Old Rules Catching Up With 'New Economy'

April 18, 2000

Dean Baker
San Diego Tribune, April 18, 2000

The free-falling stock market of last week apparently caught most investors by surprise. President Clinton, along with many other top political leaders and economic experts, deserve the blame for this. Instead of warning people about the dangers of an over-valued stock market, they chose to celebrate the “new economy.” As a result of their irresponsibility, many people have needlessly placed their life’s savings at risk.

The fact that the stock market is hugely over-valued has been recognized for some time by most of the economists who study it. The basic arithmetic is quite simple. Historically, people have valued a share of stock at $15 for each dollar of earnings. In other words, the stock of a company that had earnings of $1 per share would sell for $15 dollars. After the recent market run-up, shares of stock were selling for more than $30 for each dollar of earnings. This basic arithmetic suggests that stocks were over-valued by 50 percent, or more.

There are two possible responses to this logic. First, it can be argued, as did some of the more extreme new economy types, that profits no longer mattered to stock prices. This crew argued that in the new economy stock prices had their own dynamic, and profits really didn’t matter.

This is an interesting idea profits don’t affect the value of stock. That’s like saying people don’t buy ice cream for the taste. Unless people buy stock because they think the stock certificates are pretty, it is hard to imagine what else could determine its value. Unfortunately, many people probably did let such nonsense guide their investment decisions.

The other possible response by advocates of stocks is that corporate profits were going to surge in the future, so it doesn’t matter that the current share prices are extremely high. If corporate profits were to double in the next four or five years, then the stock market would not be over-valued.

The problem with this view is that there are few, if any, economists who believe that it is even possible for profits to grow at this rate. Certainly no one is projecting profit growth at this pace.

In fact, it is the projections of profit growth that really make the whole story so interesting. When our politicians in Washington debate tax and spending plans for the next 10 years, they have a set of economic projections that provide the basis for the budget numbers. These projections are prepared by the Congressional Budget Office. These economic projections include projections for the growth of corporate profits.

Any politician who bothered to look at CBO’s profit projections knows that they expect after-tax corporate profits to fall by 4.0 percent over the decade, after adjusting for the effects of inflation. In other words, CBO is projecting that real corporate profits will be 4.0 percent lower in 2010 than in 1999. That’s quite different from doubling in four or five years.

Of course CBO makes mistakes like everyone else, so it could prove to be wrong about the pace of future profit growth. But, if its numbers are anywhere close to being accurate, then there is no way to justify current stock prices.

This is why the politicians deserve blame for allowing people to get caught in the stock bubble. If they took the numbers in the budget debate seriously, then they must have recognized that profits could not possibly grow fast to enough to sustain stock prices. Yet, there were very few politicians who bothered to say anything about the over-valued stock market. In fact, many wanted to put workers’ Social Security money at risk, in addition to their personal savings.

If the bubble continues to deflate, it may destroy many illusions that people held about the stock market. The most basic lesson is that money does not just fall from heaven; the stock market cannot continually soar at a pace that bears no relationship to the growth of the economy. Unfortunately, for many people this was a very costly lesson to learn. President Clinton and his crew of new economy celebrants deserve much of the blame for this.

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