Trillion-Dollar Question: How High Can Stocks Go?

John J. Raskov, a director of General Motors, a close associate of the Du Ponts, Al Smith’s choice for chairman of the Democratic National Committee, upon taking ship for Europe on March 23, 1928, sent the financial market into a wild upward spiral by his suggestion--there was some dispute about his actual words--that General Motors stock should be selling at 12 times earnings.

The price/earnings ratio of the stock is one of the fundamental determinants of its value. Multiplying the price of a share of stock by all the stock outstanding produces the total value that the stock market places on a company. Dividing that total value by the company’s actual earnings produces a measure--the price/earnings ratio--of the enthusiasm with which investors regard the company’s prospects.

A price/earnings ratio of 12, in Raskov’s day, was astoundingly high. Investors were, in effect, willing to pay 12 times what the company earned to own a piece of the enterprise. At the dizzy heights of 1929, price/earnings ratios hovered around 15. Since 1950, they have averaged about eight, and much of that time were as low as five or six. Today they are about 17.

The rise in stock prices in the last five years has been nothing short of phenomenal. Since 1982, the Dow-Jones Industrial Average has tripled from about 900 to a brief burst through the 2,700 level in late August, a compound growth rate of 25%. The market has seesawed nervously since, plummeting through 2,500 as gusts of anxiety sweep through Wall Street and quickly bouncing back when braver spirits prevail.

The first burst of market growth was driven by the new breed of corporate raiders, led by the likes of T. Boone Pickens, who decided that U.S. stocks were seriously undervalued. In the acrophobic atmosphere of a 2,700 Dow, it is hard to remember the long, tenebrous 15 years when the Dow was mired in sub-1,000 swamps. The Dow-Jones Average in 1965 was 911; in 1968, it was 906; in 1970, only 753. The market crept back over 800 by 1975, scraped 900 level again in 1980 and ended the 1982 recession stock ignominiously at 884.

In a high-inflation economy, putting money into the stock market was worse than stashing it in a mattress. Pickens’ insight was that stock prices of major oil companies were so depressed that, in effect, oil companies were for sale for less than the price of the oil they owned. Borrow money, buy the company, sell the oil, pay off the loan and turn a handsome profit. The leveraged buyout was born, fortunes made and the sudden presence of so many enthusiastic buyers, for companies of all kinds, created a momentum that has been driving the market ever since.

The question is whether the recent giddy market heights are too high? Is there a 1929 crash on the horizon? Anyone sure of the answers to those questions would, of course, be too busy getting rich to write columns. There are, however, some unusual features of the current economy that indicate the market may not yet be overpriced--but others are rather more worrisome.

The key fact in the current economy is that capital markets are now global, and the United States is still far and away the best place in the world to invest money. More than $100 billion a year is flowing into Wall Street from Europe and Japan, driving down interest rates and pushing up the stock market.

The investment markets in Japan underscore America’s attractiveness. U.S. price/earnings multiples look high at 17; but multiples on the Japanese stock market have been at about 60, the result of too many Japanese investment yen chasing too few investment opportunities.

No other country permits the free flow of capital or free-for-all creation of financial instruments as the United States does. Limiting investment channels open to Japanese citizens allows the government and major banking institutions to keep closer control over the direction of investment but creates bursting pressures for chronically over-saved investors to send their money elsewhere.

West Germany, the world’s other major industrial economy, has always been nervous about foreign investment inflows. The hyperinflation of previous generations left deep scars on the national psyche. Big as the country is, it is still too small to open itself up for an untrammeled flow of international funds without losing control of its own economy.

Investors will be wary for years of countries like France, with its on-again, off-again socialist experiments in nationalizing key industries. There are many reasons, in short, to be concerned about the level of foreign investment. One of them is not that it can disappear overnight.

There have been structural changes in the United States. Legislation to ensure adequately protected pensions, passed in the 1960s, has required corporations to build enormous pension investment funds that now total about $500 billion, all of which must be invested to earn the returns to fund future pension obligations. Not incidentally, tiny shifts in pension fund investment fashions can cause apparently enormous day-to-day swings in market prices. Modern markets provide treacherous footing for the small investor.

The final good news is that real after-tax returns on investment in the United States are probably still the best in the world, particularly with the recent tax reform. Buffeted by recurring recessions over the past 15 years, U.S. companies are lean, keeping tight control, for example, over inventories. Even with moderate economic growth, a much higher percentage of the sales dollar falls to the bottom line.

The most worrisome feature of the current picture is simply that, after a five-year boon, the U.S. financial services sector appears badly overextended. There is, for instance, at least $20 billion in leveraged buyout funds chasing companies’ stock, although with market prices so high there are few bargains left and deal terms become riskier and riskier.

To compete for the fees that buyouts bring, the big Wall Street investment houses are increasingly investing their own funds in deals. A major reversal-- a big leveraged buyout deal going into the tank, for example--could act like a financial thrombosis. It is easy to visualize a string of two or three such events--a left-wing revolutionary government in Brazil repudiates all bank debt--that could send money fleeing for mattresses and gold bars and pitch the markets into a plunge as steep as a stock broker’s leap from the 60th floor window.

There are good reasons for the recent run up in the markets. But no one knows whether the right level for the Dow is 2,700, 1,500 or 3,000. The fundamentals appear at least modestly positive but to the degree that positive psychology brought the market to its current heights, a shift in that psychology, at least in the short term, could drive the market far down indeed.