Is the Dot Com Bubble Still Hurting the Market?

Do previous stock market bubbles offer any guidance on the market action of 2010?

Before we attempt an answer, let's shine a light on "confirmation bias," in which we seek out information that confirms or reinforces our preconceived ideas. It's one of the most common and alluring traps we face as investors: Bulls tend to seek out positive evidence, dismissing negative factors, while bears focus on negative news, ignoring positive trends.

Experienced traders learn not to shun information that runs counter to their bias but to actively seek it out. It's been said one of the best investment-strategy habits is to try to prove your own biases wrong.

This explains my journalistic mission of trying to present strong cases for both bull and bear views. In late April, I suggested the low volatility Index ($VIX) was sending a warning that the risks of a decline were rising. Since topping out at around 11,200 in late April, the Dow Jones Industrial Average ($INDU) had fallen to 9,800 at that point -- a decline of some 1,400 points. Following up on the bear case, I then suggested the market top was in for the year and a severe decline (a.k.a. a crash) was possible.

But once the U.S. market fell to key support levels, I made the case for a short-term rally -- the bullish view -- and for a possible "head and shoulders" pattern forming.

Bubble Overlays

Returning to the notion that past market action may offer clues to the future, here's a simple exercise: Overlay previous stock markets' bubbles and post-bubble price movements, and see if there's any alignment.

Bubbles are attractive targets for such overlay analysis because they're unmistakable. For example, nobody argues now about whether the dot-com NASDAQ was a bubble.

Here's an overlay of four well-known stock market bubbles:

• NASDAQ from 1990 to the present, featuring the 2000 dot-com-era bubble peak

• S&P 500 from 1920 through 1942, covering the "Roaring 20s" bubble, the 1929 crash and the Great Depression

• Shanghai stock market index from 2000 to the present, tracing the 2007 bubble top

• Japan's Nikkei Index from 1984 to the present, capturing the 1989 peak

Regardless of one's bias, there's a remarkable similarity in the meteoric rise and fall of each of these bubbles, despite the different eras and nations of origin. How could this be so?

The standard explanation is that markets are fundamentally reflections of human psychology, and since the latter's basic patterns don't change, markets will predictably trace out the cycle of greed, euphoria, denial, fear and panic that characterizes all speculative bubbles, be they in tulips, land or stocks.

To compare markets from different eras, this chart lays out the timeline in months and charts price as a percentage of each bubble's peak. This enables a more or less "apples to apples" comparison of how bubbles peak, collapse and then "echo" in post-bubble rebounds.

These three key features are surprisingly uniform in each bubble: Each rises steeply in a surge of euphoria, tops out quickly and then crashes as fear and panic replace greed and confidence.

Similar Time Frames

In the years following the peaks, markets rise and fall in several recovery rallies, none of which exceeds 60% of the bubble's peak. (The straight lines on this chart are trendlines that connect the various market peaks.)

The NASDAQ (black line) begins around 1990, and 120 months later (2000) the bubble peaks and collapses. About 210 months (17.5 years) out, the NASDAQ hit its post-bubble secondary peak in late 2007.

Interestingly, both the Nikkei (purple line) and Depression-era S&P 500 both reached their post-bubble highs within this same time frame.

The Shanghai index (blue line), being the "youngest" market, is still early in its post-bubble phase and is currently closely tracking the Nikkei index chart.

The history of the S&P 500 in the late 1930s and the Nikkei in the present era offer a sobering projection of post-bubble price movement: In both cases, ultimate lows were plumbed about 280 months out (23.3 years), which for the NASDAQ would be 1990 + 23 or 2013.

Even more striking, both these bubbles hit their secondary peaks right where the NASDAQ is now.

The saying is that history doesn't repeat, it echoes. And the history of speculative stock bubbles strongly suggests that all bubbles echo the same underlying pattern of human psychology. If that's credible, investors should be wary about the next few years.