Hey Drew,

I like and respect your work on Y2K. But several times you have chimed in that you don't think the stock market is overvalued at all; in fact, in your estimation it could (I'm speaking from memory) almost double from here and still not be overvalued.

This position has me completely baffled. Here are the points of my confusion.

1) Don't P/E ratios apply anymore? If so, then the market clearly is overvalued. If not, why not?

2) How can an economic growth rate of ~3-4% sustain a stock market growth rate of ~15% year after year? This is especially confusing when the companies represented by many of the highest flying stocks have no profits nor any prospects for profits.

3) Greenspan was on record a few years ago that Dow 6000 was "irrational exhuberance." Was he wrong then? If not, then isn't Dow 11,000 now absolutely insane?

4) J. K. Galbraith is also on record as saying that the Fed has allowed itself to get itself into just the same mess it faced in the late 1920s with respect to the market. Given that he is one of the foremost experts on the '29 crash, how do you explain his position vs. your own optimism?

I'm not trying to bait you by any means. I'm just totally baffled that someone so obviously knowledgeable and intelligent could hold what is to me a totally inexplicable position.

Thanks.

-- David Palm (djpalm64@yahoo.com), May 14, 1999

Answers

David,

Well, others may chime in, and their opinion could be as good (or better) than mine. But since you asked me, let me give it a shot:

1. PEs are not the only measure of valuation. In fact, by some measures of valuation, the market became overvalued in 1958- and has been ever since (that was the year bonds started yielding more than stocks- historically, it had been the opposite, because stocks were considered riskier investments than bonds, and hence needed a higher dividend to justify that risk). IMVHO, valuation is in the eye of the beholder. Barron's recently published a very interesting little tidbit, showing that if you subtracted the top 10 stocks out of the S&P 500, the PE of the S&P "490" dropped from something like 32 to 18 (I'm guessing at the 32 number, but I'm pretty sure the lower number was 18). That's not that far off a general historical norm.

In addition, the market swings over long periods of time from wildly undervalued to wildly overvalued. The market was *massively* undervalued in 1982; we have been simply correcting it since then. Valuation, IMHO, is not a timing tool; it's what might better be called a general background indicator (and even then, there are many different methods of determining valuation). A market can go overvalued, and simply get more overvalued for years on end. Eventually, of course, you pay the piper- but valuation alone is highly unlikely to tell you when that time will come.

2. Re the growth rate of stocks vs the economy: look at larger time frame. If I recall correctly, I *think* (emphasize on the word think) that the growth of the market, at least up until a year or two ago, roughly correlated with the growth of the economy since the mid-60s. Remember, the market went *nowhere* in the 70s, while the real economy, adjusted for inflation, was growing. So the market had some catching up to do. And don't go by the profit picture as a sole measure either. Profits were up 40% in 1994- and the market went sideways the whole year. By contrast, as I recall anyway, there have been profitless years when the market went straight up.

3. Greenspan was dead wrong, IMVHO, on that irrational exuberance remark. I felt so at the time at he said it. I just thought he was crazy. (A correction, yes, that was expected- and obtained in spring 97- but not "irrational exuberance"). Interestingly, the Fed (and other government authorities) are now much more likely than not quite concerned with not wanting the market to fall too much, since it could hurt consumer confidence (not to mention the so-called "wealth effect")- and that is considered key to Y2K right now. Quite a switch from "irrational exuberance" at 6400.

4. I didn't know Galbraith had said that, but if he did, he's just wrong, IMHO. There is, IMHO, *absolutely*no* solid parallel to now and 1929. I could write a literal book on how dead wrong I consider that belief; there are just an overwhelming number of factors to mitigate against it. The thing is, in bull markets, you get those kind of remarks. Heck, in 1955, the Senate actually held *hearings* on the "overvalued" stock market- the Dow had crossed 400 the year before (finally surpassing the 1929 high of 381). Well, it kept right on going, to 1000 in 1966. The market was unconcerned with the US Senate's opinion of its valuation.

