Stocks: On the Up & Up?
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PAUL SOLMAN: On Wall Street it’s been the running of the bulls, stock market style. Yesterday the Dow Jones Industrial Average, which values 30 Blue Chip companies like IBM and General Motors, passed the 7,000 mark for the first time in its history. Today the Dow dipped just below 7,000 to 6989, with a loss of 33 points by the closing bell. By historical standards the bull run had been pretty remarkable. In 1972 the Dow climbed over the thousand mark for the first time.
It then took 15 years for it to double. Four years later, by 1991, the Dow had reached 3000. Four more years, and it was up to 4000. But since February of 1995, the pace has quickened. The Dow has stampeded to a 75 percent increase in just two years. The most recent 1,000 point rise was the fastest in history, a mere 82 days. But not everyone is thrilled with this accelerating pace.
ALAN GREENSPAN, Chairman, Federal Reserve Board: How do we know when irrational exuberance has unduly escalated asset values which then become subject to unexpected and prolonged contractions, as they have in Japan over the past decade?
PAUL SOLMAN: Last December, Federal Reserve Board Chairman Alan Greenspan seemed to be sending a message that stock prices were higher than corporate earnings or prospects warranted. Markets backed up right after his remarks, but not even the Fed chairman could slow down this market for long. The bulls picked up right where they left off. When the 7,000 barrier was broken yesterday, even President Clinton was brought into the discussion.
PRESIDENT CLINTON: What I need to do is try to work on keeping the economy healthy. Let’s go on and balance the budget. Let’s invest in our future, and let’s try to create a better worldwide trading system. Let’s follow our strategy and then let the market take care of itself, as long as there’s no destructive element in it. That’s what I think we should do.
PAUL SOLMAN: So why is the stock market so high, and how high is too high? We discuss that now with Abby Joseph Cohen, a managing director at Goldman Sachs, a Wall Street investment bank, and with James Grant, editor of “Grant’s Interest Rate Observer,” a financial markets newsletter. Welcome to you both. Now, Ms. Cohen, why do you think the market is going up so high so fast?
ABBY JOSEPH COHEN, Goldman Sachs: (New York) I think the stock market is doing as well as it is because the economy itself is doing so well. Since 1991 there have been any number of key structural improvements in the U.S. economy and the stock market is reflecting it.
PAUL SOLMAN: What about low inflation, is that part of the reason?
ABBY JOSEPH COHEN: Low inflation is very important, as is the decline in the budget deficit, as is the rise in the savings rate on the part of individuals, and let’s not forget that U.S. corporations are much better managed now than they were five or ten years ago.
PAUL SOLMAN: Well, one last kind of personal question: Baby boomers like the three of us, we hope, we have to put our money somewhere. Is that part of the story?
ABBY JOSEPH COHEN: It is, indeed, because baby boomers, the largest single group of people in the U.S. economy, have reached that magical age where we are saving and investing more, buying life insurance, and when we have an extra dollar of income, we’re less likely to be spending it.
PAUL SOLMAN: Okay. So, Mr. Grant, to you. Do you disagree with what Ms. Cohen said, and, if so, what’s your explanation for this rather remarkable rise?
JAMES GRANT, Financial Writer: (New York) Well, it’s remarkable, and by way of preface, I should say that Abby is always right and I’m always wrong on these things, but I thank you for having me just the same. I would go beyond what Abby has noted and point out that every–almost every single anxiety that occupied the front page of the papers in the Carter term has vanished.
I mean, there’s no more inflation to speak of; there’s no more Soviet Union. There apparently is no more menace, even crime in the city of New York is in a bear market. It, you know, is an age of wonder, so the question is: How can such a thing be priced in the financial markets, and is any price too high? And my answer to that is an emphatic yes. And I think the price people are paying now is way too high.
PAUL SOLMAN: All right. So, Ms. Cohen, why do you think that Mr. Greenspan warned of irrational exuberance back in December? I mean, what’s he worried about, and we’ll get to Mr. Grant and what he’s worried about in a second.
ABBY JOSEPH COHEN: Many years ago when I was a junior economist at the Fed, we learned that it was the job of the Federal Reserve to worry. And I think that Mr. Greenspan is concerned that there is, in fact, great willingness on the part Americans to own equities. And he wants to be sure that they are also aware of some of the risks involved.
