Market Conclusions

There are oodles of ways to forecast the stock market. One letter that landed on our desk this week does so with the gloomy claim: "The planet Mars has been sitting in a retrograde position for 10 months now."

Well, we don't have any faith in astrology. And we wouldn't dare forecast the market at all over the short term, using any forecasting means. That's not our expertise - assuming, probably wrongly, that anyone is an expert in that hazardous price-forecasting game.

But we do note with some wonder the resilience of the United States stock market. Prices have bounced a long way back from their plunge on Monday, Oct. 29. The Standard & Poor's 500 stock index - considered a good broad measure of the stocks of larger companies - climbed to 964.55 last week. That's not so far under its peak above 980 in early October.

Where to next?

Who knows!

Nonetheless, we do think it useful to look at the economic and business fundamentals behind the stock market to see if shares are overvalued. After all, since 1994 the S&P 500 has doubled.

One informative analysis comes from Richard Kopcke, a Federal Reserve Bank of Boston economist.

By most standards, Mr. Kopcke notes, stock prices are "remarkably high." Stock prices for the S&P 500 remain more than 20 times their earnings. That's near its peak for the past four decades. In the past, such high valuations have not endured.

Such a price-earnings ratio could be justified, though, if corporate earnings grow about 14 percent a year over the coming five years, Kopcke figures. That's what some Wall Street analysts are forecasting.

Or today's prices could be validated if the "risk premium" demanded by shareholders has fallen, says Kopcke. In other words, shareholders now regard stocks as less risky investments than they did in the past.

"If shareholders expect the rate of growth of earnings to be less volatile in the future than previously, they should be willing to pay a higher price for each dollar of earnings [in the companies that issue the stock] even if they expect the rate of growth of earnings to fall somewhat in coming years," he writes in the New England Economic Review.

Kopcke displays some skepticism over both possibilities. To some extent, the rise in stock prices is a catch-up matter. In 1982 the price of stocks was about eight times earnings, and the average price-earnings ratio prior to the 1990s was about 16. But, Kopcke notes, the US economic recovery is now "mature." He questions whether earnings can grow so fast in the future.

Further, the placid volatility of stock prices in the 1993-96 period appears to have ended this year. Stock price volatility has bounced back to its historical level, he says.

Kopcke takes a poke at another thesis: that stock prices are high because multitudinous baby boomers are saving for retirement by investing heavily in stock. Nonsense, he says. The Fed's flow-of-funds data show that the amount of money going into various pension schemes and other financial savings has never been so low relative to personal disposable income. It is because stock prices are up that many investors feel less obliged to set aside more savings.

Kopcke says the goal of his study is to provide investors with "the stuff to come to your own conclusion."

That's our motive too.