Take Y2K out of the picture, & I'd say Dow 18,800- chip shot. Done deal. Even *with* Y2K in the picture, it's probably likely, but you can't put the guarantee label on it. My guess would be that the market will evolve and adapt, and get to its final price destination anyway, though by a different route. However, since Y2K's impact is quite clearly going to strongest internationally, and since the big cap stocks dominate this market and realize a significant portion of their earnings from international markets- well, now, that could pose quite the problem, couldn't it? Of course, we could see unusual rotations- ie, if Company ABC gets X% of its earnings from Country Blah, and Country Blah gets hammered with a Y2K recession, then ABC could take a hit. Whereas Company DEF gets *no* earnings of consequence from Country Blah, then money might flow from the stock of X to Z. Thus the averages might stay in more or less the same price area, while individual companies take price hits due to Y2K. The possibilities are pretty varied.

Take Y2K out of the picture, and I'd remain one of the screamingest bulls in the country. Unfortunately, Y2K has indeed reared its head. Interestingly, though, there is this point: this bull market will have one more vicious bear market within it before the bull trend resumes. It could be that Y2K will be the catalyst for that bear market; I don't know.

IMHO, there are five fundamental factors for this bull market:

1. Low inflation/price stability. Long-term global disinflation.

2. Declining interest rates (on a long term basis; personally, I think real rates are still far too high; we should see a dramatic decline in the next decade).

3. Baby boomers in their peak earning & spending years (can you say, "Reagan tax cut" - ? I knew you could :) The Ronnie $$ are going into the economy, and into the market.

4. The ongoing technological revolution (which, ironically, could bite us via Y2K). From mainframes to PCs to the Net to Net2, Net3 & videophones, smart appliances, etc etc.

5. The end of the Cold War (once again courtesy of Ron). A minor but noteworthy factor.

Anyway, that's my take. Of course, I could be wrong :)

-- Drew Parkhill/CBN News (y2k@cbn.org), May 14, 1999.

Drew, I think you are exhibiting something called 'hubris' in your options. If you can naysay Greenspan and Galbraith with one sweep of the hand then that seems to be a bit much don't you think? "IMHO" attached to you comments is really rhetorical in this case and quite the opposite of what you are expressing.

This is a bubble. S&P at 36 P/E is historically both unprecidented as well as unsustainable. Most people do not tolerate bear markets well and DO pull out with significant losses. P/E is a central marker for judging valuations. Valuations do not equate to prices. They are two different things altogether.

More later.

-- David (C.D@I.N), May 14, 1999.

Hi David,

I'm not super knowledgable about equity valuation methods and models, but I tend to agree with the view that the market is generally "overvalued". I always get a little skeptical when I hear the "It's different this time" mantra, or that there is some new world paradigm.

"A Short History of Financial Euphoria" by J.K. Gilbraith describes almost everything that is happening in the equity markets right now, and especially with regard to on-line trading and internet stocks. On page 51 of that book, he summarizes all of the factors that were in play at the end of the South Seas Bubble in 1720:

"All the predictable features of the financial aberration were here on view. There was large leverage turning on the small interest payments by the Treasury on the public debt taken over. Individuals were dangerously captured by belief in their own financial acumen and intelligence and conveyed this error to others. There was an investment opportunity rich in imagined prospects but negligible in any calm view of the reality. Something seemingly exciting and innovative captured the public imagination, in this case the joint- stock company, although, as already noted, it was of decidedly earlier origin. . .And as the operative force, dutifully neglected, there was the mass escape from sanity by people in pursuit of profit."

Over the long-term (50-80 years), stock market returns as measured by the Dow or the S&P have averaged around 10% a year, yet recently, we've had year after year of extraordinarily high returns. People now expect 25% plus returns on their investments and think that they will continue indefinitely, while P/E ratios have been driven to historically high levels. Furthermore, P/E's nowadays are based on FUTURE projected earnings and stocks are "Priced for perfection."

I could be completely wrong about the valuation of the market. But ya know what? I don't care. It doesn't matter to me if the Dow goes to 20,000 by the end of the year. My personal goal is to not lose money due to a very uncertain future - I got out of everything last year and it doesn't bother me a bit to be on the sidelines watching the market go up. If Y2K isn't so bad you can always get back in next year, but if you stay in the market and it turns out bad, it may be twenty years or more before you'll be made whole again (if you can stick it out that long).

It seems as though the public as well as the financial media (especially CNBC) have lost their perspective with regard to the financial markets. Preservation of capital is no longer a valid investment goal. Why should it be when you're almost guaranteed 25% a year forever?

