The Bull Market: Keeping Perspective

The U.S. has had three years of record gains in stock prices. In each year, people who underestimated the rise lost out. This year, predicting the direction may be even harder. Following 28% average annual appreciations from 1995 through 1997, the consensus for next year is for the market to move up only 5% to 6%. Once again, a surge may surprise investors. But it would be prudent to be more cautious.

To be sure, the economy is roaring into the first quarter of 1998 with guns blazing. Jobs are tight, real wages are rising fast, inflation is amazingly low, and interest rates are falling. Consumers have money--and the confidence to spend it. Corporations have cash on hand and are pouring it into capital investments. The fourth quarter looks strong.

But there are clouds on the horizon that should give one pause. Both fiscal and monetary policies are tight all over the world. In the U.S., federal and state governments are all running surpluses for the first time in decades. Real interest rates are high by historic standards. In Europe, the advent of a single currency has governments cutting spending while hiking interest rates. In Asia, the deflationary wave is picking up steam. The world economy may not be in sync, but policy sure is, and it's restrictive. This has already cut nearly 1% off potential world growth for next year. It could get worse.

Then there is the bubble. As the Asian crisis shows, exaggerated capital flows can distort investment. Economies, even a New Economy, can grow too fast for their own good. There were times in 1997 when the stock market was frothy, running way ahead of fundamentals and exhibiting "irrational exuberance," as Federal Reserve Chairman Alan Greenspan called it. Many equity prices are back up there again. Housing prices at the top end are pretty wild, too.

It could very well be that the new wave of corporate restructuring squeezes out enough costs to keep profit margins growing and stock prices rising. From General Electric Co. to Boeing Co., manufacturers are starting a new round of cutbacks to trim capacity. Lower interest rates will also help cash flow. Both may more than compensate for tight policy, Asian troubles, and high market valuations. We hope so.

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