A 10,000 Dow Isn't So Scary

Priced to perfection. That's the Dow Jones industrial average at 10,000. It's a celebration of prosperity, a five-digit vote of confidence in the American Dream. It is also a number that gives many policymakers vertigo. To them, a 10,000 Dow validates the notion that stock prices are crazy and that we are in the midst of a financial bubble. They say the Federal Reserve should pop it gently now--with higher interest rates--before the bubble bursts, destroying the wealth of consumers and sending the economy into recession. Look at Japan, they say. Look at the U.S. in the Depression.

Our advice to the Fed: Hold on to those pins. It may well turn out that this is a bubble, but it is, to quote John Maynard Keynes, "a bubble on a sea of enterprise" that is generating strong growth, new jobs, rising tax revenues--and little inflation. Economists have consistently underestimated the strength of U.S. growth for three years now, in much the same way they've guessed way wrong about the market. Each quarter, they are "surprised." Less than three months into the year, economists are already revising their scenarios for 1999, boosting projected growth rates from 2.1% to more than 3.5%. Economists are having a hard time getting their minds around this business expansion--the longest in peacetime history, with inflation falling and productivity rising so late in the cycle. Odds are, they are also missing something about the stock market and how it should be valued.

What about those sky-high stock prices? Most valuation models, including the one the Fed uses, put the Standard & Poor's 500-stock index, currently at 1306, at about 25% overvalued. Fed Chairman Alan Greenspan warned against "irrational exuberance" back in the fall of 1996, when the Dow was at 6500, so the market and the models have diverged for some time. Again, each quarter, economists and policymakers are "surprised" at the strength of the market.

A reasonable person might conclude that, just as the old economic models seem to be broken, valuation models are busted, too. Standard & Poor's DRI has a new analysis that shows that reported corporate earnings and profits began to diverge at the beginning of the decade. Comparing earnings per share with the National Income & Product Accounts definition of profits suggests that earnings are being underestimated by--guess what--20% to 25%. What's up? DRI blames changes in accounting rules. Since 1990, companies have had to account for options, retiree benefits, and other factors in ways that have reduced reported earnings. If DRI is right, the price-earnings ratio today is only 26 on a pre-1990 basis, not 31. High, but not that high.

So the Fed shouldn't let a 10,000 Dow scare it. The models for understanding either the economy or the stock market aren't working well, and prosperity isn't something to tinker with lightly. The last time central banks tried to let the air out of bubbles in America and Japan, they precipitated the very catastrophes they were attempting to avoid. Many aspects of the U.S. economy seem to be perfect--at least for the moment. Perhaps the stock market simply reflects that.

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