The U.S. Market Is Overheated

Stocks have an artificially high value and are due for a downward correction. Pro or con?

Pro: House of Cards

Most analysts are predicting 6% to 10% earnings increases for companies in the major stock market indexes. This, coupled with the current 2% average dividend yield, would provide investors with an 8% to 12% return for the year.

Behind these estimates, however, lie a number of optimistic assumptions that call for scrutiny.

One assumption is that earnings can continue to grow faster than the overall economy. Corporate profits as a percentage of gross domestic product have been rising for the past few years—and in 2006, rose to their highest levels since 1929. Can earnings continue to outpace the economy?

Today’s low unemployment rates may mean salary pressures will eat into earnings. Rising energy costs also may erode profits.

Another optimistic assumption is the lack of any major economic disruption. There are a number of negative scenarios that could wound the market.

For starters, trade deficits exceeding $800 billion a year loom large. This means that foreign investors, mostly governments, are taking the dollars they receive when we buy their goods and services and, rather than purchasing U.S.-made goods and services, are opting for U.S. Treasury debt or corporate securities.

Over the past few years, overseas investors have poured trillions more dollars into U.S. securities than we have purchased of theirs, thus keeping U.S. interest rates low. What if foreign governments stopped buying U.S. Treasuries? Treasury bill and bond prices would drop, and interest rates would surge. Worse yet, what if they lost confidence in the U.S. and tried to sell their holdings? Interest rates could skyrocket.

What else could go wrong? The housing market could collapse as a result of rising interest rates. A conflict could shut down a major Middle East oil supplier. A terrorist attack could slow consumer spending. Changing climate conditions could disable U.S. agriculture. Inflation could jump due to a collapsing dollar. Medicare or Social Security deficits could lead to tax hikes.

This market is priced for economic perfection. Any hint that perfection will not be achieved, and a serious drop could follow.

Con: Stability, Millennium Style

There’s a good reason stock indexes are trading near their all-time highs: Corporate profits are at record levels.

Yes, quarterly earnings for the companies in the Standard & Poor’s 500-stock index did drop into single-digit territory in the fourth quarter of 2006, after 18 quarters of double-digit gains, but they still rose 7.8% in the first quarter of 2007, according to S&P. Propped up by good results overseas, companies raked in profits despite a U.S. economy that was barely growing. Gross domestic product grew 0.6% in the first quarter, but most data suggest the economy is bouncing back strongly in the second quarter. That should help companies keep those profits high.

In March, 2000, when the S&P 500 closed at a then-record of 1,527.46, its price-to-earnings ratio was 27.8. Last month, when the index finally broke that record, the p-e ratio was about 17. There’s no evidence of the "irrational exuberance" that was much in evidence seven years ago.

In fact, there’s a lot of skepticism in the market. Many investors, especially individuals in the "retail" end of the securities business, are cautious, keeping their money on the sidelines. That’s a bullish sign, because it signals the existence of many potential buyers who could still enter the market.

In the meantime, other trends are helping stocks. Corporations’ balance sheets are strong, allowing them to invest in stock buybacks or acquire other companies. The flow of dollars into private equity gives buyout firms the means to purchase businesses at a premium to market prices and take them private. The effect of all this is to shrink the total number of shares on the market. That means fewer shares to satisfy growing demand.

In the short term, the stock market "will fluctuate," as J.P. Morgan once sagely observed, as various economic worries—interest rates, housing, consumer spending—come and go. But stock prices in this market are based on a solid foundation. As long as U.S. companies keep raking in profits, the market should stay strong.

Opinions and conclusions expressed in the BusinessWeek Debate Room do not necessarily reflect the views of BusinessWeek, BusinessWeek.com, or The McGraw-Hill Companies.

Reader Comments

Mighell

The lower interest may be the major aspect of the stock market.

Silvio

The twin deficits increase the risk for the U.S. Higher risks demand higher returns. To finance its debt, the U.S. might be forced to increase its interest rate in order to keep the funding coming in. When it happens, we might see realization in the stock market.

tgolferman

Record profits due to outsourcing (slave trade) appear to have peaked. Civil unrest is escalating worldwide. Protectionism is on the rise, which means inflation will pick up. Financing the deficit will also place upward pressure on interest rates. Iraq and Afghanistan military expenditures also increase money supply and inflationary pressures. Rates are going up, up, up. It only a matter of when. Hang on, the ride may get a lot more bumpy.

Brian R.

