Handling Finances

When tech stocks boomed with three-digit price-to-earnings ratios in the 1990s and the markets produced sustained 30% growth rates, we all thought the market was a wonderful investment. When it turned out that many of those high-priced tech stocks were poorly managed and had no market for their products and services, the ‘irrational exuberance’ faded and the market fell sharply. The government’s reaction to this burst bubble was to try to limit the damage by lowering interest rates to make borrowing cheaper and thereby stimulate the economy. The economic stimulus package of 2001 that was intended to increase slumping consumer spending further limited the damage of the boom/bust cycle.

After peaking at nearly 12,000, the market dropped to almost 7000 before shooting back up to the recent high of 14,000 — well past the booming peak of 2000. Now the market is again flagging, and we’re seeing interest rates drop and stimulus packages passed. Presumably, now as before, the economy will be stimulated and markets will be held up by cheap borrowing and a short-term influx of cash.

What if the economy really needs a recession? I’ve been reading some critiques of our obsession with the stock market as an ever-growing investment tool lately (more on specific sources when I’ve had time to digest it) and while I’m not sure I agree with all the conclusions, there are a number of good points out there worth considering. For one thing, price to earning ratios — the price investors are willing to pay for the amount of money a company makes — are much higher than historic averages. In lay-terms that means that the market isn’t as high as it is because companies are doing that well, but because we’re willing to pay more for the same levels of growth. Of course, long-term, diversified investing reduces the risk of this kind of psychological effect by buying a range of investments — not just the ones that are currently hyped. Still, if the entire stock market is hyped far past what it’s historically worth, it becomes more and more important to diversify into other investments altogether rather than simply diversifying within the markets.

As much as I hate the implications of a recession, including job losses and bankrupt companies, could the implications of ever-accelerating, government-encouraged boom and bust cycles be even worse? I’ll have to look at my portfolio’s diversification and see if I can find ways to diversify outside of the markets. I’m not going to panic and switch 100% to bonds (or even 20% to bonds at this point) but as I plan my long-term investments, I’ll need to investigate the possibility that the entire stock market is highly inflated.

Please don’t hesitate to let me know if this resonates with you or if it’s the stupidest thing you’ve ever heard. I’d appreciate comments — especially those with justification — that could help me direct my investing in the right direction.

This entry was posted on Wednesday, January 30th, 2008 at 6:00 am and is filed under Economy, Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.