When Will Reality Intrude On Wall Street?

It's a new year and predictions about the stock market are falling like confetti at a ticker-tape parade. Most are worth just about that much, too. With the Dow Jones industrial average up 22.6 percent for the year, and more than doubling over the last three years, everyone wants to know if the end of this unprecedented run-up in stock prices is near.

Well, not exactly everyone. In spite of the tremendous movement of personal savings into stock mutual funds over the last decade, about 60 percent of Americans still have absolutely nothing invested in the stock market. (This figure includes all the money people have set aside in defined contribution retirement plans that are invested in stocks). And ownership among the remaining 40 percent is highly concentrated, with most households having little of their assets in stocks.

But the stock market's performance and prospects have important policy implications, especially since a 10-year bull market has pushed expectations beyond all rational bounds. A movement to privatize Social Security, for example - largely financed by Wall Street - is based on the idea that, in the long run, stocks will provide a higher rate of return for beneficiaries than the current system.

What can we say about the long-run prospects for stocks? While no one can predict what will happen over the next few decades, there are possibilities that can be ruled out as unlikely. One is that the stock market will show the kind of returns it's yielded in the past. In fact, even the more moderate gains that the market has averaged over the last 75 years - a real annual return of 7 percent - aren't likely to be repeated. [Real return is annual total return minus inflation.]

The reason is fairly simple: No one is projecting the economy to grow, over the next few decades, anywhere near as fast as it has in the past. Over the past 35 years, the economy grew at about 3.3 percent a year. For the next 35 years, it is projected to grow at about half that rate.

Bubble must burst

This means that profits can't grow, over the long run, as fast as they have in the past. And as Wall Street knows, prices of stocks must ultimately reflect the earnings of the companies they represent.

For a period of time, stock prices and earnings can be seriously out of whack: In fact, many analysts would say that's already true. Price-to-earnings ratios are currently at a near-record high of 22 to 1.

This ratio can go higher still, in anticipation of higher future earnings, allowing Wall Street's good times to roll on a while longer. But sooner or later, unless our economy undergoes some profound structural change that ups its rate of growth - something no one is predicting the speculative bubble has to burst.

Dean Baker of the Economic Policy Institute has done the calculations. Suppose, for example, that the economy were to grow as expected, and the stock market were to revert to its historic 7 percent real return. This would require, by 2015, a price-earnings ratio of 34 to 1; by 2035, 79 to 1. Clearly the bubble will burst long before this comes to pass.

And we are not talking about the record stock price increases of last three years - no one claims these will continue - but something just a fraction of these returns, which is not sustainable over the long run.

'In for the long haul'

The millions of small investors who bought the dips during the market's wild ride last October might want to think about this. "I'm in it for the long haul," was the typical statement of those who rode out the storm, following the advice of the experts. But it's the long haul that doesn't look very good right now.

From 1968-78, the stock market lost about 45 percent of its value, and a comparable downturn in the coming decades would force a lot of people to seriously alter their retirement plans.

No one can predict when reality will intrude on Wall Street, or whether stock prices will crash, stagnate, or slowly wind down. We could see another good year, though the outlook is clouded by the Asian financial crisis, projected slower growth, and the present overvaluation of stocks.

One ominous sign is that during the recent turbulence, the market was apparently sustained by smaller investors, while some bigger players got out of stocks. The big players are more likely to have done the arithmetic described above, meaning small investors could be left holding the bag in the event of a sustained downturn.

* Mark Weisbrot is research director at the Preamble Center for Public Policy and a research associate at the Economic Policy Institute in Washington.

About these ads
Sponsored Content by LockerDome

We want to hear, did we miss an angle we should have covered? Should we come back to this topic? Or just give us a rating for this story. We want to hear from you.

Loading...

Loading...

Loading...

Save for later

Save
Cancel

Saved ( of items)

This item has been saved to read later from any device.
Access saved items through your user name at the top of the page.

View Saved Items

OK

Failed to save

You reached the limit of 20 saved items.
Please visit following link to manage you saved items.

View Saved Items

OK

Failed to save

You have already saved this item.

View Saved Items

OK