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"Dollars and Sense", July/Aug 1999.

To Much Bubbly On Wall Street

As the Dow Jones soared to record heights, most of the nation, which still has little or no direct stake in the stock market, watched with a combination of envy and amusement. Both sentiments are understandable. But more careful analysis suggests a third sentiment, alarm. Although most of the nation stands to gain little from Wall Street's raging bull, it may lose big in the subsequent bust. There may be no easy way to offset the impact of a crashing market, but we should at least know the problems we face up the road.


First, some simple truths about the market's climb. The value of the Standard and Poor's 500, a broad measure of the stock market, increased nearly 400% over the last decade. After adjusting for inflation, the increase is still close to 250%.

In principle, the value of stock shares is supposed to be determined by the profits companies are expected to earn in the future. Since 1988, the after-tax profits of corporations have risen by almost 80% after adjusting for inflation - this is nowhere near the 250% run up in stock prices. As a result, the ratio of stock prices to corporate earnings is at a record high.

Historically, the ratio of the price of a share to corporate earnings per share has been slightly less than 15 to one. This means that if a company earned one dollar of profit for each share of stock it had issued, then the price of a share would be just under $15. Right now, the "price-to-earnings ratio" is about 33 to one. This means that the shares of a company that has one dollar of profit for each share of stock it issued would sell for $33.

What could justify paying so much more for a dollar of corporate earnings in 1999, than in the 1960s, '70s, or '80s? One answer is that people expect earnings to grow rapidly in the future. Suppose earnings were to double in the next five years. If stock prices didn't rise at all in that time, then the price to earnings ratio would fall to just above 16 to one - close to the historic average. If this scenario is indeed expected to materialize, then current stock prices might not be too unrealistic.

The problem with this story is that virtually no serious economic analyst expects profits to even come close to doubling. The Congressional Budget Office projects that corporate profits will be just 15.7% higher in 2004 than they are today. Once inflation is taken into account, there is almost no change at all. With profit rates already at post-war highs, it is difficult to imagine that they could rise much higher.

If the Congressional Budget Office's projections for profit growth are accurate, and stock prices don't rise in five years, the ratio of stock price to earnings will still be near record levels. If prices don't rise, someone holding stock throughout this five-year period would only receive the annual dividend payment from the corporation as their return. Currently the annual dividend payment on a share of stock averages less than 1. 5% of the share price. By comparison, it is possible to get a 30-year government bond that pays 5.7% annual interest. If investors expect stock prices to stay roughly constant, then they would be far better off holding completely safe government bonds.

If stock prices do go higher in the future, and profits do rise, then the ratio of stock prices to earnings will become even more out of line with its historic level. This is the story of a classic speculative bubble. People buy the asset (in this case stock), not because of its intrinsic value, but because they believe that someone else will come along willing to pay more for it. As long as someone else comes along, speculators in these markets can profit and get rich. But, inevitably, the bubble collapses as the market runs short of suckers.


The history of capitalism is full of such speculative bubbles. During the tulip bulb mania in Holland in the 17th century, people bet millions that the price of tulip bulbs would soar without limits. At the beginning of the 18th century, there was the "South Sea Bubble" in England, where people expected to make a fortune in the stock of the South Sea Trading Company. The 19th century saw a series of speculative bubbles in both England and the United States around the stock of railroad companies. And of course, earlier

in this century we had the huge run-up in the stock market that led to the 1929 crash and the Great Depression.

In each case, people made enormous fortunes on paper, as the price of their tulips or stock kept getting higher. The smart or lucky ones got out before the crash, and managed to pocket these gains. However, for every investor who got out in time, many more held on, hoping that the market would just keep rising. These people took big losses, in many cases their life savings.

What should we expect from a collapsing stock bubble at the end of the millennium? First, we must face the magnitude of the decline that could happen. If stock prices fell back enough to maintain their historic relationship to profits, then the decline would be approximately 55%. On average, people would lose more than half the money they have in the stock market.

There is some reason to believe that the historical relationship between stock prices and earnings may have permanently changed. Mutual funds that hold a broad index of stocks make it less risky for regular folks to be in the market, thus there are more people holding stocks. Under these circumstances, the dividend yield for any one stockholder goes down, suggesting that a price to earnings ratio of 20 to one is a more appropriate benchmark than the historic average of 15 to one. This still implies that stock prices could decline about 40% on average from their current levels.

Of course in many cases the declines would be much larger. There are Internet companies, with stock valuations in the tens of billions of dollars, which have never earned a penny. Their stock may end up being totally worthless. People usually aren't willing to pay much money for a company that only knows how to lose money.


