I'm going to talk about the valuation of the overall stock market, however, before I get started, I want to make a few statements:

• I have written stories about how I felt the market overreacted to certain events such as Greenspan's 1/4 point rate hike in March of 1997 and the Asian crisis. When Greenspan raised interest rates in March of 1997 there were no signs of inflation at the time and many reasons why there would not be inflation in the future (I get specific about the reasons in a story I wrote before the rate hike, March 5, 1997 called Greenspan, Inflation and Valuation, I talk more about the subject in a story I wrote after the rate hike, April 25, 1997 called Is Greenspan Creating Inflation?). My point was and still is, that the market's 10% correction was not for fundamental reasons, but simply due to Wall Street's overreaction to Greenspan's unnecessary 1/4 point rate hike. It's the same for the NASDAQ's 15% correction last October. The US is a trillion dollar economy (estimated GDP for 1998 is close to 8 trillion dollars), with ourselves being our biggest customer. The fact that the US may lose a few billion dollars in exports due to the Asian crisis was in no way a reason to sell off virtually every listed stock in the US. Again the correction was not due to fundamental reasons, but to Wall Street's overreaction (I talk more about the subject in a story I wrote October 31, 1997, called What Caused the Correction of October 1997?). I am mentioning this because I don't want to confuse anyone. In March and October 1997 I didn't feel that the overall market was overvalued, nor did I feel that the March and October corrections were for fundamental reasons, but for reasons I have already talked about. However, now in April 1998 I'm beginning to believe that the overall market is overvalued. Fundamentals are completely different now than in 1997. I am going to discuss how they are different in this story.

• In some of my stories I have stated that at any given time, there will be under and overvalued stocks. Up until recently, the last few years, you could buy stocks that would not be as affected during a correction. For example, small-cap stock prices are more dependent on internal forces (individual company fundamentals) than external forces such as a major economic news. Other examples could be stocks that had good earnings growth, but had low PEs and low price to book ratios. However, with today's stock market being more and more controlled by the institutions, and those institutions becoming more and more momentum investors, the chances of finding "defensive" stocks, those stocks that will weather a correction, is becoming harder. Institutions are no longer fundamentally analyzing stocks, but are simply buying and selling on momentum. My point is, it doesn't seem to matter if there are under and overvalued stocks, even if you buy undervalued stocks, they most likely, will get hit just as hard as the overvalued stocks during a correction. The bottom line is: the only way to avoid a correction is to be completely out of the market and this means being a "market timer" which historically has been almost impossible to do with any consistency.
  

• In the "Introduction" to Inside the Stock Market, I state that I believe that in the year 2010, when the first baby boomers start to retire (some will have already retired), the stock market will start feeling the strain of more money coming out of the market than going in. Just as easily as prices were driven up, they will be driven down. I still believe this is inevitable, that is, there is going to be a large shift in stock market returns when the baby boomers retire. But, where as before, I thought the stock market would just keep going up until that time, I'm not so sure anymore. This story is about why I'm not so sure anymore.

April 22, 1998

Investors buy stocks to make money rather it be through capital gains or dividends. For stocks to have capital gains or dividends the company must have earnings (make money). Not only do companies need to have earnings, but they need to grow their earnings (make more money in the future). To better understand, imagine investing in people and not in companies. There are two individuals, one is just starting medical school, and the other one is a high school graduate who is now working in construction (they both are 22 years old). The one in medical school is not making any money and even has a negative cash flow, the one in construction is making money and increasing their net worth. How a fundamental investor would look at these two as an investment may be: even though the one in medical school has no earnings, their potential to earn lots of money is higher, higher than that of the one in construction, the future doctor's stock may demand a premium over the construction worker's stock because of the "potential" for better earnings growth sometime in the future. The construction worker's stock may still demand a good price as long as they have good earnings and are growing their earnings at a good rate, say 10-25% a year.

