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To: Oeconomicus who wrote (4945)	6/2/1998 10:50:00 PM
From: Candle stick	Read Replies (1) \| Respond to of 164684

And another great article in Forbes this week, June 15th: forbes.com Don't kid yourself that stocks are not risky. They are trading at twice the price they are worth. The risks in stocks By Andrew Smithers IN THE PRECEDING story FORBES columnist David Dreman makes the argument for owning stocks now, even if you think a correction is imminent. The real risk, he says, is sitting on the sidelines and failing to keep pace with inflation. I don't buy it. U.S. shares are at least twice as high as they should be. The S&P 500 sells at 28 times trailing earnings, versus a norm in this century of 14 times earnings. You could justify a price/earnings ratio of 28 if profits were depressed and destined to rebound. But profits aren't depressed. They are abnormally high in relation to invested capital. As the return on equity is above average, the P/E should be below it. This is irrefutable unless you discard the laws of economics, which show that the cost of capital must equal its return. Being irrefutable does not stop denial. Large parts of Wall Street are in denial, since the livelihood of stockbrokers depends on bullishness. But if you talk to fund managers rather than to brokers-to people who make money by being right rather than to people who make money by being bullish-you get a different view. My colleague Stephen Wright, an economics lecturer at Cambridge University, has had discussions with fellow academics in American universities and with fund managers. He has shown that we now have enough data to test James Tobin's "q" theory, first propounded in 1969. Briefly, q theory says that the value of business assets-as reflected in stock prices must revert to the cost of replicating those assets. It makes sense. How long can Wall Street kid itself that a fiber-optic network is worth $2 billion when a new player can replicate it for $1 billion? The statistical tests show that q theory works and that the stock market today is as expensive as it has ever been, including at the famous peak of 1929. Showing that the market is overvalued enables you to predict its behavior. The tests show that the market has a 70% chance of falling over the next 12 months and a nearly 90% chance of being lower, in real terms, in ten years' time. Think about that. The chances are nine in ten that the stocks you hold today will be worth less in 2008 (in purchasing power) than they are now. Strong as the bearish case is, it is not something investors want to hear, nor that fund managers can easily use. You can't market a fund whose manager wants to sit on cash. This confronts fund managers with a huge conflict of interest. Should they look out for their own interests, or for those of their clients? If the clients understood that they had a 70% chance of losing money over the next year, they would probably wish to be liquid. But if fund managers go liquid, they have a 30% chance of being wrong and endangering their jobs. On the other hand, if the market goes down and takes investor money with it, the fund managers will likely go blameless because everyone will be in the same boat. All this provides an additional incentive for fabricators of theories about why the market is not really high. Most of these arguments are irrelevant or absurd. They are based on methods appropriate for valuing individual firms but inappropriate to the market as a whole. If a company can achieve an above-average return on its equity, it is worth a premium over its replacement value. The only debate is over how much longer the company can maintain those high returns. With the stock market as a whole, however, it becomes impossible to ascribe a huge premium to business assets, unless you make unrealistic assumptions about how much the stock of intangible capital has suddenly climbed in relation to the stock of physical capital. Today's stock market is a wonderful Lake Wobegon world, where all companies are above average. When it will end we don't know, but the odds are 90% it will end badly. Andrew Smithers is chairman of London's Smithers & Co., economic consultants.