-- Clyde (clydeblalock@hotmail.com), May 14, 1999.

David (CD),

Well, I could be wrong. Those were my concluding words.

However, people have been saying the market was "way overvalued" since 3000. It's still going up.

In every bull market, people talk about a bubble, a mania, etc. It's just my personal opinion that this isn't over. I could be wrong, as I said.

-- Drew Parkhill/CBN News (y2k@cbn.org), May 14, 1999.

Drew,

Well, since you are wearing your economist hat and not your journalist hat... I think I'll weigh in. Let's start with some reading:

http://www.dismal.com/thoughts/tpt.stm

Zandi frames the question, "What underpins our current strong economy?" Like any good economist, he finds the validity in both arguments. One, weak global markets have provided cheap foreign goods including petroleum. The 'flight to quality' by foreign investors has also fueled our bull market.

The second argument, "the productivity thing," is valid as well. I agree with Zandi, however, that productivity growth cannot be sustained at its current pace. Ultimately, our economy is all about productivity and profit. Profits are weakening and I suggest productivity will flatten.

It has been a long, wonderful run where all the U.S. economic stars have been in a positive alignment. The market is overvalued--by most methods around 20%. Of course, you can argue the "new paradigm," but I'd like to see Amazon.com actually make a profit first. (laughter)

Greenspan is scratching his head on how we can find the path of sustained growth... and avoid an overheating economy and subsequent popping of the speculative bubble. He is enough of an economic historian to know how quickly the wheels can fall off the wagon. Wage pressures will not stay dormat forever. Workers are increasingly aware of their value in a tight marketplace. At the first whiff of inflation, we'll see some money supply tightening. (And don't forget that some of our current good conditions have been fueled by a liquidity increase. Remember LTCM?). I cannot resist another Zandi quote:

"The liquidity squeeze has exposed just how quickly confidence in the U.S. economy, which is key to its astonishing performance, can come unraveled. This likely reflects a deep-seated concern that the economy and financial markets may not be on completely firm ground. Just how much of the current economic nirvana is real and long lasting, and how much of it is the result of just pure luck and raw speculation?"

I'm going to save 1929 for a whole other post, but I suggest you are both right and wrong. There are some interesting economic parallels, but often in unexpected places.

On your specific predictions:

1. On what do you base your prediction of continued disinflation?

2. Real rates are too high? Please explain this and how low do you think rates will go? By the way, how about your predictions for average annual growth in corporate profits, average annual inflation rate, average annual increase in the money supply and average annual increase in productivity?

Well, my lunch hour is only so long. Interested to hear your reponses.

Regards,

-- Mr. Decker (kcdecker@worldnet.att.net), May 14, 1999.

Drew,

Thanks for your excellent response. I appreciate hearing an intelligent argument for what appeared to me to be irrational exhuberance ("Call me Alan...").

Here's the quote from Galbraith: "There should have been far more warning about the speculative splurge on Wall Street and the extent of citizen participation. That was the mistake that the Federal Reserve made in the Twenties, and the mistake that it has made again now..." -Economist John Kenneth Galbraith, interviewed in the Observer, June 21, 1998.

One factor that is missing from your analysis that would interest me is the use of leverage to fuel the market increase. Your average American who is plopping money into an IRA or 401K is doing so using borrowed money. Not directly, of course. But with an average of $10K of consumer debt clicking along at 10+% interest and 125% of their house equity borrowed out for that new deck, they have no business going into the market with any money. That's a big domino that could easily topple if we see a serious Y2K market correction along with attendant recessional/depressional slowdown of the economy. Agree? Disagree?

-- David Palm (djpalm64@yahoo.com), May 14, 1999.

Drew,

Do you have any idea when/if the market will crumble as many have predicted? Will it be before the rollover? I've always stated "What goes up, MUST come down. BTW, I saw on a cable channel a very informative piece on a book company and it was totally overvalued. I admitt, when it comes to stocks, I'm lost. Only had a 401K once and lost it at layoff....Taxed me to death......Lol. Anyone else on predictions of when the bottom will fall out? Thanks.

-- consumer (private@aol.com), May 14, 1999.