Once the fundamental investor decides who they are going to invest in, they need to continually monitor, making sure that the investment is meeting certain criteria. The investor will analyze ratios, balance sheet, and even more subjective issues such as management, products, and competition. When the investment no longer meets specs (falls within the criteria outlined by the investor), the fundamental investor will sell. The specifications will vary, however, there will be times when an investment will no longer "fit in" to even the widest specs. It doesn't necessarily mean that the investment is no longer a good investment, but it will mean that the investment is no longer based on fundamentals, but on momentum (for my purposes I am assuming there are only two types of stock investing: 1) fundamental and 2) momentum).

This is what I think is happening to the overall stock market, it's turning into a momentum investment. No one can prove one way or another this point, but I can give you examples and let you judge for yourselves. Like I said earlier, the most important item that a fundamentalist wants is earnings and earnings growth. The best way to look at earnings and earnings growth is by analyzing trailing and forward 12 month PEs. If a stock is $10 a share and earns a dollar it has a P/E, where P = the price of the stock and E = the earnings of the stock for 1 year (4 quarters), of 10. This is a trailing PE because it is based are the last year's earnings. If we estimated the next year earnings were going to be $2 a share we would get a forward PE of 5, $10 share price divided by $2 of future earnings. Please note that the trailing PE of 10 is a known, true value, however, the forward PE of 5 is really only an estimate because it is based on an estimate, an estimate of next year's earnings.

Now let's look at some historical data on annual average PEs (not trailing or forward, but the annual average) and the CPI (inflation) and compare them to the present.

Note: in 1931 and 1932 the PE was not actually 0, but was NMF or what they call not meaningful, what it really means is that earnings were negative or losses. I don't know what the exact losses were.

I selected this period simply because it included the "Crash of 29." PEs prior to the crash were all less than 22 and even in the year after the crash 1930, the PE was still only 21.4. The CPI or inflation during this period was very good (2.4 through -1.9) until after the crash when there was severe deflation. The next period I want to look at is 1959 through 1965.

I selected this period because it's during an optimum inflation period. No inflation and no deflation. Wall Street loves to justify the extremely high current trailing PE of close to 28 by saying that's okay when inflation is so low. Well the fact is that stocks were either 50% undervalued during the period between 1959 and 1965 (optimim inflation and PEs around 18) or they are about 30% overvalued today (optimim inflation and PEs around 28). Since historically PEs have never been higher than 20-23 for an extended period of time, even during optimum inflation periods, I believe that the current stock market is overvalued by at least 15-20%.

Remember that overvalued and undervalued are fundamental terms. There is no reason why stock prices can't continue to go up even if there are not earnings now and in the future to support the increase in stock prices. But one thing you need to understand is that at these levels of stock prices and PEs the stock market is no longer based on fundamentals, but is based on momemtum.

One thing that could still make the current market a fundamental one and not a momemtum one is that earnings in the fext few quarters come in at fantastic levels. With fantastic earnings and the market staying at its current levels (9100 for the DOW and 1900 for NASDAQ) PEs would drop to "normal" levels. However, if the stock market continues to go up at greater than 10% per quarter, even superior earnings won't bring back "normal" PEs. Bottom line: the only way the stock market can be called a fundamental market is if stock prices stay about the same and earnings for the next few quarters are great. Any other case is going to point to the fact that the market is turning into a momentum market.

A question that you may be asking yourselves now is, what's the big deal, who cares if the stock market is based on fundamentals or momemtum? The answer is that a market based on fundamentals will be there for you in the future like you want it to be, for example, for your retirement. Markets based on momentum never last. No stock market ever maintains PEs of 40, 50, or 60. The classic case is Japan. When the Nikkei was at 20-25K in the late eighties, it started to become fundamentally overvalued, however, on momentum, it continued well past 50K, today it's at 15K, only 30% of its value 9 years ago. There is absolutely no reason why the same thing can't happen here in the US and several reasons why it could.

