Federal Reserve Chairman Alan Greenspan briefly shook world financial markets a couple of weeks ago with a single question: "How do we know when irrational exuberance has unduly escalated asset values?" Traders interpreted Greenspan's delicate rhetorical query, made during a speech at a conservative think tank, to imply that he believed the stock market was overvalued, and that the Federal Reserve might be about to increase interest rates in order to lower stock prices. So investors bailed out, pushing stock prices down by between 2 percent and 4 percent. Federal Reserve officials then hastened to assure the press that a rise in interest rates was not in the offing, and that Greenspan's expressions of concern were merely expressions of concern.
Is the stock market too high? If so, what--if anything--should the Federal Reserve do about it? The stakes for investors are enormous. The current value of publicly traded stocks on U.S. markets is about $7 trillion. If those stocks are overvalued by, say, a third, more than $2 trillion of the wealth Americans hold in stocks is likely to vanish if and when stock prices return to their fundamental values. "Fundamental values" is a concept easier to define in theory than in practice. It refers to the prices stocks ought to sell for based on businesses' real economic value, apart from speculation. The assumption is that stock prices will ultimately (whenever that is) return to their fundamental values, however much extraneous factors may be influencing them at the moment.
No one disputes that stock prices are very high. One standard measure of "fundamentals" is average earnings over the past 10 years, a period considered long enough for business-cycle fluctuations to average out. In a typical year, a typical stock is priced at about 15 times its 10-year average of earnings. Today the typical stock sells for nearly 30 times its 10-year average of earnings.
The argument that the stock market is overvalued--and that it will either gradually deflate or crash--is simple. Stocks are tradable pieces of paper that are merely a claim on a corporation's future earnings. And the ratio of stock price to earnings is twice what it traditionally has been. In the past, whenever general stock prices have gotten as high relative to fundamentals as they are today, the next decade has been an extremely bad one in which to invest in the stock market.
However, optimists offer three main theories why current stock prices are not too high.
First: Some claim that information technology is ushering in a generation-long economic boom. Past rule-of-thumb valuations based on earnings and dividends assume that economic and profit growth will continue in the future at roughly the pace it did in the past. But (the argument goes), because we are on the threshold of the postindustrial transformation, economic growth--and earnings growth, and dividend growth, and stock-price growth--will be faster than in the past.
Second: Others claim that the rate of return that the average investor expects to receive on stocks has fallen. That would mean that any given level of profit can sustain a higher stock price. In the past, demand for stocks was limited by fear of risk. Investors could look to the bond market and see the chance for a decent return with total safety. But (the argument goes) the 1970s inflation taught investors the brutal lesson that there is no safety in bonds: Your investment can evaporate if interest rates rise, or if inflation devalues the bonds' purchasing power. Investors today also have less fear of the business cycle and other risks associated with stocks. So investors are willing to pay more for stocks than they used to.
Third: Over the past generation, corporations have learned better how to avoid paying taxes. Some companies have pushed up their debt-equity ratios--raising more money through bonds and less through stocks--and thus changed payments (to investors) that used to be called "dividends" into "interest." Dividends are paid out of post-tax earnings, whereas debt interest is a tax-deductible business expense. Other companies have decided to buy back shares with money that would otherwise have been paid out in dividends. The money shareholders receive in this way is taxed as a capital gain, usually at a lower rate, whereas dividends are taxed as ordinary income. Furthermore, investors can choose whether to participate in the buyback or to hold onto their shares and defer taxes completely. All these various tax techniques make shares of stock more valuable, per dollar of corporate earnings, than previously.
The only correct answer to the question, "Is the stock market too high?" is: "No one knows." J.P. Morgan, the turn-of-the-century financier, had a stock answer for people who asked him what the stock market would do: "It will fluctuate." At the peak of every previous bull market, there have been experts and prognosticators declaring that the old rules of thumb are no longer valid. The most famous of these predictions came just before the stock-market crash of 1929, when Yale Professor Irving Fisher reassured investors that stock prices had attained a "permanently high plateau." But every time--until now--what had gone up has come down.
What if the stock market is too high? What if it is indeed undergoing what Greenspan calls "irrational exuberance"? This is a bad thing because the exuberance may end in a crash, and the crash may depress the general economy. It's not inevitable. The decline in prices to their "fundamental" level may be gradual, and even a crash may not turn into a larger economic disaster. When stock prices fell by a quarter in one day in 1987, the American economy barely noticed, thanks largely to quick action by Greenspan's Federal Reserve. Even so, it is better to avoid the crash-causing exuberance than it is to try to keep a crash from triggering a depression.
So if the stock market is overvalued, what should the Fed do? One answer is: nothing. The history of central bank attempts to deflate overvalued stock prices is not encouraging. The Fed's efforts to cool off stock prices in 1929 had no impact on the stock market, but it did start the depression it had hoped to avoid. The Fed's principal stock-deflating tool is an increase in interest rates, which draws money out of stocks and into bonds. But raising interest rates now (which would depress the economy now) to avoid a possible financial crisis (which would depress the economy later) is a lot like destroying the village in order to save it.
A second answer is that the Fed can express concern, as Greenspan did. Such expressions might subtly shift market psychology and begin the gradual deflation. The risk is that the shift in market psychology might not be subtle, and the deflation might not be gradual. Note how gingerly Greenspan expressed his "concern." He did not say that he was worried because the stock market was overvalued: He asked how he could figure out whether the stock market was overvalued. He did not say that he would take any action in response to overvaluation: He asked if monetary policy should be any different if there were overvaluation.
It is hard to imagine a smaller step than the one Greenspan took.