Dear Jim,
You’ve got me at a disadvantage already. It’s clear right away that my assigned role in this dialogue is to be timid and orthodox, which is a bore, while people watch awe-struck as you forge ahead to where no financial pundit has been before: the Dow at 36,000 and a profit-to-equity ratio of … 100, was it? (Better make that “no sober financial pundit.”) I hate to be the dull, sensible one.
Also, if you don’t mind my saying, your letter was very good. Nearly all the people who think, like you, that the Dow isn’t overvalued went a bit quiet this week, what with that slight panic on Wall Street and fears about higher interest rates and so on. I wondered how you’d handle it and was impressed that you didn’t blink. I suppose that’s the beauty of a fundamental valuation of 36,000. Seen in this exhilarating context, a crash of 1987 proportions–never mind that little correction of 2 percent or so–would be no more than a minor fluctuation from trend.
For the time being I’ll assume you’re serious about this 36,000 stuff, despite a nagging feeling it’s some kind of practical joke. (That would be most unfair of you: We British are supposed to be the ironic ones.) In case I’m being set up, I won’t comment further on those numbers–the controversial part of your letter, as you modestly call it–until I’ve seen the details you promise next time. Can’t wait. This time I’ll answer your points on the editorial we ran in the Economist on America’s “bubble economy.”
To help those few readers of Slate who don’t hang on our every word, here in a few short sentences is what we said: Wall Street looks seriously overvalued, and other American asset prices are starting to rise too fast. This asset-price inflation may spill over into consumer-price inflation. To lessen the danger and to reduce the risk of an even bigger fall in the stock market later, the Fed should raise interest rates now.
You call this analysis hubristic, because in saying stocks are overvalued we’re boasting we know better than the tens of millions of people, carefully sifting mountains of information, whose views get averaged out in the market. The upside mistake we think they’re making is as nothing to the downside one you think they’re making, but put that aside. Yes, we do think the market is overvalued. What exactly do we mean by this?
Only that we take history seriously, as you claim to. However you measure it, by historical standards American stocks are very dear right now. The price that people are paying for the earnings generated by American companies (the P/E ratio, in other words) is more than half as high again as its 30-year average. The market could fall by a third and the price of those earnings would still be only as high as it has been, on average, since 1970.
It is true that a lot of effort goes into valuing shares and that in some sense the market embodies all that work and information. It is also true that by this method we would have concluded a year ago (and did conclude a year ago) that Wall Street was already pricey–and selling then would have meant forgoing the past year’s rise of nearly 30 percent. The fact remains that over runs of years the market tends to revert to the mean. Stocks in the aggregate were pretty expensive, therefore risky, last year, and they are very much more expensive, and riskier, this year. My advice to people buying into this market now is simple: Either know something useful about the particular stocks in question or use somebody else’s money.
All this seems pretty straightforward to me. But, like your letter, our editorial had a controversial part: the part that said raise interest rates. The case for using interest rates, in effect, to cool the stock market is a lot harder to make, it seems to me, than the case for regarding the market as overvalued. I’m surprised you didn’t take me up on this. Perhaps you will in your next letter. But first, please, those details.
Sincerely,
Clive
