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How Much Longer Before the Oxygen Masks Drop?

With stocks rising so much faster than the economy, the air in the equities market is probably getting pretty thin

By Richard B. Anderson

Los Angeles Times, Business Section, July 22, 1997

There's an inescapable, common-sense question that's been troubling stock market investors throughout the ups and downs of the 1997 market.

As author and economist Robert Kuttner wrote in The Times at the end of 1996: "It is obvious that the stock market can't keep rising at 25% per year when the real economy is growing at 2%."

In the same sense that a bird can't fly higher than the air, the absolute size of the economy must set some limit to the size of an equities market. What we'd all like to know, of course, is the nature of that limit. How high is the air?

There is a contrast between our current experience of the market and that of the preceding generation. Until the last decade, most people did not even think about the stock market, and for much of the 1970s it was practically the last place investors wanted to put their money.

Over a period of 20 years, from 1961 to 1981, the net gain in the Dow Jones industrial average was just 144 points, or 20% (from 731 to 875). During this same period, however, economic growth was robust--the gross domestic product rose nearly sixfold, from $533 billion to $3,116 billion. (Neither figure is adjusted for inflation.)

For a variety of reasons having to do with warfare, inflation and investor psychology, stock prices were left behind by exponential growth in the economy.

In 1979, the companies in the Standard & Poor's 500 index were selling for eight times earnings, on average, while shelling out healthy dividends. Still, interest in stocks was moribund.

The tide began to turn for equities at the beginning of the 1980s, when Paul Volcker demonstrated the Federal Reserve Board's resolve to quell the double-digit inflation of previous years.

By raising the prime lending rate to 20%, Volcker precipitated a recession, but he won back the belief of investors in the financial system.

By 1984, the Reagan-era deficits had stimulated a boom economy, producing fountains of income and profits. For these and other, perhaps unknowable, reasons, stock prices started to rise, slowly and then dramatically. The Dow doubled from 1981 to '86, and doubled again by 1993.

That growth in prices was exciting enough, but few of us imagined that the most exhilarating part was still to come: The Dow has doubled once more, but this time in just 2 1/2 years, from 3,838 points at the beginning of 1995 to 7,906 currently.

Meanwhile, the economy's real rate of growth--nominal growth, before inflation--was 4.6% in 1995, 4.4% in 1996, and this year is expected to be in the 3% to 5% range.

It's the breathtaking scope and pace of stocks' gains, especially relative to economic growth, that had Fed Chairman Alan Greenspan concerned about "irrational exuberance" in market psychology late last year.

The concern that the market cannot continue to outpace the growth of the economy is undoubtedly valid. The question is whether the recent run-up has in fact been speculative and irrational, leaving open a possibility of catastrophic decline.

A short-term view leads to a positive conclusion: Yes, this must be speculation. What else could produce such spectacular results?

In the longer-term view, however, it's evident that there is a special circumstance: Stock prices lagged behind the economy for quite a long time.

Are stocks overvalued, or have they simply caught up with the increase in economic activity? If the latter is the case, perhaps today's values are not really unreasonable, and some further growth can be supported.

Investor Warren Buffett may have supported this view when he recently called the market fairly valued.

Maybe current levels are defensible. But can the market continue to rise at recent double-digit percentage rates? That's another question entirely.

One thing to consider in gauging future prospects is the amount of "catching up" that has already been done. For example, the total market value of all stocks in 1986 was 56% of U.S. GDP that year.

In 1996, U.S. stocks were worth more than the GDP, by 26%, thanks to the great 1990s bull market.

In the end, the logic described by Kuttner is irrefutable. At some point, the slowly growing economy must and will put the brakes on equity prices and the total value of stock market capitalization.

Is it possible to imagine stocks being worth twice the value of all the goods and services sold in the United States in a year? Four times as much? Ten? Individual investors have to make that judgment. But in the dimension of absolute magnitude, beyond any near-term ups and downs, the air is probably getting pretty thin for the stock market raptors.

© Richard B. Anderson, 2004

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