October 28, 1999
Fort Lauderdale Sun-Sentinel, October 28, 1999
Knight-Ridder/Tribune Media Services, October 26, 1999
Las Vegas Review Journal, October 29, 1999
October has often been a hard month for the stock market. Maybe it’s something about the impending cold and desolation of winter that dulls the animal spirits of Wall Street’s bulls. October 19, 1987 was the worst one-day plunge in the market’s history, with the Dow falling by 22.6% percent.
And then there was the Big One: October 24, 1929, the crash that set off the Great Depression. Although World War II finally ended the Depression a decade later, it wasn’t until 1959 that the stock market regained its 1929 value.
You can’t discount irrationality or superstition here, because the universe of the stock market is swimming in self-fulfilling prophecies. If enough people– especially those who can move large amounts of money– believe something is true, it doesn’t matter if it’s as dumb as a pet rock. It will become true when they start selling– or buying– according to their belief.
For a while, at least. On the upswing, there is a limit to what psychology can sustain. People will certainly continue to buy as long as they think the market is going to rise, and of course their buying will push prices up. But eventually there has to be some relationship between the price of stocks and the potential earnings of the companies that they represent.
That relationship appears to be seriously out of whack right now. The ratio of stock prices to earnings is at about twice its historic level. Meanwhile, corporate earnings growth has been nearly flat, after adjusting for inflation, over the last two years.
The long-run arithmetic is compelling. If we assume that today’s record price to earnings ratios aren’t going much higher, then stock prices can only grow as fast as earnings. Since earnings (profits) do not, over the long run, grow any faster than the economy, we are looking at capital gains of about 2 percent annually. Add in the current dividend payout of about two percent, and investors will be lucky to get a 4 percent rate of return on stocks over the coming decades.
The current real return on an inflation-indexed US treasury bond– on which the interest and principal is guaranteed– is about 4.1 percent. So the only reason to hold stocks right now, rather than bonds, is if you think that the bubble in the stock market is going to get bigger. And you can sell before it bursts.
A new study by M.I.T. Professor Peter Diamond confirms this analysis, which was first put forth by economist Dean Baker in a policy paper two and a half years ago. Diamond notes that in order to earn its historical 7 percent real rate of return, the stock market would first have to fall by about 50 percent. Diamond’s analysis is that of a cautious academic, who is one of the nation’s leading macro-economists– not a Wall Street guru trying to forecast for investors the ups and downs of the stock market.
The paper was issued a few weeks ago by the Center for Retirement Research at Boston College. Both Diamond and Baker have addressed the question of stock market returns in order to correct an error in the national policy debate over Social Security– namely, the assumption by Social Security’s Trustees that the stock market can be expected to generate a 7 percent annual rate of return over their 75-year planning period.
Interestingly, the White House has now announced that it will shelve its proposal to put 15 percent of the Social Security Trust Fund in the stock market. This is a good move, and it is more than likely that the President’s advisors had a glance at Professor Diamond’s paper before making this decision.
Meanwhile, there are other pressures bearing down on the stock market: fears that the Fed may raise interest rates next month, or that a falling dollar may cause foreign investors to dump U.S. stocks.
Japanese investors, in particular, know what a stock market bubble looks like. At the end of 1989 their Nikkei stock index hit 38,900; nearly a decade later it is still down by more than half, at 17,650.
The market may well get through October and even the last winter of the 20th century without any major disasters. But the millions of people who recently put retirement savings in the stock market, after being assured by investment counselors that stocks cannot possibly under-perform bonds over the course of several decades, may well end up with a stomach ache they never bargained for.