Let’s be clear about one thing. Dave states that I’m arguing that growth is anemic and he argues that growth has continued–but there’s no reason to argue. We can look at facts. As I stated before, since the end of 1996 S&P earnings are going to be up about 2 percent, based on estimates for 1998 year-end earnings of about $39.50. In that time the S&P 500 has been up 69 percent. Meanwhile, since the end of 1994 earnings are up 29 percent, while in that same period the market’s up 177 percent.
So those are the facts. We can call them anemic, we can call them growth, but the fact is that for the last couple of years there has been no earnings growth, while the stock market is up basically 70 percent. And we now have a price-earnings ratio that’s over 30 times earnings, which is a multiple generally reserved for fast-growing businesses that grow 25 to 30 percent a year depending on interest rates. Or you can get p/e’s of that height when you’ve been in a depressed period. It’s hard to argue simultaneously that this is the greatest, longest boom of all times and that earnings are depressed. We’ve got a multiple that doesn’t fit the numbers and a rate of change of market prices that doesn’t fit the growth rate. “It doesn’t fit” is my opinion, but the numbers are facts.
The bulls make a pretty legitimate claim that endurance of and consistency of growth tend to make people want to pay a higher multiple. I think that is a fact. But if you think about it from a real investment standpoint and what has happened historically, after we’ve had a long period of growth we tend to have multiples start to contract, because from a probability standpoint chances are growth will slow down. Things don’t tend to grow forever. In individual stock cases there will always be the Wal-Marts or the Microsofts, but there will be a lot more that don’t make it and stumble for every one that does well.
We see periods where people forget this and place large multiples on things after they’ve grown for a long time. A lot of the big Nasdaq 100 stocks have multiples over 70 times earnings, and most of them aren’t growing much over 25 percent a year. Multiples have expanded precisely because the companies have grown, but the question is, will they continue to do so? I would argue that it’s less reasonable to expect that when there are so many problems in the world. Future growth is what matters.
I believe people don’t quite understand the situation. They think we bailed out Mexico and we got through the period fine, but at the time we had one Mexico and the rest of the world was booming. The world now has a lot of problems that resemble Mexico’s–although not that severe–and we’re still growing. So it’s not the same. I would argue that even though things have gone well, it’s reasonable to conclude that multiples should be contracting rather than expanding.
The problem with all this is, there is no margin for error. There is no margin of safety, and investing is about balancing risk and reward. Risk never gets brought up anymore. So when you pay these large multiples on the hope that growth continues, and the evidence shows that earnings growth has been dramatically outstripped by price appreciation, you are setting yourself up for real trouble. If we revert to median valuations in the stock market–just median, mind you, not a discount, like when this bull market began in 1982–it would imply a decline of 40 to 50 percent, depending on the particular measure that you want to use.
So I think that the risk and reward are out of all proportion. And that is why I conclude that if things go wrong, we will end up with a much more severe problem than just a boring bear market, which Dave feels is our worst outcome. When I weigh the evidence and all the other events that have occurred, it looks like when we have a reversion to the mean in the stock market (after all prosperity isn’t permanent), it will lead to major economic trouble.
Once again, folks have learned the wrong lesson. In 1987, people concluded erroneously that there’d be a wealth-effect induced recession because of the crash (I was not in that camp, by the way). The fact that there was no wealth effect and we kept growing has caused people to believe that it will ever be thus. This time I believe there will be a wealth effect. When the stock market declines and we have a bear market, economic activity will be severely impacted. Risk and reward are dramatically out of whack and investors should act accordingly.