PAUL SOLMAN: But is he, himself, then being irrational by making these pronouncements?
ABBY JOSEPH COHEN: Mr. Greenspan did not say the U.S. market was irrationally priced. What he said was how will we know when it is? And, by the way, he did specifically say that when inflation is low, stock prices do rise. And that happens because the quality of earnings is good. And when inflation is low, there are reasons to believe that economic expansion will continue. So there is rationality behind stock prices rising when the economy’s doing well.
PAUL SOLMAN: Okay. So Mr. Grant, how rational, how irrational is the stock market right now? You’ve said for a long time you think it’s headed for a tumble, right?
JAMES GRANT: It’s a truism of every great market top that things are compellingly rationale. Otherwise, people wouldn’t buy. It’s–the chairman’s–Chairman Greenspan’s job to worry, but you know, I think he feels properly that the Federal Reserve is complicit in what has become a financial mania. Never before has a dollar of dividend income, a dollar of corporate earnings, or a dollar of corporate net worth been quite so pricey by almost any measure.
PAUL SOLMAN: Could you explain what you mean by that, because those are the kinds of terms–
JAMES GRANT: No. It’s–these are very simple terms. If people walk into Bloomingdale’s, they look for low prices. People walking into financial markets paradoxically seem to prefer high prices. And the way you measure price in terms of stocks is what do you pay for a dollar of what corporations can offer, and what corporations can offer is their own net worth, what the stockholders own, what they pay out in income to stockholders called dividends, and what their profits are, called earnings.
So these are–people oddly enough seem to prefer higher prices in stocks to lower. They certainly don’t prefer those when shopping in a grocery store. So I think Chairman Greenspan is, you know, being a student of financial history, understands that there are moments in which people drive prices up and up simply because they are going up. And you note today that one of the most sought after kinds of investment is a kind of a non-investment is a kind of a non-investment in equities. People want index funds.
That is to say, they want a basket of stocks comprising an index, and they want these stocks because they want to be in the market. They are not choosing businesses that strike them as being compellingly valued or businesses that are offering products they use every day. They are wanting to be in the market, and wanting to be, they are in, and the act of investing has driven prices up to what I think everyone must concede are extreme.
PAUL SOLMAN: Do you concede that, Ms. Cohen, are they an extreme? Have they been driven up to what everyone he says would consider an extreme?
JAMES GRANT: I said almost everyone.
PAUL SOLMAN: You said everyone, I think, but anyway, we’ll allow you to amend that.
ABBY JOSEPH COHEN: No, I will not concede that point. While it is true that prices, themselves, are at record levels, so too are the underlying fundamentals. And what we like to look at is how those stocks are priced, relative to the earnings being generated by the companies and so on.
PAUL SOLMAN: Now, Mr. Grant was just talking about fundamentals, wasn’t he? So your version of the fundamentals is different?
ABBY JOSEPH COHEN: It is somewhat different. Let me also point out, though, the following, and that is when this bull market began, stocks were selling very cheaply relative to the fundamentals of earnings and cash flow and dividends. And now they are not. We think, however, that stocks are now reasonably priced based upon those fundamentals. Our conclusion is that this has been a bull market thus far with abnormally strong returns and going forward, it will be a bull market with normally good returns; that is, returns that rise as improvements in the economy occur, as improvements in corporations occur, but we no longer have that gap because stocks are no longer “too cheap.”
PAUL SOLMAN: Mr. Grant, would you actually urge members of our audience to take their money out of stocks? I mean, you have been pessimistic for a while now, and as you pointed out earlier, you were wrong about it?
JAMES GRANT: By way of penance, I’m not going to advise anyone to do anything, but I would like to point out that if stocks merely do okay, that is to say if they go a little bit up but mostly sideways, you’re not going to get much out of them to eat. You’re not going to have much to live on.
If you were to come in to a $5 million inheritance and keep it all and invest that inheritance in the Standard & Poor’s 500 Index–that is the most closely watched Blue Chip Index–you would take home about $90,000 a year before tax, and it would be $50,000 after. Now, $5 million is a lot of money. Is that the kind of income that you really expect to get from that sum of money? Well, stocks aren’t the only thing to do in finance.
