Visions, Not Bubbleheads
By Lawrence Kudlow
Following on the heels of Alan Greenspan?s famously inaccurate "irrational
exuberance" stock market description first made in 1996 (nearly 100% 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 ten-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 bubbleheads have been wrong. Until very recently, both
pre-tax and after-tax S&P 500 capitalized 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% 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% from 8.2% 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%
peak-to-trough loss in the S&P 500
index. But corrections come and
go. Part of the game. Fortunately,
bond rates are now heading down.
Since late 1991, when the cyclical
business recovery really began, the
S&P 500 has increased at a 17.1%
annual rate of price gain.
Capitalized after-tax earnings for
the index have increased at a
27.9% yearly pace. As the market
gradually caught up to earnings,
outsized yearly market gains of 20% 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% 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% 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% annually for non-farm and
non-financial businesses, and over
6% for manufacturing. This
compares to a meager 1*% 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
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