“For God’s sake, let us sit upon the ground, and tell sad stories of the death of bubbles” — William Shakespeare, Richard II (slightly adapted!)

Wall Street has accepted that 1999-2000 was a bubble, but they think the quiet gentlemanly decline of November-April, followed by the subsequent modest recovery, was its death.

Not so: bubbles don’t die quietly, they implode. The valuation bubble in the U.S. stock market hasn’t imploded; hence it is still alive, and implosion is yet to come.

The reason for this is the “physics” of bubbles, if you will. By definition, a bubble is a period when the prices of a particular group of stocks become inflated far beyond any reasonable estimate of the stocks’ intrinsic values. The inflation process in a company’s stock itself has very considerable effects on the underlying company. Buoyed by a cost of capital that is effectively zero or even negative, the company buys other companies at over-inflated valuations and engages in investment projects that make sense only on the most optimistic estimates of the market for the company’s products.

Even more dangerously, staff become the scarce resource, so they are hired — on wildly inflated remuneration packages — based on projected demand for the product in 2005, rather than actual demand today.

Once the stock ceases to ascend, a number of bad things happen. The staff discover that the valuations of their stock option packages are theory rather than practice; new staff in particular discover that they are working for a relative pittance.

Consequently, while business in the industry remains relatively good, the company faces the possibility of losing key staff to competitors who are still hiring. The company discovers also that it has staffed and equipped far in excess of the current level of business. Consequently layoffs and investment cutbacks are the order of the day, with consequent damage to staff morale and to the financial health of the company’s suppliers.

Faced by this bad news, the company’s stock then begins a serious drop. Apart from annoying investors intensely, and damaging the company’s reputation, this drop will cause financial difficulties in those members of senior management that have spent “not wisely, but too well” and now see the value of their stock and stock options dropping precipitously.

If the company has made acquisitions for stock, there will arise the question of a huge goodwill write-off; as JDS Uniphase has just graphically demonstrated, if the company’s market capitalization drops below the book value of the companies acquired, the book value has to be written down immediately.

If, on the other hand, the company had made acquisitions for cash, the slowdown in the business immediately calls into question the viability of its financing structure, will generally raise the cost of any new borrowing or refinancing the company does, and may cause it to sell off otherwise valuable operations in order to avoid debt default.

That is the stage we have now reached. The marginal operations, from Pets.com to Webvan, have gone bankrupt, but there are still a large number of Internet and telecom related companies, from Cisco and Deutsche Telekom downwards, which have cash reserves and substantial operations that appear at least potentially profitable.

Had the bubble never happened, so that their current stock valuations and operating position had been arrived at by gradual growth, most of these companies would survive relatively comfortably, financing themselves by a new stock issue if necessary.

However, business, like life, is path dependent. The bubble companies did not get to their state today by steady growth, they got to it by spectacular overvaluation followed by collapse. If JDS Uniphase, for example, needs more money, it cannot usefully attempt a stock issue, because its stock is down 94 percent from its high, thus the vast majority of its investors are disgruntled in the extreme and would see any attempt to stabilize the price for a new issue as a chance to get out of their losing position.

Even at this level, JDS Uniphase’s stock is valued at five times sales, in a situation where losses are likely for the next several quarters, not least a further huge (by the standards of any company except JDS Uniphase and Nortel) write-off of most of its remaining $12.3 billion in goodwill.

Further, JDS Uniphase, after its layoffs, will be a company of 9,000 employees, but it will not be a company of 9,000 employees that has grown organically, it will be a company of 9,000 employees who once had 16,000 other colleagues, and who thought in the past they were going to get rich from stock options that have become a mockery — they will feel both impoverished and insecure, a devastating combination in terms of morale.

Add to these problems of finance and employee morale the problem of being in a business all of whose buyers are suffering from a capital spending hangover and financial difficulties of their own, and you are looking at a company that will have great difficulty surviving, however good its basic business.

This, therefore, is why bubbles do not simply deflate, but die.

Individual stocks can survive membership in a bubble (McDonalds, after all, was a member of the early-70’s “Nifty Fifty”) but the psychology of bubble collapse produces a wasting disease in the companies concerned that is generally fatal. The financial and morale difficulties of a company whose stock price has soared and then crashed are very severe, and generally cause a high level of carnage among companies that have been involved in bubbles.

In the general economy, too, the effect of a bubble followed by collapse is far more negative than continuous slow growth. The bubble produces a huge misallocation of resources (think of the record — double the next best year — level of private equity investments, over $100 billion, made during 2000) which in turn produces an excessive risk aversion and scarcity of investment resources once the bubble has broken.

It is well known that operating in a cyclical business like steel or automobile manufacturing is much more difficult than operating in a steady business like food or even pharmaceuticals. The creation of a bubble, with its exuberant forecasts of permanently raised growth in productivity and the economy as a whole, makes the entire economy undergo a violent cycle, both in terms of output and financing availability. The result is a lengthy hiatus in the economy’s growth path, which may in the event be irrecoverable.

In the 1930’s, lost output based on 1920’s trends was never recovered; in the 1970’s, lost productivity growth after 1973, compared with the 1948-73 average, was also gone forever.

For a large bubble, the process takes a considerable amount of time, at least 2-3 years before a bottom can be reached. It is generally thought that the topping out of a bubble must be signified by a cataclysmic stock market crash as in 1929, but this is not the case; the 1968 bubble initially deflated only gradually, with the full gravity of the downturn becoming evident only after the Penn Central crash in May 1970.

Yet that downturn, which lasted in real terms until 1982, wiped out 80 percent of the real value of stock market investments, a loss that was only made up a quarter of a century later, by the long bull market of the 1990’s.

We have not, therefore, seen the bursting of the 1997-2000 economic and stock market bubble, but only the deflation of its most extreme manifestations in the New Economy.

Even the New Economy companies that are apparently sound and successful will find it difficult to survive. EBay, for example, a thoroughly attractive concept that has proven ability to generate profits, is still selling at 140 times earnings, which valuation must inevitably deflate, and cause difficulty for the company when it does (also, it may be thought that auctioning of non-essential memorabilia may not be quite the business in a recession that it is in an economy whose consumer spending, and credit card usage is still running at unsustainable levels — Sotheby’s and Christies, after all, are both highly cyclical companies.)

As the New Economy companies run out of wriggle room, their demise will cause substantial additional economic difficulties — job loss and bankruptcy are by no means cost-free processes, either to those involved or to the economy as a whole.

To quote another great Englishman, Winston Churchill, we are not at the end of this downturn, we are not even at the beginning of the end. We are, perhaps, at the end of the beginning, but so what? The bubble is so far only deflated, not dead. The second phase of its demise, unlike the second half of World War II, promises to be very much nastier than the first.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.