• Irresponsible institutions and inexperienced small investors. The institutions have used advertising to convince all the small investors that all they have to do is to use dollar-cost-averaging, invest in stock mutual funds, and stay in it for the long-term, and they will have a nice nest egg waiting for them when they retire. Unfortunately, this is not necessarily true. If too much money was coming into the stock market, driving stock prices up past their fundamental values, how would it be slowed down, that is, the money coming in? Small investors are not going to stop giving money to the institutions through 401k plans because they don't have a clue as to what market valuations even are and also because of what I said earlier, small investor have all been convinced that all they need to do is to just keep contributing, don't worry about current market levels, just keep contributing. The institutions are not about to start changing their operations. They're in fat city. There is no way that the institutions are going to come out and say, "You know, we really have pushed the market to the stratosphere and maybe it's time to start backing off and allocating funds to a different category." This is a lose/lose situation for the middle class. They don't know any better simply because they are not professional investors, and the people they are paying to look out for their best interests could really care less about their best interests.

  One question to ask yourself is do I see this happening around me personally. That is, are you investing most of your money in stocks now, say more than 80%? Are most of your friends and relatives? Are you aware of the current levels of the US stock markets, or do you not care, that you are a long-term investor and don't really care where the markets are on a month to month basis? You trust your mutual fund company to look out for your best interest?

• Wall Street is "selling" (marketing) stocks. Wall Street's biggest sells pitch is that stocks have always had the best returns of any investment over a long period of time. This may be true now and in the future, who knows. But one thing for sure is that the stock market is different now then before, because now there is a big marketing machine (Wall Street) pushing everyone to buy stocks. Before most people didn't even have anything to do with stocks, stocks were allowed to grow based mostly on fundamentals. With the current frenzy of stock ownership it is very possible that stocks could get severely overpriced before anything corrects.

  I think it's interesting to point out here that this frenzy goes way outside of the US borders. Investors outside the US seem to think like most small investors here, that the US stock markets have guaranteed great returns as long as you invest each month for the long-term. I'm sure there are overseas investment companies that are pushing US stocks as much as the companies here are pushing them. This makes the situation even that much more critical.

  It's funny how in 1984 the vast majority of Americans thought that the stock market was a risky place to invest. The PE ratio of the stock market then was 9.8, in 1998 it's almost 3 times as high, but investors think the stock market has minimum risk...as long as you invest for the long-term. Between now and 1984 the stock market has gone up by almost 700% (14 years). In 1984 the stock market had gone up by only 90% from 1960 to 1984 (and that's a 24 year period).

  My point is that it's different now then before because Wall Street, along with help from the insecurity people feel about Social Security, is actually marketing stocks, selling them like cars and tennis shoes. Remember GM in the 50s and 60s, they were selling some of the most inefficient and unreliable automobiles in the world (like Wall Street is selling overpriced stocks now) and would have continued to sell them if not for the oil embargo and foreign competition. The point I tried to make in the previous bullet was that there is nothing to stop it or control it, the push for buying stock. Nobody guessed what would happen to GM and no one knows what's going to happen to Wall Street.

• The sheer dollar amount of the current market levels. I feel that one of the most important considerations an investor needs to think about with the markets at their current levels is the sheer dollar amount of those levels. When I started to invest in 1984 the market value in dollar amount was just over $1 trillion dollars, now it's over $10 trillion. Take for example 1) last year the stock market added $3.6 trillion to household net worth. The total GDP, that's everything, consumer, business, and government, was $7 trillion. 2) A 10% movement in the market adds...or subtracts $1 trillion in market cap, that's real money, money held on balance sheets that banks loan against. 3) A relatively small amount of money will come into the stock market or an individual stock and the market cap of the investment will go up by 10 fold or more, unfortunately, I don't know how to get any exact values, that is, X amount of dollars comes in and the market maker/specialist jacks up the stock price X amount which inturn adds X amount to the market cap of the particular investment. However, I can give an example: today Microsoft was up 4 points and there was 20,000,000 shares traded, even if I make a ridiculous assumption and assume that all 20,000,000 were bought it would have cost $2 billion dollars (the amount I would have needed to pay the market maker outright to buy those 20,000,000 shares), with that purchase the market makers raised Microsoft stock by $10 billion dollars (2.5 billion shares outstanding times a 4 point stock movement), that's a 5 fold increase and that's assuming that all 20,000,000 were bought. My point is, that the market drives up stock prices so much on such a small investment.

