Knight-Ridder/Tribune Information Services, July 18, 2002
Back in March 2000, when the stock market bubble was beginning to deflate, I talked to journalists from the nation's major newspapers about what it meant. Almost all of them held the view that there was nothing definitive that could be said about whether the stock market, as a whole, was overvalued. The value of stocks, they said, was what investors were willing to pay for them.
Even today, as the stock market plunges to new depths, it is widely believed that the accounting and other corporate scandals have caused the market to crash. But this has it backwards: it is the bubble that caused the accounting abuses (by dramatically inflating the rewards, and encouraging investors and politicians to ignore the deceptive practices). The scandals are just one way of discovering what happened during the wild, unsustainable run-up of stock prices in the roaring 90s.
We are witnessing a "correction," in the most genuine sense of that euphemistic expression. Contrary to popular belief, stocks are not worth whatever people are willing to pay for them -- certainly not in the long run. A bubble can persist for years -- just look at Japan, where the Nikkei stock index hit 39,000 in 1989. Nearly 13 years later, it hovers at 11,000. All bubbles must eventually pop.
But how can we tell when there is a stock market bubble? This is actually fairly simple, at least for bubbles of the size that we have had in the last few years. If the average stock is priced so high that it becomes impossible to project an economic future in which investors would want to hold stocks, then we have a bubble. This has been the situation for years, and so it was easy to show arithmetically -- as we did several years ago -- that stock prices must come down quite drastically.
Fed Chair Alan Greenspan understood this when he made his famous statement about "irrational exuberance" in December of 1996. But he backed off after the market plummeted in response to his remarks, and the bubble swelled rapidly for three more years.
Investors forgot that the value of stocks must be proportional to the earnings of the underlying companies. But earnings, or profits, grow with the economy -- and there are limits to how fast the economy can grow. The price of the average stock has for years been inconsistent with even the most wildly optimistic growth scenario.
And it still is. Even after the past week's carnage, the price-to-earnings ratio of the average stock is about 20 to 1, or about a third higher than its historical average of 15 to 1. Before the tech stock bubble began to deflate, we often heard that we were living in a "new economy" in which such "old economy" rules relating stock prices to earnings didn't apply. We now know that these pronouncements were delusional.
But if no one can demonstrate a logical reason why investors would want to hold stocks for much lower returns (as reflected in the higher price-to-earnings ratio) than what they expected in the past, then stocks are still overvalued. Which means that the $7 trillion in wealth that has vanished since the market's peak is -- to say the least -- not coming back any time soon.
The nation's collective denial about this is unfortunate, because there are important lessons to be learned from the bubble. Number one: let's not repeat it. However much bubble-driven consumption may have fueled the expansion of the second half of the 90's, there are more sustainable and less wasteful patterns of economic growth. Businesses can go back to making money the old-fashioned way -- by producing goods and services.
Second, all those investment firms who advised their clients that the stock market was guaranteed to out-perform bonds "over the long term" were wrong and negligent in their advice. The long-term is actually the time horizon over which a bubble is sure to burst. People who bought into the bubble with the intention of holding for the long-term -- mostly ordinary employees saving for retirement -- were practically guaranteed to lose. There is a class- action lawsuit here waiting to happen.
Third, our political leaders -- of both parties -- deserve much of the blame for the bubble and the corporate abuses that accompanied it. Alan Greenspan should have stuck to what he knew was true, and other political leaders should have joined him. With a modicum of courage they could have prevented most of this mess, and millions of Americans would not have lost so much of their retirement savings.