After the Bubble

A look at a century of investing puts a couple of really bad years in perspective, as investors move from irrational exuberance to irrational despondency.

September 1 2002

The bear market spanning the last 2.5 years has been very trying for stockholders. From the peak of the S&P 500 Index of 1527 on March 27, 2000, to the bear-market low on July 23, 2002, of 798, stocks have fallen almost 48%, just shy of the largest postwar bear market that occurred in 1973-1974. Investors are plagued with losses in their accounts and are left wondering, "What got us into this horrendous market, and what does this mean for my financial planning going forward?"

There are two roots to the market's current malaise. First, the huge bull market in technology stocks created an extremely overvalued tech sector. The first part of this bear market was just a correction of these excesses. The second part was caused by the corporate scandals that have rocked Wall Street and have created a crisis in confidence in the earnings being reported by firms.

Although the bull market of the 1990s lifted all stocks, the 17.4% annualized return of the Wilshire 5000 during that decade is puny compared with the 31.3% return experienced in the tech-laden Nasdaq average. Nasdaq returns from December 31, 1990, to the peak on March 10, 2000, were 33.5% per year. In the four years preceding the peak, the Nasdaq increased nearly 400%, an annual rate of increase of almost 50%.

The public's fascination with the Internet and related technologies led to the most unprecedented valuations of large capitalization stocks in U.S. history. In March 2002, six of the top 20 stocks ranked in terms of market value (Cisco, AOL, Sun Microsystems, Oracle, Nortel and EMC), exceeded 100 times earnings. JDSU and Yahoo!, each of which had a market capitalization of over $90 billion, had P/E ratios in excess of 600.

Valuations such as these had absolutely no historical precedent. The highest P/E that had ever been accorded a large capitalization stock before the last bull market was the 95 P/E ratio that Polaroid had reached in December 1971. Do you need to be reminded that Polaroid, now in bankruptcy, did not fulfill the expectations of these enthusiastic investors 30 years earlier?

I was extremely concerned that the magnitude of the technology bubble was so great that when it broke, it would adversely affect the entire market. Research told me that no stock, once it reaches big-cap status, has ever been worth 100 times earnings on the basis of its future performance. I put these concerns into an Op-Ed piece in The Wall Street Journal on March 14, 2000, "Big Cap Stocks are Sucker's Bets." I voiced similar concerns on CNN's Moneyline the Friday before, on March 10.

Given my past fondness for large-cap growth, many considered it somewhat ironic that I was telling investors to sell these stocks. In my book Stocks for the Long Run, I illustrated that many of the Nifty Fifty large-cap growth stocks that crashed precipitously during the 1973-1974 bear market actually were worth the prices paid for them at the market peak. In fact, in a chapter entitled "The Nifty Fifty Revisited," I showed that big-cap growth stocks were worth, on average, about 40 times earnings and on occasion 50 or 60 times earnings. This surprised many Wall Street portfolio managers. In the 1980s and early 1990s many still remembered the collapse of the Nifty Fifty and were reluctant to buy stocks selling above 30 times earnings. It should not be considered unusual that once the reluctance to pay up for growth stocks vanished, the pendulum would swing too far in the other direction. In early 2000, no P/E seemed too high to pay for growth stocks, especially if they were tied to the "new economy."

The subsequent fall of the Nasdaq was brutal. A dot-com index of 24 Internet stocks fell from a high of 1350 in March 2000 to a low of 71 in July 2002, a decline of nearly 95%. The Nasdaq itself fell by more than three-quarters, and the big-cap tech stocks noted above fell somewhere between 84% and 99%. Non-tech stocks, fortunately, were little affected by this drop, and in March 2002 the Dow Jones Industrial Average, composed of mostly "old economy" stocks, was actually above the level attained in March 2000 when the Nasdaq reached its peak.

