Will There Be a Day of Reckoning?
 
 
 

    A few nights ago, I mentioned that Microsoft had made 9.4% on their cash last year. Re-reading it, I learned that that was true, but misleading. Microsoft's target is about 4.5%, but 2001 was a bumper year for bond returns.

The Stock Market Can Only Rise Faster Than 1.4% per Year Through Price Inflation
    The output of all the companies in the United States must surely be closely related to its Gross Domestic Product (GDP). It's probably almost the case that the total output of all the companies in the U. S. is the GDP. So the output of all the companies in the U. S., measured in dollars, must increase each year at roughly the same rate as the GDP. The inflation-corrected GDP rises at, typically, 1% to 3% per year during times of economic expansion, and may, I believe, go slightly negative during recessions. Its overall average over the past century is, I think, the 1.3% or 1.4% per year that Harry Rood has suggested for the inflation-adjusted average rates of rise of the DJIA and the S&P 500. And it's that--the link to the underlying economy--which provides an independent standard of valuation for the stock market. The most important consequence of this link between the total value of all the stocks in the U. S. and the U. S.' Gross Domestic Product is the fact that the  total price of U. S. stocks should rise at only the glacial rate at which the GDP rises. Any time it rises faster than an inflation-adjusted rate of a few percent per year (and that only when the GDP is rising at an inflation-adjusted rate of a few percent a year), it is accomplishing this by inflating beyond its current level. It's also worth noting that the inflation is exponential rather than additive. The stock market has to inflate faster and faster to keep up any given rate of rise (e. g., 20% a year). It's like a drug addict requiring more and more to get the same high.)

The Fed's Formula
    In 1997, when the stock market began to go beyond its historic limits, I became concerned and tried to find out why. A few months later, Alan Greenspan expressed his concern about the overvaluation of the stock market, labeling its excesses "irrational exuberance". It wasn't long afterward that the Federal Reserve presented its formula relating the "earnings yield", which they defined as the reciprocal of the price/earnings ratio, to the yield on the 10-year Treasury bond.

    At the time, in spite of Dr. Greenspan's earlier warning of "irrational exuberance", the two yields were about equal, suggesting that Dr. Greenspan had changed his mind, and now found the stock market to be fairly priced. That  allayed my concerns about the stock market being overpriced. If the Fed said it was OK, that was good enough for me.
    Apparently, the rest of the investment community also accepted the Fed's new formula as the metric by which equities would now be valued. We would quit worrying about dividend yields and book values, and would rely instead on this formula that related interest rates to corporate earnings.
   By March, 2000, the earnings yield on the S&P 500 hit 3%, which, I'm sure, implied that stocks were very overpriced, even by the new  standard of comparing earning yield with the yield on the 10-year Treasury bond. . Unfortunately, I wasn't paying attention at the time.
    Of course, what counts is not whether I think the stock market is overpriced, or even, perhaps, whether you think the stock market is overvalued. It's what the investment community thinks about stock valuations that sets their prices. However, by relying solely upon the price-to-earnings ratio of the overall stock market indices to set fair market value for stocks as a whole, corporate earnings could reasonably be expected to become a target for manipulation and "window dressing". That must have been aggravated by the stock option accounting rule that allows corporate executives to become extremely rich by elevating the earnings--and therefore, the prices--of their stocks. Lowering dividend yields was one way to enhance earnings, and dividend reduction rapidly spread throughout industry. During the latter 90's, this must have seemed like the best of all possible worlds. Everyone got richer--on paper. However:
    On the flip side of the Fed formula is the fact that the Fed rule spells trouble for the stock market if the interest rate on 10-year Treasury bonds rises. And the current forecast is that rising rates are expected beyond 2004.
    Of course, this projection can be blind-sided by the unexpected.
    If I can arrive at this, so can many, many others. It will be interesting to see whether the current doldrums in the stock market is a transient thing on the way to the bull market of 2004, or whether it reflects a growing awareness that the stock market is very richly priced.
    I suspect that a day of reckoning must sooner or later arrive. Time will tell.