Ignore the Bubbleheads: Invest with Vision
By Lawrence Kudlow
CNBC.com Contributing Editor
Following on the heels of Alan Greenspan's famously inaccurate "irrational
exuberance" stock market description first made in 1996 (nearly 100 percent
ago on the S&P 500, a virtual doubling), numerous gurus of the pessimistic
persuasion have echoed that same thought. A tulipmania, a South Sea bubble,
crash of '29, crash of '87, crash, crash, crash.
A couple of very self-important tenured professors from, respectively, the
people's republics of Cambridge and New Haven, have recently unfurled the
same banner of cynical gloom. Yale's Robert Shiller, using 10-year moving
averages of price-earnings multiples, believes today's stock market is still
substantially overvalued and therefore irrationally exuberant.
Ten-year P/E multiples are sort of like using a rotary phone to dial into the
Internet. But no matter, he's tenured. And the rumor is that it was Shiller who
first fed (force-fed?) Greenspan the now famous line.
Paul Krugman of MIT seems to believe that perhaps the stock market rally
contained some elements of rationality, but all that is over and George Bush is
wrong to propose stock market investment accounts for Social Security
because future market gains will never be as strong as past gains.
Call this future irrational exuberance.
Not to demean the judgement of these Ivy League dons, but there is a second
opinion, using a basic corporate finance analytic, developed years ago by
Arthur Laffer and Victor Canto as a stock market strategy guide, that suggests
the 1990s stock market advance was an entirely rational response to the
transforming effects of the information economy that raised capital investment,
productivity, profits and non-inflationary economic growth far beyond the
expectations of all the best and brightest experts.
A simple discount-earnings model that uses Baa-rated corporate bond yields to
capitalize corporate profits into a notional stock market value shows that the
bubble-heads have been wrong. Until very recently, both pre-tax and after-tax
S&P 500 earnings consistently outperformed the S&P 500 stock market index.
Only in the past five quarters has the S&P 500 index caught up to the
capitalized corporate profits measure. Indeed, it is this "catch-up effect" that
helps explain the steep 26.5 percent S&P 500 market rise since the end of
1998.
Right now, the stock market is right about where it should be. Not over-valued
or under-valued. In relation to the model of capitalized corporate profits (S&P
500 after-tax earnings divided by the Baa corporate bond yield), the market is
well valued.
The late winter jump in corporate bond yields to 9.2 percent from 8.2 percent
was the major factor in the so-called April/May massacre. That discount rate
rise, which lowered the present capitalized value of future S&P 500 profits,
generated a 5 percent peak-to-trough loss in the S&P 500 index. But
corrections come and go. Part of the game. Fortunately, bond rates are heading
down.
Since late 1991, when the cyclical business recovery really began, the S&P
500 has increased at a 17.1 percent annual rate of price gain. Capitalized
after-tax earnings for the index have increased at a 27.9 percent yearly pace.
As the market gradually caught up to earnings, outsized yearly market gains of
20 percent or more became commonplace.
To cynics, pessimists and other representatives of the Forces of Darkness,
these outsized gains looked like a bubble. But the Internet economy was taking
over.
Information technology contributed nearly one-third to economic growth in the
second half of the '90s. Technology investment, the driving force behind the
productivity surge, contributed roughly three-fourths to total private business
investment. Sometimes it contributed 100 percent to investment.
It is exactly this technology investment that paved the way for the surprising
strength in productivity-induced profits. A recent Commerce Department report
refers to this "capital deepening", where the ratio of the capital stock of
computer hardware to hours worked increased on average by 33.7 percent
annually during the late 1990s. Heavy capital investment in computer software
and communications equipment also occurred.
As a result, U.S. productivity unexpectedly boomed to a range of 3 to 4 percent
annually for non-farm and non-financial businesses, and over 6 percent for
manufacturing. This compares to a meager 1.5 percent annual productivity rise
over the prior two decades. Stronger productivity lowered business costs and
raised business profits.
Cynics sometimes called it the "profitless prosperity." Actually, it has been the
inflationless prosperity. As technologist Joseph Schumpeter accurately
predicted, periods of rapid technological advance produce more growth, with
greater productivity, at lower prices. Or, more money chasing even more goods.
Few people understood or anticipated the dramatic earnings increase that
worked in the 1990s to drive share prices higher and higher. It wasn't excess
liquidity bubbles, but profits. It wasn't tulipmania, but technology spillovers and
applications. It wasn't diminishing returns, but increasing returns. It wasn't
excess money supply, but large increases in money demand.
Right now the U.S. economy is in something of a stall, and so is the stock
market. Heavy Y2K-related consumer spending in 1999 was borrowed from
2000. Higher gasoline prices are throwing off a temporary tax-hike effect.
Federal Reserve liquidity withdrawals and interest rate hikes have modestly
raised financing costs.
But long-term interest rates, which are just as important as corporate profits in
determining future stock market values, perhaps even more so, are headed
down. Ten-year Treasury rates have dropped 80 basis points from their peak.
So have Baa corporate rates. These interest rate moves are slowly turning the
tide toward a more positive market outlook.
Meanwhile, market price indicators of lower future inflation suggest reduced
interest rates ahead. The TIPS spread has narrowed to two percentage points.
The slope of the Treasury yield curve is inverted. Gold is steady and the dollar
is strong. Monetary base growth created by the Fed and MZM transactions
demand in the economy are well balanced.
And let's not forget that the technology revolution is far from over. We've not yet
seen the full impact of the productivity-enhancing technology investment wave
on profits. The cyclical element of productivity and profits may temporarily slow,
but the long-term cycle is still intact.
In fact, it may well turn out that profits in the next year or two will continue to
outperform expectations, just as they have in the past.
The slowdown may not be so slow, and the recovery may be more robust than
experts believe. As the Fed tightening cycle comes to an end, the whole
interest rate structure will descend.
So capitalized earnings may continue to outperform. Ditto for the stock market.
Technology growth is the force, and technology stocks are the play. Big cap,
mid-cap, small cap. Technology growth is the play.
Value stocks won't get true value unless they develop a technology strategy.
This is the era of growth, not limits. Technology begets growth. And growth
creates value.
Let's leave the pessimism to certain precincts in Northeastern university towns.
Much better to keep the faith. Faith is always the spirit. |
