THE BLOG
07/30/2007 08:08 am ET Updated May 25, 2011

Bubblicious

Call me Kreskin.

Less than two weeks ago, as the Dow Jones Industrial Average was closing above 14,000 for the first time ever, I wrote an op-ed for the Los Angeles Times designed to offer some historical perspective on the auspicious occasion and bring a little needed skepticism to the festivities. You can read the whole thing here, but to get the gist all you need to do is look at the closing line: "if history is any guide, this party could turn ugly."

Now, after a week of market mayhem, those words loom like a prophecy. Since the Dow hit its all-time high of 14,121 on July 19 the index has lost more than 6 percent, or nearly 1,000 points. The reasons for the tumble are worries about the consequences of financial bubbles and concerns that lenders soon will dam the flow of cheap cash that's been flooding our economy and keeping the stock market afloat - the same factors mentioned in my L.A. Times op-ed.

As you can imagine, my phone's been ringing quite a bit since then. Producers from CNN, CNBC, and the BBC have called, as have other financial journalists, asking me to look into my crystal ball for their audiences. But here's the catch: I'm no soothsayer and there was no mysticism behind my "bold call." Instead, as I gladly tell anyone who asks, all you need is a decent history book and a little common sense to understand what's happening today.

The truth is I never intended to make a "call" and never imagined the stock market would break within days of my op-ed. For all I know the market could rally this week and run through the end of the year. When it comes to market timing, anyone who tells you they know exactly where stocks are going from minute-to-minute is full of crap. That's the thing about markets. Figuring out which general direction they're headed over time isn't all that difficult. But pinpointing when they'll get there is much trickier.

Basically all I did was bring up some historical facts and apply them to current events, which led me to the conclusion that the stock market likely was in for trouble. This is hardly revolutionary stuff. But what made it seem novel, I think, is that surprisingly few investors actually know or care much about our financial history, despite the growing impact Wall Street and the financial world has on our daily lives. This more than anything explains why we become so mesmerized by financial bubbles again and again and again.

But that doesn't mean you have to be in the dark with the rest of the crowd. Indeed, history offers so many crucial lessons and the financial markets provide so much information that spotting trouble isn't hard if you step back and know what to look for. When determining if you're in a bubble, for instance, the first thing you want to see are unusual signs of what former Fed Chairman Alan Greenspan once called "irrational exuberance." Remember back in the 1990s, all those guys with no financial training who thought they could outsmart Wall Street pros by flipping Internet stocks? That's what we're talking about. Most recently, the clearest evidence of a bubble is the Dow put on 1,000 points in the three months leading up to its cracking 14,000 and nearly 3,000 points in the past year. That's what bull markets look like after a visit to Barry Bonds' doctor.

Of course, we don't necessarily have a problem just because the stock market's rising rapidly. Bull markets can run for years and years with no consequences when economic conditions are strong, the geopolitical scene is stable, and companies are operating with increased efficiency. The problem is our economy right now is shaky at best, the geopolitical landscape is downright terrifying, and it's not like technological innovation is reinventing the business world as it did during the 1990s Internet boom. So there must be something else driving all this activity.

Which brings me to the second thing to look for when trying to spot a bubble: easy access to capital. Throughout the history of financial markets this has been the single most important factor in developing bubbles. Give people the ability to borrow large sums of money and they're bound to run into trouble. Easy cash actually has been propping up our economy for years, be it in the form of variable rate credit cards or no down payment mortgages. But here the most important capital was the hundreds of billions of dollars being raised by banks and other lenders to finance corporate takeovers, the soft underbelly of this stock market.

Over the past year corporate mergers and acquisitions have been happening at a historic rate. In 2006, a record $3.6 trillion in corporate assets were bought and sold worldwide, and we're on pace to smash that mark before the end of this year. It's reached the point where just about every publicly traded company is a potential takeover target. And since most companies are bought out at a premium to their current stock price, takeover speculation has become the rising tide lifting all of the stock market's boats.

The problem is this pace of M&A activity isn't remotely sustainable. Eventually some of these deals will go bad or some of these lenders will get into trouble and the music will stop. And that's when it's going to get ugly. How do I know this? Because history tells us that's what ALWAYS happens. When a bull market is built on the perception that companies could be bought out for more than they're currently worth, and then it turns out that there aren't actually buyers for those companies, well those stock prices are bound to fall back to reality. And that's pretty much what's starting to happen now.

The place to look for evidence of these problems isn't even the stock market - it's the debt markets. There you'll find that last week lenders suddenly became skittish about financing a number of aggressive multibillion dollar takeovers, from Chrysler, to the British drug store chain Alliance Boots, to GM's sale of its Allison Transmission unit. A few months ago all of those deals were no-brainers. Now lenders have decided to pause and think twice, causing investors to wonder if this is the beginning of the end. And like that, many decided to head for the exits. The result: Wall Street's worst week in a long time.

Naturally, the question on everyone's mind right now is, where do we go from here? And, frankly, the answer is I don't know - and neither does anyone else. Some market experts say we've been through a correction and stocks will resume their upward trajectory. Others aren't so sure. Personally I doubt we've seen the bottom. But to be honest, the best idea for you is to brush up on some history and determine what you think for yourself.

It reminds me of something the late author and Harvard economist John Kenneth Galbraith said several years ago when I interviewed him for my own Wall Street history, What Goes Up. Speaking of the stock brokers, analysts, financial advisers, and others who are so eager to give us advice about what's going to happen next in the unknowable financial markets, he warned: "Don't listen to anything these people say. Just be guided by history." For everyone with money in the stock market today, truer words have never been spoken.