Only a couple of months ago, many of the market's averages were hitting all-time highs: the Dow Jones Industrial Average, other broad large-cap indices such as the Russell 1000 or S&P 500, mid-cap indices such as the S&P Midcap 400 Index, and smaller-cap indices such as the S&P SmallCap 600 and Russell 2000. But in the weeks and months since then, market bulls have felt a lot of volatility and pain, continuing right through today's market action.

And so we've heard a lot of talk lately about whether we're seeing the start -- or, perhaps, whether we're already part of the way through -- a market crash. The market's actions over the past couple of days have added fuel to the fire. If there are sound reasons to fear a full market crash, then it's time to come up with a decent alternative to sinking new money into the market.

Indications of a coming crash
Back in 1934, Benjamin Graham, the creator of securities analysis, wrote that there are three forces behind a market crash.

  1. The manipulation of stocks.
  2. The lending of money to buy stocks.
  3. Excessive optimism.

Let's assess the level of each factor today.

1. The manipulation of stocks
Graham was quite familiar with this factor, since it played a key role in the market crash of 1929. Before the SEC was created in 1934, the federal government exerted very little regulation over the markets by -- and what little existed was patently ineffective.

Things have markedly improved since then. However, because of the vast amounts of money people so quickly made at the end of the '90s, those who followed the market closely were taking various market manipulations for granted. The broad manipulation of the IPO market and the trading of favorable research reports for investment-banking work by Wall Street's top (and middle and bottom) analysts were just two of the contributing factors to the crash that lasted from 2000 to 2002.

Today, however, there is far less potential for market manipulation. A better-staffed SEC; new regulations on the books, including Reg AC (requiring a greater level of disclosure by analysts); the structure of IPOs; and even Sarbanes-Oxley (expensive, but effective) mean that whatever manipulation happens in today's market is largely relegated to micro caps.

2. Lending money to buy stocks
Excessive use of margin contributed to the market collapse in the early part of this decade, and it was also a main culprit in 1929. Back then, an investor only had to have 10% equity and 90% margin to buy stocks. Low interest rates have also led to excessive lending over the past few years in the housing market -- and they were a contributing factor to the tech bubble of several years ago.

I have to admit that this factor remains somewhat troubling today. According to a recent Barron's article, there is a higher level of margin debt for the NYSE and Nasdaq today than at any previous time -- $303 billion, just slightly higher than the peak of $300 billion set in March 2000 -- though, figuring in inflation, it's not setting any records. I'd keep an eye on this factor, but I'd measure its effect through the lens of the third factor.

3. Excessive optimism
Given the current price-to-earnings multiples out there, even the most downcast curmudgeon simply can't argue that today's prices reflect excessive optimism.

Stocks are squarely in the range of normal P/E multiples, while they continue (at least this past quarter) to realize earnings growth that is higher than the historical average. Moreover, the companies behind these stocks sport record amounts of cash on their balance sheets and continue to increase their reserves even as they repurchase shares, pay dividends, or both.

For a quick comparison of what "excessive optimism" looks like, observe some of the multiples of prominent stocks from the era of "irrational exuberance."


Average 1999 P/E

Current P/E




Motorola (NYSE: MOT)



Cisco Systems



Johnson & Johnson (NYSE: JNJ)



Procter & Gamble (NYSE: PG)






Anheuser-Busch (NYSE: BUD)



Bristol-Myers Squibb (NYSE: BMY)



S&P 500 average



You can see further evidence of the zeitgeist of the period by reading about what prominent financial publications were tagging as surefire stocks. Today, though, the market as a whole is trading at around 16 times earnings, comfortably within the range of the historical average. Indeed, in comparison with interest rates (the Federal Reserve model), today's earnings yield points to fair-to-underpriced securities. You cannot bend, fold, spindle, or mutilate these figures to arrive at the conclusion that there is rampant excessive optimism built into today's domestic stock prices. Foreign emerging markets? Yes, perhaps there, but not here.

The Foolish bottom line
While earnings growth could slow, given the strength of balance sheets and the proclivity of companies to buy back their own shares right now, continued earnings-per-share growth looks like a good bet for a while.

So now appears to be a good time for staying in the market, particularly with all of the recent choppiness, which causes other investors to sell for no better reason than that stocks are going down. Motley Fool Stock Advisor is staying fully invested, a strategy that has helped us produce returns of 52% versus 15% for the S&P over the past five years. Enjoy a free, 30-day no-risk guest pass to our service, including coverage of more than 60 stocks.

This article was originally published on Feb. 15, 2007. It has been updated.

Bill Barker does not own shares of any company mentioned in this article. Microsoft and Anheuser-Busch are Inside Value recommendations. Johnson & Johnson is an Income Investor pick. The Motley Fool has a disclosure policy.