Wall Street's super bulls continue to run rampant

By Larry Elliott

LONDON: April, said TS Eliot, is the cruelest month. Not as far as markets are concerned. There seems to be something about October's falling leaves and declining share prices. Tuesday was the 12th anniversary of the crash of 1987. It is 70 years this month since the mother and father of all crashes, in 1929. Share prices had a pretty rough ride in New York on Friday, ending the week 630 points lower after Alan Greenspan warned that the market was overvalued.

It is now almost three years since Federal Reserve chief Greenspan warned of the "irrational exuberance" gripping the stock market, and the market has responded by blowing him a giant raspberry. Anybody who sold in late 1996 would have missed out on three years of substantial capital gains, interrupted only briefly -- if savagely -- by the crisis of globalization in the summer and early autumn of 1998.

The bulls on Wall Street see the latest wobble as merely a temporary dip -- a good buying opportunity for those brave souls ready to take the plunge when stocks look cheap.

On the television shows in America devoted to the stock market a seemingly endless series of fund managers appear on screen talking up the market in the most egregious fashion. There are books on sale and online which state with confidence that the Dow Jones is heading for 36,000 or some such absurd number. It is said that information technology has rewritten all the rules of the market; what once looked like a bubble is a bubble no longer.

This is a dangerous illusion. An asset bubble is an asset bubble whether the commodity is a tulip or a share in microfloppy.com. And make no mistake, Wall Street is deep into tulip country.

All the recent evidence suggests that the U.S. market is dangerously overvalued. At some point, the market is likely to come down to earth with a bump; the real questions are whether that moment has now come and whether the economy is also set for a hard landing.

Mike Lenhoff, of the Capel Cure Sharp brokerage, is one of those who think the market is in a secular upswing. His argument is that there are three types of macroeconomic regimes -- inflationary, deflationary and disinflationary. The only type of macroeconomic background that is supportive of the equity market, he says, is the one that happens to be in force now, a disinflationary one.

"This means that it is premature to be calling the top of the market. The bears may think the equity market is excessively valued -- and they may be right -- but it is likely that the current period of market consolidation will, as in many previous such periods, prove to be another long-term buying opportunity."

To the extent that nobody can ever know for sure when bull markets are going to come to an end, Lenhoff is correct. There may still be some juice left in U.S. equities. But such is the extent of Wall Street's overvaluation and so serious are the looming problems in the U.S. economy that it would be unwise to bank on it.

Among those convinced that Wall Street is overvalued, there are two schools of thought. The first argues that over- investment, particularly in the new technologies, is leading to a squeeze on corporate profitability, which is why the prices of goods in the shops are still coming down in what will soon be the longest period of expansion in American history. Judged by Lenhoff's criteria, corporate America is heading for a period of deflation, which will be bad for equities.

The other school sees it quite differently. Five benchmarks of stock market performance each tell the same story. Whether it is the price-earnings ratio or the dividend yield, the market is overvalued compared to its long-term average. On some measures it is a third overvalued, representing a drop of 2,000-3,000 points. On others it is overvalued by 100 percent, which would suggest a halving of the value of shares.

The economists Bill Martin, of Phillips & Drew, and Wynne Godley, of the Jerome Levy Institute in the United States are, if anything, even gloomier. In a reworking of a paper they produced last December, the pair come to the conclusion that their original analysis needed updating because it was too optimistic. Without a massive 30 percent fall in the dollar and deficit spending of 5 percent a year, they fear that the United States could "easily become a new-millennium version of Japan."

Many of the arguments used to justify the boom on Wall Street were rehearsed a decade ago for the Nikkei when it was standing at the threshold of 40,000. Japan was the pioneer of new technology, its industry looked strong and inflation was low. Assets might look expensive by historical standards, but this was a different world. Today the Nikkei is still less than half its value of a decade ago.

Martin and Godley's point is that the rapid growth in the American economy over the past few years has been less the result of a new paradigm than of a good old-fashioned explosion in debt. They note with concern how there has been a plunge in private net saving triggered by rising share prices.

The long term trend in U.S. net saving is around 1 percent, with deviations from the benchmark normally short-lived and modest. As recently as 1994 net saving was 0.5 percent. Today there is net dissaving in the United States to the tune of 5.5 percent of gross domestic product. When Martin and Godley assumed that net saving had remained close to its long-term average, with a small current deficit and a small budget deficit (as opposed to a colossal current deficit and big budget surplus) the result was to halve U.S. growth from 3.5 percent after 1994 to 1.7 percent.

It is not difficult to see why net saving has fallen -- people have ploughed every cent they have, and a lot more, into the stock market. "Both in scale and duration, these excesses far exceed those associated with the ephemeral 1987 bubble," say Martin and Godley. "The proximate cause appears to be complacency about the risk of holding equities, a dream state fostered by new-era euphoria and, latterly, the perceived willingness and ability of the Federal Reserve to underpin the S&P (the Standard & Poor's index).

So what happens now? Martin and Godley argue that to keep the American economy going at even moderate rates of growth of around 2 percent would require a further rise in private spending in relation to income, and thus a further fall in private net saving. "The dependence of growth on falling saving has quite implausible implications," they say. "Either households would have eventually to devote nearly a quarter of their income to debt service (payments of interest and principal) or Wall Street's bubble would have to inflate further."

This, of course, is what the Wall Street super bulls envisage. More likely, however, is that net saving will not just recover to its long-term average, but -- as in almost every other aftermath of an asset bubble -- overshoot considerably. According to Martin and Godley, the result if that happened would be five years in which U.S. gross domestic product fell by 0.3 percent a year on average, with unemployment above 11 percent by 2004.

The knock-on effect of all this would be enormous. Financial market turbulence in the second half of the 90s has affected the periphery of the global economy but not its core. Now it is threatening to do just that.

The bad news is that the certain fall in the value of the dollar would probably send Japan back into recession, and hit the export-led recovery in Europe. Capitol Hill would become even more aggressively isolationist and protectionist. The good news is that a crisis in the world's biggest economy might -- just might -- knock some sense into policymakers and force them to rethink the way the global economy is managed.

-- Guardian News Service