Why stock market bubble may continue to deflate

The stock market fluctuated last week. So what?

Most investors probably don't give much of a hoot about daily, weekly, or even monthly bounces in stock prices. But they would really like to know where prices will be a year, two years, five years, and a decade from now.

That's especially true with the deflating of the 1990s stock-market bubble. Today, the New Economy looks not quite so fancy. Yet many investors want to know if stocks are reasonably valued now, and if they should put their spare cash into the market.

Promoters of stock investments tend to cite the average 7 percent annual real return on stocks since 1926, before the Great Depression. It's a handsome return compared to that of corporate bonds.

Or they may refer to the 18 percent per year average gain on the Standard & Poor's 500 stock Index from 1981 to 1999.

But these salesmen don't usually talk about the long periods - a decade or so - when stock prices went nowhere. The Dow Jones Industrial Average averaged 906 in 1968. In 1983, it stood at 844, with some not-so-big fluctuations during the in-between years. Then in 1984, it finally beat 1000.

Lacy Hunt, an economist with Hoisington Investment Management Co., in Austin, Texas, figures the stock market is due for a repeat of such poor performance after the bubbly 1990s. He sees a decade when United States stock markets are "unable to move." Investors basically get zero return.

That's because, in his view, stocks are excessively valued today, despite the drop in prices since the market peaked in the first quarter of 2000.

One classic measure of stock value is to compare their price with corporate earnings. By that P/E measure, the S&P 500 stands about 28 times earnings, way above the 13 to 15 that might be considered more normal. Though stock prices have fallen, earnings have dropped even more.

Further, the value of all corporate stocks today amounts to about 110 percent of the nation's gross domestic product, the output of all goods and services. More usual is 65 percent, says Mr. Hunt.

Not all analysts are as bearish as Hunt. Economists have devised several methods of determining what is fair value for stocks, and these tell somewhat different stories.

One caution: "They don't tell you what the stock market is going to do over the next six months or tomorrow," notes Paul Kasriel, director of economic research at Northern Trust Co. in Chicago.

David Wyss, chief economist in New York for S&P, for instance, figures stock prices are "pretty close" to what they should be. The S&P 500 stood last week at about 1060, or 6 percent above the 1000 he calculates as the proper value.

Mr. Wyss's calculation is based on both corporate earnings and the yield on 10-year bonds. (Bonds are often viewed by investors as the prime alternative to stocks.)

This formula, he argues, forecasts the market better than the P/E ratio alone. It tells him that over the next several years stocks will still offer a higher return than bonds. But there could be a long period when the return on stocks will fall below the 7 percent average.

This has implications for the hope of the Bush administration to privatize Social Security, allowing individuals to place their pension savings in stocks.

"It doesn't seem quite as much fun," says Wyss.

Dean Baker reaches an even gloomier conclusion. The Center for Economic and Policy Research economist notes that when the market peaked last year, the value of all stock was $17.8 trillion.

At that time, profits were near their cyclical peak. So it's likely that profit growth will be "considerably lower" than the historical average for a period ahead.

The value of all stocks already has fallen to $13.6 trillion, or about 1.36 times GDP. The ratio remains far above the historical average of 0.9 times GDP. That implies trillions more of "illusory wealth" could vanish to get back to that average.

Noting that high stock prices tend to shift wealth from lower-income people to high-income households that own the bulk of stock, Mr. Baker concludes: "There is no reason to want the stock market to rise."

Many investors will disagree.

There are other ways to value the stock market. Arthur Laffer, famed for holding that tax cuts can increase government revenues, maintains that stocks are currently underpriced. The San Diego economist's method assumes that the value of a stock today is the discounted value of the companies' future earnings.

Northern Trust's Mr. Kasriel quarrels with Mr. Laffer's statistics. And he ends up not seeing much undervaluation.

Stocks clearly became overvalued around 1996, Kasriel says. That didn't stop stocks from rising further back then. "But don't extrapolate the returns of the late 1990s into the future or you will be disappointed," he cautions.