  I don't honestly believe that the market makers/specialists/and institutional investors even realize how much market caps are changing. They always talk about how $20 or so billion came into the market this period, but they never seem to think about the fact or question the fact that during that same period, that $20 billion caused market caps to go up by $100 to $200 billion (all that's necessary to increase market caps by $100 to $200 billion is a 100 to 200 point change in the Dow). By contrast when the Asian markets fell last October it was estimated that total losses were $200 billion and Wall Street just about had a coronary over that.

• The fact that earnings are not supporting the increase in stock prices quarter after quarter. Here are four graphs: 1) the S&P 500 PE versus the S&P 500, 2) Microsoft's PE versus Microsoft's stock price, 3) Dell's PE versus Dell's stock price, 4) Gateway's PE versus Gateway's stock price. All four graphs cover a three year period (1995-1998) and all PEs are trailing PEs. I selected the S&P 500 because it is the most widely used index and I selected Microsoft, Dell, and Gateway because this is the computer age and these are three of the biggest software and hardware manufacturers in the world.

  

  

  

  

  Earlier I said that one thing that could justify the lofty PEs would be good earnings. From the above four graphs it really looks like year after year for the past three years, those great earnings (relative to increases in stock prices) just aren't catching up with stock prices.

  From an article in Business Week (4/27/98), "Profits Take a Pounding. But Do Investors Care?" "They're counting on a rebound in the second half" This statement suggests to me that PEs are just now starting to trend higher and as long as there is great earnings in the second half everything should level out (stock prices and PEs). However, it looks like (from the graphs) that PEs have been wanting exceptional earnings for several quarters now, but they just aren't coming around. But, who knows, maybe the earnings will finally catch up to the lofty levels of stock prices in the second half of 1998?

• The lack of diversity in the market. Even though the investment companies tell investors to diversify, they themselves are doing anything, but that. Most mutual funds have over half their assets in a few stocks, 20-30 (for larger funds the number is higher). If diversity is so important, which I think it is, why do Microsoft, Intel, Cisco, Dell, and Worldcom/MCI make up 25% of the total market cap of NASDAQ (only 5 companies, there are 5500 listed on NASDAQ)? If anything goes wrong with this group it could really rock the market.

• The fact that some parts of the stock market are turning into nothing less than gambling houses. Three years ago most of the market was based on fundamentals, for the next three years (95-97) it would shift to a momentum based market, and now in 1998 there are sectors of the market that individuals are treating like gambling houses. Those individuals are made up of small investors, traders, and institutions. I personaly don't care how I make money in the market, but if I was gambling I would admit it, and not try to pawn it off to myself, let alone, my customers that it was "investing." The frenzy with the net stocks this past month is nothing more than a big gamble. K-Tel up 500%, Cybershop up 200%, Infoseek up 100%, Lycos up 100%, all in just a couple of weeks. If more fund managers get addicted to this kind of "investing" look out.

• Money management firms selling out. I'll let Forbes magazine (4/20/98, pg. 217) say it,

  "If you look at the numbers that the public sees, all is bliss in the fund business...To the masses, Wall Street is a great place to make money. Day after day the Dow and the S&P hit new highs. Who cares if stocks are trading at double their normal price/earnings ratios?"

  "But if you look around, you notice some smart guys trading their spreadsheets for ships' logs. Do they know something we don't? The fabulous 16-year bull market has been good to these people. How much better can it get? Who wants to be around when the correction comes and the common folk no longer heed your pitch about always buying on dips?"

