Los Angeles Times, January 5, 2001
Sacremento Bee, January 10, 2001
The Federal Reserve's surprise interest rate cut on Wednesday gave the wounded stock market a shot of adrenaline, but it's hard to make up for the market's worst performance in more than a decade and a half. The Nasdaq's record 39% loss over 2000--down more than half from its peak--permanently shattered the illusion that prices can be bid up to any level that investors are willing to pay for them, and stay there.
Still, many people assume that because stocks have historically outperformed bonds over long periods of time, this will continue in the future.
We often hear investors say that they are "in it for the long haul," as if it were guaranteed that stocks will be a good investment if they are held for a long enough period of time, something they are often told by investment counselors. Ironically, it is the long-term future of stocks that looks bad now. And unlike stock prices in the short-term, which can fluctuate wildly, one can actually say something definitive about the long run.
The average price of stocks is still much too high, even after the correction of 2000, to be justified by earnings that the economy could generate in the future. In other words, it is not possible to come up with a scenario consistent with anyone's projections about the economy that would make investors want to hold stocks for a long time, unless stock prices were to first drop very steeply.
Dean Baker of the Center for Economic and Policy Research was the first economist to work through the arithmetic of this "bubble" market, and his findings have since been confirmed by other prominent economists. It works like this: In the long run, investors hold stocks only because of the earnings of the underlying companies. Stockholders get a return from two sources--the shared earnings paid in the form of dividends and an increase in the price of the stock (capital gains).
The average dividend is only about 1.5%. Capital gains, over the long run, cannot grow much faster than the economy, unless you invest at a point where stocks are undervalued relative to future earnings. But the average stock price relative to earnings--known as the price-to-earnings ratio--is still near twice its historic level. So unless you are willing to believe that stock prices are unrelated to the profits of the companies they represent, you can't expect capital gains much higher than the long-run growth rate of the economy, at least from here on out. That rate is currently estimated at about 2.2% annually.
That adds up to 3.7%. Even if growth turned out to be considerably higher than the 2.2% that economists are projecting, it couldn't solve the problem. It just doesn't make much sense to hold stocks rather than a U.S. Treasury bond, which has a similar real (inflation adjusted) return but almost no risk. Unless, that is, you think that other investors are going to keep bidding up the price of stocks independent of earnings--in other words, that the bubble will grow. But speculative bubbles can't grow forever; eventually they must burst.
Of course this analysis applies only to the whole market, or the average stock. If you can pick the next Microsoft or Wal-Mart and get in early enough, you can still do very well. But this is not easy to do. So most individual and institutional investors maintain some sort of diversified stock portfolio that moves more with the broad market. And at some point they are going to move out of those stocks, in large numbers.
Depending on the steepness of further market declines, there is a real danger to the U.S. economy. Japan's stock market lost nearly 40% of its value in 1990--a decade later it is down even more, 64% from its peak in 1989--and its economy has yet to recover.
The Japanese scenario may be less likely here, but it would be foolish not to act before a downward spiral began. The Fed should continue to reverse the six unnecessary rate hikes that it has imposed over the last year and a half. Both Congress and the executive branch should abandon the extremist and groundless economic theories, which we could tolerate while the economy was booming, that advocate paying off the national debt over the next 12 years. A commitment to pay down the debt is a commitment to reduce demand and slow the economy at a time when we really don't know where the bottom of the current economic slowdown is going to be.
The record stock market run-up has generated great wealth for some--but not most--Americans, who still own little or no stock even in retirement funds. The majority, who did not share in the festivities, should not get stuck paying the bill.