What Ails the Market?

April 20, 2003 • Commentary
This article was published in the Washington Times, April 20, 2003.

Does the stock market hate both war and peace? Nearly everyone had been saying stocks were depressed by war uncertainties that would vanish with victory, bringing a huge victory rally. Why didn’t that happen?

Sure, it will take several months to get Iraq oil back on the market. Meanwhile, the U.S. government has unwisely decided not to fill that void with strategic reserves. Sure, there are still big uncertainties about the costs and dangers of occupation. But two of the biggest uncertainties have, in fact, been resolved — namely, the duration and damage of war itself and the risk that Iraq’s oil fields might be seriously damaged.

A new study available at nber​.org, “What Do Financial Markets Think of War in Iraq?” concludes that “war lowers the value of U.S. equities by around 15 percent.” Professors Leigh, Wolfers and Zitzewiz even offer lukewarm tips: “War is bad for consumer discretionary industries, airlines, finance and information technology.” It seems to follow that winning the war should have raised U.S. stocks by 15 percent, but that hasn’t happened. There was more involved than war jitters.

This is the third year in a row when pundits tried to blame weak stocks on touchy investor psychology. Last summer, the stock market was said to be depressed because previous corporate scandals had caused a loss of investor confidence. After President Bush got behind the Sarbanes‐​Oxley accounting bill, however, the Dow fell 400 points in two days. Stocks have yet to regain the level that existed before the government kindly offered to restore our confidence in federal regulation.

In 2001, the favorite theory was that the market was down because a bubble had burst. Stocks were down because they had been up. This is a remarkably unsophisticated theory of financial markets, which may explain its popularity at the International Monetary Fund. The IMF estimated that a $10 rise in oil prices would cut U.S. economic growth by 0.6 percent. Yet now that oil prices have fallen about $10, the IMF reduced its forecast of U.S. economic growth. Those who always insist on being gloomy about the United States naturally prefer psychological to logical explanations.

All recent efforts to explain low stock prices by mood swings are logically equivalent to asserting that corporate earnings are fine, it is just prices that are low. Whether they know it or not, those blaming low stock prices on attitudes and emotions are asserting that the ratio of stock prices to earnings (the P-E ratio) is much too low. That assumption is hidden, but not necessarily wrong. Bearish complaints that the P-E ratio is “above its historical average” are meaningless, because that is to be expected when interest rates are far below their historical average.

To find out if an unduly depressed P-E ratio is really the reason stocks are so cheap, it helps flip the price‐​earnings ratio upside down. Doing that makes the inverted earnings‐​price ratio comparable to an interest rate. For S&P 500 stocks, the resulting earnings‐​price ratio was 3.18 at the end of last year, based on earnings over the previous year. In 1999, when we were supposedly near the end of a huge bubble, the earnings yield was almost identical — 3.17.

Since the relationship between stock prices and earnings was unchanged, the entire drop in S&P 500 stocks since 1999 was due to lower earnings. There is nothing left to explain. That casts considerable doubt on the notion that there was some inexplicable “bubble” in 1999 (aside from Nasdaq).

Interest rates, however, are lower today than in 1999. The E-P ratio is normally a shade below the yield on 10‐​year Treasuries, which dropped from 5.65 percent in 1999 to 4 percent at the end of last year. So the 1999 market may have been a little too optimistic and/​or the current market may be a little too pessimistic. Still, the psychology has not changed that much. What changed were earnings.

The only way to break that link between lower earnings and lower stock prices is to claim reported earnings are not exaggerated (as congressional reformers claimed last year), but understated. And one way to justify that curious claim is to use the government’s profit figures. By that measure, after‐​tax profits first fell from $542 billion in the fourth quarter of 1999 to $429 billion in the fourth quarter of 2001, but then rose 10 percent to $473 billion by the fourth quarter of 2002.

Such prominent economists as Alan Greenspan and Art Laffer have suggested these government’s profit figures are more accurate than corporate reports. The Commerce Department subtracts the actual cost of exercised employee stock options from profits, for example, and adds it to employee pay.

Accurate or not, federal profit estimates tell us nothing about the earnings that matter for stocks. Federal figures cover nearly 6,000 corporations (including farms) — few of which have publicly traded stock. And, as the study mentioned earlier pointed out, “Publicly traded firms tend to be more cyclically sensitive than others.”

Putting undue emphasis on investor psychology allows both optimists and pessimists to say investors are nuts. To say the market is grossly undervalued today or that it was irrationally exuberant in 1996 simply means anyone making such statements claims to be wiser than the rest of us. It may seem easy to assert that investors are an irrational, moody bunch, making foolish investment decisions for foolish reasons. But the evidence says markets are wise and it is the second‐​guessers who are nuts.

Earnings for the S&P 500 peaked at 13.74 cents a share on March 31, 2000. At the end of last year, earnings per share were down to 3.41 cents a share — a drop of 75 percent from the peak, even though the S&P index was down “only” 41 percent. The fourth quarter was likely a fluke, with war risks pushing energy costs up and profits down. Unit costs of labor rose 3.8 percent while prices rose only 1.2 percent. Companies will produce and hire more when it becomes profitable to do so. Then stocks will rise.

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