Committee Of Correspondence

What is Wall Street Saying?

Robert Shiller
7:46 a.m.  Tuesday  7/23/96

Robert Litan likens the ups and downs of the stock market to the movements an airplane makes when it hits air pockets. I find this a strange analogy. An airplane has a pilot with sophisticated equipment who will make sure that, after any disturbance, the airplane will return to the correct altitude. With the stock market, who is the pilot? Are we flying at anything like the right altitude?

Mr. Litan seems to urge blind faith that, since the market has always outperformed bonds over very long intervals of time, it must always be a good investment. Trust the market just as you trust your pilot. But history shows that the stock market has under-performed bonds for periods even longer than a decade. Moreover, who is to say it could not yet do even worse than it has?

For another aviation analogy for the stock market, I think we should consider the story of synchronized flying teams, who stay in formation by following each other very closely. Thus, if the leader crashes, the whole formation crashes too. Now, add to this story that there is no leader.

The air-pocket analogy may be influenced by our last experience with a crash; after 1987 the U.S. stock market rebounded nicely. But history has other lessons too; the Tokyo market has not rebounded from its crash of 1989 to 1992. The U.S. stock market seems to be overpriced now, and this overpricing seems to be associated with exaggerated optimism for the economy. We appear to be flying at the wrong altitude, and a correction could be substantial and lasting. An enduring 40 percent decline in the U.S. market over the next five or 10 years is a plausible scenario.

Robert Litan
9:03 a.m.  Tuesday   7/23/96

Our moderator asks what we have learned since the crash of 1987, when despite the fears of many, the stock decline had little impact on the real economy. In particular, say this time stocks drop four times as much as they have already. Is there reason to expect the economic impact to be four times what we’ve already experienced?

The truth is no one knows. And even the 1987 crash wasn’t a good experiment, because as our moderator reminds us, stocks started recovering almost immediately after the initial plunge. The more relevant hypothetical is if stocks plunged this time and stayed down, somewhat like they did during the 1970s episode that Dr. Stein mentioned at the outset (and as Prof. Shiller appears to forecast).

In my last message, I gave a back-of-the-envelope that the stock plunge so far–assuming it is not quickly reversed–could shave roughly 0.2 percent off GDP growth. Make the plunge four times as large and sustained, and the wealth effect could knock 0.8 percent off GDP growth–a much more significant figure, especially when you consider that the Fed is doing its best to keep GDP growing no faster than about 2.2 percent (the potential growth rate of the economy). The difference between 1.4 percent and 2.2 percent is the difference between a stable economy and a “growth recession” (recession because generally any time the economy grows slower than the potential rate unemployment rises).

Of course, these estimates imply too much precision. Any sustained drop in stock prices would also dampen investment; so too, would the drop in consumption. So I could easily see a much larger impact from a sustained steep decline in stock prices than what could otherwise expect from what has occurred so far.

I, too, am somewhat puzzled by James Glassman’s argument that the latest correction is due to a sudden realization by market players that the Democrats will sweep the elections. For one thing, Clinton has had a big lead in the polls for some time now, and I find it hard to believe that the money managers who seemed to have triggered the latest price plunge have just suddenly discovered this.

At the same time, I am willing to concede that much of the run-up in stock prices in 1995 reflected the expectation that the Republican Congress would drive the federal budget into balance on some reasonable time path. But when the budget talks collapsed over the winter, the market confounded a lot of people (including me) by continuing to rise. It’s hard to credit the market’s faith in the Republicans after that, especially when they took such a drubbing in the polls for being so willing to let the federal government shut down. Stocks continued rising, apparently out of the belief that earnings would, too–not because of the market’s love affair with Republicans. By the same token, the fear that earnings growth will not continue, coupled with fears of rising interest rates, appear to be much better at explaining the recent stock plunge than any political explanation.

In fact, Prof. Shiller is so pessimistic that he sees another 40 percent sustained plunge for stocks. For that to happen, it seems we need another big jump in long-term interest rates and/or a big drop in earnings growth. I can see a slowdown in earnings as the economy softens, but that very softening is likely to moderate any move toward higher interest rates. So while I can concede the possibility of a further plunge in stocks, I would assign a small probability to a drop as large as 40 percent.

The reality is that I’ve given up trying to time the market. The best strategy for most investors still is dollar-cost-averaging, putting something in a little at a time, regularly, and letting the chips fall where they may. Over the long run, you’ll do better this way than investing in anything else.

If you have a much shorter time horizon, then sure, Prof. Shiller’s warnings should be heeded. Put a larger fraction–perhaps one-third to one-half of your portfolio in short-term bills, while keeping the rest in stock–if the recent and likely future volatility makes you nervous.

Finally, not to overkill the airplane analogy, we do have a pilot of sorts–Alan Greenspan. But the plane he pilots is nothing like the modern jet we’re accustomed to. It’s a Rube Goldberg device, with other players (Congress/the president), and oftentimes it has a mind of its own.

James Cramer
10:21 a.m.  Tuesday  7/23/96

Crash? We just had a crash. Now, of course, we are going through the usual re-testing. I think the speculative stocks have much further to fall; but I think we have seen a bottom for high quality names like INTC and MSFT (no plug intended, as you hate MSFT or something).

More important, I see a new method, a new prism of analyzing stocks. We have come to the end of the line for the “earnings expectations” model of making money. Momentum investing won’t work. Now what we care about is franchise, pricing power, monopoly. Those that have it will get great multiples. Without it, you can take the stock to zero for all I care.

Out with tech except for a couple of hallowed names. In with banks–who made terrific money despite a horrendous bond market, which everyone said couldn’t happen–and with natural gas/gas pipelines and oil drillers. Drugs, foods are just fine.