The second leg of the bear market, which occurred in the spring and summer of 2002, was sparked by concern over earnings quality and corporate governance. The Enron affair was the catalyst that made investors realize that something was seriously amiss.

Throughout the bull market of the 1990s, management put increased emphasis on generating capital gains for investors in lieu of paying dividends. The reason for this shift was two-fold. First, investors were becoming more tax-sensitive, and the capital gains tax, which could be deferred, was only one-half the top rate on dividend income. And a new powerful force pushing for capital gains was the emergence of employee stock options. For option holders, capital gains--and not dividend income--are the sole source of increased value.

As long as the retained earnings were real and being used effectively to create value, the emphasis on capital gains instead of dividends was beneficial for most investors. Younger investors did not want taxable income, and older investors could liquidate shares at ever-rising prices to generate income at the favorable capital gains tax rate. But if those earnings were not real, there was real trouble brewing.

In the 1990s the definition of corporate earnings was evolving in a way that also spelled trouble. Management became increasingly reliant on an undefined concept of "operating income" instead of on "reported income" that conformed to Generally Accepted Accounting Principles.

Operating earnings were almost always higher than reported earnings because the former eliminated one-time charges, such as write-offs and restructurings that depressed the official GAAP reports. Analysts readily cheered the concept because they had a hard time forecasting these one-time changes and felt that pro forma earnings presented a cleaner picture of the ongoing operations of the firms. Soon operating earnings became the focus of investors and traders alike.

The problem was that operating earnings were not defined by the accounting profession and could be readily manipulated by management. Increasingly firms wrote off losses (such as inventory losses, restructuring of continuing operations, etc.) instead of subtracting such expenses from operating profits. The Enron scandal made us realize how easy it was to hide billions of dollars of expenses in special purpose enterprises and other off-balance sheet entries that analysts did not understand or uncover.

Panic about fraud and earnings quality spread when questions arose over the earnings quality of firms such as Tyco, WorldCom and Global Crossing. It became more serious when the earnings of several large pharmaceutical firms and even General Electric, the bluest of the blue chips, came into question. Suddenly there was no place to hide.

The Need for a Dividend Deduction

Investors soon discovered the dark side of relying almost exclusively on earnings to value stocks. As I pointed out in a Wall Street Journal editorial, "The Dividend Deficit," on February 13, 2002, the confidence investors placed in earnings instead of dividends was new. Throughout the 19th and the first half of the 20th century, more than 75% of the historical real return of stocks was through dividends and not capital gains. Dividends were regarded as the true signal of value, and investors put little confidence in and paid little attention to the profit reports of firms.

In research with my colleagues Andrew Metrick from Wharton and Paul Gompers from Harvard Business School, we noted that a simple change in the tax code could completely reverse the decline in dividends: Make dividends tax deductible at the corporate level. Firms with real earnings (and the great majority of firms have not faked their profits) would pay them out as dividends and, much like when firms float bonds and pay interest costs, they would receive a corporate tax deduction.

This proposal cures many of the corporate governance issues currently plaguing U.S. capital markets. It would reduce the incentive for firms to increase their leverage in order to receive the tax-deductible interest costs and thereby stem the sharp rise of corporate bankruptcies that we have seen recently. Increasing dividend payments also reduces the incentive for firms to issue options, since in a world where dividends are the primary source of return, capital gains would be harder to come by and options would be worth far less. This proposal would therefore increase the incentive to pay employees with "restricted stock" that receives dividend income. And since the only practical difference between compensating employees with stock versus options is that stock grants must be expensed on the income statement while options do not, this proposal, in effect, would also likely make earnings numbers more reliable. Finally, this proposal would eliminate a firm's incentive to reincorporate outside the United States to avoid taxes on non-U.S. income. Instead of using legal maneuvering to incorporate in a tax haven in Bermuda, firms could automatically avoid these taxes by paying out profits as dividends.

