After two weeks of whip-lash-inducing volatility in the stock market, during which every day's closing bell brought a sigh of relief that at least that day's chaos had ended, you can be forgiven for wondering if anything but late-summer delirium is behind the market's gyrations. Certainly if you spend too much time watching the financial-news channels, you'll quickly be drowned in talk of "technical indicators" and "trader sentiment," and it doesn't help that the mainstream press has been oddly silent in the midst of all the turmoil (the Dow's cumulative 400-point drop a couple of weeks ago, for instance, barely registered in the dailies). All this notwithstanding, there are some fundamentals about this market that you can hang on to -- basic truths that can help you get a handle on the bull market, if not the bull.
1. The bull market of the nineties was the real thing. Contrary to what the perma-bears have said, the ride of the bull has not been one big speculative bubble. Stock prices have risen for most of this decade for the best of reasons: a remarkably benign macroeconomic environment -- low inflation, low interest rates, and rapid growth -- and skyrocketing profits for U.S. businesses. In the first quarter of last year, for instance, the 900 companies on BusinessWeek's Corporate Scoreboard saw their net income rise an impressive, unprecedented 21 percent.
There are plenty of reasons for this historic high -- better inventory control and increased investment in technological infrastructure, for starters, not to mention downsizing, the weakening of unions, and the dramatic increase in the use of temp workers. It's not simply that corporate profits have been growing along with the economy, in other words. Instead, corporate profits have been growing much faster than the economy -- and the stock market has responded accordingly.
2. The Goldilocks economy is the real thing, too. Historically, when inflation appears to be under control, investors are willing to place a higher value on every dollar of future earnings a company will produce. This makes perfect sense, since the value of a company at any particular moment is the value of the stream of cash it will produce in the future. But you can only know the value of that stream of cash if you have some sense of what a dollar will be worth ten years from now, which means you need to be willing to presume that inflation is going to remain stable. Inflation has been under control for almost this entire decade, and Alan Greenspan is God -- so of course corporate price-to-earnings (P/E) ratios went way up.
3. We haven't seen this before, but on the other hand, we have. To be sure, there are a lot of things about the business climate of the nineties that are brand-new. Most notably, the fall of the Soviet Union and the opening up (at least partway) of China have created a new global marketplace for U.S. corporations to plunder, while the historically unprecedented growth of the Asian tigers (until their markets crashed and burned, of course) and the resurrection of many Latin American economies have created additional export markets and new cheap-labor markets.
On the other hand, the combination of low inflation and excellent corporate performance is not new, and was certainly characteristic of both the early-to-mid-sixties and the twenties.
4. Let's face it: Sometimes stocks do get ahead of themselves. By almost any measure, this is now one of the three or four most expensive stock markets in history, up there with 1929, 1962, and 1987 (all of which were, of course, followed by crashes). The S&P 500 trades at 28 times current earnings and 22 times estimated earnings for the next twelve months (estimates which at this point seem unreasonably high). That's far above the typical P/E ratio (16 to 18) in times of low inflation and reflects the fact that the S&P is up 22 percent over the past five years -- way beyond its historical average.
5. Which would be okay, except that stock prices have kept going up while everything else has just been treading water -- or sinking. A year ago, the S&P 500 was trading at 23.4 times earnings. Which means that over the past twelve months, investors have decided that a dollar of earnings for an S&P company is worth 19 percent more than it was a year ago. But a year ago this August, the tidal wave that was about to swamp Asia was barely a gleam in currency traders' eyes, while corporate performance over the previous year had been stellar. So it's baffling that the market is more optimistic about the future now.
That's especially true when you consider that, as Greenspan said a couple of weeks ago, the full effects of what's happened in Asia have yet to hit our economy (and things don't seem to be getting any better over there). The Asian crisis has, of course, had a paradoxical impact on the U.S. stock market, hurting corporate earnings but also luring foreign investors to the relative safe haven of the stock market and also helping keep inflation low. In the long run, though, the damage to earnings is what counts.
6. Earnings drive the market -- and earnings are slowing. In the first quarter of 1997, those 900 companies on BusinessWeek's scorecard saw their profits jump 21 percent. In the first quarter of 1998, those same 900 companies saw their profits jump just 4 percent. And as of last week, with half the companies in the S&P 500 reporting earnings for the second quarter of 1998, profits were up just 3.7 percent.
Where for most of this decade, stock prices rose in some reasonable relationship to earnings growth, the past year in general and the summer rally in particular have untethered stock prices from any foundation in reality. Take PC manufacturer Gateway. It just reported earnings that were 7.5 percent higher than a year ago. But in that same year, its stock price has doubled (and it was already pricey 52 weeks ago). If a company's stock increases in value by 100 percent while its profits are increasing by 7.5 percent, something has gone wrong. When the relationship between a company's stock price and its intrinsic value seems so tenuous, deciding when to buy or sell it becomes especially tricky.
7. And it isn't over yet. Although Wall Street analysts have been forecasting a very bullish end to the year, if what we've seen in recent months is any indication, those forecasts will very soon be adjusted downward. Analysts have already started to revise their optimistic third-quarter predictions, and a host of companies said in the past two weeks that they expect "challenging" conditions in the months ahead. On the most mundane level, earnings and sales move in tandem over the long run, and as the U.S. economy slows (Greenspan suggested a 2 to 2.5 percent increase in GDP in 1999), so, too, will corporate revenues.
8. The good news? The economy can remain strong even while corporate profits shrink. When you look at the relationship between U.S. corporations and the American economy, it's worth keeping in mind that competition exerts downward pressure on everyone's profits. Now, the 30 companies in the Dow and many of the companies in the S&P 500 are not, by any stretch of the imagination, in truly competitive markets. But in the past couple of years, a number of dominant companies -- Intel, Compaq, and Motorola, to name but a few -- have seen their profits eroded by the loss of market share and the impact of price wars.
9. Remember, even a correction would still leave us far ahead. The best thing for everyone involved would probably be if the market just went sideways for a couple of years. But even if a bear market does hit and drive the Dow back to, say, 7,000, that would still leave the market where it was in April 1997. Can anyone really make the argument that the fundamental outlook for corporate America is 30 percent better today than it was then?
10. All of this doesn't mean you should sell. It is, of course, a market of stocks and not a stock market, which means that even today there are companies that investors are underpricing, that are worth a lot more than the market believes them to be worth. (And you can't figure out which companies they are just by looking at P/E ratios, because even high-priced companies can be undervalued.) More to the point, even if the stock market is terrifically overvalued, there's no point in getting out unless you believe that you can get in again at exactly the right time. Since 1982, 91 percent of all mutual-fund managers have failed to beat the S&P 500. That means one thing (and you've heard this before): In the long run, the market is right.
In an ideal world, every investor would be as prescient (and calm) as Warren Buffett. In 1969, at the height of go-go market frenzy and coming off a year in which he had recorded a 59 percent return, Buffett folded his investment partnership and gave his investors their money back because the market had gotten to a place where he could not understand it. Four years later, as the market was giving back more than 30 percent of its value, Buffett started buying. But we don't live in an ideal world. Sometimes you see it coming, and it still doesn't make sense to get out of the way.