Jewish World Review April 13, 2000/ 8 Nissan, 5760
http://www.jewishworldreview.com -- PROFESSORS KRUGMAN (MIT) and Shiller (Yale) keep telling us that stock markets are inherently irrational and wildly overvalued. Trouble is, they've been saying this for the better part of the past eighteen-year bull market.
Here's a second opinion. Stock markets are inherently rational, and they are correctly valued. In a moment, I'm going to show that some major market indexes are today exactly where they ought to be.
Before the proof, here's a third opinion. The principle reason for volatile market swings is irrational government policies. That is, monetary, tax, regulatory or trade policies that block economic growth and global commerce. Arthur Laffer calls this the four prosperity killers. This list of irrationally exuberant and wealth-destroying economic policy killers is as valid today as when Art first minted the list about 25 years ago.
So when a federal district judge throws the whole anti-trust book and the kitchen sink at one of America's greatest companies, a company that has consistently promoted stronger growth and productivity, at lower prices, investors start heading for the exits in response.
And when an assistant attorney-general in charge of trust-busting tells the public that "This landmark opinion will also set the ground rules for enforcement in the Information Age", rational investors anticipating a wave of technology innovation-killing government regulations then head for the exits en masse and in unison.
Not to put too fine a point on it, but it's sort of like a bunch of highly intelligent college kids bolting a classroom, perhaps after one of Professor Krugman's lectures. There must be a good reason. Unguided missiles, however, frequently blow up unintended targets. It can be ugly. Like the stock market earlier this week, following the Microsoft announcement.
Now for some proof that markets today are actually valued rationally. A simple model of capitalized corporate profits can be used. Actual profits between the fourth quarter of 1994 and the fourth quarter of 1999 are discounted to capitalization by using the 30-year Treasury bond rate.
First let's look at the S&P/Barra Large Cap Growth Index. Net income stood at $12.6 billion in 94/Q4, with an average Treasury bond yield of 7.96%. So the capitalization stood at $158 billion ($12.6 billion divided by 7.96% equals $158 billion).
Net income for this group stood at $39.3 billion in 99/Q4, with an average T-bond rate of 6.25%. So the capitalization stood at $629 billion. Therefore, between 1994 and 1999, capitalized corporate profits for large cap growth stocks increased 31.8% per year.
Guess what? The actual Barra Large Cap Growth Index appreciated in price by 31.9% per year between 1994 and 1999. So the actual performance of the index has done exactly what the point-to-point capitalized profits calculation said it should do.
Now let's look at the so-called value group. In 94/Q4, net income for the S&P Barra Large Cap Value Index stood at $39.9 billion (names like Boeing, Ford, JP Morgan, Nike and Sears). With a 7.96% 30-year bond rate, the capitalized value came to $501 billion ($39.9 billion divided by 7.96% equals $501 billion).
For 99/Q4, net income for the big cap value group was $68.7 billion, with a 6.25% bond yield. So the capitalized value came to $1.1 trillion. Therefore, the yearly growth of capitalized corporate profits has been 17% per year. Guess what? Over the past five years the S&P Barra Large Cap Value Index appreciated in price by 20% a year. Pretty close. Maybe value stocks are teensy bit undervalued.
Now let's test technology. In 94/Q4, net income for the S&P 500 Technology group (names like Qualcomm, Microsoft, Dell, IBM and Cisco, which are also represented in the big cap growth index) registered $6.6 billion. So at the 7.96% bond rate, capitalized profits stood at $82.9 billion. In 99/Q4, tech profits were $19.8 billion. So with a 6.25% bond yield, capitalized profits were $317 billion.
Therefore, over the past five years the S&P Tech group appreciated in price by 30.7% annually. This is actually a bit less than the 34% yearly rate of price increase for the Nasdaq index. So perhaps the Nas was slightly overvalued. But of course there are a lot of names in the Nas that are not included in the S&P Tech group. So it's an imperfect comparison, but reasonably close nonetheless.
Of course we don't yet have 2000/Q1 profits, so the test stops in the fourth quarter. But there was very little net price movement in the rather volatile first quarter trading, including this past week (of the new second quarter). My guess is, however, that profits for all these groups did very well in Q1. So based on the capitalized earnings test, market indexes today are still about where they should be based on the discounted profits model.
The key point in all this: if the government would keep its cotton-pickin' mitts off the economy, then market valuations will be successfully priced by well informed investors who recognize that our non-inflationary technology-driven rapid growth era is quite capable of generating massive wealth gains through the stock market.
Corrections will come and go, but the underlying long-term trend is very
positive. Assuming no prosperity killers. Highly regarded economics
JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.
03/28/00:Governments roil the Markets