The Great Market Bubble Debate

Two bulls and a bear square off on what the markets have in store

Never mind how high stock indexes soar, just buy and hold. That's conventional wisdom today. But what if it's wrong? What if investors are resting atop a bubble that's set to burst?

That is the case made by Andrew Smithers and Stephen Wright in their new book, Valuing Wall Street: Protecting Wealth in Turbulent Markets. Using a yardstick called the "Q ratio," the two British economists foresee U.S. stocks plunging by at least half their value over the next few years. Q, first formulated by Nobel laureate James Tobin, represents the ratio of the stock market's total value to the fair value of all corporate net worth. Why does Q matter? Because in the end, it is real assets that must generate the real returns that investors earn--not the casino-type investments based only on earnings projections that have largely been driving the market. Today, Smithers and Wright warn, Q is 2.5 times its long-run average and poised to snap back to more accurately reflect real assets. Investors, they say, should sell stocks now and hold cash.

If they're correct, then some other prominent recent writers on investing in stocks are dead wrong. More than any other book, Wharton School economist Jeremy J. Siegel's Stocks for the Long Run has popularized the buy-and-hold philosophy. Last fall, Kevin A. Hassett and James K. Glassman extended Siegel's research with their hyper-bullish Dow 36,000. Smithers, Siegel, and Hassett met recently at Business Week's New York offices to debate the issues before a panel of editors. Here, in edited excerpts, is what they said:


How do you see the market today?

Smithers: Wall Street is in a bubble. And when you know Wall Street is in a bubble, you know that you're in a period of extreme high risk, with an extremely high probability that the market will be down over the next three to five years.

Siegel: Seven percent per year [average] real returns on stocks is what I find over nearly two centuries. I don't see persuasive reasons why it should be any different from that over the intermediate run. In the short run, it could be almost anything.

Hassett: Dow 36,000 is an attainable goal. It seems kind of absurd to think of such a huge climb happening in, say, five to 10 years or three to five years. But we've had an increase very similar to that in the past five years. The process that's going on now that's giving us, say, 20% returns a year or more, will continue a little bit longer.


Is the economy becoming more virtual--that is, less manufacturing, more software and services--and what effect can we expect that to have on market valuation?

Smithers: It doesn't affect the value of companies at all. The cost of capital has to equal its return, so you always get back to square one. Companies revert to the cost of creating [companies] just like any other goods.

Hassett: If you spend lots of money on advertising, then you've got Coke instead of RC Cola, and so maybe you can charge more. If you spend money on R&D, then you make something that you can leverage into lots of profits. The proportion of [research and development] investment to GDP in the last 10 years or so has about doubled! If you plug that into regressions that predict what the level of Q should be, you are going to get a much higher level than you would get in the past. That doesn't mean that we should ignore Andrew [Smithers'] book or that we shouldn't be worried a little bit about the signal from Q, but it should not have you running for the exits.

Siegel: There might be some very good reasons why Q has risen recently. What I think is really happening with a lot of firms--Microsoft, Cisco, and others--and I'm not justifying all their valuations here; I've come out actually objecting to some of these--is the fact that we are scooping the rest of the world. In other words, there are temporary profits of a first mover, of an innovator, and that is proceeding very rapidly and much more rapidly than other times, [which] I think could justify the fact that market value is temporarily far above replacement costs.


The market is extremely highly valued, whether by Q or by any measure of earnings--higher than it was in 1929 and 1966. Why, then, should the consequences not mirror what they've been in the past?

Siegel: Have we learned anything over the past 50 years? When we compare a 100 years' p-e's, we're going through the Great Depression, a banking collapse, and all the rest. Have we learned how to prevent a banking collapse? A Great Depression? I would say, yes, we've had incredible success. Have we been in the longest economic expansion in history? I would say yes. Are earnings of the top companies growing at the fastest rate that they ever have, far faster than the peaks that you mentioned in the past? Yes.

Hassett: If you look at profits and you look at free cash flow, then the last five years have been astonishing, just astonishing. U.S. firms are tremendously profitable. That profit growth gives you a big margin of error to get higher valuations than what we have now.

Smithers: The big change in profits in the last five years is [because leverage] has risen greatly, so that the equity earnings have risen much faster than profits. The ratio of debt to total value in U.S. corporations in the post-World War II [period] has risen from, roughly speaking, 15% to roughly 50%.