  "More than 100 money management firms have sold out, in whole or in part, in the past two years, and the pace is accelerating."

  Why do you think so many management firms have sold and are selling out? Could it be that they think things are going to get worse, I doubt very much that they would be selling out it they thought things were going to get even better?

One final thought, it looks like asset allocation, that is, the percent amount that investors have in the three basic investments: stocks, bonds, and cash is becoming a one-sided issue. 100% in stocks and none in bonds and cash. I say this because Fidelity has $600 billion under management and $400 billion of that is in stock mutual funds. And when you consider that the wealthy are usually not concerned about capital growth, but are concerned with capital preservation, I wouldn't be a bit surprised that most of that $200 billion that isn't in stocks, but in more conservative investments like bonds and cash, belongs to the wealthy and the part that doesn't belong to the wealthy, most likely, belongs to the old (who are generally more conservative with their investments). What this means is that there are probably a lot of baby boomers out there that have a stock allocation of 80-100%. The only one who knows is you. You might want to rethink your asset allocations and adjust as necessary. Also, no matter what portion you are going to allocate to stocks, I still think your best bet is index mutual funds. There is no reason to believe that the institutions are going to change the color of their spots. They have been buying the large cap stocks, those that make up the indexes such as the S&P 500, for the past three years, and will most likely continue to do so in the future.

ADDENDUM (April 27, 1998)

Less then 5 days after I first posted this story, Wall Street has already reinforced a couple of my points:

• I said that you would not be able to find any defensive stocks, stocks that would not be affected by a correction. This occurs when investing turns into momemtum investing. When institutions are no longer fundamentally analyzing stocks, but are simply buying and selling on momentum.

  This is exactly what happened today, Europe, Asia, Latin America, US stock markets, all hit hard. small-cap, mid cap, large cap stocks, all hit hard. Tech stocks and non-tech stocks, all hit hard. Cyclicals, financials, transportation, and utilities, all hit hard. One thing I'm not saying is that there were not some sectors or some stocks that did better than others, no way is everything going to be equally affected.

• I said that the stock market was one driven by momentum and that investors in 401ks weren't going to slow the stock market down because they have been "conditioned" to believe that as long as they dollar-cost-average and invest for the long-term they have nothing to worry about. Institutional investors weren't going to slow the stock market down because they're in fat city, as long as the small investors keep giving them money each payday through 401k plans, they would keep buying stocks rather they were overvalued or not.

  Well guess what, who's going to try and slow down the stock market? Mr. Greenspan and the Fed by suggesting a possible interest rate increase, that's who.

  This is crazy, why can't Greenspan and Wall Street get together and discuss the fact that the stock market is fundamentally overvalued? Why does there have to be threats or actual interest rate increases? As you saw today, threats of a rate increase, affects markets all over the world, and it affects the stock market here for all the wrong reasons. There is no threat of inflation and therefore should be no rate hikes or threats of a rate hike.

  Even in Greenspan's own words, "In the long run, the price [of a stock] is determined by how good a company it is." Wall Street tells their customers the same thing, use fundamental analysis, and invest for the long-term. Not Greenspan or Wall Street suggests that you should be a momentum investor and to buy something just because it's going up. Since both Greenspan and Wall Street know about fundamentals, why don't they talk about them. Why does there have to be threats of a rate hike which really isn't going to affect the stocks that are necessarily overvalued?

  For example: Microsoft has a PE of 58 even though its earnings for March 31, 1998 only grew at a 25% rate ($0.50 per share for the 3Q as compared to $0.40 per share for the previous quarter). Microsoft has a PE of 58 even though the consensus earnings estimate for Microsoft for Jun of 1999 is only $2.03 per share, only a 19% increase over the estimated $1.71 a share for June of 1998. I am only using Microsoft for illustrative purposes (EPS and estimates from Yahoo/Zacks, last updated 4-27-98). My point is that Wall Street has to start practicing what it preaches and that is to get off the momentum bandwagon and start fundamentally analyzing stocks. Slow the market down by fundamental analysis, not by an unnecessary rate hike that can affect all stock markets and economies too.

