent inflation sinks in.

There are further details about U.S. inflation statistics that are troubling for the Fed and are probably a reflection of the rising bubble in the tech sector atop an already strong stock market. The Bureau of Labor Statistics data used in calculating the CPI claim that the price of housing has risen about 2.2 percent in the past year. That low level measures the cost of renting a house, not the cost of buying a house. The cost of buying a house has risen by 8 percent in the past year, and that rate has recently accelerated. Statistics released in October show that the average new-home price rose at a 24 percent annual rate during the previous three months.

The tech-sector bubble has been superimposed on a powerful rise in the overall U.S. stock market. Between the second quarter of 1998 and the second quarter of 1999, the higher prices of stocks and a derivative increase in home prices pushed up the net worth of U.S. households by $2.5 trillion (from about $31.5 trillion to $34 trillion). The rise in net worth means that, thanks to rapidly increasing share prices, the assets of U.S. households have risen even more rapidly than the households’ rapidly rising liabilities. There is a borrowing boom going on in the U.S. household and corporate sector, but the increase in borrowing (liabilities) has, so far, been overshadowed by the extraordinary rise in assets, thanks particularly to higher equity prices.

In this latest phase of the U.S. stock market boom, a high-tech bubble has pushed up wealth even further over the past eight weeks, although the increases are probably more narrowly concentrated on those who happen either to work for or to own shares of companies in the high-tech sector. But the rise in tech stocks has been spectacular enough to preserve 15 to 20 percent increases in the overall indices, and thereby to continue to support a high level of spending growth in excess of income growth.

Viewed broadly, American balance sheets will look fine as long as stocks stay at current levels. The big concern is that stock prices could drop rapidly, and the bubble in the high-tech sector is not a comforting sign. Assets will be eliminated while liabilities remain in place, and U.S. spending will have to be cut even more rapidly than a drop in wealth alone would dictate.

It is asset inflation--higher private wealth from higher share and house prices--that is driving the U.S. economy in this vibrant, investment-led expansion, which is closer to a nineteenth-century boom than anything we have seen in this century. The resulting strain on output capacity is showing itself in a rising current account deficit (American borrowing from the rest of the world) that will require still higher interest rates to induce further growth and foreign lending to American individuals and companies. A global configuration of accelerating American demand-growth, driven by higher asset prices, and Japanese repatriation of foreign investments has created a situation that is unsustainable.

If the world’s largest borrower, America, has to borrow more as its current account deficit rises, driven higher by faster demand growth that in turn reflects a stronger and stronger stock market, and the world’s biggest lender, Japan, wants to lend less as its losses on foreign-asset holdings mount because of a rising yen, U.S. real interest rates have to rise further—probably by a full percentage point, to 5 percent. Add that to a 3 percent inflation rate and you have U.S. market interest rates approaching 8 percent next year. That will place a very heavy strain on the stock market, and especially on the tech-sector bubble.

The tech-sector bubble being created atop a U.S. equity market that is already 50 percent above normal value (given current earnings prospects and interest rates) is dangerously unstable. Increasingly rich market players, who bid up house prices at more than 20 percent a year while buying bonds that are pricing long-term inflation at 2 percent, are living with a contradiction that cannot persist. Market interest rates of 8 percent will be needed to eliminate the contradiction, unless a stock market plunge cuts spending and the rising U.S. current account deficit. A currently "unimaginable" 8 percent level for interest rates--markets are looking for current rates of not much more than 6 percent to be the limit--will strain the Goldilocks American economy and markets to a breaking point.

When the Crunch Comes

Having said this, I should add that the party will no doubt last at least until the next Federal Reserve Open Market Committee (FOMC) meeting on February 1, 2000. The FOMC left rates unchanged at its meeting on December 21, 1999, not wishing to introduce any additional strains as markets struggle to cope with actual or imagined Y2K problems. However, beyond early February the U.S. tech bubble, and with it the U.S. stock market, could run into some very serious problems. Among them are the already mentioned probable rise in U.S. inflation rates to more than 3 percent and a continued strain on world assets markets from the tendency in Japan to repatriate funds. Japanese credit markets are still priced for deflation because the Japanese economic recovery, which was expected to materialize during the second half of 1999, has failed to appear. Japanese domestic demand, in sharp contrast with U.S. demand, actually fell at an annual rate of more than 5 percent during the third quarter. Unless the Bank of Japan acts soon to force Japanese lenders back into global markets--by printing more money, pushing the yen back down, and thereby helping to reflate Japan and the global economy--the strains on U.S. equity market valuations will increase.

If history is any guide, the U.S. Federal Reserve will ultimately be forced to prick the bubble in the U.S. tech sector. The huge increases in wealth created by the tech-sector bubble atop a 50 percent overvalued broad U.S. equity market will push up U.S. demand at an unsustainable pace. Inflation may not be as serious in registering the unsustainable growth of U.S. demand as a rising U.S. current account deficit may be. We shall probably see a moderate rise in inflation, along with a rapid rise in the U.S. external deficit; the two together will press the Fed to raise interest rates in order to slow U.S. demand growth. Usually, equity markets are the first to fall when the central bank moves to restrain excessive demand growth or its symptoms. That was the case in 1929 in the United States and in 1989 in Japan--and, as noted above, the U.S. tech-sector bubble has exceeded by a wide margin the valuations of the U.S. Dow Jones in 1929 and the Japanese Nikkei in 1989.

As heady as the run-up in the U.S. tech sector has been, elimination of the bubble will come as a relief to most U.S. financial managers, who currently have no choice but to buy tech stocks on the supposition that the next buyer will pay even more for the stocks. That is neither a good nor a sustainable way to allocate capital. An important question facing U.S. investors, and investors and economies worldwide, is how the broad U.S. equity market will behave after the tech-sector bubble bursts. If U.S. stocks were to return to normal valuations conditional on interest rates and expected earnings, they would fall by 40 to 50 percent from current levels. That is not an unreasonable outcome, since the tech-sector bubble is essentially an anti-valuation approach to the stock market that is pricing stocks with no reference to fundamentals. Once that bubble bursts, investors will probably return with considerable fervor to employing fundamentals in the pricing of the equity market.

The macroeconomic problems associated with a sharp drop in stock prices will be formidable, though not impossible to overcome. U.S. balance sheets will look considerably worse, and spending growth will have to be cut, in order to rebalance assets and liabilities.

Looking back, historians may conclude that the emerging-market crises of 1997-1998 were the root cause of the U.S. equity bubble in 1999. By cutting the demand for raw materials and capital in the rest of the world while inducing the Fed to cut interest rates, the emerging-market debt crisis provided a tremendous tail wind for the U.S. economy and stock markets. Consistently, but somewhat ironically, the return of emerging markets to economic health during 1999 has begun to place powerful stresses on the sustainability of the U.S. stock market boom. An additional accident, the Y2K problem, has probably delayed a Fed tightening by several months. Normally, an interval of that length would not be significant, but this time it may have been. The emergence of a true tech-sector stock market bubble in the United States required only eight weeks during the last part of 1999. It could grow considerably larger during the first month of 2000. By then, the Fed will be playing catch-up on the need to tighten, and subsequent rate increases will be more than simply a "take back" of the anti-crisis rate cuts that were undertaken during the fourth quarter of 1998.

John H. Makin is a resident scholar at AEI.