Is the Dow really heading for 36,000?
t NEWS ANALYSIS Apocalyptic warnings of an imminent market crash are echoing around Wall Street, but according to a new book, the risk of holding equities has virtually vanished - so analysts should stop worrying
Monday 20 September 1999
James Glassman and Kevin Hasett of the American Enterprise Institute - whose book Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market is published this month - believe, roughly, that history is bunk.
They argue that generations of investors who experienced the Great Crash of 1929, the crashes of 1974 and 1987 and the low growth of the Seventies, have sought a premium for the risk of losing their shirts in another crisis.
According to their theory, however, an unprecedented surge in equities, typified by the powerful performance of the Dow - from 2,500 to 10,000 in the past 12 years - means the risk of holding equities has diminished, possibly even vanished entirely. Therefore, if shares are as risk-free as gilt-edged bonds, analysts should stop worrying if stock prices soar and yield drops.
Think of it this way. Imagine you own a house in an area thought to be prone to earthquakes. The risk of it suddenly disappearing down a continental fault cuts its value to pounds 60,000 compared with a market norm of pounds 100,000. The rent is pounds 500 a month or pounds 6,000 a year.
Suddenly a seismological survey puts your area out of danger and the value of your home soars to pounds 100,000. The rent, however, stays the same. The result is that the yield - the rent divided by the house price - has tumbled to 6 per cent from 10 per cent. A risky asset has become a risk- free asset and there is no need for a risk premium of 4 per cent.
Messrs Glassman and Hasett say that small investors have rejected the conventional model that says stocks are overvalued when the ratio between the stock prices and the company's earnings goes too high by historical standards.
Traditionally, the dividend yield plus a forecast real growth in dividends over a long run should equal the real interest rate plus an equity risk premium to measure the extra risk compared with bonds or cash.
But the authors say: "The term `too high' relates only to history not substance. To believe that the market is overvalued, you have to believe that the risk premium, once irrationally so large and getting rationally small, will become irrationally large again."
First, they say that while stocks are a risky bet over a year, over a 30-year period the risk actually falls below that of bonds and even of Treasury bills. Secondly, assuming that dividend growth will continue to grow at 6 per cent but allowing for the growing popularity for companies that do not pay dividends but achieve huge rises in their share price, they believe dividend yield could fall threefold from 1.5 per cent to 0.4 per cent while still allowing shares to have what they call a "perfectly reasonable price". In other words the value of the Dow Jones could quadruple to 36,000 without shares becoming overvalued.
Research by Jeremy Siegel, of the University of Pennsylvania's Wharton Business School, shows that over hundreds of years and across different stock markets, equity returns tend to average at 7 per cent. Since compound returns from Wall Street have averaged 13 per cent since 1982, one of two things has to be true - there has been a structural shift in the market and the economy or we are about to have a crash.
Stephen King, managing director of economics at HSBC, is a leading advocate of the latter. He points to a number of indicators in the US economy that point to a "bubble" in the US that will burst. Stockmarket disasters have typically followed an external shock or the pursuit of policies that have failed to rein in economic excess.
Mr King said theories attempting to reinvent the wheel only appear during times of massive appreciation in equity prices. "No one was peddling these theories three years ago. It is only now when the stock market is more difficult to explain and people are looking for explanations," he said.
He recalls a rash of articles in the press at the time of the Japanese boom in the Eighties. One bank even alerted investors to the fact that the Nikkei was set for years of super-performance and not to miss out. Even in the UK in the Eighties, analysts were explaining away stock-market booms, 30 per cent house price inflation and a ballooning current account deficit up until the moment it started to go wrong.
In the US the warning sign flashing red is the current account deficit, which hit an all-time record for the second quarter. This will be no problem as long as the US economy can continue to attract foreign investment.
However, with the dollar falling, inflation rearing its head and doubts emerging about the "new paradigm" of high employment, high growth and low inflation, the bubble may be about to burst.
Mr King said he had no argument with the theory that equities tended to rise over the long term - to smooth over one-off shocks - and pointed to the traditional outperformance of stocks over gilts.
"But there's a fundamental flaw," he said. The analysis confused an ex ante risk premium - or the excess returns investors expect to compensate for the extra risk - and an ex post analysis of the premium.
"Returns are higher for equities than government bonds but that seems to relate to the risks you take when you buy equities and when you buy bonds," he said.
"If you hold a bond, on its maturity you will get your money back but there's an outside possibility that you could lose all your money if you hold equities."
He said this meant there had to a premium for the extra risk involved. "It would be that some reduction in the size of the premium is warranted but bigger claims then the equity risk premium can go to zero are going too far."
Or as another economist said: "Watch out for anyone attempting to explain why the stock market can just carry on rising - they are probably trying to sell you something."
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