Scary Stuff: Maybe the End Really is Coming

Over the longer term, the ability to expand credit without a monetary constraint has sustained both the U.S. economy and financial markets. We are now witnessing what it means to have that flow of credit stanched to the mortgage market. For the equity market, it removes a major prop under prices; that is, the ability to arbitrage cheap credit versus equity, or in simpler terms to borrow on the cheap to buy stocks. Without those financial steroids, equities have folded like Mark McGwire in front of a Congressional committee.

But more important are the implications for the nation as a whole.

"The Roman Republic fell for many reasons, but three reasons are worth remembering: declining moral values and political civility at home, an overconfident and overextended military in foreign lands, and fiscal irresponsibility by the central government," says David Walker, the head of the Government Accountability Office, in a recent speech. "Sound familiar? In my view, it's time to learn from history and take steps the American Republic is the first to stand the test of time."

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So they argued that P/E ratios should not be based on only one year’s worth of earnings. It is much better, they wrote in “Security Analysis,” to look at profits for “not less than five years, preferably seven or ten years.”

This advice has been largely lost to history. For one thing, collecting a decade’s worth of earnings data can be time consuming. It also seems a little strange to look so far into the past when your goal is to predict future returns.

But at least two economists have remembered the advice. For years, John Y. Campbell and Robert J. Shiller have been calculating long-term P/E ratios. When they were invited to a make a presentation to Alan Greenspan in 1996, they used the statistic to argue that stocks were badly overvalued. A few days later, Mr. Greenspan touched off a brief worldwide sell-off by wondering aloud whether “irrational exuberance” was infecting the markets. In 2000, not long before the market began its real swoon, Mr. Shiller published a book that used Mr. Greenspan’s phrase as its title.

Today, the Graham-Dodd approach produces a very different picture from the one that Wall Street has been offering. Based on average profits over the last 10 years, the P/E ratio has been hovering around 27 recently. That’s higher than it has been at any other point over the last 130 years, save the great bubbles of the 1920s and the 1990s. The stock run-up of the 1990s was so big, in other words, that the market may still not have fully worked it off.

Now, this one statistic does not mean that a bear market is inevitable. But it does offer a good framework for thinking about stocks.

Over the last few years, corporate profits have soared. Economies around the world have been growing, new technologies have made companies more efficient and for a variety of reasons — globalization and automation chief among them — workers have not been able to demand big pay increases. In just three years, from 2003 to 2006, inflation-adjusted corporate profits jumped more than 30 percent, according to the Commerce Department. This profit boom has allowed standard, one-year P/E ratios to remain fairly low.

Going forward, one possibility is that the boom will continue. In this case, the Graham-Dodd P/E ratio doesn’t really matter. It is capturing a reality that no longer exists, and stocks could do well over the next few years.

The other possibility is that the boom will prove fleeting. Perhaps the recent productivity gains will peter out (as some measures suggest is already happening). Or perhaps the world’s major economies will slump in the next few years. If something along these lines happens, stocks may suddenly start to look very expensive.

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