THE STOCK MARKET: BUBBLE TROUBLE?
The subject of most interest to American investors is, of course, the stock market. The current economic expansion has been accompanied by and, in part, propelled by an unprecedented climb in stock prices. As of the March 24 close, the Dow Jones industrial average stood at 11113, up an astonishing 370% -- or more than 17% per year, excluding dividends -- from its October 1990 low of 2365, and up an even more astonishing 1330% -- or more than 16% per year -- from its 1982 low of 777. Broader measures of stock prices, such as the S&P 500 stock index, show similar levitations. The Nasdaq composite index has risen even more steeply -- it closed at 4963 on March 24, up more than 33% per year from its October 1990 low of 325.4. These increases are far greater than the historical rate of about 6% per year for large-company stocks, and it is natural to wonder whether the current lofty stock prices can be sustained. Is the stock market fairly valued, as many claim, or is it an unsustainable bubble that will eventually burst? To address this question, it is helpful to remember that -- when fundamentals are relevant -- stock prices depend mostly on two variables, company profits -- usually called "earnings" by the companies -- and interest rates. Typically, as one would expect, higher earnings lead to higher stock prices. Also, because stocks compete with bonds for investment dollars, when interest rates are lower, stocks are relatively more attractive than bonds as an investment, causing stock prices to be higher. A quantitative estimate of "fair value" for the S&P 500 index is provided by the "Greenspan/Yardeni" model of stock valuation, so named because it is a modification by Deutsche Bank chief economist Ed Yardeni of a model developed at the Federal Reserve, whose chairman is Alan Greenspan. This model says that "fair value" for the S&P 500 index is projected operating earnings for the S&P 500 over the next twelve months (as estimated by I/B/E/S International Inc.) divided by the yield on the U.S. Treasury 10-year note. This model provided a fairly good correlation for the price of the S&P 500 index for the years 1980 through 1998. The current estimate for 12-month forward earnings for the S&P 500 is about $60 per share, and the yield on the 10-year note as of March 24 was 6.17% -- or 0.0617 -- yielding a fair value estimate of 972 for the S&P 500 index. On March 24 the index closed at a record high of 1527, and according to the model was 57% overvalued.
Of course, the Greenspan/Yardeni model is not universally accepted as accurately predicting fair value for stock prices. Earnings estimates may be inaccurate, and some may believe that bond yields are either too low or too high. The model is largely empirical, and it can be argued from a theoretical standpoint that the model is either too conservative or too aggressive in its predictions. I believe that the model provides a useful semi-empirical framework with which to view stock prices, and in my view stock prices on March 24 were even more overvalued than the 57% figure given by the model, because I believe that we are nearing the end of the current economic boom and earnings will turn downward in the near future. I also expect interest rates to exhibit somewhat of an upward trend in the near term, largely because I believe that consumer price inflation will approach the four percent level by the end of the year. All of this means that the stock market would be ripe for a substantial downturn, perhaps of about 50%, which will probably begin within the next 12 to 18 months. Because of its more precipitous rise of late, the Nasdaq composite index is likely vulnerable to an even steeper decline.
(3/27/2000)
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NEW VERSION!
Portfolio To Begin 2000
Money Market Mutual Fund 60%
(T. Rowe Price Prime Reserve Fund)
"Short" Mutual Fund 13%
(Prudent Bear Fund)
Gold/Precious Metals & Minerals Mutual Fund 12%
(Fidelity Select Gold Fund)
Japanese Stock Mutual Fund 6%
(T. Rowe Price Japan Fund)
International Stock Mutual Fund 5%
(T. Rowe Price International Stock Fund)
Pacific-Ex Japan Stock Mutual Fund 4%
(T. Rowe Price New Asia Fund)
(Updated 1/9/2000. My apologies for the slight delay.)
Through May, the model portfolio declined by 1.5%, while the S&P 500 lost about 3% and the Nasdaq composite index fell 16%. The worst performer in the model portfolio was the Select Gold Fund, which lost 19.9%, followed by the Japan Fund, which slipped 15.8%. The international equity segments are all down for the year. The Prudent Bear Fund was the best performer in the portfolio with a gain of 10.3%. I continue to believe that the portfolio represents a desirable allocation going forward.
(6/2/2000)