More doomsday


When the Wall Street collapse does arrive, just how bad will it be?
Tony Jackson, FT, 99-07-10

These are unsettling times for those of us who have spent the past decade or two commenting on the equity markets. It is splendid news that the Dow, the FTSE and related indices are at record levels, having doubled and redoubled every few years since 1982. But how many of us kept the faith and saw it coming?

There have been one or two steadfast bulls, such as Abby Joseph Cohen of Goldman Sachs. Some might regard them as jammed barometers which happen to have been pointing to fair during a record sunny spell. But doubtless that is just sour grapes.

When it comes to Wall Street, in particular, a lot of intelligent people have been wrong for a long time.

Leave aside the fact that UK fund managers have been underweight in US equities throughout. To take a more prominent example: when Alan Greenspan, chairman of the US Federal Reserve, made his remark in December 1996 about irrational exuberance, the Dow was nearly 5,000 points lower than it is today.

But, of course, Greenspan is not a mere observer. The rise of the US market since its setback in 1987 can be divided into two phases: from 1987 to the end of 1994, in which the Dow doubled, and the period since, in which it has almost trebled.

The acceleration was kicked off by the Fed's decision early in 1995 to stop raising interest rates. Late the following year, Greenspan was moved to issue his ineffectual warning. Now, he has at last decided to raise rates again - but in such a half-hearted way that the equity market, at any rate, seems scarcely to have noticed.

One result is that bond and equity yields have become disconnected, to an aweinspiring degree. Just before the crash of 1987, long bonds yielded an unprecedented 3.5 times more than equities. The figure then retreated to a more normal 2.5 times. It now stands at 5.

Of course, we are told that this relationship no longer holds good. No one cares about dividends any more. The correct measure is that of bond yields divided by the earnings yield.

Awkwardly enough, that ratio has also reached the screamingly high levels of 1987. Time to change yardsticks again.

This kind of rationalising is natural enough. If you want to believe the market is cheap, you need to provide yourself with soothing arguments. Old hands may recall that, at the peak of the Tokyo market 10 years ago, analysts insisted earnestly that western valuations did not apply in Japan: and that in any case, if regarded properly, the Tokyo market multiple of about 150 was really only 15 and cheaper than Wall Street. Fat chance.

In the US, the latest version of this seems to involve iguoring data on corporate earnings. For a couple of years, earnings growth has been fairly sluggish. And, at 33, the trailing p/e on the Standard & Poor's Composite index is off the map in historic terms.

Ah yes, we are told. But that leaves out the fantastic growth potential of e-business. The new economy self-evidently deserves three-figure multiples - otherwise, all those internet initial public offerings (IPOs) would be priced wrongly - and it did not exist five years ago. Ergo, historic comparisons are useless.

This argument is disposed of briskly in a recent circular from HSBC. Strip out computer services, hardware and telecoms and the US market still is overvalued in historic terms. Anyway, the argument is bogus. There have always been highly rated sectors. If you strip them out now, you would have to strip them out of the historic record as well.

All of which brings us back to our starting point. Many of us have felt a nagging sense of unease about Wall Street for some time, and we have been quite wrong. Short of jamming our own barometers to fair, what more can rationally be said?

Perhaps only this. Most of the forces driving Wall Street since 1982 have been real and powerful. If observers were slow to grasp them, so much the worse for the observers. But there have been other, cloudier forces at work which might be expected in the long run to lead to overkill.

The forces in the first category can be summarised quickly. First and most crucial is the conquest of inflation. Others include the impact of networked technology on the US economy, the changed saving habits of baby boomers, the opening up of world markets and the reining in of the US budget deficit.

And the other forces? Start by recalling how much else has changed in 10 years. The industrial supremacy of Japan has been eclipsed. Communism has collapsed. The gospel of shareholder value has swept the world. To an extent inconceivable a decade ago, the American way has triumphed.

And a good thing, too, most of us would say. But history does not stand still.

Think of it this way. In time, all market movements overshoot. What we have here is the biggest bull market of the century in which the Dow has multiplied elevenfold in 17 years. The chances of it not overshooting, and damagingly, are minuscule in the long run.

So, from what level will the collapse happen, and how bad will it be? At that point, I throw in the towel. Barton Biggs, Morgan Stanley strategist, once said sagely you never know what is enough until you know it is more than enough. The fact that he said it 3,500 points ago, dammit, is neither here nor there.

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