What is the chance that large foreign buyers of our Treasuries will start buying markedly fewer of those Treasuries? The answer is likely somewhere between slim and none. Where would a buyer prefer to buy --France, Argentina, or the USA? Not only should we not expect a reduction in the value of Treasuries bought by foreigners but also we should expect those purchases to increase markedly. Oil at 70 bucks a barrel results in a lot of cash to spend, and we in the USA have the paper the buyers want. Interest rates, including mortgage rates, aren't going anywhere.

New Times

The good news in all this is that America has lost its No. 1 position as the world's growth engine. The importance of a healthy America for the rest of the world is lessening every day.

Two hundred fifty million people cannot be the growth engine of the world forever; there is a power switch happening.

ZERO

China exports deflation. Chinese products are good and cheap. Who can raise prices in that world? The Chinese currency may get more expensive, but productivity in China is increasing. China, the enemy to some, is the dragon that slew U.S. inflation.

rolando

A spike in the interest rate in the U.S. would bring down companies like Wal-Mart and many who work with bank money, since the interest rate is low. Leverage is key in the U.S. economy. If the passive interest rate rises, there will be a fall in the stock market and the economy will take a big hit.

john

As long as hedge funds and private equity groups have access to large amounts of capital, they will artificially keep the support level for stocks high. If indeed money tightens up and these groups can't buy up good companies, the stock prices will have to test a new bottom.

Global liquidity is in good shape, and that's one of the best indicators the market is on a bull run for the intermediate term. On the other hand, in the short term, we could have a sharp correction over the next few months.

Robert

I have to agree with those who point out that credit/liquidity is key to propping up the markets in the short run. However, several points should be considered in regard to valuing U.S. markets:

1. Part of the run-up in nominal prices has been inflation. The DJIA in real dollars is still below its 2000 peak (dollars measured from 2000).

2. Foreign purchases of Treasuries have already dropped off steeply. Much of that money will find its way into Sovereign Wealth Funds in Asia, further shifting the weight of global investment.

3. China and India are consuming vast quantities of energy to fuel their growth. Their energy
consumption is going parabolic while global energy production remains relatively static. Energy is going to become way more expensive and will ultimately become the factor limiting further global economic growth. The markets assume a much more productive future than will probably be the case.

In short, U.S. markets will probably suffer from an adjusted distribution of global liquidity that will increasingly pour into Asia. In nominal terms, U.S. markets may hold up for quite a while but at the cost of a drastically devaluing dollar.

BOB BOYLE

Buy Honeywell, and see how much money you make. You need large caps with global exposure.

4GMF.org

The crashed U.S. Medicare and Social Security systems force many smart people and global talents to move back to China and India, where they can live in paradise with their technologies. Hence every single day, we are losing our ability to compete, and it will eventually affect our global economy.

Basically, the current U.S. economy is not as good as we've heard, and inflation is actually much higher. The stock market is strong to compensate for the weak dollar and inflation.

Strategery

We cannot continue to export our wealth through trade imbalances, and then borrow that money back to "fuel" our economy. One of these days, we will be forced to repay China and everyone else we borrowed from, resulting in a drastic lowering of our standard of living. Some countries that use U.S. dollars for their currency are converting to euros, further lowering the dollar's value. Corporate profits are now the highest since 1929? And what else happened that year? If corporate profits are so high, that means workers are underpaid and financially overextended, similar to the conditions in the 1920s. Save your pennies and lock in interest rates now.

Squeezebox

Several factors not mentioned: 1. The vast wealth in pension funds needs to be invested somewhere. The best returns at the moment are private equity funds. Being awash in cash, they keep buying out the stock market. 2. Companies are showing a preference for stock buybacks rather than retained earnings. 3. The rise in fuel prices will make local manufacturing on a smaller scale more profitable than sticking goods on a boat and sailing them off. The domestic companies and multinationals that avoid getting eaten by private equity will see their stocks rise as real unemployment falls.

Holly Garfield

I believe the new levels of global interaction will keep many of the "what if" scenarios from happening. When asking "what if" you should also ask "why would?"

We need to consider a timeline when looking at corrections. A 6% to 10% correction will take how long to get back to the same point? You may end up with a short-term problem that will work itself out if you have sufficient reserves and diversification. This is where global diversification can make a U.S. correction (or China, India, etc.) a relatively small event for an investor.

I look at a 25% to 30% predicted correction in China's Shanghai market in my portfolio. I have about half my investment in two China funds, one is Hong Kong based, and the other is Shanghai based. With that kind of correction, I would see a two to six month delay in one of my funds and less in the other, with little effect on the rest of my funds. What initially looks like a big problem ends up being a fairly small blip.

