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A Dow That Can't Fall to Earth? Dream On
As the Dow crosses 10,000, some Wall Street stock market promoters rely on
the New Economy to justify their claim that share-price growth far in excess
of growth in gross domestic product can go on indefinitely. They make me
very nervous. But before the rebuttal, let's concede what's new about the New
Economy. Mainly, it is more flexible and capable of faster, noninflationary
growth than most economists recently thought possible.
Why? One candidate is deregulation. Another is wage discipline. Another is
globalism. But the most important reason is technology. After a long lag, the
gains from information technology are finally showing up in the productivity
statistics. GDP growth rates in excess of 3% are not only thinkable but
normal.
We can all celebrate higher growth. But in the medium term, higher growth does not necessarily
translate into ever-increasing stock prices, especially when the market is already sky-high. Stock
prices reflect earnings and dividend growth, the rate of inflation, and expectations. Other things
being equal, higher earnings and lower inflation translate into higher share prices. But at a time
when dividend payouts are meager and earnings unspectacular, stocks are attractive mainly on
the expectation of capital appreciation.
PANIC SELLING. Today, the ''rational'' part of high price-earning ratios reflects low inflation.
The ''irrational'' part reflects the expectation that share prices will continue rising at exceptional
rates. Either factor, however, could go into reverse. Even with low inflation and a real growth
rate of 3%, there is nothing about the New Economy that justifies price-earnings ratios much
higher than their current levels, already near historic highs.
Recent reports of lower corporate earnings stimulated a brief sell-off. Even modest signs of
inflation would signal panic selling. In the past, despite the standard economic narrative,
inflation has only rarely been kindled by macroeconomic overheating of the sort manageable by
Federal Reserve intervention. The notable inflation of our time, in the 1970s, was a complex
brew of external shocks compounded by random accidents, cost-of-living escalators, and a real
estate bubble. Virtually nobody predicted OPEC's oil price quadrupling, much less that it would
combine with several years of crop failures and a sharp rise in medical costs. The high inflation
of the 1970s sent stock prices tumbling, and consumer savings defensively went into housing,
which only further spiked inflation. None of this was predicted or easily managed.
Inflation is less likely to accelerate in a deregulated economy, thanks to intense price
competition, but inflationary shocks are far from impossible--and could be quite damaging. The
higher the current multiples go, the more they are vulnerable to random events, which (by
definition) cannot be either anticipated nor capitalized in share prices. A few more years of the
stock growth we've enjoyed lately would send p-e ratios into triple digits. The motivation to
invest in stocks would then be exclusively based on expectations of still higher prices, since
dividend returns would be even more trivial than they are today. I don't know what this reminds
you of, but it reminds me of Japan. There, unsustainable share prices reflected a rigged system of
cross-ownership. In our case, though the ''market'' is speaking, rather than an old-boy network
keeping silent, the result is not dissimilar: a stock bubble.
Economist Dean Baker recently warned of what he called ''bull-market Keynesianism'': With
ordinary wage growth sluggish, much of today's prosperity reflects the wealth effects of high
share prices. People who own stocks feel prosperous, and they spend freely. But let share prices
fall, and you get economic contraction across the board.
Among their other odd side effects, stock market bubbles produce effervescent prophets of
permanent prosperity. Among the most inventive are James K. Glassman and Kevin A. Hassett
in their forthcoming book Dow 36,000. Their notion is that the risk premium of stocks relative to
bonds is irrational and that logically it should narrow to zero. For the real long-term yield on
stocks to equal that on government bonds, they calculate, the p-e ratio would need to quadruple
to about 100--which would put the Dow at around 36,000, ''tomorrow, not 10 or 20 years from
now.'' But surely there is a good reason for that risk premium. Stocks are riskier than bonds.
Have we forgotten even that?
The permanent-prosperity crowd also points to the optimism of individual investors as a positive
indicator. But this should be less than reassuring to the small fry. Historically, it's the little fish
who get swamped when the tide turns.
BY ROBERT KUTTNER |
