6:28 a.m. Monday 7/22/96
"What is Wall Street saying?" "Why does the market sometimes fall precipitously in the course of a day?" "Will the market crash?" I believe that we cannot begin to answer such questions until we make a systematic study of the expectations and speculative motives of the people--investors--who move markets. You hope to get some answers? You have to ask them.
Since mid-1989, Fumiko Kon-Ya, Yoshiro Tsutsui and I have been sending out nearly identical questionnaires concerning expectations and speculative motives every six months to professional investors in both the United States and Japan, so that we can make valid comparisons both through time and across countries. We were lucky to start just before the crash in the Nikkei in Japan that began at the very end of 1989, in which Japanese stocks lost nearly two thirds of their value by 1992, so we observe Japanese investor attitudes throughout the event.
Our research is still in its infancy, and we find the results a little hard to interpret. From these results I find myself pessimistic about the market outlook now in the United States, but other interpretations are possible. Look at my home page under investor attitudes to study the evidence in detail.
Our U.S. respondents are not telling us now that the probability of a one-day crash is high now; we asked them explicitly about this. Nor do they particularly tend to think that the U.S. market is overpriced now, and they are more optimistic than ever before about long-run earnings growth. But, note that we asked Japanese investors the same questions about Japan just before the peak that preceded their crash, and they didn't particularly think that the probability of a crash was high, didn't think that the Japanese market was overpriced then, and they were most optimistic about earnings growth.
We asked U.S. investors if they agreed with the statement: "Although I expect a substantial drop in stock prices in the United States ultimately, I advise being relatively heavily invested in stocks for the time being because I think that prices are likely to rise for a while." When we asked this, we were in effect asking if short-term speculative motives for buying were on their minds. In our latest results, 32.5 percent of U.S. investors agreed with this statement, the highest percent we have recorded since 1989. In Japan, where we asked the corresponding question about Japan, the highest proportion agreeing ever recorded there 39.1 percent came just before the peak of their market.
6:29 a.m. Monday 7/22/96
The price of a share of stock represents the value--as it's perceived by investors today--of a company's expected stream of earnings in the future. That perception is not much more than a guess, and it's a guess that's constantly changing, for lots of reasons.
Many of those reasons involve the operations of the company itself. For instance, if earnings in the most recent quarter are disappointing, then investors figure (naturally) that earnings in the future might not be so terrific either, and they re-price the stock accordingly.
Other factors that change perceptions of value lie outside the company. Interest rates are the best example. If they rise, then the company's costs go up, its customers become strapped and less likely to buy its products, so profits won't be as high as previously expected. Also, the company's stock becomes less attractive to investors who can get a certain return of, say, 8 percent on a medium-term Treasury bond.
"All investment returns ... are dependent to, varying degrees, on future events," wrote Burton Malkiel of Princeton in A Random Walk Down Wall Street (Norton, 1973). "That's what makes the fascination of investing: It's a gamble whose success depends on an ability to predict the future."
Lately, the stock market has become very volatile, going up and (mostly) down more sharply than at any time in the past three or four years. It stands to reason, then, that many investors are becoming pessimistic in their predictions of future events.
I think those events are political. Here's why:
There has been a clear pattern to the activity of stocks during President Clinton's term. From the date of his election to the date the Republicans' surprisingly captured both houses of Congress, the Standard & Poor's 500 Index, a good measure of the market, returned 9.6 percent on an annualized basis (including dividends). Such a return is a little below average for stocks over the past 70 years.
But from the date of the GOP victory in November 1994 to the defeat of their balanced-budget plan by the president at the end of 1995, the S&P returned 32.3 percent (again, annualized). Since then (Jan. 2 to July 19), the return has been 4.2 percent--or 7.8 percent annualized. Over the past two months, returns have been sharply negative.
The main reason for the pessimism, I think, is that the market is now anticipating a Democratic sweep in November. Such an event would produce, at best, terrible uncertainty and, at worst (as far as the market is concerned), higher taxes and increased regulations that would diminish the flow of future earnings for many American companies.
Am I certain that politics is the "X" factor driving the market? No. But "something" new is happening.
