Dow 5000. Don't LaughChristopher Farrell
A tattered dollar. A slowing economy. Rising prices for raw materials. Hardly a recipe for a roaring stock market. Yet the Dow Jones industrial average has soared past 4300, gaining more than 500 points this year. Is this yet another misadventure on Wall Street, a manic euphoria that makes for a speculative bubble and spectacular blow-off?
Certainly, market mavens are worried that the party is about to end. Stock market valuations are lofty by some measures. And fear that mounting price pressures will ignite inflation haunts the market. "We have concerns about a 4% to 5% inflation rate in the second half of 1995," says Edward G. Riley, chief investment officer for the private bank at the Bank of Boston Corp. Adds John P. Hussman, a money manager and investment newsletter writer based in Farmington Hills, Mich.: "There's a likelihood of slipping into a bear market at any time."
"IDEAL CLIMATE." Yet the economic fundamentals suggest stocks have a long way to go. In the new '90s economy, productivity has been rising at about a 2% average annual rate, double that of the previous two decades. The startling gains from corporate restructurings and the high-tech revolution will pay dividends for years. U.S. businesses are seeing remarkable profit growth, and disinflation continues. "Strong growth without inflation is an ideal climate for stocks," says Jeremy J. Siegel, professor of finance at the Wharton School.
A few economists are even starting to tempt the fates. "The Dow is heading for 5000," says Edward E. Yardeni of C.J. Lawrence/Deutsche Bank Securities Corp. 5000? Over the next several years, 5000 is not as outlandish as one might think, considering that it's only 14% above current levels.
Of course, like any other market, the stock market will take sudden, stomach-churning dips or stagnate for months on end. Risks are multiple in the new global economy, too, from unexpected currency devaluations, like the recent Mexican peso crisis, to political upheavals in developing nations, such as the anticipated power struggle when Deng Xiaoping passes away in China. Still, in the U.S. there are none of the economic and financial excesses that typically scream "trouble ahead." The banking system is sound. This is the first business expansion in the postwar period not fueled by a double-digit rise in corporate debt. "The economy has no significant imbalances that are necessary for a recession to happen," says Mark Zandi, economist at Regional Financial Associates Inc.
Indeed, the one credible threat to the market--an overheated economy--is fading fast. Last year's interest-rate hikes engineered by the Federal Reserve are ratcheting down the economy's growth rate to a more sustainable pace. Gross domestic product slowed from a 5.1% annual rate in the fourth quarter of 1994 to 2.8% in the first quarter. And there's little to fear that the "soft landing" will turn into a nosedive. The U.S. economy is resilient and prospects for a long global upturn are bright. Economies are expanding in 46 out of the 49 countries followed by Allen L. Sinai, chief economist at Lehman Brothers Inc. The synchronous growth of so many countries in so many areas of the world has no precedent in modern economic history, says Sinai. With U.S. export-oriented companies looking forward to record sales this year and next, the economy could easily reaccelerate.
But won't a rebounding economy lead to higher inflation, rising interest rates, and lower stock prices? Forget it. Wall Street has insisted that a robust economy would ignite inflation--and sink the market--for more than four years. It has been dead wrong. The reason is "a huge array of forces pushing the U.S. toward lower inflation," says George W. Jacobsen Jr., chief investment officer at money manager Trevor Stewart Burton & Jacobsen Inc. Among them: the Federal Reserve's tight-money policy; declining real government spending; brutal competitive pressures from deregulation and globalization; and consumer "vigilantes" who hunt down the best prices. To top it off, U.S. companies continue to make gains in productivity, which lead to lower costs.
Just as important for the stock market, labor costs are remarkably subdued. Despite the economy's heady 4.1% growth rate last year, the employment-cost index, which includes wages and benefits, rose a mere 2.9% in the 12 months ended in March of this year, the smallest yearly gain since the index was first compiled in 1981. "The employment-cost index is consistent with our forecast for a deceleration in consumer inflation, bringing the [consumer price index] for 1995 below the 2.7% rate of 1994," says Richard F. Hokenson, chief economist at Donaldson, Lufkin & Jenrette Securities Corp.
The combination of high productivity and tepid wage increases is pushing corporate profits through the roof. In the latest business cycle, profits have exceeded the recovery in earnings during comparable periods by 70%, according to Henry Kaufman, who heads his own investment firm. With order books strong and exports improving, another rise in profits is likely this year, albeit at a somewhat slower pace than last year's 40% jump. In the first quarter, earnings for the 900 companies on BUSINESS WEEK's Corporate Scoreboard rose a strong 30%.
Solid corporate earnings explain why stock market valuations aren't zany. Equity prices are high, but not unreasonable considering the profit boom. Today's price-earnings ratio of 16 on the Standard & Poor's 500-stock index is below the p-e of 21 a year ago. Bonds have rallied over the past few months, with the yield on the 30-year Treasury bond falling by half a percentage point, to 7.25%. At current interest rates, the S&P 500 doesn't appear overvalued, according to Byron R. Wien, chief U.S. equity strategist at Morgan Stanley & Co.
True, the dividend yield on the S&P hovers around 2.6%, about as low as it has ever been, and a sign that stocks may be overpriced. Instead of hiking dividends, though, many companies have accumulated cash and engaged in large-scale repurchases of their stock--in effect, a policy that creates capital gains for shareholders, which is capped at a 28% federal tax rate rather than a top rate of 40% for dividends.
TOO ROSY? What's more, faced with billions of dollars in bills to pay for their children's college educations and their own retirements, an aging population is putting more of its income into stocks. Look at 401(k) retirement savings programs. According to data compiled by Access Research, a pension consulting firm in Windsor, Conn., equity investments make up 19% of 401(k) assets, up from 10% in 1990. Even more striking, approximately 70% of all new 401(k) contributions are going into stocks.
Is all this too rosy an outlook? Of course, economists are notoriously bad at forecasting markets, second only to doctors and dentists. Still, on the most fundamental level, the U.S. stock market reflects the outlook for the U.S. economy. And with inflation beaten into the ground and productivity on the rise, the signposts are pointing to better stock times ahead.