The plethora of warning articles almost guarantees that there will be no big
crash this month.
TUESDAY OCTOBER 7 1997
Financial Times
"There is no cause for worry. The high
tide of prosperity will continue."
Andrew W. Mellon, 1928.
Andrew Mellon, one of the great
financiers of his era, had no doubts. Neither
did US president Calvin Coolidge, who told
Congress at the beginning of 1928 that they
and the country "might regard the present
with satisfaction and anticipate the future with
optimism". These views were the conventional
wisdom of their day. They proved horribly
wrong, all the same, when the stock market
collapsed. Today, with a bull market longer
and stronger than that of the Roaring 1920s,
the question must be whether so resounding a
crash could happen again.
The coming 10th anniversary of Black Monday
on October 19 can only sharpen anxiety.
Between September and November 1987, the
Dow Jones Industrial Average lost 29 per cent
of its value, much of this on October 19, when
it fell 23 per cent. As the chart shows, the rise
in the index since 1994 shows a remarkable
parallel with what happened in the three years
before the crash of 1987.
A deep bear market in the US must be the
biggest threat to today's bright picture of more
widely shared economic growth. Yet, in its
latest World Economic Outlook, the
International Monetary Fund merely
mentioned - rather than stressed - this
concern.
One reason for such insouciance could well
be what happened after the 1987 crash. The
Dow recovered its pre-crash levels by the
second half of 1989. Since then it has risen
more than 200 per cent in nominal terms.
Standard & Poor's Composite Index is also up
some 200 per cent over pre-crash levels. In
retrospect, the dramatic events of a decade
ago were but a brief hiatus in the bull market
of the past one and a half decades - a period
when real returns on holdings of US equities
have been roughly double their long-run
average of 6.6 per cent.
On a number of standard measures, US
equities were about as cheap in the early
1980s as at any time since the early 1920s.
There was room for a massive recovery. When
it came, it generated correspondingly huge
returns on equity investments. Over time, such
returns have come to seem normal. This has
encouraged more buying of shares, pushing
values up further. Equity investment is now
widely seen as offering a guaranteed path to
ever-greater wealth.
This is how markets come to blow bubbles.
Standard indicators suggest that Wall Street is
indeed overvalued. At such times, it is also
standard behaviour to argue that standard
indicators are meaningless.
On Standard & Poor's Composite Index, the
dividend yield is down to 1.6 per cent. This is
roughly half what it was in the 1960s and also
less than half what it was in the early 1990s.
But the dividend yield is not a fundamental
indicator of value. The price-earnings ratio is
far more suggestive.
According to Professor Jeremy Siegel of the
Wharton School, between 1871 and 1992 the
price-earnings ratio averaged 13.7. Now it is a
little under 24, close to an all-time high. Even
in October 1987, it was only 22. Over the past
120 years the price-earnings ratio has
oscillated between euphoric peaks of about 25
and depressed troughs of not much above 5.
Ultimately it has reverted to mean.
The only year since the second world war
when the price-earnings ratio was higher than
at present was 1992. That was the beginning of
the cyclical recovery, when the share of
corporate profits in gross domestic product
briefly dropped to 6 per cent. By the second
quarter of this year, the share was close to 10
per cent. This is not as high as in the
mid-1960s when it reached 12 per cent, but
well above its trough. The real return on
corporate equity, back at over 8 per cent, is
also up to levels not seen since the mid-1960s.
Combined with economic growth running at
around 3 per cent, the recovery in the share of
profits in GDP has generated growth in profits
of 10 per cent a year in real terms since 1992.
This recovery has underpinned the stock
market surge. Yet for anything like this to
continue over the next five years, the share of
profits in GDP must reach unprecedented
levels.
Another mean-reverting series is the valuation
ratio - or "Tobin's Q", after the Nobel-laureate
James Tobin of Yale University. This index
measures the ratio of stock market value to the
net assets of companies, at replacement cost.
When the ratio is low it is cheaper to buy
companies on the floor of the stock exchange
than to make investments. When it is high, the
reverse is true. A symptom of a high valuation
ratio is strong investment. This is precisely
what is to be seen, with growth in private
non-residential fixed investment of 8.5 per
cent a year since the second quarter of 1992.
Among the analysts that have placed
particular weight on the valuation ratio is
Smithers & Co, a London-based investment
adviser. Using a series produced by the
Federal Reserve, recently revised to give
lower values for the latest years, it points out
that the market is currently at close to 130 per
cent of underlying corporate net worth. This is
higher than at any time since 1920, double its
long-run average and about three times higher
than a decade ago.
Copious efforts have been made to argue the
message of the valuation ratio away. It is
suggested, for example, that economic growth
- and so returns on capital - will be higher than
previously or that intangible assets are more
important than before. Neither of these
arguments is compelling.
Nothing, for example, suggests that the
underlying growth rate of the US economy is
faster than in the 1960s. And if it were, it
should not alter this ratio. Moreover, even if
intangible assets have become more
important, the effect should have been an
upward drift in the ratio over a long period.
This has not happened. Instead, there has
been a big revaluation since the start of the
1990s. Analysts who argue that present
valuations are right must believe the market
was dramatically wrong for two decades. Why
should one accept the market is more reliable
now, at historically stretched valuations, than
when they were far lower?
There are two possible responses. One is that
historic benchmarks are now irrelevant. The
justification would be a glorious
transformation in the US economy - for which
there is virtually no evidence. This would then
be a brave new world. The other view is that
present valuations are hugely exaggerated. If
so, this would not be the first time recovery
from depressed values has generated an
overshoot in market valuations of the
underlying earnings and assets.
This is not a forecast. It is an observation.
What it does do, however, is indicate the
nature of the risks. Current valuations do not
mean the market will collapse tomorrow, next
week or next year. But the probability that
market valuations will halve over the next
several years must vastly exceed the chance
that they are about to double.
Indeed, if history is a guide, such a highly
valued market could tumble a long way. A fall
of two-thirds would not be unprecedented.
Impossible? Hardly. It may need only a brisk
rise in inflation and a correspondingly strong
response from the Federal Reserve to trigger
the change in mood. Mellon was wrong. Will
today's Wall Street geniuses prove any wiser?
[EMAIL PROTECTED]
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Regards,
Tom Walker
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knoW Ware Communications
Vancouver, B.C., CANADA
[EMAIL PROTECTED]
(604) 688-8296
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