Wall Street Debates Its Fate

To some observers, this year's sharp runup in stock prices, on the heels of the booms of the 1980s and early 1990s, bears eerie similarities to the euphoria that prevailed in the late 1920s and late 1960s. To others, it heralds the emergence of a new economic era that spells continued strong equity gains.

If the first group is right, the third great bull market of this century could be drawing to a close. And the risks are growing of an extended market slump, such as those that slashed stock prices by 80% and 57% in real terms in the wake of the two earlier bull markets of the twentieth century.

In a recent study, economist Martin H. Barnes of The Bank Credit Analyst concludes neither view is valid. "A correction may be overdue," he says, "but a major bear market is not yet in sight."

To be sure, Barnes spies numerous signs of "speculative froth" in the market. There are now 40% more bond and equity funds, for example, than there are stocks on the New York Stock Exchange. Margin debt recently climbed above 1% of gross domestic product--exceeding the previous postwar cyclical peak reached just before the 1987 market crash. And cash reserves of equity funds are close to a 20-year low.

Other possible signs of excessive optimism include the record pace of mergers and acquisitions, the growth of personal finance magazines, and the public adulation of successful investors such as Warren Buffett. Indeed, the very claim that the stock market has entered a new era echoes similar views voiced with passionate conviction by market bulls in the late 1920s and late 1960s.

On the other hand, Barnes notes that both the equity share of household financial assets and the value of new stock issues as a percent of gross domestic product are still far below previous peaks. And despite the "new era" hype, almost as many investment advisers are currently bearish as are bullish.

Although the current dividend yield of stocks is very low, Barnes notes that this reflects corporate decisions to forgo dividend hikes and to retain strong earnings. Indeed, his analysis of current price-earnings ratios and recent earnings trends indicates that investors are not anticipating any major earnings acceleration in the years ahead.

More important, Barnes points out that major bull markets typically end when speculation and optimism are rife in the face of an increasingly restrictive monetary squeeze. In light of today's low inflation and sluggish economy and the likelihood of further monetary ease, he predicts that "while the 1980s-to-1990s bull market may stumble, it still has some distance to run."

Before it's here, it's on the Bloomberg Terminal.