Back to Stock Price Inflation
I'm again led back to the fact that the stock market is severely
inflated. Many small investors may not realize this, having never been exposed
to absolute yardsticks of stock value, but we know otherwise. I get the impression
that it's going to be "business as usual".
Let's revisit that absolute yardstick. I just finished reviewing
the performances of Fidelity's Select Funds. The past 10 years look absolutely
smashing, with the S&P 500 slightly more than quadrupling. You can see
how people would look forward to "business as usual". It's hard to believe
that most of that rise was a result of stock price inflation. So let's take
a stroll down Wall Street and find out how much of what was which.
Consumer price inflation between early 1992 and early 2000
was about 1.23. Dividing 11800 (the Dow in early 2000) by 2900 (the Dow in
early 1992) yields 4.07 for the rise in price in the Dow over the eight-year
period. Dividing this by 1.23 to get the inflation-adjusted rise in stock
prices, we have 3.31 for the inflation-corrected increase in stock prices.
If we divide this by an assumed 1.3% long-term rate of rise for the inflation
adjusted Dow, we get a stock price inflation of about
3-to-1 over the eight-year period. Since this period started
when the stock market had already experienced an eight-year run-up from
its bottom in 1982, prices were about in the middle of their ranges,
with a 1990 Dow value of 2600, a P/E ratio of 15.3, a dividend yield of 3.9%,
and a book value ratio of 1.98.
In other words, in early 1992, stock price inflation was
already about twice what it was at the 1982 bottom.
Another way to assess this situation is to look at the Dow
at its bottom in 1982 (776) and at its peak in early 2000 (11800). The ratio
of top (11800) to bottom (776) is 11800/776 = 15.21. The ratio of consumer
price indices is given by 516/289.1 = 1.784. Dividing 15.21 by 1.784 gives
8.52 as the inflation-corrected ratio of the DJIA iat its top in 2000 divided
by its bottom value in 1982.. Part of that rise can be attributed to the long,
slow advance of the DJIA over time.... specifically, about 1.3% per year
for 18 years. This yields a factor of about 1.27.. Dividing 8.52 by 1.27
produces a stock-price inflation factor of about
6.7. (Actually, from 1995 through 1999, Gross Domestic Product
increased about 4% per year, so the rate of rise of the Dow may have legitimately
been more than 1.3% per year during the nineties.)
Wow! That's a lot of froth!
What the Experts Say
There must be cogent arguments why the currently enormous
stock price inflation (presently about 5-to-1) is justified. On the other
hand, our most respected analysts of the nineties--Abbe Joseph Cohen, for
example--were telling us how things weren't overpriced in the nineties. Money
Magazine has an article in its current issue about "The Worst Analyst Ever?"
It then proceeds to tell how "Analyst Jack Grubman earned $20 million a year
while he spurred on the telecom craze. Now investors are paying the price
for his giddy vision." Mr. Grubman was the expert on telecommunications.
He used his charismatic poition as a dealmaker to help his firm (Salomon
Smith Barney) bring in $1.8 billion in telecom fees over a four-year period.
About him, it was said, "When Grubman said wonderful things about a company,
it was like a narcotic---everybody wanted it. He walked around like he was
a god. And it was perceived in the industry that he was a god."
So that's part of the picture. Is Salomon smith Barney repentant
about contributing to the dot.com bubble? Do you think they would refuse another
$1.8 billion if it meant another round of razzle-dazzle? How fastidious do
you think big brokerage houses, competing with each other for business, are
about avoiding great windfalls of money even when they might know that one
of these days, the music will stop, and there'll be a whole passel of suckers
(imprudent investors?) who will lose money in the stock market?
Both Salomon Smith Barney and Mr. Grubman have gotten to keep
the money they brought in during the nineties. Mr. Grubman must have about
$100,000,000, if he saved his income.
Just because everybody's doing it and financial analysts are
praising it doesn't mean that it's a wise idea.
Current Financial News
Financial commentaries tonight are observing that tech stock
prices are still overpriced. It's also stated that Alan Greenspan is
holding interest rates low even at the risk of inflation in an effort to jumpstart
the stock market. He's also concerned about the fact that the stock market
isn't rising, and signaling an upturn. In the meantime, the bond market is
milling around nervously, concerned about the possibility of renewed inflation
because the Fed is keeping interest rates too low too long. This also
suggests that Dr. Greenspan anticipates a rising stock market even
though he certainly has to know that the market is already very overpriced.
Right now, the stock market is treading water, even though it's pretty obvious
that there's a recovery underway. Can the pros be expected to keep this bubble
inflated? Is a suspicion that we're standing on thin ice over a crevasse
putting a damper on the stock market's recovery?
Predicting Recessions and Recoveries
Two economists have developed a
Long Leading Index (LLI) gauge
that attempts to predict economic turning points. Alan Greenspan is
said to be one of its fans. The LLI gauge is available only to large-institutional
subscribers, but there is information about this available free on their web
page. One danger they mention is the idea that an economic revival may bring
back the cheerleaders for the New Era , saying, "Hey we're back! The New
Era Economy lives." (The New Era refers to the idea that society was supposed
to be recession-proof. The Federal Reserve was thought to have the tweaking
of the economy so well in hand that it could control the economy without
more than a business slowdown. The good times would just keep rolling.) It
may have been thought that the stock market would just keep climbing, as
earnings continued to rise. I suppose the srgument was that as long as earnings
continue to iprove7% or 8% a year, stock prices could continue to rise 15%
or 20% a year. If you've abandoned all the traditional rules governing stock
prices, why not?
One analyst is predicting a Dow of 12000 by the end of 2002.
That would be almost three years beyond the March, 2000, pinnacle of
11800. Inflation would render it somewhat below the 2000 wavetop, although
a Dow of 12000 would look good in the headlines. As I've mentioned, it could
go to 13500 in early 2004 or 14000 in late 2004 through inflation alone.
Of course, the DJIA and the S&P 500 are masking the carnage
that took place in secondary issues, and especially, in technology stocks.
The NASDAQ is still below 40% of its year-2000 market top. (It drooped to
315 in October, 1990.)