My studies have shown that there is a very tight period, four to six months, between the bottom of the market, which I put at late March or early April, and the actual bottom of the economy. If we add five months to April, we get Septemberbasically saying that September is going to be the turnaround, and we are going to start up from there....We would have to see economic activity head up by September. If it does not, then you would have to say the market is premature in its celebration.Q: And, in any case, isn't the market's price-earnings ratio still high by any historical standard?A: There is no question [that p-e's] remain high by historical standards. There is [also] no reason why the p-e should go back to 15 just because 15 is the average over the past 50 years. There are a lot of favorable factors that justify a p-e in the low 20s rather than the mid-teens. But then there's also the question of whether, from current levels, the stock market can generate those 7% real returns that have marked the long-run average.... The returns on the market looking forward may not be as favorable as the long-run historical average.Q: What, then, does today's higher market multiple imply for real equity returns in the future?A: We could see 5% to 7% real.... But suppose we have 6% real returns. Those are still considerably more than the 3.5% you'd get from an inflation-indexed bond. It's a smaller premium than what has been the historical norm.Q: Do you subscribe to the idea that higher valuations reflect the New Economy and productivity gains from advances in information technology?A: I am skeptical. The problem is that a lot of these information gains are also making the economic environment much more competitive. And people are ignoring the fact that when we see rises in technology, only for a very short term does it fall to the bottom line. Very soon afterward, it's competed away and gives way to lower prices for consumers. And this idea that higher productivity growth constantly pumps profits I don't think has a real strong empirical backing. Certainly, on a theoretical basis, there is much to question about that.
So, [as for] extra productivity growth, I am not saying that's bad for earnings. But I think it's too convenient and sometimes too easy a rationale. Actually, I like to point to other factors leading to higher valuations, including much lower transaction costs. Diversification costs are very much lower. I like to talk about the favorable capital-gains taxes we have now. I like to point to the fact that companies are turning taxable dividends into lightly taxed capital gains [by] buying back their shares. Low inflation is also a positive factor because our tax system is not indexed to inflation on capital gains, and that can be a strong effect.
There are a lot of other reasons, including a more stable macroeconomic setting, despite the [current] slowdown. When we take a look back in history, a lot of the real low stock prices [come] after depressions, banking collapses, double-digit inflation. I believe we know enough to completely avoid those incidents. And so, the greater macroeconomic stability in and of itself certainly might be enough to drive equity prices higher.Q: So what strategy would you advise individual investors to follow?A: Equities offer an edge over bonds, though the edge is smaller than it has been over the past 50 years.... In the short run, there might be a little bit of an edge given to value [stocks} over growth [stocks]. There is a lot of worry about earnings quality in the tech sector, so there might be some movement toward those sectors where people are sure of their earnings.Q: Then you would underweight technology stocks?A: Yes. The truth is that technology has not been a good long-term hold. If you take a look through history, very few [tech] stocks have done extremely well in the long run. I mean, it surprises people, but had you bought IBM stock after 1958 you would have fallen behind the S&P, even holding it until today.Q: What are you researching now?A: One question I've been working on is: What are the right price-earnings for the market given the current situation? I'm also going to be writing a book on investment strategies in, I guess you could call it, the post-bubble economy.Q: What would surprise readers of your earlier work about your next book?A: That you could believe in the New Economy and yet find it real tough to make profits in the market. I mean, some people think: "New Economy. Higher productivity is a slam dunk. Market is up 10% to 15% a year."
I don't think so. I think it's going to be very tough.
An extended version of this interview is also available.