August 16, 1998
Chicago Tribune, August 16, 1998
The stock market’s current troubles have raised the question of whether stocks are overvalued. Surprisingly few investors have given serious consideration to this question. If they did, many would not be holding stocks right now.
Stocks are at record highs relative to the earnings of the companies that they represent. In the parlance of the business press, the average price to earnings ratio is now about 25 to 1.
Anyone who is invested in the stock market– which includes about 43% of households if we count retirement holdings– ought to think about what this means.
Let’s walk through it for a bit. If we assume that this ratio is not going to go any higher, then stock prices have to grow at the same rate as earnings, or net profits. How fast can profits grow? In general, we would expect profits to grow at the same rate as the economy.
The economy is projected to grow at about 2% annually over the next decade. So that would allow for a 2% increase in the value of stocks. Of course, shareholders also receive dividends. The average dividend payout is currently about 2%. If we add this to the increased price of the stock, we get a total return of 4%.
How can shareholders earn more than this (as they have, for example, over the last three years, in which stocks have doubled in value)? There are basically two ways this can happen: first, the price of the stock can rise faster than profits, because people expect higher earnings in the future.
This can explain part of the bull market over the last 10 years. But major forecasters, for example the Congressional Budget Office, are actually predicting a decline in earnings over the next decade. And in any case the problem gets bigger– in the form of an overvalued stock market– each year that profits do not grow as fast as stock prices.
That’s how we got to the record PE ratios of today’s market. It is therefore not believable that investors are, on average, holding stocks with such low earnings relative to their value because they think that profits will be vastly higher in the future.
The other reason to hold stocks is if you think that their price will rise regardless of what earnings do. Keep in mind that investors can currently earn a real return (after inflation) of about 4% on a short-term government bond, with virtually no risk. So anyone holding stocks right now is betting that stock prices will rise fast enough to deliver a return that is much higher than the firm’s earnings.
In other words, we have a speculative bubble. Investors are holding stocks because they believe that other investors will continue to buy them and drive prices up. It must be assumed that a lot of big players, especially, are holding stocks in the belief that they will be able to jump before everyone else does.
This is not a game that I would like to play. The overwhelming majority of mutual fund managers cannot outperform the market, and they live and breathe its every move.
Of course the bubble does not have to burst– it could possibly deflate slowly. And in the short run, prices are determined by market psychology and are therefore very unpredictable. But sooner or later stock prices will have to fall into line with earnings.
When that happens, a lot of people are going to be disappointed. But it will be good for the country to rid itself of the unhealthy worship of the stock market that has spread like a virus during the last decade.
The run-up in stock prices has infected millions of people with a get-rich-quick mentality that was once confined to the most speculative traders on Wall Street. It has spawned the illusion that wealth is actually created in the ever-expanding casino of financial markets, when in fact it is merely redistributed there. And this redistribution is from the bottom to the top of the income ladder. All of the progress toward equality that had been made since World War II has been wiped out, and the $9 trillion increase in household stock assets over the last decade– most of which has occurred in the last four years– has certainly contributed to this reversal.
A return to normalcy for the stock market will also put to rest all these fantasy-based notions about privatizing Social Security. As Dean Baker of the Economic Policy Institute has already shown, the stock returns promised by the privatizers cannot be reconciled with their own assumptions about economic growth.
Thirty years ago if an investor got a 2% real return on bonds, and maybe two or three times that in the stock market, that was considered good enough. We were much better served by such a financial system, which was also a lot smaller than its bloated high-tech counterpart of today. The economy grew a lot faster, and unlike today, the gains from growth trickled down to the majority of the labor force.
That was before the upper classes decided that double-digit returns on their wealth was a hereditary entitlement. They won’t like to lose that entitlement, but they’ll get used to it.