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Fool On The Hill

Wednesday, January 20, 1999

FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan

Market Bubble? Prove It

Two years ago, Federal Reserve Board chairman Alan Greenspan asked, "[H]ow do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions ...?" In other words, how do we recognize a stock market bubble that, when burst, will damage not just stock prices but the real economy?

The question has worried Greenspan ever since. After all, the Dow has since risen 45%, from 6,437 to 9,336, while the S&P 500 has soared 69%, from 744 to 1,257. Commentators have repeatedly argued, and often just assumed, that "the market" is overvalued. In my view, though, most of this talk is stupid and irresponsible because it's based on a misuse of historical market data, a misunderstanding of how stocks should be valued, and a misreading of Greenspan's own analysis of our economy.

Sure, changing economic conditions could make it clear that stocks have overshot their fair value and that the earnings growth figured into stock prices won't materialize. But I haven't seen a convincing argument for this so-called market bubble, and the clearest confirmation of my sanity is Greenspan's reluctance to do more than worry aloud about equity prices.

Let me show you what a misreading of our situation looks like. The New Yorker's August 17 issue featured a story called "Pricking the Bubble" by John Cassidy, that magazine's regular financial correspondent. Despite The New Yorker's well-deserved reputation for smart commentary, you would be hard-pressed to find an intelligent-sounding article that looked so completely wrong so quickly.

Written early in last year's market sell-off, Cassidy's piece argued that the market was still overvalued based on traditional metrics such as the price-to-earnings (P/E) ratio and average dividend yield, and that the Dow could fall to around 5,500. He quoted Milton Friedman and Paul Samuelson, Nobel laureate economists of very different intellectual schools, both of whom insisted that the U.S. markets were in the middle of a bubble. He then drew a lengthy comparison between the Federal Reserve's inaction in the period leading up to the Great Crash of 1929 and Greenspan's similar inaction in 1998, arguing that Greenspan simply had to prick this bubble to avoid a catastrophe.

Cassidy asserted that Greenspan would raise interest rates, "possibly as early as next week." He said the "official explanation... will be a revival of inflation fears, but the real reason will be the effect that the stock market is having on the economy." The market would then fall further since bear markets "are typically preceded by a shift toward tight money."

But things didn't turn out quite like Cassidy figured. Greenspan soon told us that it was during that very mid-August meeting that the Fed moved from a tightening bias toward a balanced stance that made a rate hike less likely. Indeed, Greenspan's speech on September 4 signaled that the chairman was probably thinking of cutting interest rates. Fears of deflation soon swept over investors. Perhaps the only thing that kept the U.S. markets from thoroughly joining and, inevitably, exacerbating the growing global financial panic was Greenspan's personal willingness to do exactly the opposite of what Cassidy had so recently concluded Greenspan must do.

Sure, a lot happened in the month or so after Cassidy's article appeared. Still, his entire argument turned on what was basically a lame use of "old methods of valuing stocks." Going back to 1928, the historical median P/E ratio of the S&P 500 is around 14.6; yet, it's stupid to assume that P/Es will or should return to that level.

Stocks valuations are rightly based on a discounting of future cash flow. High P/Es do signal high expectations for growth, but some of these expectations will be met. A classic example comes from Stocks For the Long Run, where Jeremy Siegel shows that in 1972, the so-called Nifty Fifty stocks traded for an average of 42 times earnings, more than double the P/E for the S&P 500 index at the time. Many believed the Nifty Fifty were way overvalued, and some individual stocks certainly were. Yet, Siegel argues that, as a group, their subsequent performance justified even their peak prices.

Other factors play into valuations, too. Earnings are simply worth more when inflation is low and alternatives to equities, such as fixed-income investments, deliver low returns. Also, the compositions of the S&P 500 and the Dow have changed over time. These indexes now include a number of leading companies, such as Microsoft (Nasdaq: MSFT), America Online (NYSE: AOL), Cisco (Nasdaq: CSCO), and Intel (Nasdaq: INTC) -- and even IBM (NYSE: IBM), Disney (NYSE: DIS), and Coca-Cola (NYSE: KO) -- that would be stunningly undervalued if priced according to current earnings and short-term growth prospects alone.

As long-term bull Abby Joseph Cohen of Goldman Sachs has argued, our economy has undergone major transformations. In the last seven years, technology has tripled as a percent of gross domestic product (GDP). At the same time, profit margins have risen to the highest levels in 25 years. Return on equity (ROE) for U.S. companies has shot up to an historic high. And return on invested capital (ROIC), a key measure of corporate profitability, has soared and remained high for several years now, as businesses make better use of their resources. To argue that "the market" is overvalued, one must explain away these facts.

Greenspan has also frequently discussed the role of technology-driven productivity gains in shaping what he has called a "virtuous cycle." Productivity growth fosters increases both in real wages and in corporate profits, which have spurred more spending on productivity-enhancing capital equipment and continued education, all of which helps moderate inflationary pressures. This cycle inspires confidence in investors, thus reducing the risk premium they expect for investing in stocks or bonds, which in turn cuts the cost of capital for companies looking to fund expansion.

"As I have testified before the Congress many times," Greenspan reiterated today, "I believe, at root, the remarkable generation of capital gains of recent years has resulted from the dramatic fall in inflation expectations and associated risk premiums, and broad advances in a wide variety of technologies that produced critical synergies in the 1990s."

Greenspan has repeatedly worried, as he said today, that the recent growth rates are unsustainable. "Through the end of 1998, the economy continued to grow more rapidly than can be currently accommodated on an ongoing basis, even with higher, technology-driven productivity growth." He's also noted, as he did today, "the possibility that the recent performance of the equity markets will have difficulty in being sustained" because the "level of equity prices would appear to envision substantially greater growth of profits than has been experienced of late."

Yet, does Greenspan think we're experiencing an economic and financial bubble? In short, no. My view is that he simply hasn't convinced himself one way or another. His speech today revealed his keen appreciation for the way that higher stock prices have fueled consumer spending and pumped up the economy. Greenspan wouldn't mind seeing stock prices hibernate a while. Still, he has said that bubbles are often only obvious in retrospect. That's partly because one cannot know until much later whether markets have discounted more growth than can ultimately be delivered. Yet, Siegel's example suggests the inverse is also true. Only years later could one say that the alleged Nifty Fifty bubble was actually an instance of the market discounting future growth almost perfectly.

Last April, Greenspan said he was willing to believe that the markets (with the Dow around 9,000 and the S&P around 1,120) were "fairly valued" assuming the virtuous cycle could persist. "I am not wholly alien to that point of view," he told a group of newspaper editors. He's clearly been entertaining this point of view as seriously as he's considered what might derail this economic expansion. So he surely recognizes the historically high P/Es and the low dividend yields, but he also knows that these metrics alone are almost meaningless. Context matters. The current context has encouraged him to watch and wait, to let this economic experiment play out since it offers the potential for a higher standard of living and price stability.

Reporters like Cassidy who fall back on the historical P/E factoid to argue that the market is overinflated are basically screaming that they have no idea how companies are, or should be, valued. My advice is for you simply to throw down any article where someone uses this stat uncritically and unqualified because the whole article is likely to prove dangerous to your wealth. Historical P/Es alone simply have nothing much to tell us about valuations today.

[Note: Look for our upcoming report on how some of the major magazines covered last year's market mayhem. Available tomorrow on The Motley Fool site.]

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