I know I am supposed to be more worldly/cerebral. But I’m in the business of calling bottoms. We have one, now for the Dow. NASDAQ–you are on your own.

James Glassman
10:27 a.m.  Tuesday  7/23/96

At its May meeting, the Fed pointed to the possibility of a stock market decline in the second half of the year as a restraint on economic growth–a reason not to raise interest rates right now. In other words, markets do affect the real economy. I think 1987 was an anomaly: The crash and the recovery were so close together that most investors had no time to react. A grinding bear market like 1973-’74, when stocks fell 42 percent over 21 months, would be something else entirely. Especially now.

In 1980, financial assets amounted to roughly twice the average annual income of an American family; today, the figure is three times. More and more of us have defined-contribution pension plans like 401ks, meaning that we can see every month or every quarter just where our retirement assets stand. When your Fidelity statement shows that your $200,000 nest egg is now worth $150,000, will you simply sit back comfortably and say to yourself, “Oh, not to worry. I know the market always comes back”? Or will you cut back your purchases and live more frugally? Or pull your money out of the market and help accelerate its decline? It’s not a pretty picture.

In the average bear market (we’ve had 12 since 1948), stocks have dropped 18.9 percent. From its high in May, the Dow is now down just 6.6 percent–or one-third of the typical bear-market decline. What will happen if the market keeps falling? The effect on households–and on the economy–could be powerful.

I am not so sanguine as Mr. Litan about the ability of Americans to continue flying if the turbulence gets really severe (though I think it’s a lovely metaphor). Also, in this regard, Mr. Shiller’s research is troubling: he finds that as the market rises, investors get more optimistic when history and reason should tell them the opposite. In response to the moderator: I am not saying that politics is always the main force that moves markets; usually, it isn’t. I just think that this time it’s helped speed the decline. Or, at least, I hope it has. An even more frightening prospect is that the market still hasn’t yet caught up with the political situation and there’s worse to come.

A final pessimistic note: I just checked the Russell 2000 average, which measures small stocks. It has declined on 12 of the past 14 trading days.

James Cramer
10:45 a.m.  Tuesday  7/23/96

My take is that other than redemptions, there really isn’t much pressure on the market. If you net out stock buybacks and the cancellation of stock offerings (which, despite the publicity that IPOs and secondaries are still hot, nothing, I repeat, nothing is getting done save Pharmacia and EDS, and both are AAA) you will find a very large reduction in equities this quarter. Also, the money flows into Gillette, Pepsi, Coke are extraordinary.

The paradigm is 1990. An oil shock plus a recession and a terrible decline in real estate resulted in phenomenal p/e expansion for Merck, Bristol, Coke. I think the same thing is happening now. The 1983-’84 IPO meltdown is being repeated. Tech reminds me of real estate in the 1980s. Got overheated.

I am not only betting that we will not have a crash, but that we are about to go much much higher. I am a buyer of IBM, INTC, PFE, GE, SLB as we talk.

Wealth effect? Doesn’t matter. No more than .25 percent GNP. Or else we would have seen a big decline already in 10-day auto numbers. My department store check indicates no real slowdown.

Keep an eye on the CRB. It’s collapsing. The market seems to be saying that Greenspan is about to tighten just when commodities, particularly lumber, plastics, and the now-phony copper, are plummeting.

That’s why Clorox, Proctor, Colgate are soaring.

Also, no crash: The speculators have been wiped out. Check out IOMG.

I know this is all very cinema verité for the academics in this discussion. But there is room for everybody.

Herb Stein
1:59 p.m.  Tuesday  7/23/96

Today’s submissions from our panelists raise many questions, and I shall refer to a few.

Probably the most eye-opening statement is Shiller’s that, “An enduring 40 percent decline in the U.S. market over the next five or ten years is a plausible scenario.” Of course, the word “plausible” does not necessarily imply a very high degree of probability. I have no reason to deny what he said, but I think our readers would like to know, as I would, why he chose this number. In the statement he submitted Monday he seemed to rely very heavily on the results of interviewing investors in the United States and Japan. Does the 40 percent figure emerge from such interviews? Apparently not. He says that, “The U.S. stock market seems to be overpriced now, and this overpricing seems to be associated with exaggerated optimism for the economy.” Is he saying that there is something about the economy that investors do not know but that they will learn and that will be a surprise to them, causing to change their valuation of stocks substantially? What kind of thing might that be?

The 40 percent figure is interesting because it is about the size of the drop after December 1972. That was a period of real surprises. The worldwide food shortage and the oil shock were surprises. The political turmoil connected with Watergate was a surprise. And so, I suppose, was the decline in the real money supply in 1974 and the rise in the high-employment surplus. I am not asking Shiller or any other panelists to forecast surprises. But it would be interesting to identify what might be surprises. Investors probably would not be surprised to learn that the economy is growing only by about 2.5 percent a year. And if Glassman is correct, investors have already had all the bad political surprises they can get and any future surprise would be good.

Litan says the magic word, “Greenspan.” That goes back to a question I asked in my opening remarks. What can the Fed do to shield the economy against the consequences of market declines? Everyone has agreed that the 1987 decline did not have a big effect on the economy because it was short-lived. But at the time many people thought it was short-lived because of something that Greenspan did. Was that incorrect? Could he do it again?

As for Cramer, I will offer a caution that I should have set forth at the beginning. There will be many words and acronyms that the moderator and at least some readers will not understand. Have mercy on us. I don’t know what IOMG is, and I am ashamed to admit what other acronyms I don’t understand. Also I don’t understand what is meant by saying that what we care about is “franchise, pricing power, monopoly,” not “earnings expectations.” Does that mean that “franchise, pricing power and monopoly” have value aside from the expectation of the earnings they will yield?