8:27 a.m. Monday 7/22/96
I hate to fly. Air pockets make me very nervous. The recent airplane crashes haven't helped any. But I still fly because I know that the odds are still overwhelmingly in my favor (even more so than driving).
Judging from the recent reaction to the stock market plunge last week, most people think of the stock market the same way--and that's good. They know that the market can hit the equivalent of air pockets--some quite unsettling--but that, in the long run, returns from holding a diversified stock portfolio beat those from bonds (probably by at least three percentage points per year).
In fact, I have more confidence in the average person, whose wealth increasingly is held in mutual funds, thinking long-term than I do the professionals who manage the funds. More than half the assets held in equity funds are held in tax-deferred retirement accounts, and thus are very unlikely to "run" on bad news. By contrast, money managers who are judged on their short-term returns, are much more likely to behave like cows and to run with the herd.
Fortunately, so far, most individual investors haven't been cows either (although $4 billion was reportedly withdrawn from mutual funds last week, the largest figure since January 1992).
What then caused the stock plunge the last two weeks? Like air pockets, daily or even weekly gyrations in stock prices cannot be well predicted--at least while you're in the air. But before a plane takes off, or even while in the air but well in advance of bad weather, radar can tell pilots that they are likely at some point in the flight to experience turbulence.
Several signals of upcoming market turbulence were provided in advance of this latest downturn. About six weeks ago, Business Week ran a cover story about America's "love affair" with stocks; that should have made you nervous. (It made me that way, but I didn't sell --just like I even get on a plane knowing that the flight may be bumpy.) Then came the double-whammy in early July of an unexpectedly strong growth in employment, followed by unexpectedly poor earnings of some technology companies. The first caused investors to fear an increase an interest rates (almost always bad for stocks) and a broad slowdown in earnings growth (also bad).
More broadly, one has to wonder how in an economy whose potential growth rate is only about 2.25 percent, stocks can continue to return 30 percent or more per year--the pace of last year through the end of June this year. In short, investors had all the warnings they should have wanted that an air pocket was ahead; only the exact timing was uncertain.
What's ahead? Almost certainly more air pockets, as the economy continues to bump up against its potential growth rate. But I don't foresee a crash (a drop of, say, 10 percent in the Dow from where we are right now). All the economic news continues to point to continued expansion. Inflation remains generally stable. Fed Chairman Greenspan sent exactly the right signals to investors last week: that the economy was weaker than many thought and that interest rates would be increased only if that forecast proves incorrect. During the balance of this year, stocks should resume their upward climb, albeit a slower, bumpier--but healthier--pace.
Will last week's "correction" significantly dampen the economy? Doubtful. The best estimates I've seen indicate that consumption changes, at most, by 5 percent of any change of wealth. Last week's plunge probably cost investors several hundred billion dollars. If it is not corrected, then consumption could be negatively affected by $10 to 15 billion, or about 0.2 percent of GDP at annual rates. This would be a welcome cooling off of the recent torrid pace of economic activity, but hardly one to get excited about. And if the market goes back up, this dampening effect will never materialize.
1:48 p.m. Monday 7/22/96
I suppose we now have the answer that J.P.Morgan allegedly gave to the woman who asked him what was going to happen to the stock market. "It will fluctuate," he explained. If that was good enough for J.P.Morgan it should probably be good enough for us. Perhaps we will return to this and see whether we can put a little more flesh on that answer.
I am a little puzzled by Mr. Glassman's emphasis on the relation between politics and the market. The worst stock market experience of the postwar period came during a Republican administration (of which I was a part) with a staunch Republican inflation fighter running the Federal Reserve. Maybe we weren't "Republican" enough. That has been said.
Can we now turn to the question of the effect of stock-market declines on the rest of the economy? Mr. Litan deals with that and says that the effect of last week's decline would be slight. But that was a very small decline. Would a decline, say, four times as big have four times as big an effect, or would the effect be bigger--for psychological reasons or because the prospect of regaining former levels would seem smaller. After the really big decline in October 1987 there were many predictions of a substantial effects on the economy as a result of the decline in investors' wealth. That did not seem to occur. Have we learned something about these relationships that we did not know nine years ago?