December 11, 2002
I have been asked if the latest stock market rebound
from October 11 is the beginning of a new bull market or just another
"suckers rally" such as the one that occurred after the July lows.
Of course, no one knows for sure.
However, stock values appear to fluctuate both because
of fundamental factors impacting asset values and because of psychological
factors. I believe that
fundamentals ultimately dominate, but the recent bubble in values of
technology stocks provides evidence that investor psychology is very important
in determining near term stock market moves.
For a new sustained bull market to have begun, it is
necessary that the economy is in the early stages of an economic expansion.
Otherwise, fundamentals will cease to re-enforce investor psychology
and any bull market created by psychology must be short lived.
While the case for economic expansion is not
overwhelming, virtually no reputable economist is calling for economic slowing
beyond the current quarter. Household
purchasing power is growing and corporate investment restraint appears to be
diminishing. Sales to
international customers also are beginning to grow, although purchases from
abroad are growing even faster.
Monetary policy is expansionary by any measure that
economists can invent. The thrust
from last year's tax cut is waning, and the booster is not scheduled until
next year. However, even this
unfortunate timing of tax cuts cannot be viewed as restrictive. In short, the case for sustained expansion is stronger than
the one for retraction.
Thus, a necessary condition for a sustained bull
market probably has been met. (If
I could be sure, I would be much stronger in my rejection of the "suckers
Nevertheless, bears have roared during expansions,
1962 is a good example, when market values of enterprises have greatly
exceeded the current value of future returns that those enterprises can
Currently, stocks are selling on average at 18 times
analysts' projections of next year's earnings.
Furthermore, analysts are notoriously optimistic before a year begins.
Thus, prices may be closer to 20 times what will really occur.
This currently is a steep price to pay for near term
earnings. Of course, if 2003 is
the beginning of a period of explosive earnings growth, then such values could
persist. Strong productivity
gains and low production costs may indicate that earnings could be growing
faster in future years, when sales finally grow robustly.
However, I would not assume that costs can be
contained as sales grow. Compensation
per hour worked grew well above recent year averages in the third quarter.
Can productivity continue to more than compensate for these labor
Fortunately, another factor impacts whether too much
is being paid for future earnings. That
factor is interest rates. Low
interest rates mean that future profits are worth more today than if interest
rates were high. Thus, the
enterprise is worth more, if interest rates stay low.
Again, low interest rates in the future is not a sure
bet. Nevertheless, enterprise
deserve a higher value relative to next year's earnings than they did when
interest rates were not low. My
own work suggests that if historical norms were adjusted for current interest
rates, we should be willing to pay about 22 times next year's earnings to
match those norms.
In short, the 20 times that I think will actually
occur if stock prices remain unchanged remains a ten percent bargain.
Thus, my fundamentals suggest that we are in a sustained bull market,
although we probably should call it a calf market for its strength.
Now for the psychology.
We do not have good measures of psychology.
Confidence and anticipations surveys provide some insights, but they
are based upon a blend of fundamentals and hopes or fears.
However, measures of recent stock market performance
are available and accurate. As a
rule, stock market values tend to fluctuate with rising, falling, or static
The almost continuous plunge in values from August
through early October is an anomaly that expresses extreme psychological
discomfort. Policies did not
change. No new corporate
management failings were exposed. Yet
prices plunged. In July alone,
more than $58 billion was withdrawn from equity investing.
When investors confront their fears and overcome them,
the foundations for a stock market advance are laid. When October reached the intra-day lows of July and then
rallied, that could be viewed as facing our fears and beginning to overcome
Must we revisit those fears? Stock analysts who study the behavior of the market are not
sure. However, the signs look
good. The latest stock market
highs have been higher than the highs before the October rally began.
If the lows are higher than the previous lows, then the upward channel
will be established.
Indeed, if stock values went straight up rather than
establishing rising channels, as
they did early in 2000, that would mean speculation has re-appeared.
Currently, the Nasdaq index almost fits that description, but not
In the end, stock fundamentals when appropriately
adjusted for changing interest rates, appear to be favorable. The psychology embedded in the pattern of stock prices may be
forming a rising channel.
There is no sure bet, but double digit gains in stock values are likely in 2003.