Lovely while it lasts
 
IT HAS undeniably been lovely, and we hate to spoil the fun just as you head for the beach. But it is high time that investors took a more sceptical look at the world’s soaring stockmarkets. In America in particular, the current bull run has been astonishing. Although prices have risen pretty steadily since the crash of 1987, the really giddy growth has been crammed into the past 21/2 years. Wall Street’s rise since late 1994 has added $5 trillion to the value of shares, creating paper riches for millions of Americans. How long can such loveliness last?

Nobody really knows. Just over a year ago investors were holding their breath as the Dow Jones Industrial Average pushed towards the 6,000 mark. It is now over 8,200 and looks set at this rate to top 10,000 in 1998. Last December Alan Greenspan worried aloud about the market’s “irrational exuberance”. But even the Fed’s chairman has now been silenced by the Dow’s further rise. Calling the top of a surging bull market is clearly a mug’s game, for a newspaper no less than for a central banker.

There is, however, a far more dangerous sort of game that mugs can play. This is the game of piling into shares at prices that the economic fundamentals simply do not support. In such a case investors are merely betting that the market is going to rise before it falls, and—the entertaining and nail-biting part—that they will find someone more gullible to sell to just when the time is right.

Most recent stockmarket commentary has focused on the fear that the American economy is in danger of overheating and that this will force Mr Greenspan to snuff out inflation by raising interest rates. But a Fed-engineered slowdown is only one of the ways in which the bull run might end. An equally likely outcome is simply that growth will not be strong enough for long enough to justify present stockmarket prices. To see why, it helps to recall some elementary facts about the setting of share prices.

A little light number-crunching

To justify the present mighty run, bulls point out that America’s economy is in better shape than ever: low inflation, low interest rates, booming growth after 61/2 years of expansion and so forth. The trouble with all this is that the value of shares today has nothing to do with the past. Their value represents the market’s guess of how much profit American firms will generate in the future.

In the end two things determine the price of a share: the amount of cash investors expect to receive from the company’s earnings, and the difference between that amount and the income investors could earn by choosing instead to place their money in a safer fixed-interest investment. How justified do Wall Street’s current valuations look in the light of present earnings and interest rates?

Long-term interest rates are presently running at around 6.5%. In the past investors have, on average, demanded an extra five percentage points or so to compensate for the extra risk of holding shares. One cheering theory holds that today’s investors, many of them baby-boomers investing over long periods for their retirement, are no longer so unhappy about the short-term volatility of stocks compared with bonds.

But even if this were true, and the risk premium had fallen by half to 21/2%, shareholders would have to earn a return of 9% a year to justify current valuations. At present the firms listed in the S&P 500, America’s biggest publicly traded companies, are paying dividends of around $115 billion a year, only around 1.6%. Of course, this paltry dividend yield does not include the capital gains that investors expect in future. Ultimately, though, such increases must be backed up by rising dividends. To justify current prices those dividends will have to grow fast (by about 71/2% a year, it turns out) to generate a reasonable return. And since inflation is currently running at around 3% a year, firms’ profits must rise by 4-5% in real terms indefinitely.

To many bulls this seems easy (see article). The profits of America’s non-financial companies have been growing by 19% a year during the current expansion. But this is hardly a guide to future performance. Since profits tend to be low during recessions, they rebounded sharply as America’s recovery took hold. Now, though, the recovery is no longer new. With the expansion beginning to moderate, and labour markets tightening, firms’ output cannot grow faster than productivity without reigniting inflation.

There is of course a delightful notion that productivity in America is in the throes of a secular rise, thanks to the spread of information technology, deregulation and globalisation—and to the virtuous interaction of these things. Although official numbers do not yet support this case, the difficulty of measuring productivity accurately in a service-driven modern economy is widely acknowledged. Even so, for investors to base their expectations on such anecdotal evidence is perilous in the extreme. Historically, real productivity growth has risen at 2-21/2%. It would have to rise by twice as much to deliver the needed 4-5% growth in real profits.

There is a third way—beyond growth in output or growth in productivity—for firms to increase their flow of profits, and therefore buoy up share prices. They can also, if workers oblige, divert a bigger share of their revenues from wages into profits. Economists are having a lively debate as to whether this diversion is taking place, and to what degree. But even if it is taking place, it must be close to its limits in an economy at pretty full employment. After years of holding steady, unit labour costs have been on the rise, which means that wage increases are at last beginning to outstrip productivity gains.

As befits a bit of light number-crunching to take to the beach, much of the foregoing could be written on the back of an envelope. And as proponents of rational expectations love to point out, the market knows all. In this case, it certainly seems to know something The Economist has missed. Still, our best wishes for the holiday season.