  As far as irrational exuberance goes, this time it's different. When Greenspan first made his irrational exuberance statement in 1996, the stock market was at 6500 and had a trailing PE of about 20, now the stock market is up by $2.5 trillion and has a trailing PE of about 26 (meaning the stock market is 35% higher and PEs are 30% higher now then in 1996).

ADDENDUM (April 28, 1998)

Today on CNBC I heard one stock market guru say they estimated earnings growth of 0 for this year and maybe even next year, but they thought the stock market should go higher. This is ridiculous, with the current PE of 26 you have to have some earnings growth to support stocks at these levels. In my opinion, this guru is definitely supporting the fact that the stock market is being view as a momemtum play.

Another guru stated that there was no problem with the stock market at its current levels as long as the long-bond went to 5 1/2% and they thought that would happen by year end. Wall Street continues to try and justify lofty stock prices by playing around with inflation, the long-bond, and PEs. I have one question for Wall Street:

I had a chart for the S&P 500 PE and S&P 500 for the period 1959-1965. It showed inflation was between 1.0 and 1.6 for the period and PEs were between 17.0 and 21.7 for the period. During that period the stock market went up by about 40%, and the long-bond was between 4 and 5%.

Compare that to the present. Inflation has just gotten below 2% within the last year and the PE of the S&P 500 is 26 (and estimates for earnings for the S&P 500 are flat). For the past 5 years the market has gone up by 144% and the long-bond for the past 5 years has been between 5.75 and 8.2%.

If you are correct and the stock market should go up even further, then the stock market back in 59-65 was severely undervalued. PEs were lower, inflation was better, and the long-bond was lower. Why then, back in 1959-1965, weren't you really pushing stocks higher?

The reason why? Because the stock market wasn't that undervalued back then. Also, and more importantly, Wall Street wasn't marketing stocks back then. If I watched a Giants game back then, I didn't see TV ads saying, "buy stock mutual funds." If I read the evening paper back then, I didn't see ads saying, "buy stock mutual funds." The government back then wasn't warning people that Social Security might go bankrupt sometime in the future, the news media back then wasn't warning everyone about how Social Security wasn't suppose to be enough for someone to retire on so you had better be saving more on your own. Major corporations back then weren't telling their employees that they don't want to be in the retirement business and are going to halt all defined benefit plans for something new called IRAs and 401ks.

Wall Street you might as well admit it. It worked. You have convinced everyone that they should buy stocks, and that's just what they are going to keep doing until the bubble bursts. Yes, it could go up for another year, another two years, who knows, but no matter how much further up it goes, it's not going up because stocks are worth that much, or because inflation is at a certain level, or because earnings are estimated to be flat for the next year, or because the long-bond is at 6%. It will be going up simply because the momentum is there, momentum created by the Wall Street Marketing Machine.

ADDENDUM (June 15, 1998)

Since the day I wrote this story, the DOW and S&P 500 are down over 5%, NASDAQ is down over 10%, and sixty percent of the stocks listed on NASDAQ are down more than 20% year to date.

ADDENDUM (September 12, 1998)

On Wall Street Week (PBS) yesterday, Harvey Eisen, Chairman at Bedford Oak Partners, was asked what he made of the situation. The situation being the stock market decline (On September 11, the averages stood: Dow at 7796, NYSE at 500, S&P 500 at 1009, the AMEX at 613, the NASDAQ at 1642, and the Russell 2000 at 354.), he replied,

"It's simple, we had a stock market crash. The month of August was only exceeded by the month of October, 1987. This is a stock market crash. The averages are down 20%, the Russell is down over 30%, the average NYSE stock is down close to 40%, the average NASDAQ over 50%. CRASH!"

Rukeyser then asks, "What do we do about it?" This is when you change the channel, the last thing you want to do is listen to Wall Street.

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