The Bubble Is Beginning to Burst
The six-year bull stock market, matching our steadily improving economy, has added much wealth to stockholders. Common stocks, however, are extremely overvalued and the roughly 5% drop so far this month could be just the beginning of the long-overdue corrective bear market. The conclusion that stocks still are overvalued is based on the facts that prices of stocks are too high in relation to companies’ earnings and dividend yields are too low.
Our country has come a long way since July 15, 1979, when President Carter gave his famous “crisis of confidence” speech. Poor Carter suffered from one of the highest “misery” indexes: rate of inflation plus the rate of unemployment. The Arab oil embargo had driven inflation to a hyper level, causing the Federal Reserve Bank to raise interest rates to unprecedented levels, which caused widespread unemployment. Around that time, on Aug. 11, 1979, the Dow Jones Industrial Average was 750. That would have been the best time to buy stocks because they were so cheap by common measures. The price-earnings ratio of stocks was 9 and the dividend yield was 6%, compared with 21 and 1.7% now.
The tenfold increase in the stock market over the past two decades has, in Federal Reserve Chairman Alan Greenspan’s lexicon, created a state of “irrational exuberance.” I agree with him and believe that the conditions are ripe for a huge stock market correction. There are many factors supporting this conclusion:
* We have not had a correction greater than 10% since 1990 (because of the Gulf War), which in itself is a record. Twice before, the market has had a similar string of advances. One of those times ended in the crash of 1929, which gave us the New Deal and the beginnings of our welfare state. The second was the short-lived correction of 1987: The market dropped 36% percent in less than two months, but regained higher levels within one year. Most of today’s investors do not remember the grinding two-year correction of 1973-74. The stocks market gave up 45% of its value and it took a painful eight years to recoup that loss.
* Many analysts believe that things are different now because of low inflation and the fact that foreign competition in a free trade environment will keep wages under control. I disagree. The General Motors and United Parcel Service strikes show that labor wants a bigger piece of the economic pie created in our booming times. In 1987, many analysts pointed out that the then 22 price-earnings ratio for U. S. stocks was not really that high when compared with the 66 p/e ratio of Japanese stocks. The Nikkei average then proceeded to go down from about 40,000 to 15,000.
* The “wealth effect” of the rising value of stocks, added to the record high in consumer confidence levels, puts pressures on the price of goods and services.
* What additional good news is there to propel the market forward? The agreement to reach a balanced budget by the year 2002 is in place and the deficit is now approaching $36 billion. Everyone knows that the balance would have occurred earlier without the agreement and that the deficit will go up over the next few years. Does anyone remember that the deficit at the end of the Gramm-Rudman-Hollings plan was higher than at the beginning? Can today’s inflation and unemployment rates go lower? How much better can the good news get?
* The U. S. stock market has had little competition from other forms of investment, but it will not always be that way. Bonds, foreign stocks and U.S. real estate currently are less expensive than U. S. stocks. Precious metals, after their 10-year slide, are attractively priced.
* The booming world economy will put pressure on the price of commodities, especially petroleum, which with higher labor costs eventually will fuel a bout of inflation. Quote from Carter’s speech: “Beginning this moment, this nation will never use more foreign oil than we did in 1977. Never.” Oh yeah? Some unpredictable foreign event (conflict in the Middle East) will again demonstrate our huge dependence on foreign oil.
* Baby boomers investing in tax-deferred plans for their retirement are fueling this stock market boom. They are heavily invested in stocks because they have learned that stocks are the best investment vehicle. Although stocks are volatile, the boomers claim that they have the stomach to hold onto their investments through market declines. I don’t believe them. They experienced the short-lived ’87 crash but not many of them remember the long-lived one of 1973-74, when they were only twentysomethings.
Can’t we find some middle ground between a “crisis of confidence” and “irrational exuberance”? As students of the stock market, we cannot predict what it will do tomorrow. But each of us should study the past and be prepared through diversification to weather the storms that surely will come.