Siegel: The firms that are growing the fastest have no leverage. The firms that are the Old Economy, they're selling at seven times earnings, have all the leverage--like the GMs and the airlines. Incredible amounts of debt. Take a look at the leverage of the Microsofts and the Ciscos, and there's zero leverage. So I don't understand how leverage is a source of the increase in profits. I disagree with that very strongly.

Smithers: The overvaluation of the market measured by Q is based on the [Federal Reserve's] estimate of the total value of all stocks. It's an aggregate value. I've absolutely no view whether one set of stocks vs. another is expensive, but I have a suspicion that what we've got now is a bubble on top of a bubble.


If you grant the point that there's an acceleration in the rate of earnings growth, and perhaps even of productivity growth, and that there's something in technology and the organization of society that's responsible for this, do you still see the market as overvalued?

Smithers: Absolutely! Return on equity is independent of the speed of growth of the economy, and that is a point of history and a point which I think goes to the future as well.


Are there precedents for bubbles occurring in the midst of bull markets?

Hassett: Nobody has ever made a convincing case that there's been a stock market bubble in the U.S. That doesn't mean that the market doesn't go down. But what it does mean is that at no point in time could a reasonable person look at where everything is and say, "That's ridiculous."

Siegel: That's, of course, what Greenspan is saying: You don't know when you're in a bubble.

Smithers: We looked at what has happened when Q has gotten to this sort of level in the U.S. In every previous instance--1906, 1929, 1937, 1968--the bubble has been followed by a crash and a severe recession.


Should individual investors simply buy and hold the market or try to get in and out based on the signal of Q?

Smithers: We're at the peak, and the return on holding equities is probably going to be half its long-term average. At the moment you can do better in [Treasury Inflation-Protected Securities].

Hassett: Some people say that TIPS are riskless. And I have to say that people who have bought those things in the last few years have been crushed. They've lost a lot of money, maybe 10% of their capital. So if you're a short-run investor and you buy TIPS, then they could be very risky if the interest rate changes. But if you're a long-run investor, they're not so risky. That's an analysis that bears are willing to allow you to apply to TIPS, but not to the stock market. And what Jeremy has taught us is that the stocks [hold] the same [risk to a long-term investor].


Has there been any change in the relationship between the stock market and the economy?

Smithers: The evidence for a bubble is in the economy as well as the stock market. What bubbles do is create unrealistic expectations for future returns from equities and other assets. Therefore, they tend to depress savings. You have a household savings rate which has dropped to nothing. Secondly, because the cost of capital is very cheap, you've got a big, big investment boost. What's happened at the moment is that the private sector of America is running at cash deficits of about 4.5% of [gross domestic product.] That is the exact thing you'd expect from a bubble impacting on the economy.

Hassett: I disagree. There has been a change in how the stock market is related to economic activity. As more people own stocks, changes in the stock market affect consumption more now than they used to. If you give an extra few hundred thousand dollars in stock to Bill Gates, then he's not going to buy extra hamburgers. But if you slide down the income distribution, it might really affect what people do. And this is something that Alan Greenspan has alluded to about one of the reasons why he's concerned that the stock market might be more inflationary now. Is there a sign of a bubble? No, I don't think so at all. Again, from the free cash flow and profit data, firms are making great money on their investments.

Siegel: The stock market is more important today for the economy, just because of the psychology--the importance of the market and the interest of the public in the market. If the market crashes, people are going to get pessimistic. Even when they don't understand all of the economic linkages, they know crashes have been associated in the past with some bad economic times.

I still believe that the market is very rooted in economics and in earnings. We see what happens whenever a firm misses its earnings estimate--it gets slammed; it can lose 40%-50% of its value in one day. So those people who say that there's no connection between what's going on in the market and the earnings haven't been looking at all at daily events.


Do you think that if there's a bubble in the U.S. economy that everything is going to come down together?

Smithers: Yes. As I tried to explain, I think that what happens is that when you get a bubble in the stock market, it produces profound disequilibrium in the economy, and that is happening at the moment. You can see this in the imbalance between the private-sector domestic investment and private-sector domestic savings. You are having to import something like 4% per annum of capital from abroad. And on top of that, the U.S. government is running a surplus. So the private sector is having to increase its borrowings or raise new equity every year--4% or 5% faster than it would otherwise have to do. In an equilibrium, you'd get debt probably rising more or less in line with GDP. In the current situation, because of this cash deficit in the U.S. private sector, you're tending to get debt rising at 10%. Once you get into compound interest rates of [debt], you're in trouble.