Even counting those who own stock in mutual funds through their retirement accounts, just over half of the population has no money in the stock market (according to the Federal Reserve Board). Why should the typical worker care if yuppies get burned by their foolish gambling? It turns out that, while most workers don't stand much to gain by having the market go up, they have a lot to lose when it goes down.

Throughout the '90s expansion, and over the last three years in particular, the economy has been driven primarily by a consumption boom. As people buy more, household savings rates have hit record lows. The savings rate was actually in the first quarter of 1999. People are far more indebted relative to their income than ever- even compared to the last peak right before the last recession.

This consumption boom in turn is driven by the boom in the stock market. As people see the value of their stock holdings rise, they feel more comfortable spending their whole paycheck. In many cases, they feel they can even borrow against their home or run up credit card debt because of the we they have accumulated in the stock market.

While a stock boom can drive a consumption boom, a stock bust will lead to plunging demand. The conventional wisdom among economists is that a one dollar increase in stock wealth leads to a three cent increase in consumption. If stock prices fall enough to bring the price to earnings ratio down to 20 to one, this would mean a loss of $5 trillion dollar of wealth , and a subsequent drop in consumption of $170 billion. A decline of this magnitude would lower economic output (GDP) by at least 2.5%, and probably lead to an increase in the unemployment rate of at least 2%.

If price-to-earnings ratios fell back even further to their historic levels, it would mean a loss of $7.7 trillion in wealth and a $230 billion reduction in consumption. This would reduce GDP by at least 3.5%, and probably cause the unemployment rate to rise by more than three percentage points as growth slows and companies lay off workers. A stock market crash will throw the economy into a serious recession that hurts even those who don't own stocks.


The fact that the stock market is significantly over-valued is widely recognized by economists. The International Monetary Fund even warned about the impact of a stock market crash in its last two reports on the United States. Yet, little is done to try to slow the run-up and avoid the inevitable economic fallout from a plunging market.

The reason is quite simple. For politicians and central bankers, it is easiest to do nothing and hope that the crash doesdt happen on their watch. This allows President Clinton and Federal Reserve Board Chairman Alan Greenspan to bask in the glow of a booming economy. With any luck, they'll both be in retirement by the time the market comes back down to earth.

It is also not clear exactly what they should have done to prevent the stock market boom. As governments have discovered through the years, there is no simple way to influence the direction of financial markets. Nonetheless, it is possible that continued statements by someone as respected in financial markets as Alan Greenspan could have prevented this run-up. While Greenspan did warn of the market's "irrational exuberance", this was a onetime warning issued more than two years ago, when the market was at about half its current level. A bit more concerted effort may have met with more success.

Of course, Wall Street is not just a place where stock prices move up and down. It's also an industry that has been incredibly profitable as trading has risen eight fold in the last decade. Politically connected Wall Street investment bankers and brokerage firms did not want to hear politicians trashing their business. A central banker, or a president, who warned of the dangers of an over-valued market would have faced considerable hostility from the financial industry. Clearly the current group of office holders was not prepared to pay this price.

Nor has the economics profession done much to warn the public of the dangers of an overvalued market. This is particularly ironic because mainstream economists are so obsessed with the failure of people to save money. For some reason, they seem more upset when the spending is by mothers on welfare, Social Security beneficiaries, or government employees than when the big spenders are yuppies with booming stock portfolios, partners in Goldman Sachs, or the latest Internet billionaire. Consistency is apparently not a common practice among economists.


Even workers who never invested a dollar in the market will suffer from the unemployment that would certainly follow any stock market crash. But many moderate income workers do have a direct stake in the market now that the vast majority of their pensions take the form of tax sheltered retirement accounts such as a 401 (k). These plans provide no guaranteed benefit to workers. At her retirement, a worker gets exactly what she has managed to accumulate in these accounts.

Right now, a large percentage of the assets in these retirement accounts is in stock funds. In some cases this is due to the deliberate decision of workers to take an additional. risk with their money. In other cases, it is due to the deceptive practices of fund managers who get extra commissions by pushing people into the stock market. Regardless of the reason, after the crash, some of these accounts will lose 40%, or more, of their value. Millions of workers will find that they have much less money to retire with than they had expected and be forced to delay their retirement by several years.

In short, the post-crash world is not likely to be a pretty one. The people who take the biggest losses will undoubtedly be wealthy speculators who should have understood the risks. The Yuppie apostles of the "new economy" will also be humbled by a plunging stock market. But these people can afford large losses on their stock holdings and still maintain a comfortable living standard. The real losers from a stock market crash will be the workers who lose most of their pensions, and the workers who must struggle to find jobs in the ensuing recession. Once again, those at the bottom will pay for the foolishness of those at the top.

(Dean Baker is an economist with the Preamble Center in Washington D.C.)