The Market Can't Soar above the Economy Forever

Investor exuberance in the `90s -- and `80s -- has resulted in unrealistic stock prices. A return to historical norms will cause serious pain

By Robert Kuttner

The stock market, along with the economy, has rebounded from last year's lows. But by historical standards, it remains seriously overvalued. And there's little reason to believe profits will grow at a rate that would justify rapidly rising stock values. That suggests the market could remain fairly flat in this decade, with far-reaching economic consequences.

Despite the bust in tech stocks, price-earnings ratios remain astronomical--about 22 for the Standard & Poor's 500-stock index, based on expected earnings, and over 60 based on current earnings. The historic norm is around 14. And in the wake of Enron Corp., it has become clear that corporate earnings generally have been somewhat overstated, through such gimmicks as failing to count stock options as expenses.

For two decades, stock prices have outstripped corporate profits and the growth of the economy. During the late bull market, the Dow Jones industrial average more than tripled. But during the same period, gross domestic product rose only about 30% and corporate earnings rose just 60%. BusinessWeek recently reported (BW--Apr. 1) that the total return on stocks was even better during the 1980s business cycle than in the 1990s. So since the early 1980s, the rise in the stock market has outpaced economic growth by something like four to one. This, obviously, can't continue.

Since 1982, the total inflation-adjusted return on stocks (including dividends and capital gains) has been about 12% annually. Historically, the real annual return on common stocks has averaged 7%. Since stock prices are set both by profits and by expectations of what other investors will pay for stocks, annual returns can exceed the 7% norm for years and even decades--but not indefinitely. Yale University economist Robert J. Shiller has called this a "naturally occurring Ponzi process." As Shiller has noted, stock prices also can underperform the economy for long periods. Between January, 1966, and January, 1986, annual total returns to stockholders averaged just 1.9%.

For the stock market to turn in anything like its recent performance, either p-e ratios would have to soar into the triple digits or corporate earnings would have to consume an ever increasing share of the economy. Economist Dean Baker at the Center for Economic & Policy Research in Washington calculates that corporate earnings would have to grow twice as fast as GDP for the p-e ratio to stay at current levels. With increased productivity growth and a slight decline in the labor share of GDP, some modest rise in corporate earnings is possible--but not at two times GDP growth. Massachusetts Institute of Technology economist Peter A. Diamond finds that stock prices will have to decline significantly over the next 10 years, merely to accommodate the likely reversion to the 7% long-term trend. Just to add one more bearish indicator: Interest rates, kept low during the recession, have no place to go but up.

If we have a relatively flat stock market while the real economy catches up, what would be the consequences? For one thing, younger workers just getting into stocks would be disappointed. The alternative of fixed-income investments looks likely to pay paltry yields for the foreseeable future. Most Americans do not have significant stock holdings. Even those older people who enjoyed capital gains in the 1980s and '90s would now face low annual returns on their stock market investments in their retirement.

Just as the "wealth effect" of a booming market increased consumption in the 1990s, a flat or declining market would likely depress consumption in this decade. And a flat stock market would make it harder to sustain the current net inflow of foreign capital on which the U.S. has come to depend.

Pension plans and life-insurance companies that assume a 7% normal annual return would also be hard-pressed. If actual returns slip below that benchmark, defined-benefit pension plans cannot meet commitments. In the 1990s, a booming market allowed many corporations to withdraw money from pension funds on the premise that they were overfunded. A little-noticed provision of the recently enacted "stimulus" bill allows companies even greater latitude to raid pension funds. But if anything, a flatter market means corporations will need to start putting money in again, which would depress net profits. Universities, foundations, and other nonprofits that got somewhat spoiled in the 1990s are already taking a hit. Foundation grants are down, and universities are hiking tuition to make up for slumping endowments.

A soft stock market would make stock options less attractive. Corporations would need to make up the difference with salaries, also at the expense of net earnings. Finally, a flat market should slow down the campaign to privatize Social Security. While one might say good riddance to both trends, this is small comfort. The broader economy could be paying the costs of irrational exuberance for some time to come.

Robert Kuttner is co-editor of The American Prospect and author of Everything for Sale

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