Why then is the Dow so high?

Smithers: Because it requires, I assume, more and more pull to get [foreign investment] in here in terms of higher returns. If the returns on equity are particularly high here, people will push money into the U.S. until they realize [the returns] are ephemeral.

Hassett: The two most important pieces of news out of the Fed this year are one, the flow-of-funds [report] that came out in March. It showed that free cash flow is soaring, which means that our firms are really getting money to their shareholders. The second piece of evidence that was astonishing was a recent paper by two of the best young guys at the Fed that showed the productivity gains of the information-technology revolution are so astonishing, so profound, that they're in the data now. Five years ago, these guys wrote a paper using the same methodology, and they couldn't find a thing, and they were pilloried.

Siegel: Greenspan always suspected that productivity figures were being underestimated, and now we're beginning to see productivity growth actually accelerate.

Smithers: I'm afraid I see no evidence.

Siegel: You don't believe the real GDP figures then?

Smithers: Let's talk about productivity. I suspect that U.S. long-term productivity has picked up a trifle, but I don't think it's probably picked up very much, and the reason for that is twofold. Productivity is very pro-cyclical--it swings up and down with the economy. We've got a very strong economy at the moment, and we've had strong pickup in the short-term data.

Hassett: O.K., but in Andrew's world we have to stop and think, if given the things that he said are true, then basically everybody but Andrew is being stupid because the firms are investing like crazy. People are buying stocks.

Siegel: Towards the end of a business cycle productivity growth actually tapers off significantly. First of all, as the unemployment rate goes down, the marginal workers that you're getting are less skilled. As you bring more plant and equipment into use, that's usually less efficient. It is really unprecedented for us to have the productivity growth that we have experienced over the last three to four years.

Smithers: I didn't realize that you thought these were the last stages of the cycle.

Siegel: [Laughs.] Well, a more mature stage.


Mr. Smithers, do you have a theory of stupidity to explain why investors continue to behave foolishly, bidding these prices higher and higher over these many years?

Smithers: Not a theory of stupidity--and I wouldn't like to think that I'm the only sane man around.What we point out is that the development of the employee stock option has massively changed management's motivation. We also point out that profits in the U.S. are significantly overstated as a result of employee stock options not being deducted as they should be from profit-and-loss accounts. What has happened is that the normal tenure of senior executives in U.S. companies has shortened and therefore they are very concerned about the short-term price movement of their stock. It's a great mistake of not having rigorous accounting for employee stock options.


So what's the right investment strategy?

Hassett: If you're in for the long run, you should be in stocks still. I think a person who has a shorter horizon should definitely be buying fixed-income, too. If you're getting close to retirement, then you might have to eat some of your money, and having things that have higher current yields is important.

Siegel: I have voiced my concern about the technology sector, and I sometimes advise people to shade down from that sector relative to its percentage in the [Standard & Poor's 500-stock index.] I really am concerned with these companies that have p-e ratios of 90, 100, and above. I still think stocks, as a diversified portfolio, are the best long-run investment. I will say that indexed bonds at 4% are an attractive hedge at the present time. To get a 4% real rate of return, although it's not as high as 6.5% to 7% that we talked about in stocks, as a guaranteed rate of return is certainly comforting against any inflation.

Hassett: If Andrew is right--and he could be, there's a lot of good argument in his book--then what happens is that the market drops by 50% or so, probably a little more, but then after that you could expect a historical return. That means that maybe seven or eight years from now you would pass the person who puts all of his money in bonds right now if you held through the whole thing.

The Great Market Bubble Debate

Siegel: Andrew would have to admit that that person would be much better off.

Smithers: Not have to admit. One of the points that we make carefully in the book is the right time horizon. If the stock market halves, which Kevin [Hassett] considers to be a possibility and I consider to be a probability, then it will take, I'm afraid, rather more than six or seven years at a 6% compound return before you've outperformed the people who are getting 3% or 4% real on their cash or their TIPS. It would take a very great deal longer.

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