07-20-2002
COLUMN: Wall Street's Frolics, and What They Mean for the Economy
In case recent events had passed them by, Alan Greenspan told the members
of the Senate's Banking committee on July 16 that Wall Street had been
"skittish" lately. Not just skittish, in fact, but "notably
skittish."
And people say Greenspan talks funny. "Skittish" is the very
word. "Playful, lively or frivolous," according to my
dictionary. Absolutely. How investors chuckled as they watched the S&P
500, which by mid-June had playfully shed about a quarter from its peak,
bubble over with liveliness and slump another 15 percent. Such frivolity
is more than some investors can stand.
Greenspan's self-righteousness was as interesting as his vocabulary.
"Perhaps the recent breakdown of protective barriers"-by
"protective barriers," he means inhibitions about greed and
recklessness-"resulted from a once-in-a-generation frenzy of
speculation that is now over." Yes, it most likely did result from
that. But the chairman, in his fashion, always did what he could for the
frenzy. He abandoned neutrality (let alone skepticism) so far as Wall
Street was concerned as far back as 1996, when he famously mused over the
role of "irrational exuberance." After that, as the market
soared through the late 1990s to its peak, Greenspan was ever on call to
enthuse about the economy's remarkable strides in productivity-dismantling
protective barriers left and right, lending the "New Economy"
far more credibility than it would otherwise have had.
Still, it is hard to quarrel with much else that the chairman said this
week. Post-bubble, Greenspan is sounding a lot like a prudent central
banker. The economic fundamentals are strong, he said, which is true, as
far as it goes. But there are risks, he added, and these have been
compounded by the crisis of confidence in standards of corporate
governance. This is also true. The overall mood was warily upbeat:
"The effects of the recent difficulties will linger for a bit longer
but, as they wear off, and absent significant further adverse shocks, the
U.S. economy is poised to resume a pattern of sustainable growth." He
said the Fed expects the economy's output to grow by 3.5 to 3.75 percent
during the course of this year and by 3.5 to 4 percent in 2003-roughly in
line with the consensus of private forecasts, and fast enough to push
unemployment down a bit.
It could happen. But what about this risk of "significant further
adverse shocks"? All will be well, the Federal Reserve believes, so
long as nothing bad happens. Agreed. The question is, what bad things
might happen?
One possibility is that the stock market will fall a lot further. Pinch
yourself, and remember just how far the market rose, in recent years,
above historically typical valuations. One measure of this is the
so-called "smoothed price-to-earnings ratio" (the average share
price divided by the trailing 10-year moving average of earnings per
share). For the S&P 500, this ratio has fluctuated for the past 130
years around a mean of 16. Whenever the ratio has moved much above that
average, share prices have tended to fall, pushing the ratio back down
(and the converse, when the ratio has fallen below the average).
In the boom of the 1920s, the smoothed P/E ratio reached 28-its highest
level until the late 1990s. The subsequent Crash of `29 pushed the ratio
way down: for a spell, to less than 16. At the beginning of 2000, not
quite at the market's peak, the ratio was an incredible 45. To bring the
ratio back to its historical average, the broad market needed to fall by
nearly two-thirds. So far, it has fallen by only about two-fifths. Put it
another way: The S&P 500 dropped from around 1,500 at the top to less
than 900 earlier this week. For the smoothed P/E ratio to get back to its
historical average, the index would need to fall to around 500.
This is only one valuation model-for most of the previous century, a
pretty successful one. Other approaches, entirely defensible in terms of
methodology, yield predictions that are much less scary. Having abandoned
traditional valuation methods altogether in the late 1990s, most analysts
have now taken them up again: dividends, earnings, bond yields, risk
premiums, that kind of thing. But the calculations are sensitive to small
changes in assumptions. Superficially similar and equally
"orthodox" approaches can therefore give widely varying results.
That is why a lot of analysts, even though they are doing their arithmetic
in the old-fashioned way, can plausibly conclude that the market is now
about fairly valued, or somewhat undervalued.
Even according to that alarming smoothed-P/E approach, things may be less
bleak than they seem. As Greenspan argued this week, the American economy
does show signs of reaping lasting productivity gains from new
technologies. This implies a slightly higher rate of long-term economic
growth and slightly faster growth in earnings than are embedded in the
smoothed-P/E method. In turn this implies that a P/E somewhat higher than
the historical average of 16 may be justified going forward.
For what little it is worth, that would be my guess, but we will see.
Right now, though, the problem is this: The confidence the markets once
placed in unorthodox (and in some cases, completely unhinged) valuations
of one kind or another has vanished. Once you get back to basics, the
possibility that the market may have a lot further to fall has to be
faced. It is a frightening thought-and in financial markets, fear is often
self-fulfilling.
Would further steep falls in the market hurt the real economy very badly?
They might. Up to now, the economy's resilience in the face of the long
and sickening slide in stock prices has been remarkable. Few would have
predicted it. Consumers have kept on spending, buoyed by the Fed's low
interest rates and by rising equity in their homes. The administration's
fiscal stimulus (ill-designed as it may have been in many respects) has
helped as well. As a result, the recession was short and mild, and the
recovery seems to be gathering pace. Unless the share-price frivolity
flattens out pretty quickly, this recovery is in jeopardy.
Business confidence is already quite weak; the investment drought is a
sign of that. If it slumps more, battered down by the markets, companies
will be increasingly reluctant to hire. This in turn will hit consumer
spending. If the markets continue to tank, consumers may anyway decide to
curb their spending in order to restore their savings, and the economy's
tentative upward momentum may fade.
As they say on Wall Street-more and more, these days-the risks are on the
downside. This is why Greenspan was right to signal in his report to
Congress that he had no plans to raise interest rates in the next few
months. If he were confident in his growth forecast, interest rates as low
as they now are might be difficult to justify. Until the recent outbreak
of playfulness, a lot of Wall Street economists were expecting rates to
start moving back up this year. Greenspan, for now at least, is saying no
to this-because he is not, in fact, all that confident. With inflation
subdued, he reckons it would be a better mistake to keep interest rates
too low than to raise them prematurely. That makes sense.
Greenspan also had things to say about the crisis in American
capitalism-audit, accounting, and corporate governance. For the most part,
he merely echoed the recent censorious comments of the president, adding
more ominously that there may be additional bad news to come. He also
reminded Congress of his support for the expensing of stock options (that
is, for an accounting treatment that requires their cost to be charged
against earnings). The failure to expense options, Greenspan pointed out,
exaggerated the surge in earnings reported to shareholders between 1997
and 2000 (or, especially in the New Economy companies that sprang to life
in that period, it suppressed reported losses). Now, with the markets
struggling, option schemes are being replaced with cash and other forms of
pay that are expensed. This switch exaggerates the extent to which
profitability has suffered.
Fair point. Still, so long as the details of stock-option schemes are
fully disclosed to shareholders, it seems a second-order question whether
they are expensed or not. What matters far more is that executives have
lied to investors, and auditors helped them do it. Strong audit reform is
crucial, and should be pushed through. For the rest, the danger is in
responding too heavy-handedly to corporate-governance problems that either
are not amenable to a regulatory solution or have already been remedied by
the end of the New Economy mania of the late 1990s.
Greenspan is right to worry about the fallout from the Wall Street
bust-but in making prudence and probity respectable again, the slump has
already done more to improve corporate governance than legislators ever
will.
Clive Crook
National Journal
