Committee Of Correspondence

What is Wall Street Saying?

Robert Shiller
8:06 a.m.  Wednesday  7/24/96

The possibility that the stock market might be 40 percent lower in 10 years may seem eye-opening, but such an event is not uncommon in history. There have been 15 different years in this century in which the real value of the Standard and Poor’s Composite Index fell over 40 percent in the succeeding ten years: 1908-’12, 1937, 1939, 1965-’66, and 1968-'73.

Many people have been reacting lately to the fact, as documented by Jeremy J. Siegel in his recent book Stocks for the Long Run, that there is no 30-year period in U.S. history in which stocks have under-performed either cash or bonds. This fact is commonly taken as implying that stocks simply dominate the other investments. But note that the time interval that Siegel chose–30 years–is quite long. He was forced to choose a long time interval to make such a statement.

The 40 percent decline that I said is plausible is approximately the forecast of the real price decline in the next 10 years from a simple statistical model that I estimated, based on a price-earnings ratio. You can find the technical description of this forecasting model on my home page under “price-earnings ratio.”

Of course, the actual total 10-year real return from investing in stocks wouldn’t be as bad as negative-40 percent. With a dividend-price ratio of around 2 percent, the accumulated dividends might be expected to offset a good share of the losses.

James Glassman
8:45 a.m.  Wednesday  7/24/96

I am glad to see Mr. Cramer weighing in. He always has interesting things to say, and he’s now on the topic that my readers, at least, want discussed: What should I do with my money?

Mr. Cramer believes that we’ve already had a crash in tech stocks (by the way, the Russell 2000, an index of small stocks, has declined in 13 of the past 15 trading sessions–down 10 percent since the start of the month) but that larger companies, with an industrial or consumer franchises, will be buoyed. Investors are seeking shelter; they’re moving from stocks that seem to be riskier to ones that seem safer. But investors are already paying $37 for every $1 of Coke profits (about twice the market average). How high can it go?

This brings me to the question that I have been grappling with for the past year: If you hate this market, as I do, believing that it’s overvalued by any traditional yardstick and that it’s gotten so much good news that it’s forgotten what bad news (including political bad news) is, then what do you do?

Do you stay in, going along with Mr. Litan’s prescription of buy-and-hold? Do you get out, believing in Mr. Shiller’s 40-percent-drop scenario and the frightening Japanese example? Or do you hop from one sector to another, as Mr. Cramer seems to have been doing (or get someone like Mr. Cramer to do it for you)?

My own answer to this question starts with a belief that the market now has three tiers:

1. Vastly overvalued, “Silly Season” tech stocks, which are now getting their comeuppance. Cramer cites Iomega, the portable disk maker, which has dropped from $54 to $16 in two months, but still may have a long way to go: it was $6.50 on Feb. 2.;

2. Stocks like Coke and Gillette, which I call Thoroughbreds and which are wonderful companies but are hugely expensive;

3. And finally what I called “Branded Wallflowers,” that is, stocks like IBM, Citicorp and Merrill Lynch, which are strong companies with good names that have been shunned by the market and remain relatively inexpensive (for example, in terms of the ratio of their price to their earnings). I would continue to buy these third-tier stocks, expecting to hold them as long as Mr. Litan’s plane stays in the air, which I hope is forever.

Robert Litan
9:02 a.m.  Wednesday  7/24/96

Our moderator asks what can the Fed do, if anything, to moderate the consequences of market declines?

For starters, I think it is widely conceded that Greenspan played an instrumental, behind-the-scenes role in preventing the 1987 crash from having major macro consequences. Not only did the Fed pump up the money supply temporarily, providing liquidity to the market, but he and (then) New York Fed President Gerry Corrigan reportedly twisted the arms of major banks to lend to brokerage houses that had liquidity problems settling trades. Without the latter, it is quite likely that the crash could have brought some securities firms down, unsettling the markets further.

There seems to be no similar danger so far, at least from publicly available information. So no need for Fed arm twisting.

As to providing a temporary infusion of liquidity (beyond the normal, gradual increase in the money supply the Fed would make possible anyhow)–this is something the Fed can always do if it has to, that is, if the market tumbles sharply and suddenly (probably more than 200 points in a single day). And even, the Fed doesn’t necessarily have to actually add to bank reserves (by purchasing an extra dose of treasury bills). All it has to do is announce that it is ready to provide liquidity as needed; the announcement alone should be enough to calm people down. (Fed Vice Chairman Johnson did this in October 1989, apparently without Greenspan’s advance approval.)

But for now, the Fed and many private forecasters are projecting continued, although slower, economic growth in the quarters ahead. This should prevent inflation from accelerating and avoid the need for further tightening (which would be bad for stocks). Unless the market gets markedly worse and there are signs that investment is softening, I wouldn’t counsel a major change in Fed policy.

As for what the average investor should do, my advice remains unchanged. All depends on your time horizon. If it’s long like mine, then hold on tight and take some alka seltzer. If it’s short, move some money now held in stocks to safe assets. But I wouldn’t pull entirely out of the stock market, which is what you would do if you believe Shiller. (Of course, if everyone followed Shiller then his prophecy would come true, wouldn’t it? And I, for one, wouldn’t want that to happen.)

Herb Stein
2:02 p.m.  Wednesday  7/24/96

When I said that Shiller’s reference to a 40 percent drop in the stock market was “eye-opening” I didn’t mean to say that it was impossible, improbable or implausible. I meant that it was not what I had in mind before he said it. I don’t know whether most investors have that in mind either, because I have no information on what investors have in mind except what they do in the market. Since Shiller has a model from which he derives this estimate, perhaps he can tell us whether 40 percent is the most probable prediction of his model or only one within the range of “plausibility.” He points out that there have been 15 years in this century in which the real S&P Index fell over 40 percent in the succeeding 10 years. Is he suggesting that the chances are 15 out of 96? In many of the cases he lists, we can identify some powerful factors–war, inflation, political upset. That was why I was trying to elicit from the panel some hypotheses about events that might initiate a large decline.

Unlike some of the other panelists, Shiller does not offer us any advice about what to do. I can understand this and don’t want to press him on it, but since we seem to be so much in the advice-giving business I just want to say that we have room here for his.

As for Cramer, I think I hear what he is saying, but I don’t have any idea of his reasons for saying it. What makes him think that a certain stock or class of stocks has “bottomed” and others have not? What information does he look at to say things like that?

I keep looking for a “larger” meaning in all this, and I will ask you all about this one. Some of you are saying that earnings in the high-tech sector were grossly overestimated and the prices of stocks of that sector grossly overvalued. But there was a lot of stock issued by that sector at those valuations and the proceeds were invested in high-tech industries. Does the subsequent reaction indicate that that real investment was a mistake and that the nation’s savings would have been better invested elsewhere? Does this experience have any implications for the efficiency of the market in directing the flow of real investment?