A Look at the Crash Five Years Later - TheStreet

Can it happen again?

Five years ago, the

Nasdaq Composite

hit its all-time closing high of 5049. The next day, the index began a slide that took it down to 1114 -- almost 80% -- on Oct. 9, 2002. Five years after the Bubble of 2000 broke, the Nasdaq Composite is still down almost 60%.

The damage to other measures of stock market value isn't quite as graphic, but it's painful enough. The

Dow Jones Industrial Average

, which has flirted with 11,000 for the last week, posted a record high close at 11,723 on Jan. 14, 2000. By Oct. 9, 2002, the Dow would drop to 7286, a loss of nearly 40%, before beginning a steady recovery. On Tuesday the Dow closed at 10,913, 7% below its 2000 high.

No wonder investors are obsessed with bubbles. Is there a housing bubble? A consumer debt bubble? A U.S. dollar bubble? A bond market bubble? A stock market bubble?

There's still too much money sloshing around the globe; leverage in the bond and currency markets is still frighteningly high. And as

Federal Reserve

Chairman Alan Greenspan bemoaned recently, investors are far too complacent about making high-risk investments at very modest risk premiums. All those conditions are necessary precursors to bubbles and the nasty plunges that pop them.

Five years after the bubble burst in 2000, we don't know enough to even identify the specific part of the financial markets that might blow up next. But what we have learned about bubbles -- some of it since the last one burst -- argues that many investors are worried about the wrong sources of potential trouble. The still-young study of bubbles explains:

Why the housing market and the consumer-credit markets aren't the bubbles most likely to burst.

And why


places to watch for the next bubble are the hedge fund industry and the derivatives market.

Bubbles, according to current theory, aren't bubbles at all. They're actually cascades, something like an avalanche or a pile of sand.

The Slippery Slope

Cascades are structures that are stable -- until suddenly they're not. Snow piles up in a mountain pass, snowflake by snowflake, day after day. And each day the pile of snow doesn't cascade down the slopes to bury unlucky skiers. Until, one day, of course, the snow doesn't stay put and roars down the mountain.

You can see the same kind of behavior in a pile of sand or a tower of blocks. Or in the financial markets. In 2000, for example, the price of


(AMZN) - Get Report

went up and up and up, with each day adding another brick to the wobbly tower, until one day the tower came tumbling to the ground.

The mathematics of systems like these is incredibly complex, but we can abstract a few basic rules that explain why and when cascades happen.

First, there's the rate at which new snow or sand is added. Logically, you'd guess that the faster material is added, the faster a stable pile will turn into an avalanche. Actually, it's even worse than that: Adding snow or sand twice as fast will create a cascade in less than half the time.

Second, there's the physical stickiness/slipperiness of the material of the pile. Snow slides on snow more easily when a warm sun has added a certain amount of melt water to the mix. The frequency of avalanches goes up during melt periods.

Third, the slope of the pile (or of the mountain under it) influences not just how quickly a stable snowfield will turn into an avalanche, but how fast it will move downhill, how much momentum it will pick up and how far down the hill the avalanche will move.

Three Rules of Bubbles

Turn these three rules of snow into rules of money to see how financial bubbles behave.

1. Think of the money being added to a financial system as equal to the snow falling on a potential avalanche. Add money to a market at a slow enough rate, and buyers and sellers have a chance to adjust their pricing expectations over time. Add money too quickly, however, and the high prices created by that flood of money turn into high returns that suck in even more money.

In retrospect, it's clear that huge injections of liquidity into the financial markets -- in 1998, to keep the meltdown of Long Term Capital from turning into a global problem, and in 1999, to avert any potential liquidity problems caused by the Y2K computer glitch -- supplied the fuel for the bubble that burst in 2000. Today, global liquidity is still high, thanks to easy-money policies designed to keep consumer growth chugging along and to keep currencies such as the yuan and the yen from soaring against the U.S. dollar.

2. Think about the stickiness/slipperiness of the different kinds of money used in specific financial markets. Mortgage money, I'd argue, is very sticky -- it's relatively hard to move around. A foreclosure isn't instantaneous, for example. To get mortgage money to move easily, it has to first be turned into a derivative (an investment that derives its profit potential from the volatility of an underlying stock, bond or index) that can be traded electronically.

