The Stock Market

Dear Clive:

       Hey, nice timing!
       The Economist does a cover story on “America’s Bubble Economy” urging the Fed to “raise interest rates now” in order to pop the balloon of a stock market filled with hot air. And what happens? Over the next week, the Dow Jones industrial average dropped 103 points–the first time the Dow was down in any week since Jan. 9–and then on Monday, to the great delight of all of you in St. James’, the Dow dropped another 147 points (or about 2 percent).
       But enough compliments. The truth is that, in arguing that “America’s economy is being inflated by over-valued shares,” the Economist is committing an act of hubris of the sort the Economist typically criticizes in others. Sure, markets overshoot and undershoot, but it’s wise to have a healthy respect for the judgments of tens of millions of people making pricing decisions based on mountains of information.
       You argue that “in part, America’s higher share prices are justified by genuine improvements in performance.” In part! But mostly not. You think that the notion of a “new economy” is overblown and that money growth is the main impetus for stock-price growth.
       It is a weird world indeed where a big increase in money only affects some assets but not others–apples but not oranges, stocks but not socks. The latest year-on-year increase in consumer prices in the United States is 1.4 percent. The producer price index for all commodities has fallen for the past four months. It’s now 2.5 percent lower than it was a year ago.
       How do we explain the fact that there’s too much money around, but it seems to be chasing some things and not others? Here’s a theory: The demand for shares of stock is increasing (and thus prices rising) because investors believe they are bargains–that their prices are low, not high.
       You think investors are wrong, I suspect, and so do others. But one thing I have learned about the market–and about individual stocks–is that at any time you can make good arguments about share prices going in either direction.
       For instance, I could say right now that Eastman Kodak stock will drop since Fuji Photo Film will be able to lower its costs thanks to the Asian crisis; I could also argue that Kodak’s management has been reinvigorated, has finally shrugged off its complacency as a result of the tough competition of the past few years.
       It’s the same with the market as a whole. Trying to predict its short-term (a few months to a few years) course is an exercise in futility and vanity. Its long-term course is another matter. We can make some judgments based on history: Over the past 70 years, a diversified portfolio of large-cap U.S. stocks has returned an annual average of 11 percent; over the past 190 years, an average of 7 percent after inflation. For periods of 20 years, the returns are remarkably stable–less risky, concludes Jeremy Siegel of Wharton in his book Stocks for the Long Run, than bonds or Treasury bills.
       The warnings about the market being overvalued are, frankly, getting a little old. I can go back three years and point to lots of Cassandras telling my readers to get out of the market (and perhaps persuading some). But since then, the Dow has risen 110 percent.
       If market timing were expensive merely for the market-timer, I wouldn’t worry. But it’s expensive for people who believe them, too. What I tell readers is to stay in the market for the long run (meaning at least seven years). Otherwise, you’re just playing roulette.
       Now for the controversial part: With my collaborator, Kevin Hassett, an economist at the American Enterprise Institute, I wrote an article in the March 30 Wall Street Journal that argued something is indeed changing with stocks–not because of a “new economy” but because of changing perceptions of risk by investors.
       For decades, economists have studied something called the “equity premium puzzle.” Why is it, they have wondered, that stocks return so much more than bonds? The answer seems to lie in perceptions of risk. In the long run stocks are no more risky than bonds (maybe less risky), but in the short run stock prices are extremely volatile. As a result, the theory goes, investors demand high returns from stocks to compensate for taking on risk.
       What is changing, we believe, is that investors are becoming–quite properly–less risk-averse. Hassett and I think that stocks and bonds should produce returns that are roughly the same, since the risk levels for the long run are equal. That means that stocks could be priced two to four times higher than they are today (yes, the Dow at 36,000 and profit-to-equity ratios of 50-to-100).
       I’ll get into details in a later letter.