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Bloated Prices On Wall Street?


Economic Trends

BLOATED PRICES ON WALL STREET?

Stocks' value may soon exceed GDP

In the wake of July's sharp market downturn--and rebound--the bulls and bears on Wall Street have tussled over whether or not stock prices really are overvalued. At least one bearish analyst, James A. Bianco of Arbor Trading Group Inc. in Barrington, Ill., believes the markets have never been more overvalued than they are today. He points to some broad macroeconomic measures to bolster his case.

Bianco tracks total stock-market capitalization as a share of America's gross domestic product--a price-earnings ratio for the broader economy, if you will. By this measure, stocks are at an all-time high, at roughly 94% of GDP as of June. Previous peaks from earlier cycles: 81.4% in August, 1929, and 78.1% in December, 1972--periods that were followed by severe bear markets.

Add in the bond market's total capitalization, as measured by the Lehman Aggregate Index, and the value of financial instruments hit a record-breaking 153% of GDP at midyear 1996--well above the 57% reading in 1982, the beginning of the current bull market.

It's not just these ratios that concern Bianco. He also observes that M2--a common measure of the total amount of money in circulation--amounted to a mere 52% of the value of the stock market in June. That's one-third of the average reading this century. Concludes Bianco: "We can't have the Dow at 7000 and the long bond [yield] at 6%, because there isn't enough money to go around for both."

Some market seers think Bianco's indicators are flawed. Don R. Hays, a bullish strategist at Wheat First Butcher & Singer Inc., suspects that market capitalization has been inflated over the decades by the shift among many entrepreneurs toward operating public, rather than private, companies. But Bianco notes that research by Minneapolis' Leuthold Group shows that every time since 1926 that the stocks-to-GDP ratio crested above 70%, the median annual return averaged just 4.3% over the next five years. By contrast, when stock valuations were less than half of GDP, the market generated double-digit returns over the following five years.BY DEAN FOUSTReturn to top

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FIERCE HUNGER FOR CAPITAL MAY BOOST WORLD INTEREST RATES

Demand from developing nations is soaring

By historical standards, long-term interest rates in many key nations are high if adjusted for inflation--a development that some economists attribute to a global shortage of capital. But given the efforts of the U.S. and European governments to lower their fiscal deficits--among the biggest sources of pressure for many years--this should bode well for interest rates.

Not necessarily, says John Praveen, senior international economist at Merrill Lynch & Co. Praveen says explosive growth in developing nations such as Indonesia, Malaysia, and the Philippines should actually increase the demand for capital in coming years. Praveen calculates that, worldwide, capital demand should outstrip supply by $110 billion this year and $115 billion in 1997--a nearly two-thirds increase over 1995. That could send "real"--or inflationadjusted--interest rates even higher.BY DEAN FOUSTReturn to top

THE FED'S MOVING BENCHMARK

What's roiling the fed funds rate

Over the past year, the Federal Reserve has had a hard time keeping the federal funds rate--the price it sets for overnight loans between commercial banks, and a key benchmark for long-term rates--at its target level, currently 5.25%. That's partly the result of increased speculation over the Fed's next policy move. But there could be another factor at work: growing use of retail "sweep" accounts by large banks.

The Fed requires banks to set aside reserves of 10% on deposit bases above $52 million--a sore point with most big banks, since the Fed doesn't pay interest on those reserves. So more banks are using sophisticated software that estimates withdrawals to "sweep" cash out of checking accounts and into money-market savings accounts, which pay higher interest rates but are not subject to the costlier reserve requirements of the Fed.

But if banks miscalculate withdrawals, they must turn to a shrinking federal funds pool to raise their reserve levels--demand that has caused the intraday funds rate to swing by as much as three percentage points recently. Louis Crandall, chief economist at R.H. Wrightson & Associates, a New York fixed-income research firm, speculates that further volatility could prompt the Fed to abandon the overnight funds market in the future and instead use a more stable rate as a policy lever.BY DEAN FOUSTReturn to top


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