If we start looking at a correction in the timeframe "how long to get back to the starting point?" format, we investors can get a better handle on the damage level and mitigation/recovery process. This is a handy viewpoint, especially in today's global market where growth rates vary widely.

Another item to consider is the ability to correct any growth anomalies. The U.S. currently has federal interest rates mid-range to allow for substantial adjustment, so we have a built-in safety net. Most of the rest of the world is in the same condition, so we will have some time to adjust our investment strategies before major damage can be done if we properly diversify. If interest/reserve rates near an endpoint, the potential for more rapid changes grows greater.

The global economy is changing its balance rapidly, so we can expect a steady stream of corrections for quite some time. Many, if not all, of the mentioned factors will contribute to these corrections at some time. Asia/Pacific Rim and Latin America have a long way to go and the market size to make massive balance changes ahead. Africa will join the global party some time, too. While there will be many corrections and rebalancings, the potential for a long global bull market is here. We investors need to keep on our toes.

Martijn Sjoorda

A colleague sent me the following link:
http://www.youtube.com/watch?v=9ZrCkBJVlm4

Under the header "Important stock market update"

It's funny--and funny it was--that he should send me this, because I sat down to write him that, while it is of no real concern to us, I am noticing that "The Market" is making a very serious attempt to B.S. itself collectively again, toward a bear market, this time.

As usual, I haven't seen any truly convincing data. I think I am seeing a pattern, though.

All (investment) banks need to make fees, because if they don't make fees, their balance sheet eventually goes awry and they go down in credit rating, so they can provide less credit, so their clients will go down, because they can't feed their respective beasts. All advisers (lawyers, accountants, consultants) to banks need to make fees. Investors need to make money. But because credit is a good thing, a sizeable chunk of them effectively aren't investors, but borrowers. They do not invest; they borrow ever more money against increasingly fewer assets.

So first, some of the smartest guys at the banks come up with something. In the mid nineties it was "on balance hyper leveraged corporate finance." And everybody agreed for a while that this was a good, new thing. Since effectively that defied the laws of mathematics and a few others, something had to be done after a few years. So the smart guys came up with another smart thing. "Why don't we put a spin on securitization?" they asked themselves. And spin it they did. Next to the on balance hyper leveraged corporate finance, they found ways to generate funds for off balance financing. To astounding levels.

And then everybody was really surprised that this did not work out. Not for Internet companies and a few years later, because the stakes were a little higher on that and they did possess or professed to possess something vaguely resembling assets, energy, and infrastructure companies. And in the wake of it, the stock market saw a massive downturn. Which again, professedly, surprised the shoes off most of the smart guys mentioned earlier.

So for a while, everybody who might have lost his common sense temporarily went back to what always worked: If you want a healthy economy, at the top, you need governments that keep the budget reasonably in check (think all you like about the Clinton Administration, but this they did) and down below, companies that contribute to that economy by making more than they spend with a sane balance sheet and growing at a reasonable rate.

Not so our smart guys. Because the beasts must be fed. So they thought to themselves: "What can we do?" And they moved down the food chain. So over the past few years, they stuck to their deep held belief that credit is a good thing. So they started providing it literally, as one of them proudly described it "to anything that still had the semblance of a heartbeat in it." No assets? No problem. No credit rating? No problem.

And again, they were somewhat surprised that the failure rate on that type of credit was significantly higher than on traditional consumer credit. "What can we do?" they asked themselves. "Aaa," said one of them. "Remember the good old days of securitization?" "Yeah!" replied the others. And they went ahead and did it.

And now, they are beginning to see the end of the tenability of that position. Hence they start talking about a bear market. So they can blame the market and look for the next game.

My dad started his career as the deputy chief of the military police in the Royal Dutch Marine Corps. His superior was an old major who believed in discipline and tough love. Sometimes a marine would get in trouble financially. He'd bail them out, personally. But he would also sit them down and take them through the following legendary standard conversation:

"Marine!"

"Yes, sir, Major, sir!"

"You smoke roll-ups?"

"Yes, sir."

"Get out your cigarette paper"

"Yes, sir"

"Give me one"

"Yes, sir."

"Notice there is a fold in the middle?"

"Yes, sir."

"That has a purpose. On the left, you scribble what you earn. On the right, you scribble what you spend. There must always be more on the left than on the right."

"Do you get that, Marine?"

"Yes, sir Major, sir!"

"Good. Now get the %^&* out of my office and don't let me see you here again!"

Ted Wallace

There are always going to be good stocks to trade regardless of current market conditions.

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