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 uncertainty. 

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 fast. 

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. 



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