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.