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Well, maybe -- and maybe not.
Consider the market's
price-earnings (PE) ratio. The PE compares a stock's price with the company's earnings
(profits) and is a basic tool of financial analysis. At the end of July, the PE for the entire
S&P 500 group of stocks stood at almost 27: stocks were priced at 27 times their companies'
recent earnings. That's nearly twice the historical average of 14.5 going back to 1870,
according to finance professor Jeremy Siegel, author of "Stocks for the Long Run." Stocks
supposedly represent the present value of all future profits, so today's astronomical PE must
mean that either (a) despite the economic slowdown, the long-term outlook for profits remains
strong, or (b) investors are collectively crazy -- the market will drop or stagnate for years
because stock prices have gotten way ahead of profits.
Of course, most investors hold
firmly to (a). If they didn't, the market would be lower. Inflows to stock mutual funds,
though down from last year, remain healthy: $47.5 billion for the first half of 2001. Many
investment professionals feel similarly. One survey of investment newsletters classifies 46
percent as "bulls" and only 28 percent as "bears." Just last week, respected stock
strategist Abby Joseph Cohen of Goldman Sachs told CNBC that the worst is over for the economy
and the market. But this reassuring consensus has some notable dissenters.
"I am still
skeptical that an economic recovery is just around the corner and that The Bottom [of the
market] has been made," writes Barton Biggs, a senior investment strategist for Morgan
Stanley. "It strains credulity that so gigantic a speculative boom dissolves into so mild a
bust that almost everybody goes happily on their merry way again."
If Biggs is right,
the economy could lose one of its last shields against recession -- consumer buying. Though
increasing less than in 2000, it has cushioned the fall in business investment spending.
Consumer spending has in turn been buoyed by huge realized capital gains, after-tax profits on
stocks actually sold. In 1995 they totaled $140 billion, equal to 2.6 percent of disposable
personal income, say economists at Goldman Sachs. By 2000 they'd exploded to $534 billion,
equal to 7.6 percent of disposable income. A lower stock market would ultimately squeeze this
source of cash and, almost certainly, weaken spending.
So who's right about the
What's incontestable is that the PE has broken out of its historical range.
"Until five or six years ago, anything above 24 or 25 was considered absolutely shocking,"
says David Blitzer, chief investment strategist for Standard & Poor's. But in the late 1990s
the PE for the S&P 500 regularly reached the high 20s or low 30s. By Siegel's figures, it hit
a record 34 in early 2000. Some of the rise represented speculation. Stock prices were bid up
to phenomenal levels even when companies had puny (or no) profits.
The simplest theory
for today's high PE is that the speculative spirit survives. People continue to believe --
setbacks are temporary; the New Economy promises a gold mine. Microsoft's present PE is a
lofty 48, Intel's 41. Who knows what's right? It's impossible to say what the market PE
"should" be, because that would require knowing future profits, inflation and interest rates
(bonds and bank certificates are rival investments). No one knows any of these
Siegel attributes the market's high PE to a series of changes that, he argues,
have made stocks less risky to hold: (a) Recessions have become less frequent and milder,
meaning less disruption of profits; (b) capital-gains taxes -- now generally 20 percent -- are
the lowest since 1941; (c) the costs of buying and selling stocks have dropped; and (d) low
inflation may make stocks more valuable because inflation-induced price increases aren't
taxed as capital gains. "When you add all these up, I think a PE in the low or mid-20s is
justified," says Siegel. "But that doesn't mean it couldn't go back to 15."
a high PE ultimately requires strong profits -- and this implies a speedy economic recovery.
Stock PEs often rise in an economic slump, because investors assume that profit declines will
quickly be reversed. Well, there's plenty to reverse. Profits are dismal. The official
figures come from two sources: the U.S. Commerce Department and company reports. By the
Commerce numbers, profits have dropped 11.8 percent since peaking in the third quarter of
2000. But these figures don't include one-time write-offs and cover only the first quarter of
2001. A Wall Street Journal survey last week of 1,138 company reports for the second quarter
found that profits -- including write-offs -- were 67 percent below those of a year
"Businesses won't stop cutting jobs and capital spending until profits stop
falling," says Mark Zandi of Economy.com. Like most forecasters, he expects a revival by
year-end. Lower interest rates, lower energy prices and the tax cut should restore confidence
and spending. Should this fail to occur, present market values will almost certainly qualify
as another "bubble." It's also possible that the drip, drip, drip of bad
corporate-earnings reports will slowly drain investors' confidence and spontaneously depress
the market -- and the economy. Alan Greenspan likes to say that a bubble becomes obvious only
with hindsight. But even now the market is providing an impressive imitation.
2001 The Washington Post Company