Derivatives can be traded in the blink of an eye, often faster than stocks and bonds, so quickly that buyers and sellers have almost no chance to actually think before a buy/sell decision gets executed. Much of the time, computers do the work, taking advantage of tiny disparities in price to shift billions around the globe.

Derivatives markets never catch their breath. By the time a human actually sees a trade, it can be very old news. The momentum feeds on itself: The faster that trades are made, the faster prices move up or down, and on and on.

3. Think of leverage as the slope of the mountain under the potential avalanche. The more leverage in a financial market, the steeper the slope of the mountain and the faster a financial avalanche can move downhill. That's because the more buyers use borrowed money to increase their profit if markets go up, the quicker they have to sell when a market heads south. Leverage of 10 to 1 isn't unknown in the world of hedge funds. It doesn't take much of a downward move to wipe out the hedge fund's capital in such an investment and bring nervous creditors hammering on the door.

The Trouble Spots

If you apply these rules to the financial markets, you wind up with a bubble-potential index for specific sectors of the financial markets.

Low bubble potential: housing and consumer debt.

Yes, consumer and mortgage debt are at historically high levels, and the payments are affordable to many consumers and homeowners only as long as interest rates stay low. But these markets just don't combine high-slipperiness/high-leverage characteristics in a way that would produce a high-velocity cascade of the kind we call a bubble. If folks can't meet their credit card bills or mortgage obligations, the default that triggers the sale of assets takes place one household at a time over weeks, if not months.

Leverage in these financial products is high if you think of the amount of money consumers have borrowed against their underlying equity, but the leverage is relatively small if measured against what a creditor would be able to recover in the case of default. Asset prices could certainly decline in the housing market from current levels, and a consumer debt crunch would slow the economy measurably, but these are events that unfold much more slowly than the quick bubble burst of 2000.

Moderate bubble potential: the U.S. dollar market.

The currency markets certainly meet the threshold for slipperiness and leverage, but the landscape is full of buffers that are likely to slow down any cascade. Those buffers take the shape of the world's central banks, which have a vested interest in the orderly workings of the currency markets, have strong motivation to buy when others are selling to keep the markets orderly, and have the billions of dollars in cash needed for meaningful intervention. It's not that some currency-trading hedge fund couldn't blow up, but it's likely that any such explosion would result in quick and massive central-bank action to limit the damage.

High bubble potential: the hedge-fund and derivatives markets.

Both specialize in highly slippery kinds of money with high leverage potential. And because the hedge fund and derivatives markets are so lightly regulated and so difficult to track from the outside, a downward move here could develop considerable momentum before anyone noticed. Intervention by the Fed would be almost certain. But the derivatives market is so large that the Fed -- with the U.S. Treasury and Mint essentially at its disposal -- might not have the resources to stop a slide.

Why should you care? Hedge funds and derivatives markets borrow their money from banks. (They're on the hook for some part of the more than $197 trillion in derivatives outstanding as of June 2004, according to the Bank of International Settlements -- the trouble is, no one knows what part.) When a trade goes bad and a borrower defaults, somebody -- quite possibly one of the big banks that dominate this market -- is left holding the bag. In that case, a bank not only lacks the money to make new loans, it may have to call in old ones.

All the big banks are exposed. And if the wrong big bank gets hit, the whole financial system starts to tremble.

The possibility that a hedge fund could blow up or that some derivatives trade could unwind in a spectacularly disastrous fashion isn't the kind of problem that keeps most investors up at night right now. We tend to imagine that the next disaster will resemble the last one.

Consumer debt, rising interest rates, the national deficit and the falling dollar occupy our imaginations because they're highly visible and easy to grasp. But the problems in these areas aren't likely to turn into bubbles and busts.

It's the grinding problems and our failure to address them -- and not some 2000-style bubble and bust -- that will, in the long run, determine our and our children's prosperity.

At the time of publication, Jim Jubak did not own or control shares in any stocks mentioned in this column.