Bursting Mr. Greenspan's Bubble
By James K. Glassman and Kevin A. Hassett.
Wall Street Journal, September 3, 1999
Mr. Glassman and Mr. Hassett, fellows at the American Enterprise Institute, are the authors of "Dow 36,000," just out from Times Books.
DOW 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market

Has Alan Greenspan joined the ranks of bubbleologists? In a speech Aug. 27 in Jackson Hole, Wyo., he referred to the "extraordinary increase in stock prices over the past five years" and warned that markets become irrational, then eventually revert to the mean. He wasn't explicit (of course), but the clear implication was that this market is a bubble and that he may have to raise interest rates to prick it before it gets too big.

It was nearly three years ago, on Dec. 5, 1996, that Mr. Greenspan issued his famous admonition bout the "irrational exuberance" of investors. At the time, the Dow Jones Industrial Average stood at 6437.

When he delivered his latest jeremiad, the Dow was 4653 points higher.

In between, it appeared that Mr. Greenspan had become more comfortable with higher stock prices -as a reflection of technology and productivity gains. Now, as Dan Bernstein and Vivin Oberoi of Bridgewater Associates wrote this week, his comments suggest that he "is inclined to believe that current U.S. asset pricing is in some kind of bubble."

If that's true, he joins a group that is both distinguished and embarrassingly wrongheaded. Consider the bubbleologists at The Economist magazine, whose perpetual taste for imminent stock-market disaster is reflected in such headlines as: "Echoes of the 1930s" (Jan. 5, 1991), "Heading for a Fall" (April 17, 1993), and "America's Bubble Economy" (April 18, 1998). "It is quite possible," said The Economist on Aug. 8, 1998, that "economic changes have merely masked the growth of a stock-market bubble that may now be bursting. So there is no telling how low prices could go."

Prices rose 29% in the year following the magazine's pronouncement, continuing the bull market that began in August 1982 with the Dow at 777.

Bubbleologists think stock prices are driven by a kind of insane euphoria that will end any minute. According to these analysts, if price-to-earnings ratios exceed 20 - or is it 15? - then the market is headed for a bad fall. But why should certain P/Es constitute a ceiling? In our new book, "Dow 36,000," we argue that the old valuation model for the market, based on P/Es and dividend yields, should give way to one that focuses on stocks' actual cash returns over time. When you apply our model, the market looks like a very good deal, even at today's prices.

What is a bubble anyway? While the term is tossed around loosely, what economists define as a bubble is a large increment to a stock's price that is present only because that price is expected to be even higher tomorrow, not because of any sound fundamental reason. In other words, there is a bubble if a price is bolstered by the greater-fool theory - that you might be a fool if you buy a stock but you can soon find a greater fool to sell to at a higher price.

Suppose investors were well aware that Internet stocks could not possibly achieve earnings high enough to justify current valuations, but these investors were nonetheless convinced that other investors would pay higher prices anyway. Then, we could safely say that there was an Internet bubble.

While the example sounds familiar, the truth is that no one has ever found convincing evidence of such a bubble for the U.S. market as a whole. Reviewing a large literature in the Journal of Economic Perspectives, Robert P. Flood, a senior economist at the International Monetary Fund, and Robert J. Hodrick, of Columbia University, concluded, "No econometric test has yet demonstrated that bubbles are present in the data."

What about the Crash of 1929?
It may have burst the only true bubble in modern U.S. market history, but many scholars aren't so sure. Gerald Sirkin, writing in the Business History Review, calculated that earnings in 1929 would have had to grow at 9% for another 10 years in order for the peak P/E ratio of 20.4 to have been warranted. And 9%, it turns out, was the average growth rate from 1925 to 1929. The point is not that markets don't crash but that they rarely get so out of line that investors can be called wildly unreasonable, operating on the greater-fool theory in setting prices.

In the case of the Great Crash, economic fundamentals (including Fed policy) turned sour quickly, and prices tanked with them.

What about 1999?
Let's step back and look at prices, or value, in general. "The value ascribed to any asset," Mr. Greenspan said in his Jackson Hole speech, "is a discounted value of future expected returns, even if no market participant makes that calculation." Exactly. In the case of stocks, it is the present value of the free cash that the company will generate for its shareholders during its existence.

To make things simple, let's consider a firm that pays a substantial dividend each year. The firm's present value depends on three things: today's dividend per share, the anticipated future growth rate of that dividend, and the risk premium that is applied in discounting future dividends. (The risk premium is the extra return that investors demand over Treasury rates in order to compensate them for buying an asset whose returns are volatile.)

The first two components are easy to observe. The Wall Street Journal reports dividends in its stock tables, and researchers at Value Line and elsewhere publish their projections for dividend growth rates. With those two inputs and the value of the firm, it is a trivial exercise to calculate the equity risk premium both for individual firms and for the market as a whole. Doing these calculations for companies that don't pay dividends is trickier, but not difficult or controversial.

In our book we show that, assuming dividend and cash-flow growth consistent with historical rates, the current equity risk premium is about three percentage points. Recently, James Claus and Jacob Thomas of the Graduate School of Business at Columbia University used different methodology to come to the same conclusion.

In other words, investors are currently saying: In the future, cash flow growth will continue at about the same rate as it has since World War II, and interest rates will be about where they are today in real terms. And we want a 3% premium for holding stocks instead of less risky bonds. That's how we're pricing stocks.

That sounds eminently reasonable. So where's the bubble?

In his Jackson Hole speech, Mr. Greenspan properly concentrated on the risk premium, but appeared to say that 3% was too low. But it is not; in fact, it is too high. The historical evidence is clear: In the long run, stocks are no more risky than bonds, whose real (after-inflation) returns can prove relentlessly negative.

In his book, "Stocks for the Long Run," Jeremy Siegel of the Wharton School at the University of Pennsylvania writes: "Although it might appear to be riskier to hold stocks than bonds, precisely the opposite is true: the safest long-term investment for the preservation of purchasing power has clearly been stocks, not bonds."

We believe that, instead of 3%, the risk premium should be close to zero.

Mr. Greenspan's concern with what he considers high stock prices isn't new. In a strikingly familiar phrase in the March 1959 issue of Fortune, as a young consulting economist, he warned of investors' "over-exuberance."

Fortune's Gilbert Burck wrote: "Greenspan is worried lest stock prices take off in a steep rise. Once stock prices reach the point at which it is hard to value them by any logical methodology, he warns, stocks will be bought . . . not for investment, but to be unloaded at a still higher price."

At the time, stocks were rising sharply. In 1958, the Standard & Poor's 500 returned 43%. But, despite Mr. Greenspan's concern back then, the market doubled over the next seven years. Rising prices do not a bubble make.

Still, in his Jackson Hole speech, Mr. Greenspan's puckish ambiguity and his undeniable intelligence were evident. For instance, he made a strong case for respecting the pricing judgments of "millions of investors, many of whom are highly knowledgeable about the prospects for the specific companies that make up our broad price indexes."

So, we can't be certain he has gone over to the side of the bubbleologists. His speech also does an important service in focusing attention on the most important challenge in finance today: finding a new forward-looking model for valuing stocks to replace the old P/E model that has been repudiated by the past two decades of market history.

The Shakespearian chant "Bubble, bubble . . ." is not enough.

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