I think an orphaned and neglected corner of the financial markets is the tax-exempt bond market, so humble, so sexless, you can get without stretching 5 ½ or 6 or 6 ½ percent, depending on the vehicle, that is tax exempt. People conspicuously do not want fixed income securities because they don’t go up 5 points every day, but it’s the thing that people don’t want that so often turns out to be the better investment.
PAUL SOLMAN: And possibly the safer one, I take it, from what you’re saying?
JAMES GRANT: I think so.
PAUL SOLMAN: Ms. Cohen, you’ve been quoted to the effect saying that Wall Street is moving to a new era. It reminded me of the famous economist Irving Fisher’s legendary pronouncement, “Stock prices have reached what looks like a permanently high plateau.” And he was a very famous economist. And that was just weeks before the 1929 crash. I’m sure people have reminded you of this before. Do you worry that you’re kind of–do you view yourself as being euphoric here?
ABBY JOSEPH COHEN: Well, first of all, I was not the one who said we have moved into a new era. But let me quote another economist, and that was John Maynard Keynes, who said, “When the facts change, I change my mind. What do you do?”. And what has happened over the last five years is that this economy is moving very differently than it had been moving in the preceding ten and twenty years. Inflation is not galloping upward.
And the budget deficit is not galloping upward, and corporate profit margins are not collapsing the way they had been. And I think that there are many things which are quite different about the economic expansion of the 1990’s.
PAUL SOLMAN: That’s true, isn’t it, Mr. Grant? I mean, we’ve had–
JAMES GRANT: Sure.
PAUL SOLMAN: –a discussion about the–
JAMES GRANT: It is–
PAUL SOLMAN: –rate of employment, for example.
JAMES GRANT: Yes. It is, you know, the backdrop could not be more perfect, but I would–I would offer this as a way of interpreting the news. If you go back and look at major lows, despairing, give-up bottoms in the history of the U.S. stock market, what you find is the mirror image of today.
1942, perhaps the defining bottom of the 20th century, totalitarianism was ascending, the very physical survival of the United States was in debt, owing to the early stages, the setbacks in the early stages of war. Taxes were confiscatory. Capitalism was apparently dead. People had written off the possibility of demographic improvements, and there was to be no baby boom. So at that moment stocks were literally being given away.
No one wanted them. They were priced for liquidating value, and today the news couldn’t be better, and stock prices, I think, by many measures have never been higher. So, you know, you have to ask wouldn’t you have been better off buying and being bullish and being committed to this, you know, this completely hopeless idea of capitalism in 1942, and yes, you would have been.
Doesn’t it follow that in millennial moments, such as this one, you are advised to at least look skeptically at the millennium and to wonder wouldn’t I be better off with some safety in my portfolio, as well as some risk, and I think it’s at this moment that risk is least visible, least apparent, it is most dangerous.
PAUL SOLMAN: One very last, quick question. Okay. If there were a drop or a correction, crash, how serious would it be? What would happen, Ms. Cohen, I know you don’t believe it’s going to happen, but what would happen to our viewers if that occurred?
ABBY JOSEPH COHEN: I don’t expect it within my forecast arising which, of course, would be this year and next. I believe that what will ultimately cause the next bear market is a very significant problem in the U.S. economy. Normally, the preconditions for a bear market are significant degeneration; inflation begins to rise dramatically; Fed policy begins to push interest rates not just modestly higher but poisonously higher, and we move into an economic recession. Profits don’t just slow, but they actually collapse.
And this is something I don’t see within 1997 or 1998. But let me make one point, and that is earlier in this decade we were more enthusiastic about equities than we are right now. In portfolios we were recommending 75 percent waiting in equities. We’re down to a 60 percent waiting, so we have adjusted, if you will, the risk level in those portfolios.
PAUL SOLMAN: And, Mr. Grant, the consequences for people, just very briefly, who are watching this program if a crash were to occur.
JAMES GRANT: They would lose a lot of money.
PAUL SOLMAN: Well, let’s leave it, I guess, at that. Thank you both very much for joining us.