SYNOPSIS: One year anniversary column. Following the plunges of an irrational market.

According to the theory of efficient markets, the market value of a company depends on its expected future profits. The price of the company's stock then fluctuates only on the basis of real news — information about fundamentals that leads informed investors to revise their estimates of those future profits.

Yeah, right.

Back when the Nasdaq was soaring above 5,000, those who suggested that maybe this was a bubble — that the underlying profit prospects for tech stocks, and for that matter stocks in general, didn't really justify those valuations — were dismissed as old-fashioned types who just didn't get it.

But sure enough, it was a classic bubble — a natural Ponzi scheme in which rising prices rewarded those who believed that prices would rise, and made skeptics, however cogently their positions were argued, look like fools; and the boom continued until the scheme ran out of suckers.

Now, however, prices are falling, and the Nasdaq in particular is falling even faster than it went up. So the question now is whether the markets have returned to sanity, or simply inverted their previous delusions. Are we still witnessing a correction of the exaggerated values of nine months ago, or have we gone straight from bubble to panic?

An honest but unhelpful answer is that nobody knows; a more detailed but equally unhelpful answer is that it's possible to make a case either way. But on the whole, I'd vote for panic. If you look not just at the fact that people are selling, but at why they're selling, it suggests that we're still looking at herd behavior; it's just that now the herd is running the other way.

Now let's admit that some would argue that stocks in general are still overvalued. On average, companies still have a market value that is considerably higher compared with their current profits than the historical average. I can offer some pretty good theoretical reasons for believing that the historical price-earnings ratio is a bad guideline, that stocks have historically been underpriced; but given what's happened recently one can forgive people for being a bit skeptical. The only thing one can say is that the case for higher price- earnings ratios was made by many economists long before the bull market. It may be wrong, but it isn't one of those rationalizations cooked up to justify a bubble in progress.

Meanwhile, the stories people are now telling to justify selling seem to me as irrational as those they used to tell to justify buying.

For the really striking thing about the recent plunge in stocks is that it is all tied up with fears of recession. And while we could indeed have a recession this year, for the prices of good growth stocks — the stocks of companies that have real businesses and real profits, but that have been valued by the market at high multiples of current earnings — to tank on that possibility just doesn't make sense.

After all, when a stock is selling for 50 or 100 times the company's current profits per share, that value has to rest mainly on prospects for the future — that is, on the profits the company is expected to earn, not next year but some years from now. Now suppose that the U.S. economy is currently falling into a recession. That will certainly hurt profits this year, maybe next — but the economy will recover, and the slump should have very little impact on expected profits 5 or 10 years out. In other words, growth stocks ought to be less affected by the prospect of an economic slowdown than the stocks of slower-growing, old-economy companies.

The fact that it's working the other way, that recession fears are having their biggest impact on the stocks of companies whose value shouldn't much depend on what happens over the next year or two, suggests to me that we are indeed looking at a panic rather than a justified correction.

Of course, the psychology of panic is as hard to fight as that of a bubble. Just as irrational exuberance can look like wisdom during a sustained stock boom, irrational pessimism can look like wisdom during a sustained stock slump.

But let's try to keep some perspective. The lesson from this wild market isn't that manic is bad, depressive is good; it's to beware of mood swings.

Originally published in The New York Times, 1.3.01