4.14.00
Market Meltdown, Huh?

4.14.00
The Second Appomattox

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Rapists Like GunControl

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Why You Yellow Bellied...

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Bush Courts Gay Republicans

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Elian: The Movie

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Colorado Senate Rejects Gun Legislation

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Unreliable Guns Aren't Smart

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Will Gore Be Held Accountable?

4.06.00
Turning on Greenspan

4.04.00
Two Cheers for W.'s Environmental Message

4.04.00
A Well Endowed Democracy

4.03.00
An Unsettling Antitrust Case

4.03.00
The Ph.D. with the Lamp

4/14/00 5:35 p.m.
Market Meltdown, Huh?
Don’t jump out the window, says a respected economist. It’ll get better.

By Victor A. Canto, of La Jolla Economics

kay, the short term looks grim. However, if the calculations I have made are correct, the worst is behind us — and we can remain bullish about the long-term prospects of the U.S. economy.

Can we account for the current downdraft in the financial markets? I believe we can. The most recent inflation numbers were not very good. The CPI rose at a 5.7% annualized rate. Given the Fed phobia of inflationary pressures and the rise in inflation expectation, we would expect a rise in interest rates (i.e., the discount rate) of, say, approximately 25 basis points.

But that’s not all. I also believe that as a result of Y2K business--and consumers accelerating their purchases of durable goods — 1999 real GDP growth borrowed about 1% from 2000. Thus, we can expect the real GDP to slow down to approximately 3.5% during the current year. Both the rise in rates and the slower growth will have a negative impact on the market. Using our valuation model, the spread between the bond yields and the after-tax nominal GDP growth will increase to approximately 3.6%; that would put the market price/earnings ratio at 27.7, or about 15% below the market peak.

That’s not good. But as the year progresses, Alan Greenspan will bring U. S. inflation down to the 2% range, interest rates will decline, and the robust economic performance will continue. We will look back and view the recent decline as a buying opportunity. I think we should also take advantage of this downturn to reexamine some of the recent arguments as to whether the stock market is fundamentally overvalued.

Over the past few weeks, there has been an increase in the frequency of articles arguing that it is, in fact, overvalued. One argument used to support that view is that the P/E ratio for the market as a whole — and a number of high fliers in particular — is well above the historical norm. The obvious implication is that a market correction is around the corner, and those P/E ratios will decline. The year-to-date performance of the Dow Jones and the S&P500 is frequently interpreted as evidence that the correction is on its way.

Another argument made by the bears is that if you use standard earnings discount models, the earnings of high P/E companies have to grow at astronomical rates. These rates, it is argued, are almost impossible to attain unless some of these companies capture the whole market, and then some.

One of the problems with the bears’ valuation model is that they change only the earnings, and keep the discount rate constant. Another problem is the horizons used in their analysis. They assume that businesses are finite concerns rather than on-going entities with extremely long horizons.

A Simple Valuation Model
Let’s consider the ultimate on-going concern, one that lives forever. If that business earns a dollar per year in perpetuity at a zero interest rate, the dollar is worth an infinite amount. However, if the dollar is discounted at a 5% interest rate, then the net present value of the income stream is $20. If we now allow the earnings to grow by 3% per year, the value of the income stream is $50. The mathematical formula is one divided by the difference between the discount rate and the earnings growth.

Whenever earnings growth equals or exceeds the discount rate, we get an infinite valuation. Thus, to get a finite P/E ratio, earnings growth must be less than the discount rate. Thus all the calculations that show that the high fliers would have to increase their earnings at exorbitant rates would imply that the company would become the whole economy and cannot be true.

If the value of a company is to be finite, then the longer those outrageous projected-earnings growth rates are estimated to last, the lower the earnings growth has to be in the out years (to achieve a finite valuation). Remember that in an ongoing concern, average after-tax earnings growth cannot exceed the discount rate.

To get a P/E ratio of 100, all we need is after-tax earnings growth to be 1% less than the discount rate. Similarly, to get a P/E of 50, all we need is for after-tax earnings growth to be 2% less than the discount rate. Thus, to arrive at a reasonable estimate of the market value or P/E ratio, we need to develop some long-run estimates for the economy’s discount rate and earnings growth.

Reasonable Proxies for the Economy’s
Discount Rate and Earnings Growth
I believe reasonable proxies exist. I have a hard time dealing with the concept of a risk premium for the market as a whole, because we generally interpret the concept of risk as a covariance with something else. Just as people take the market beta to be one, it follows that the market risk against itself is zero. Using that line of reasoning, we conclude that the long-term government bond yield is a reasonable approximation for the economy’s aggregate discount rate, so we interpret changes in the bond yields as the market’s revision to the long-run discount rate.

The next issue to address is how to develop an estimate of the sustainable level of earnings growth. The rationale is fairly simple. We look at the market’s valuation as an approximate value of the capital stock in the U S. The output of that capital stock is, roughly speaking, GDP. Obviously, we would have to net out depreciation and other items, but the figure is a good approximation. Changes in GDP growth are used as the market’s revision to the sustainable rate.

The final point that we need to raise is, How good a proxy is nominal GDP for earnings growth? Our answer is that it is a pretty good one. During the 1965-1999 period, earnings as measured by the National Income and Product Accounts increased at an average of 1.713% per quarter — while nominal GDP grew at 1.87%.

Are Current Market Valuations Reasonable?
Based on the data, we believe we’ve found a quick and dirty way of not only obtaining an estimate of sustainable earnings, but also a way to estimate the revisions in sustainable earnings. To see this, consider that during the last three months of 1999, 10-year T-bond yields were in the neighborhood of 6.5%; nominal GDP growth was approximately 6%, which--given the 39.6% personal income tax rate — leaves us with a 3.6% after-tax nominal GDP growth. The previous calculation suggests that 10-year T-bond yields exceed after-tax GDP growth by approximately 2.9%. That would put the expected market P/E ratio in the neighborhood of 34; at the end of 1999 the market P/E ratio stood at 32.85.

This back-of-the-envelope type of calculation goes a long way to explain the market’s valuation. We also believe that it could be quite useful in illustrating a very important point; that to keep the P/E ratio increasing, all we need is a narrowing of the difference between the discount rate and after-tax earnings growth. Let’s consider the following hypothetical example. If the Fed is truly on a price rule and it brings the economy’s inflation rate down to zero, what should the level of 10-year T-bond yields be? Our answer, not much more than 4%. To have the market P/E ratio increase to 40, all we need is for earnings growth to be 2.5% less than bond yields. Given those numbers, the answer comes to 1.5%. Since we have a marginal tax rate of 39.6% and there is no inflation, it follows that 2.5% real earnings growth will produce a 40 P/E. The 2.5% number is quite interesting, for looking at the period beginning in 1965, real earnings growth has averaged 2.8% per year. Thus our calculation suggests that there is no reason why the P/E ratio shouldn’t continue climbing as long as inflation is under control and we grow at our historical rate. The major point is that our calculations assume an earnings and GDP growth rate lower than we have experienced the past few years.

In other words, even with a slowing trend for earnings, we get a higher P/E. All that we require is that the discount rate falls even more. If one believes, as we do, that a 4.5% bond yield is a reasonable target, then a market P/E of 40 is not out of the question. Therefore, based on this calculation, we remain bullish about the long term prospects of the U.S. economy.

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