Although the deductibility of dividends would increase the credibility of corporate earnings and provide a real source of cash return, investors would remain confused by the proliferation of earnings concepts and the potential for management to abuse them. This is why Standard & Poor's concept of "core earnings," proposed in May 2002, is so critical.

"Core earnings" achieve what "operating earnings" intended--that is, core earnings are the best measure of the ongoing profitability of a company's core businesses. The core earnings method subtracts option expenses, portfolio gains and most restructuring charges from reported earnings, while it adds back goodwill charges and other write-downs associated with mergers. The core earnings concept is extremely demanding. A review of all S&P 500 firms showed that core earnings in 2001 were only 83% of reported (or GAAP) earnings and only 66% of operating earnings (assuming JDS Uniphase, which took a whopping $56 billion write-down, is excluded). The 17% difference between core and reported earnings was almost all option expenses, as the net effect of other adjustments (including exclusion of the gains from pension portfolios) was essentially zero.

What about today? Operating earnings on the S&P 500 Index are estimated to be about $50 per share in 2002, but about $40 when looked at from the standpoint of core earnings. Does that mean the market is overvalued? Undervalued? Fairly valued? Before we can answer that question, we must first determine: What is the right P/E ratio for stocks?

Some bearish forecasters have maintained that the long-term average P/E ratio of 15 is appropriate and that the market thus has considerable more downside risk at current levels. Yet the market has been significantly above its long-term average for quite some time. As the market P/E ratio rose to record highs during the last bull market, equity investors searched for reasons to justify these higher valuations. The two most popular explanations offered by Wall Street were: (1) low inflation and low interest rates, and (2) faster economic growth. Unfortunately both of these reasons for higher stock prices are flawed on theoretical and empirical grounds.

It is true that bonds are the major asset class that competes with stocks in investors' portfolios, so one might expect that low interest rates would be favorable for stocks. But since in the long run low interest rates are caused by low inflation, the rate of growth of earnings, which depends in large part on the rate of inflation, will be lower also. Over long periods of time, changes in the inflation rate cause changes in earnings growth of the same magnitude and should not influence the valuation of stocks.

This proposition is borne out by the historical data. The average P/E ratio for stocks in the 19th and early part of the 20th century was essentially the same as that after World War II, although before the war inflation averaged zero and interest rates were quite low, while after the war average inflation and interest rates have been significantly higher.

This analysis also indicates that the "Fed model," which compares the interest rate on long-term government bonds to the earnings yield on stocks (the inverse of the P/E ratio), must be approached with great care. Stocks are real assets and bonds are nominal assets. At low rates of inflation, and especially in situations where deflation is threatened, bonds take on a special risk-hedging quality that is totally absent from stocks. The fact that from 1929 through the 1930s government bonds were by far the best asset to hold is not lost on investors. At very low rates of inflation, such as we have today, the Fed model breaks down and stock returns will disconnect with bonds returns, as they did in the first half of the 20th century.

A second explanation for higher P/E ratios is that accelerating productivity gains will drive economic growth, earnings growth and stock prices to higher levels. Since stock prices are the present value of future dividends, it would seem natural to assume that economic growth would raise future earnings and dividends and be an important factor influencing stock prices.

But this is not necessarily so. The determinants of stock prices are earnings and dividends calculated on a per-share basis. Although economic growth influences aggregate earnings and dividends favorably, it does not necessarily increase the growth of per-share earnings or dividends.

The reason for this is that economic growth requires increased capital expenditures, and this capital does not come freely. Implementing and upgrading technology requires substantial investment. These expenditures must be funded either by borrowing in the debt market or by floating new shares. The added interest costs and the dilution of profits that this funding requires place a burden on the firm's bottom-line profits.

Many investors believe that investment in productivity-enhancing technology can increase profit margins and spur earnings growth to permanently higher levels. But "cost-saving investments," frequently touted as a source of increasing profit margins, only temporarily affect bottom-line earnings. As long as these investments are available to other firms, competition will force management to reduce product prices by the amount of the cost savings and extra profits will quickly be competed away. In fact, capital expenditures are often undertaken not necessarily to enhance profits but to preserve profits when other firms competitively adopt the same cost-saving measures.