Today, the CPI figures came out for April -- increase of 0.7% (> 8.4% annualized). By rule of 72, value of cash will decrease by 50% within 8.5 years. How would you guys factor that in?

-- A (A@AisA.com), May 14, 1999.

Well, folks, it's Friday, & I can't be here too long, but...

Clyde,

One point about your note on long-term average returns: remember, they are just that: *average*. That means some periods of higher to much higher returns, and periods of the opposite.

Mr D,

Why did I think we'd hear from you? :)

The problem with a lot of what you write ("How long can this go on?") is that many economists have been saying have been saying "It can't go on" for years- and it still is. I think because of the factors I mentioned above, primarily. The economic variables, well, vary :), so to speak (productivity, etc). This is a super-complicated subject, and I tend to be obsessive on detail, so I probably can't answer it succinctly.

Continued disinflation: let me ask this: what would stop this trend? What are the chances of re-ignited inflation? I say, functionally, zero (here we get into deep discussions of the root causes of the 70s inflation, which is wayyyyyy beyond the scope of this forum). No, I still believe that within 10, 10+ years we will indeed see actual consumer deflation. Demographics (aging boomers, less consumer spending) will play a part in that.

2. Why real rates too high? The bond market is still pricing in fear of the 70s inflation. I'd knock maybe another point off bills, definitely 2 off Treasuries. Larry Kudlow made a good argument for this point of view late last year; unfortunately, I don't have his paper around at the moment. Shilling, of course, agrees. If I told you my long term rate opinions/guesses, you'd think I'd lost it :) But, if we do get consumer deflation, then we'll get the rates which accompany it. Lowwwwwwwwwww.

Corporate profits, money supply, productivity, I don't do. I mean, I just don't follow them *that* closely. I look at things in terms of broad trends. Average annual inflation rate: declining from current rate, gradually, to negative post-2010 or so.

I will give you a (worthless) Dow prediction, though (it's worthless because we don't know the Y2K impact yet): Dow 16,000 by 2002.

David P,

My guess is the underlying economic strength will prevent that debt domino from toppling. Of course, when this boom ends, debt could become a pretty big problem.

Incidentally, hasn't Galbraith been predicting 1929 since about 1995? I'm not sure, just wondered.

consumer,

I have no idea when Y2K will hit the market, or even if it will, in the sense that many people expect. We may go through a period of gyrations (that's being expected in the industry, at least by some), but ultimately, I believe the market will simply price in Y2K's economic impact- earnings, future growth prospects, whatever. The market adapts. Of course, to know Y2K's impact on the market would be to know Y2K's impact on the economy- actually, on the world economy. That's the key question, and no one knows the answer- not that a lot of people aren't trying to figure it out. I read a story from, I believe, Australia, last year, where some economists just simply said Y2K could not be anticipated, because there were too many factors to consider. Without question, absolutely true.

A,

I think the inflation figures are a blip. Of course, a succession of equal numbers would prove me wrong. But, we've had both inflationary & more heavily-disinflationary periods since 1982. Today's figures are nowhere nearly enough to signal a change in trend.

-- Drew Parkhill/CBN News (y2k@cbn.org), May 14, 1999.

Oh, BTW, David C,

I don't consider it hubris to simply disagree with Greenspan, or Galbraith (don't tell me you're a left-winger like *he* is, are you?)

OTOH, reverse it- you are "naysaying" Yardeni, Cohen, et al- good people with good records- much better at predicting than Greenspan.

-- Drew Parkhill/CBN News (y2k@cbn.org), May 14, 1999.

Drew, you did say you were expressing your opinion. And you did say you could be wrong. Great!

Again, prices (what people pay) and valuation (what it is worth) are two different things. I really do not care what people are willing to pay for stocks today. That is relative to people's emotional state. What I am interested in is what the valuation (the practical worth) of the stocks are Vs. what people are willing to pay. By *_ALL_* historical measures of valuation today's market is completely overpriced in comparison to its valuation. Even Warren Buffett says that he can't find anything to buy in this market either in the USA or Britian. He's a value hunter and he's not buying, he's selling.

