February 4, 2004
After a year of strong stock market gains, and a January
that also had rising values, at least until the Federal Reserve decided to
change the way it described holding the line on policy changes, some investors
are questioning whether there is more upside in this stock market.
At this point, I always remind anyone reading or listening
to me that as an economist, I make my living giving advice, not following it.
Now that you are forewarned, let me explain how I would go about
answering the question of where the stock market is going.
In an efficient market, the equity portion of enterprises
would be valued on the basis of the current purchasing power derived from its
future stream of earnings. For this
exercise, let's ignore the forecasting problems derived from risk and
If companies can increase profit margins, raise their share
of the overall market, or be placed in a market sector that is growing faster
than the economy, then future growth will be a multiple of the growth of the
economy. For all companies,
however, earnings growth probably is close to sales growth over time in the
absence of effective balance sheet
leveraging and tax changes on equity earnings.
As you can see, a great deal of guesswork actually goes into determining the value of an enterprise.
However, let us assume the leveraging is not changing
rapidly and that no tax changes have occurred.
(Actually, an accelerated depreciation program that was designed to
stimulate the economy will expire next year.
To that extent, an adverse tax change might lower equity values soon.
So, the key variables remaining are earnings projections
and interest rates. If earnings
projections are rising because of an improving economy and interest rates are
falling, the 2003 scenario, then stock values rise.
If interest rates are rising and earnings projections are declining, the
2000 scenario, then stock values fall.
In 2004, earnings projections are rising but interest rates
also are forecast to increase. To
determine whether stock values will rise or fall now depends both upon the
relative strength of the increases and the possibility that the market was not
efficient, thus either over- or under-valuing enterprises as the year began.
Earnings projections have been rising along with the
economy all year. While forecasts
may remain low, analysts almost never under-forecast earnings two years in a row
(there have been no two year periods of under-forecasting earnings since 1940).
To be sure, the economy appears to be growing faster than originally expected. So, I will give the benefit of the doubt and assume that some under-forecasting still exists (but it cannot be large).
Now we come to the exuberance or depression of investors.
Almost 70 percent of all investors are bullish.
That is a high percentage that normally occurs before market corrections.
On the other hand, investors may have over-sold securities in the
downturn, just as they over-bought in the previous bubble.
The evidence on this issue is mixed.
Equity values are large relative to economic activity.
They are down from historical peaks, but remain well over 100 percent of
GDP. This can only be sustained if the returns to capital have
increased significantly or the percentage of capital financed by equity is
shrinking (the alternative is borrowing). (Equity
almost always earns more than bond holders).
The latest revisions to GDP show significant improvement in
after tax operating earnings. On
the other hand, there is little evidence that equity is changing its share of
capital returns. My conclusion from
this analysis is that equity should have a higher than historical value relative
to GDP, but not dramatically higher.
An alternative measure, used by the Federal Reserve,
compares to earnings yield of stocks to the yield on ten year government bonds.
When the earnings yield is significantly higher than the bond yield,
stocks are undervalued. When the
reverse occurs, such as from 1998 through 2002, stocks are overvalued.
Using that measure, stocks remain undervalued, but the gap is closing
So, what is the bottom line on all this musing?
My conclusions is that stocks remain under-valued, but not
by much. Values should grow
slightly faster than the growth of nominal GDP, about 10 to 13 percent.
Large companies with international production, many of the Dow stocks,
should grow better than the overall market because of the impact that a weak
dollar has upon their earnings.
Many of the technology stocks could be over-valued. Investors are looking at how much they have fallen, not how much earnings can grow. I would expect NASDAQ to under-perform other stocks. I may be far from the mark but I have given some insights into how I am aiming.