The data on economic growth and earnings back up these points. Real per-share earnings growth from 1871 through 2001 has been a paltry 1.25% per-year, considerably below the nearly 4% growth rate of real GDP. Earnings per share growth fell far behind aggregate economic growth over the long run because of the cost to fund capital expenditures. In fact, the 1.25% growth in real per-share earnings can be explained solely by the investment of retained earnings and not by aggregate economic growth.

Why the Bears are Wrong

If lower inflation, interest rates and faster growth are satisfactory justification of higher stock valuations, does that mean that the bears are right? Are we in for an even more substantial correction? The answer is no. Things have changed to make stocks worthy of higher valuations.

Over the past 50 years our macro economy has clearly become more stable. The two worst economy-related events for equity prices, the Great Depression of the 1930s and the double-digit inflation of the 1970s, will never happen again. The mistakes of the central bank during these two episodes are widely understood and can be easily avoided. (Even Japan's current "depression," which was caused by serious mistakes by the Bank of Japan, is vastly less severe than the depression that enveloped the world in the 1930s). It was from these episodes that equity markets were slammed and P/E ratios driven down to the single digits. Excluding these episodes leaves historical earnings multiples in the high teens.

Another significant factor arguing for higher valuations is the far greater liquidity of today's market. Now even small investors can fully diversify and index their investments to virtually any market index at a cost of a few basis points per year. In the 19th and early 20th century it would have been quite difficult and costly for investors to achieve such complete diversification.

Finally, taxes on capital gains are the lowest since 1941. Since inflation is also low and capital gains are not indexed to inflation, the effective capital gains tax rate has been cut dramatically. If dividends are made tax deductible at the corporate level, this will also be a boon for stocks. Only a dramatic political shift that would raise taxes on shareholders would make equities unattractive from a tax standpoint. But the large and increasing influence of the shareholding class argues against this happening, despite the popular indignation against corporate misgovernance that has taken place recently.

Given all the above factors, P/E ratios in the low 20s are quite reasonable for stocks and particularly reasonable against the tough core earnings concept. With core earnings at $40, the equilibrium level of the S&P 500 Index should be somewhere between 800 and 1000.

From current levels, there is no reason why stocks cannot achieve their long-term historical returns of 6.7% per year after inflation, a level that would double purchasing power approximately every 10 years. There is no question in my mind that stocks will beat government bonds hands-down over all intermediate and long-term periods.

At present, government bonds are being bought as a short-term hedge against uncertainty and a falling stock market. Those hedges (like gold acting as such a would-be hedge for many years) have historically had very unsatisfactory returns. The real return on gold has been zero over the past 200 years. The historical real return on long-term government bonds has been 3.5%. But the current inflation-indexed 10-year bond is yielding only 2.6%. Going forward, the real returns on standard government bonds could be only 2% or less.

No doubt the bear market has been painful. But investors and financial planners alike must note that looking ahead, we are investing at levels that are more than 40% below the bull market peak. My research shows that once the market has declined by this magnitude, the long-term real returns on equities have been extremely rewarding to investors. It must be remembered that stocks would not be offering premium returns unless they exhibited risk. The fortitude of investors to hold through these trying times has made equities the best performing asset class in history.

We must also remember in trying times like these that the pendulum swings both ways. We heard people talking about the "irrational exuberance" of the market two years ago. It is also possible the market enters a period of "irrational despondency," where the market continues to fall for no good reason. This could create enormous opportunities for anyone willing to step in and buy stocks in the midst of doom and gloom. The wise Frank Williams, a successful stock trader of the early 20th century, summed up this situation well when he stated, "The market is most dangerous when it looks best; it is most inviting when it looks worst."