Whatever fund managers may claim, Wall Street is dangerously overvalued. Larry Elliott reports
April, said TS Eliot, is the cruellest month. Not as far as the markets are concerned. As Professor Tim Congdon pointed out recently, there seems to be something about October and declining share prices.
This week was the 12th anniversary of the 1987 crash. It is 70Eyears this month since the mother of all crashes in 1929. Share prices had a rough ride in New York last week, ending 630 points lower after the chair of the US Federal Reserve, Alan Greenspan, warned that the market was overvalued.
It is nearly three years since he warned of the “irrational exuberance” gripping the stock market. The market responded by blowing a giant raspberry. Anybody who sold in late 1996 would have missed out on three years of substantial capital gains, interrupted only briefly by the crisis of globalisation in the middle of last year.
The bulls on Wall Street see the latest wobble as a buying opportunity for brave souls ready to take the plunge when stocks look cheap.
On television in the US a series of fund managers talk up the market in egregious fashion. There are books on sale and reports online that state with confidence that the Dow Jones is heading for 36 000 or some such absurd number. It is said that information technology has rewritten all the rules of the market; what once looked like a bubble is a bubble no longer.
This is a dangerous illusion. An asset bubble is an asset bubble, whether the commodity is a tulip or a share in microfloppy.com. Make no mistake, Wall Street is deep into tulip country.
Evidence suggests the US market is dangerously overvalued. At some point it is likely to come down with a bump; the real questions are whether that moment has come, and whether the economy is set for a hard landing.
Mike Lenhoff, of the Capel Cure Sharp brokerage, thinks the market is in a secular upswing. His argument is that there are three types of macro-economic regimes: inflationary, deflationary and disinflationary. The only type of macro- economic background that supports the equity market is the one that happens to be in force now – a disinflationary one.
“This means that it is premature to be calling the top of the market. The bears may think the equity market is excessively valued, but it is likely that the current period of market consolidation will prove to be another long-term buying opportunity.”
There may still be some juice left in US equities. But such is the extent of Wall Street’s overvaluation and so serious are the looming problems in the US economy that it would be unwise to bank on it.
Those convinced that Wall Street is overvalued fall into two camps. The first argues that over-investment is leading to a squeeze on corporate profitability, which is why the prices of goods in the shops are still coming down. Corporate America is heading for a period of deflation.
The other school sees it differently. Congdon looked at five benchmarks of stock market performance; each told the same story. Whether it is the price-earnings ratio or the dividend yield, the market is overvalued compared to its long-term average. On some measures it is a third overvalued, representing a drop of 2 000 to 3 000 points. On others it is overvalued by 100%, which suggests a halving of the value of shares.
“The domestic economy is overheating, while the plunge into external deficit cannot continue,” warns Congdon. “October 1999 may break the mould, but sooner or later a collapse in the US stock market will be part of the return to a more balanced macro-economic situation.”
Bill Martin of Phillips & Drew and Wynne Godley of the US Jerome Levy Institute are gloomier. Without a 30% fall in the dollar and deficit spending of 5% a year, they fear the US could “become a new millennium version of Japan”, whose Nikkei is less than half its value of a decade ago.
Their point is that the rapid growth in the economy over the past few years has been less the result of a new paradigm than of a good old-fashioned explosion in debt.
They note the plunge in private net saving triggered by rising share prices. Private net saving measures the gap between private disposable income and total spending on investment goods and consumption.
So what happens now? Martin and Godley argue that to keep the US economy going at even moderate rates of growth of 2% would require a rise in private spending in relation to income, and a fall in private net saving.
This is what Wall Street bulls envisage. More likely is that net saving will not just recover to its long-term average, but overshoot. The result if that happened would be five years in which US gross domestic product would fall by 0,3% a year, with unemployment above 11% by 2004. The effect would be enormous. Financial market turbulence in the second half of the 1990s has affected the periphery of the global economy, but not its core.
Now it is threatening to do just that. The bad news is that the fall in the dollar would probably send Japan into recession and hit the export-led recovery in Europe. Capitol Hill would become more aggressively isolationist and protectionist. The good news is that a crisis might knock some sense into policy-makers and force them to rethink the way the global economy is managed.