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Jewish World Review June 29, 2000/ 26 Sivan, 5760

Lawrence Kudlow

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Is the sky falling? -- IN 1996 (nearly 100% ago on the S&P 500, a virtual doubling), numerous gurus of the pessimistic persuasion have echoed that same thought. A tulipmania, a South Sea bubble, crash of '29, crash of '87, crash, crash, crash.

A couple of very self-important tenured professors from, respectively, the people's republics of Cambridge and New Haven, have recently unfurled the same banner of cynical gloom. Yale's Robert Shiller, using ten-year moving averages of price-earnings multiples, believes today's stock market is still substantially overvalued and therefore irrationally exuberant.

Ten-year P/E multiples are sort of like using a rotary phone to dial into the Internet. But no matter, he's tenured. And the rumor is that it was Shiller who first fed (force-fed?) Greenspan the now famous line.

Paul Krugman of MIT seems to believe that perhaps the stock market rally contained some elements of rationality, but all that is over and George Bush is wrong to propose stock market investment accounts for Social Security because future market gains will never be as strong as past gains. Call this future irrational exuberance.

Not to demean the judgement of these Ivy League dons, but there is a second opinion, using a basic corporate finance analytic, developed years ago by Arthur Laffer and Victor Canto as a stock market strategy guide, that suggests the 1990s stock market advance was an entirely rational response to the transforming effects of the information economy that raised capital investment, productivity, profits and non-inflationary economic growth far beyond the expectations of all the best and brightest experts.

A simple discount-earnings model that uses Baa-rated corporate bond yields to capitalize corporate profits into a notional stock market value shows that the bubbleheads have been wrong. Until very recently, both pre-tax and after-tax S&P 500 capitalized earnings consistently outperformed the S&P 500 stock market index.

Only in the past five quarters has the S&P 500 index caught up to the capitalized corporate profits measure. Indeed, it is this "catch-up effect" that helps explain the steep 26.5% S&P 500 market rise since the end of 1998.

Right now, the stock market is right about where it should be. Not over-valued or under-valued. In relation to the model of capitalized corporate profits (S&P 500 after-tax earnings divided by the Baa corporate bond yield), the market is well valued.

The late winter jump in corporate bond yields to 9.2% from 8.2% was the major factor in the so-called April/May massacre. That discount rate rise, which lowered the present capitalized value of future S&P 500 profits, generated a 5% peak-to-trough loss in the S&P 500 index. But corrections come and go. Part of the game. Fortunately, bond rates are now heading down.

Since late 1991, when the cyclical business recovery really began, the S&P 500 has increased at a 17.1% annual rate of price gain. Capitalized after-tax earnings for the index have increased at a 27.9% yearly pace. As the market gradually caught up to earnings, outsized yearly market gains of 20% or more became commonplace.

To cynics, pessimists and other representatives of the Forces of Darkness, these outsized gains looked like a bubble. But the Internet economy was taking over.

Information technology contributed nearly one-third to economic growth in the second half of the '90s. Technology investment, the driving force behind the productivity surge, contributed roughly three-fourths to total private business investment. Sometimes it contributed 100% to investment.

It is exactly this technology investment that paved the way for the surprising strength in productivity-induced profits. A recent Commerce Department report refers to this "capital deepening"where the ratio of the capital stock of computer hardware to hours worked increased on average by 33.7% annually during the late 1990s. Heavy capital investment in computer software and communications equipment also occurred.

As a result, U.S. productivity unexpectedly boomed to a range of 3% to 4% annually for non-farm and non-financial businesses, and over 6% for manufacturing. This compares to a meager 1% annual productivity rise over the prior two decades. Stronger productivity lowered business costs and raised business profits.

Cynics sometimes called it the "profitless prosperity."Actually, it has been the inflationless prosperity. As technologist Joseph Schumpeter accurately predicted, periods of rapid technological advance produce more growth, with greater productivity, at lower prices. Or, more money chasing even more goods.

Few people understood or anticipated the dramatic earnings increase that worked in the 1990s to drive share prices higher and higher. It wasn't excess liquidity bubbles, but profits. It wasn't tulipmania, but technology spillovers and applications. It wasn't diminishing returns, but increasing returns. It wasn't excess money supply, but large increases in money demand.

Right now the U.S. economy is in something of a stall, and so is the stock market. Heavy Y2K-related consumer spending in 1999 was borrowed from 2000. Higher gasoline prices are throwing off a temporary tax-hike effect. Federal Reserve liquidity withdrawals and interest rate hikes have modestly raised financing costs.

But long-term interest rates, which are just as important as corporate profits in determining future stock market values, perhaps even more so, are headed down. Ten-year Treasury rates have dropped 80 basis points from their peak. So have Baa corporate rates. These interest rate moves are slowly turning the tide toward a more positive market outlook.

Meanwhile, market price indicators of lower future inflation suggest reduced interest rates ahead. The TIPS spread has narrowed to two percentage points. The slope of the Treasury yield curve is inverted. Gold is steady and the dollar is strong. Monetary base growth created by the Fed and MZM transactions demand in the economy are well balanced.

And let's not forget that the technology revolution is far from over. We've not yet seen the full impact of the productivity-enhancing technology investment wave on profits. The cyclical element of productivity and profits may temporarily slow, but the long-term cycle is still intact.

In fact, it may well turn out that profits in the next year or two will continue to outperform expectations, just as they have in the past. The slowdown may not be so slow, and the recovery may be more robust than experts believe. As the Fed tightening cycle comes to an end, the whole interest rate structure will descend.

So capitalized earnings may continue to outperform. Ditto for the stock market. Technology growth is the force, and technology stocks are the play. Big cap, mid-cap, small cap. Technology growth is the play.

Value stocks won't get true value unless they develop a technology strategy. This is the era of growth, not limits. Technology begets growth. And growth creates value.

Let's leave the pessimism to certain precincts in Northeastern university towns. Much better to keep the faith. Faith is always the spirit.

JWR contributor Lawrence Kudlow is chief economist for CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.


06/21/00: Internet-more-important-than-Fed update
06/14/00: The judicial hacker
05/16/00: Front-View Windshield
05/09/00: Don't Overreact
05/05/00: Give it Back
05/01/00: Wealth and Capital
04/18/00: Growth, Freedom and the New Investor Class--Stay the course
04/13/00: Correct Value
03/28/00: Governments roil the Markets
03/28/00: Fed should keep its powder dry
03/14/00: Reduce Debt, Derail Economy
02/17/00: Unsettled
02/10/00: Bush's Footprints
01/25/00: To preserve its standing as the world's number one economic power
01/06/00: It's not the '70s
12/28/99: They missed it
12/23/99: Bonditos
12/20/99: Dracula's Curve
12/16/99: When Alan Greenspan sneezes, Wall Street economists catch cold
12/10/99: Y2K-Related Cash
11/23/99: Y2K Money: Inflationary or Not?
11/16/99: Investor Retaliation
11/05/99: Rosy Lives
10/29/99: Drain Reserves
10/22/99: Supply-Side Is Mainstream
10/14/99: Y2K will likely bring more prosperity
10/07/99: Clinton's tax-cut veto
10/01/99: What's really bugging the stock market?
09/23/99: Growth Trade
09/09/99: Bad Dollar Logic
09/09/99: Buttered bread
08/31/99: Bull Market Alive and Well
08/26/99: Let Prices Rule
08/19/99: Blame OPEC, Not Growth

©1999, Lawrence Kudlow