A Dow That Can't Fall To Earth? Dream On

As the Dow crosses 10,000, some Wall Street stock market promoters rely on the New Economy to justify their claim that share-price growth far in excess of growth in gross domestic product can go on indefinitely. They make me very nervous. But before the rebuttal, let's concede what's new about the New Economy. Mainly, it is more flexible and capable of faster, noninflationary growth than most economists recently thought possible.

Why? One candidate is deregulation. Another is wage discipline. Another is globalism. But the most important reason is technology. After a long lag, the gains from information technology are finally showing up in the productivity statistics. GDP growth rates in excess of 3% are not only thinkable but normal.

We can all celebrate higher growth. But in the medium term, higher growth does not necessarily translate into ever-increasing stock prices, especially when the market is already sky-high. Stock prices reflect earnings and dividend growth, the rate of inflation, and expectations. Other things being equal, higher earnings and lower inflation translate into higher share prices. But at a time when dividend payouts are meager and earnings unspectacular, stocks are attractive mainly on the expectation of capital appreciation.

PANIC SELLING. Today, the "rational" part of high price-earning ratios reflects low inflation. The "irrational" part reflects the expectation that share prices will continue rising at exceptional rates. Either factor, however, could go into reverse. Even with low inflation and a real growth rate of 3%, there is nothing about the New Economy that justifies price-earnings ratios much higher than their current levels, already near historic highs.

Recent reports of lower corporate earnings stimulated a brief sell-off. Even modest signs of inflation would signal panic selling. In the past, despite the standard economic narrative, inflation has only rarely been kindled by macroeconomic overheating of the sort manageable by Federal Reserve intervention. The notable inflation of our time, in the 1970s, was a complex brew of external shocks compounded by random accidents, cost-of-living escalators, and a real estate bubble. Virtually nobody predicted OPEC's oil price quadrupling, much less that it would combine with several years of crop failures and a sharp rise in medical costs. The high inflation of the 1970s sent stock prices tumbling, and consumer savings defensively went into housing, which only further spiked inflation. None of this was predicted or easily managed.

Inflation is less likely to accelerate in a deregulated economy, thanks to intense price competition, but inflationary shocks are far from impossible--and could be quite damaging. The higher the current multiples go, the more they are vulnerable to random events, which (by definition) cannot be either anticipated nor capitalized in share prices. A few more years of the stock growth we've enjoyed lately would send p-e ratios into triple digits. The motivation to invest in stocks would then be exclusively based on expectations of still higher prices, since dividend returns would be even more trivial than they are today. I don't know what this reminds you of, but it reminds me of Japan. There, unsustainable share prices reflected a rigged system of cross-ownership. In our case, though the "market" is speaking, rather than an old-boy network keeping silent, the result is not dissimilar: a stock bubble.

Economist Dean Baker recently warned of what he called "bull-market Keynesianism": With ordinary wage growth sluggish, much of today's prosperity reflects the wealth effects of high share prices. People who own stocks feel prosperous, and they spend freely. But let share prices fall, and you get economic contraction across the board.

Among their other odd side effects, stock market bubbles produce effervescent prophets of permanent prosperity. Among the most inventive are James K. Glassman and Kevin A. Hassett in their forthcoming book Dow 36,000. Their notion is that the risk premium of stocks relative to bonds is irrational and that logically it should narrow to zero. For the real long-term yield on stocks to equal that on government bonds, they calculate, the p-e ratio would need to quadruple to about 100--which would put the Dow at around 36,000, "tomorrow, not 10 or 20 years from now." But surely there is a good reason for that risk premium. Stocks are riskier than bonds. Have we forgotten even that?

The permanent-prosperity crowd also points to the optimism of individual investors as a positive indicator. But this should be less than reassuring to the small fry. Historically, it's the little fish who get swamped when the tide turns.