In December 1996, Alan Greenspan, then chairman of the United States Federal Reserve, warned about sharply rising stocks saying ‘irrational exuberance’ could drive prices to unrealistic levels and then collapse. After these comments, the S&P 500 Index—the best gauge of large-cap US stocks—came under slight pressure, but ended the year up 20 percent anyway. This followed a 34 percent surge in 1995. Greenspan’s warning was not backed by policy. He was merely trying to jawbone. The S&P 500 went on to rally 31 percent in 1997, 27 percent in 1998 and 20 percent in 1999. The bubble burst in 2000, which fell 10 percent, followed by drops of 13 percent in 2001 and 23 percent in 2002.

In fact, the bubble got a lot bigger in tech. The Nasdaq Composite shot up 441 percent between 1994 and 1999 before collapsing 67 percent in the next three years. Speculation was so rife at the pinnacle of the tech and telecom bubble that the tech-heavy index more than doubled in a mere seven months before peaking in March 2000. The bursting of the ‘irrational exuberance’ left in its wake a lot of pain. Many sustained memories so bad they swore off stocks. Greenspan’s warning was dead on, but premature. In the end, from December 1996 through the October 2002 bottom, the Nasdaq was 14 percent lower and the S&P 500 4 percent higher. All the gains made in between evaporated.

Fast forward to the present, these indices are much higher. Perma-bulls will use this fact to sing the praises of buy and hold investment strategy, arguing that those who stayed put through the 2000-02 bear market would have come out stronger on the other side. Yet, this is not always the right way of looking at things. In the investing land, not everyone is in their 20s and 30s, who have time on their side to see through many cyclical ups and downs. Those in the latter years of their investing lives, or those that are ready to retire, do not have this luxury. One bad cycle and their nest egg is severely impaired, if not completely gone. The bursting of the tech and telecom bubble in 2000 was one such unfortunate event for many.

In the months and quarters leading up to that, many in the US left their jobs to start trading. In the heyday of the bubble, the initial public offering craze was such that it was common for an upstart tech outfit with no earnings—and not much revenue—to open multiple times its offering price. In the San Francisco Bay Area, I personally knew Nepali housewives, in their 30s and 40s, who started trading believing stocks only went up. And they did make money initially. Everyone did, except for the shorts. Longs were conditioned to buy the dips. Stocks retreated from March 2000, and these housewives bought more. By the time they realised the bull market had ended, they had lost their shirts.

Authorities need to act

This is what a bull market does. As the frenzy feeds on itself, more and more people get drawn in, particularly from the periphery. When the music stops, the Johnny-come-latelies are left holding the bag. Hindsight is always 20/20; granted raising interest rates could have adversely impacted the US economy, but Greenspan could have probably sent a stronger signal had he at least tightened requirements for margin lending. He chose not to. Policymakers are confronted with such a predicament all the time. Nepal Rastra Bank, Nepal’s central bank, is in a similar catch-22 currently. The Nepal Stock Exchange (NEPSE) has been on fire, and policymakers are wondering if they should step in to dampen investor sentiment.

Early this month, in a quarterly review of its monetary policy for the first three months of the current fiscal year 2020-21, Nepal Rastra Bank said it would review its policy on margin lending, among others. Currently, banks and financial institutions are allowed to lend 70 percent of the value of shares in margin loans; the value to be used as collateral is based on the 120-day average price or the prevailing market price, whichever is lower. Before the 2020-21 monetary policy was announced five months ago, this was 65 percent and 180 days. The policy easing helped. As of the first fiscal quarter through mid-October, banks and financial institutions’ ‘margin nature loan’ stood at Rs59.4 billion, up from Rs50.4 billion as of mid-July.

The NEPSE closed at 1362 mid-July. On the third this month, it printed a fresh intraday high of 2118—for a 55.5 percent surge in less than five months! Before this, the index essentially went nowhere for four years. The NEPSE reached its prior high of 1888 in July 2016 and bottomed at 1099 in March last year. ‘The longer the base, the higher the space’ is a popular saying in technical analysis, meaning a long base can lead to a sustained move higher. For now, however, longs are nervous if Nepal Rastra Bank indeed ends up tightening the rules on margin lending. On the sixth, which was the first trading session after the central bank’s aforementioned comment on margin lending, the NEPSE tumbled 6 percent.

Margin debt cuts both ways

The thing to remember about margin debt is that it cuts both ways. The same way it helps on the way up, it hurts on the way down. In Nepal’s case, the impact can be stronger as, given that the NEPSE only began in January 1994, investors lack access to a wide variety of tools that are available in mature markets, including options and futures. Shorting, in which borrowed shares are sold with a goal of buying them back lower thereby pocketing the difference, is not allowed. In the current context, an ability to short could have acted as an antidote to the upward pressure created by longs who buy using borrowed money. This creates an artificial upward bias. Things get aggravated when the cycle turns.

Hence, the Securities Board of Nepal deserves kudos for its November 30 press release urging investors not to invest based on rumour rather with capital preservation in mind. Nepal Rastra Bank’s planned review of its margin loan policy is in the same mould. As things stand, tighter margin rules can send a stronger signal to stampeding bulls to bring their optimism down a few notches. In the long run, this will only help Nepal’s budding capital market. Given where the country is on its growth curve, the NEPSE in all probability will be a lot higher in, say, 10-20 years. But to get there, a roller-coaster ride should not be the preferred option. There is a lesson or two in the US tech frenzy of the 1990s. The sooner speculative bubbles get pricked, the better.