We could go on. Y2K is NOT factored into this market yet. Not when major financial firms are advising their major players to be out of the markets in Q4, 1999. Well, that means they will be exiting the burning theater in Q2 and Q3, 1999. Ya, the market is a bit higher right now and some well placed people have said its because money in running to the USA as a means of reducing exposure to Y2K in other nations. Like a wave it rises the ships.

So I suppose we'll see.

-- David (C.D@I.N), May 14, 1999.

David C,

One thing you learn when doing financial analysis is that you must do your own research, and develop your own conclusions. I have sometimes learned this very painfully. So, by this point, I have no problem disagreeing with anyone, because everyone (including if not especially me) is wrong at key times (Cohen missed the crash of 87, for instance, while Greenspan completely missed the recession of 90). So, I just have to go with what I think, unless I see factual reasoning which changes my mind (which is always open, so to speak). That attitude has carried over to Y2K, BTW- somewhat to the dismay of some, it appears.

I agree, that by most valuation measures, we are up there. The Fed/Yardeni model is around 20-30% overvalued now.

BTW, though, I seem to recall Buffett worrying publicly in 1997 that he couldn't find anything to buy at that time, either. That was around Dow 6500-7000.

-- Drew Parkhill/CBN News (y2k@cbn.org), May 14, 1999.

Oh, & I agree- Y2K is not priced into the market at present. But that's because no one knows what will really happen.

-- Drew Parkhill/CBN News (y2k@cbn.org), May 14, 1999.

Drew,

Ah, a wave of the hand and we dismiss the economists.... (laughter)

We have seen an unusual confluence of events, including U.S. demographics, that have created very high stock prices. As correctedly observed, the price of the stock may not reflect its value. At some point, the market will reach its equilibrium as judged by productivity and profits. Yes, the speculative bubble could last another decade... but I doubt it.

But, you have every opportunity to back your analysis with cold, hard cash. To maximize your gains, try long options. If the market does continue to soar, you'll profit handsomely. Of course, you could take money from a dolt like me who would wager inflation and interest rates will rise. (laughter)

Say hello to Jude Wanniski for me.

Regards,

-- Mr. Decker (kcdecker@worldnet.att.net), May 14, 1999.

Mr D,

Well, I'm not dismissing *all* economists (only those who disagree with me :) For instance, Yardeni, Kudlow, Cohen (not strictly an economist, I don't think), et al- it's all generally the same camp. There are others. Again, though, I just have to come back to the same point: so many have been negative when I believed it was such a great time to be positive. I have other reasons for my views, but I don't want to go into it all (I'm running behind anyway).

Dow 18,800 by 2009 (Y2K excerpted) has been my minimum target for a long time. And, think about that- that would be a significant slowing of the rate of upward momentum in stock prices from here on out. Less than doubling in 10 years, while we've *more* than doubled in the last 5.

One other point: I've had one very rough long-term model/road map of the market for some time. It called for around 11,770 by 1999 to 2001. That would be followed by a bear market, possibly steep. And then the last, great, glorious run to new, record-breaking measures of valuation :) Y2K would fit into that scenario very well (although of course I don't know if it will).

-- Low-inflation Drew :) (y2k@cbn.org), May 14, 1999.

I disagree with the "low inflation" claims. That only works if you take the CPI as the only indicator of inflation. But the classical definition of inflation is not "rising consumer prices" but "an increase in the money supply." As I understand, our money supply is increasing at quite a high rate (is ~10% right?). Where is the money going if not into higher consumer prices? Why, into the overvalued stock market, of course (you didn't convince me, Drew. Sorry).

Lower consumer prices are due to cheaper imports and a rotten balance of trade, not to any intrinsic strength in the U.S. economy.

So, the picture I see is high but masked inflation, terrible trade imbalance, overvalued stock market, enormous goonverment and personal debt. Just in time for Y2K...goody!

-- David Palm (djpalm64@yahoo.com), May 14, 1999.

David,

Well, I prefer to use the CPI, for a variety of reasons. The money supply correlation is way too iffy (it's been projecting high inflation for years- which has never happened).

If the market is overvalued now, why wasn't it overvalued in 1995, just above 4000? Back then, everyone *screamed* about valuation. In fact, they were doing so at 3200 - "most overvalued ever" etc, as I recall. But here we are...

-- Drew Parkhill/CBN News (y2k@cbn.org), May 15, 1999.