Semi-Daily Journal

My friend and I constantly discuss what exactly these high PE ratios are telling us. I do think there is another possible outcome, that instead of a crash the market may just not grow at all throughout the next decade as earnings may catch up with current stock prices.

There are some other important issues that this brings up:

1)If there has been a change in risk tolerance, what does that mean to the risk premium? Does this mean that average real returns oo stocks in the future be lower than 7%? (I believe it was Mehra who has a paper saying that the risk premium was an artifact of high capital gains taxes, and with the current low rate the premium may be gone)

2)What effect does the life-cycle savings pattern of baby-boomers hold for future movment in the stock market? I posit that a good deal of the run up in the market in the 90s was due to baby-boomers reaching their prime earning years and starting to save greater amounts for retirement. Along with the explosion of 401(k)s, more money than before flowed into the market, leading to the great increase in stock holding in the population. This gives a reason why the stock market won't crash since much of this money will stay in the market until baby-boomers approach retirement. Even if no new money is added, there will be a desire to avoid current paper loses instead of selling (especially given the low level of interest rates on bonds). And forgive me if I don't trust broad fund managers to move portfolios well. So what happens as boomers follow the typical advice and move from stocks to bonds in the next ten years?

As to dividends-Part of the reason I think ther has been a move away from dividends to stock buy backs is that capital gains are now taxed at a lower rate than income for most holders. Is this move related to the current accounting problems, since it is easier to fake profits in statements than to come up with funds to pay dividends?

There's a fourth real possibility (not necessarily inconsistent with the other three) to be considered, as per Prof. Baruch Lev of the Stern Graduate School of Business, NYU, http://pages.stern.nyu.edu/~blev/

This is that the accounting rules used to compute earnings are breaking down and producing unreliable numbers as business value derives ever more from intellectual assets and human capital, rather than from the tangible and financial assets that the accounting rules were developed to handle.

As one example, acquisitions of intellectual assets and human capital generally must be expensed, while those of tangible assets are capitalized, which produces quite a difference on the financial statements.

When IBM bought Lotus it paid $2 billion that was allocated to the technology it was acquiring. But under GAAP rules it had to write off the $2 billion as a charge against earnings with no resulting asset appearing on the books -- whereas if it had paid the same amount for land or buildings there would have been no reduction of earnings and $2 billion more of assets on its books.

The first result in such a case is that the price/earnings and price/asset ratios rise. There is no real reason for the stock price to go down since fair value is acquired in the deal, and earnings and assets are only artificially reduced.

But later there'll be an artificial swing the other way and earnings will be inflated, because when the acquired technology starts producing a return there'll be no depreciation charge against it -- since there's no asset carried on the books to depreciate.

For IBM itself this case was no huge deal because it is so big and well understood. But for a lot of smaller businesses in the wide range of industries that now get almost 100% of their value from intellectual and human capital, real whipsaws can occur in financial statements that investors don't understand. Even inside managers may be misled by the distorted numbers into misallocating resources and capital.

The overall result for these is that distorted financial statements no longer show clear trend lines to investors. When in an optimistic mood, investors can be enthralled by exaggerated up numbers, and when in a pessimistic mood scared off by exaggerated down numbers. It's easy to see how this can contribute to overshooting in both directions. Small, innovative, tech-dependent firms are affected with the most volatility and that's just where the bubble-and-bust was most extreme. (If reported earnings don't mean much, I'll give money to anybody ... oops, now nobody).

Lev says that the basic relation between movement in reported earnings and stock price has been weakening since the 1970s, when intellectual assets started surging in value on the balance sheet. (Today even old-line industrials get like Dow get 70% of their value from non-tangible assets).

Anyone who roots around on his web site can find a lot of interesting stuff on this, both academic papers and press articles.

Regards,

>My view? A 60% chance of the third--that the stock market

>is coming down far and fast, soon...

Why so pessimistic given the strong productivity numbers you report? Assuming they keep up.

"New economy" hyperbole apart, I'd think strong productivity growth would have to translate into either higher profits or more consumer spending (which is good for business cash flow, at least) or, if they don't spend, more saving with strengthening of balance sheets and easing pressure on interest rates. Or a mix. *Something* good would have to happen.

If the markets see at least something good happening, I'd give them a reasonable chance of holding ground, treading water, for a couple or three years or so until earnigns catch up. Not accept higher multiples permanently, but avoiding a crash-and-burn.

But then I invested in Kaypro over Microsoft, so if your weren't fibbing about your working ouija board I won't argue.

If equities are overvalued today, then equities should have outperformed Treasury bonds by more than the long historic average during the 1990s. This did not happen. During the 1980s and the 1990s, the total return on the S&P 500 has been around 3%/year above a constant-maturity 10-year Treasury (where all proceeds reinvested). This is broadly in line with the 1941-80 experience for the S&P. Today's high P/E (i.e. low earnings yield) is explained by (a) low bond yields, and (b) temporarily low S&P earnings due to recession. The gap between an H-P filtered earnings yield and T-bond yields today is in line with the historic average for this yield gap.

> Today's high P/E (i.e. low earnings yield) is explained by

> (a) low bond yields, and (b) temporarily low S&P earnings due to recession.

The P/E of 30 is on trailing (depressed) earnings, while on forecast future earnings it is 18. Plugging that in to the "Fed Model", which puts the P/E up against the return on 10-year T-notes, the market looks about fairly valued now. So you have a fair point.

Yes, forecast earnings are crapulous, the Fed doesn't have a ouija board, and Mr. Greenspan invests in T-bills. But this gives an alternate measure of the order of magnitude by which the P/E may be out of line, indicating it need not take until "the next decade", as a prior poster said, for earnings to catch up to prices.

Also, the P/E should be somewhat higher than the historic average because, as I mentioned above, the expensing of intellectual and human capital which represents a growing part of business value on a macro level systematically inflates the P/E; and the historical average includes periods of war and inflation and the 70s crunch.

It seems the main problem of the moment is past overinvestment in tech. Fortunately, unlike the Japanese overinvestment in real estate which will take 40 years to write down, tech depreciates in two or three.

Until then I wouldn't expect big growth in the economy or rising stock prices. But as long as the rest of the economy is basically OK (especially productivity) and absent new bad news, I don't see any reason for the market to plunge from here. So, by default, it seems most likely to tread water for a while, IMHO, FWIW.

Peter--

Do you have a way to either post or link the H-P filtered data that you referenced? (I could do it myslef but am lazy). I guess what I am really interested in seeing is the deviations from trend the last decade produced.

I have nothing to add myself, except an old article from Martin Wolf of Financial Times because it made a very important point regarding bond yield and equities. And I think I read from him as well saying higher growth potential economy wide will lead to higher real interest rate, not higher valuation multiples.