Why the Bears Are Wrong

Yes, valuations are high against historical yardsticks, but profits are strong, and productivity is booming. This time, it really is different

By Christopher Farrell

The stock market gains for 2004 suddenly have vaporized. The Nasdaq composite index, which soared 50% last year, has lost nearly all the 7.5% increase achieved earlier this year. The Dow Jones industrial average, the Standard & Poor's 500-stock index, and other major market indexes are barely in the positive column. Is the long-anticipated correction here? Or is the market's downturn a harbinger of something far worse -- the bursting of another bubble?

The recent troubles have convinced the bubble bears to emerge from hibernation. Here's the essence of their argument: The surge in equity valuations toward the close of the 20th century created the biggest asset bubble in U.S. history. When it burst in the spring of 2000, some $8.5 trillion of stock market wealth was erased by that fall. The decline was a shock to anyone with a retirement savings plan, especially for aging boomers eager to say goodbye to their officemates for the last time. Yet the drop wasn't severe enough to purge the market of irrational exuberance, the bear argument goes.

OMINOUS TERM.

  Specifically, the average stock price in the S&P 500, which reached some 40 times earnings in the late 1990s, never fell below its historic average of 16 times earnings during the bear market. The price-earnings ratio is currently 23. By this benchmark, the stock market put on a classic sucker's rally in 2003, and a plunge in equity valuations is coming to bring down the p-e ratio to a more realistic level, growl the bears.

Yes, the market is sputtering, and the jitters could last for some time -- perhaps a considerable period. Consumers are losing confidence in a slow-job-growth economy. Money is flowing into the equity market, much of it through mutual funds, despite the industry's ongoing scandals. The pessimists include some of the smartest investors in the business, such as money manager Jeremy Grantham and economist Stephen Roach. A bubble is an ominous term in finance, typically signaling a catastrophe of epic proportions.

It's here that the bubble brief falls short, however. For one thing, corporate profits are running well ahead of expectations. Fourth-quarter earnings growth among the S&P 500 companies are up 28% from a year ago, and more and more managements are immediately handing over some of that gain to owners through dividend payments.

IRRATIONAL EXUBERANCE?

  For another, the vibrancy of labor productivity is remarkable. It has expanded at an average annual rate of 3% from 1995 to 2003, double the pace of the previous quarter century. It's the dramatic strides in corporate efficiency that account in large part for the continuing reluctance of business to add to their payrolls.

It beggars the imagination that after the vicious mauling of the 2000-03 bear market -- replete with wrenching media tales of worker hardship and retiree blues, as well as the sordid revelations of corporate malfeasance -- that irrational exuberance still stalks the land.

There's no denying that valuations are high. But changes in the economy's performance suggest that the stock market should be valued at a higher level than historic norms measured by p-e ratios, earnings-price ratios, dividend yields, and comparable benchmarks. That's the conclusion of a recent research paper, The Declining Equity Premium: What Role Does Macroeconomic Risk Play?, by Stern School of Business economists Martin Lettau and Jessica Wachter, and New York University economist Sydney Ludvigson.

"REGIME SHIFT."

  They note that their profession has documented a widespread decline in the volatility of real macroeconomic activity over the past 15 years. The trend has been subjected to a barrage of statistical and empirical tests, and the results consistently show that employment growth, consumption growth, inflation, and overall gross domestic product growth have become more consistent. Perhaps stock prices' shift to a higher level reflects the decline in macroeconomic risk -- which also means that future returns will be lower. The authors believe that this "marked change seems to be better described as a structural 'break' or regime shift."

Of course, a popular saying on Wall Street is that the four most dangerous words in finance are "this time is different." That's good counsel, yet occasionally there have been major breaks with history. Peter Bernstein relays one of the most striking Wall Street discontinuities in his 1996 book, Against the Gods: The Remarkable Story of Risk. Up until 1959, recalls Bernstein, dividend yields on common stocks exceeded bond yields. Whenever the dividend yield on stocks came close to that of bonds, stock prices fell and the common equity dividend yield went back up.

This was a financial relationship investors could trust, a genuine signal that the stock market was overvalued. Yet in 1959, stock prices soared, bond prices fell, the dividend yield on stocks fell below the yield on bonds -- and stayed there. The old relationship between stocks and bonds vanished, a transformation partly driven by the emergence of sustained inflation in the post-World War II economy. Bernstein wrote that in the years following 1959, his investment partners, all veterans of the Great Crash, "kept assuring me that the seeming trend was nothing but an aberration. They promised me that matters would revert to normal in just a few months, stock prices would fall, and bond prices would rally. I am still waiting."

A stock market correction? Sure. Months of investor nervousness? O.K., maybe. But a bubble about to pop? The mass mania isn't there. No, it will take a sharp change for the worse in the underlying economic and political fundamentals to send the stock markets spiraling downward. And the economic outlook suggests that day isn't coming anytime soon.

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online

Edited by Douglas Harbrecht

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