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By Tom Elia
October 18, 2002
The New Editor
(This column originally appeared in FrontPage Magazine.)
A large part of the Democratic Party's election strategy to criticize the Bush Administration's
economic policy has focused on the decline of the stock market.
Pointing to the loss of $5 trillion in total market capitalization since January 2001, the
Democrats have chosen to pin the blame for the market's decline on President Bush's policies.
While it's certainly true that the market has declined during this period, efforts to tie Bush to
the market slide falls way short of proving a connection.
In order to provide the necessary perspective, a quick review of one of the most basic
market fundamentals is in order.
It is important to note that a stock's price is determined by what the market's best guess at
what its future earnings will be. In other words, the stock's price represents the present
value of future, estimated earnings.
This relationship is often described as the price-to-earnings ratio, or PE. Historically, the
stock market's PE has roughly been about 20, less the rate of inflation.
As most people now realize, this ratio was much, much higher during the last few years of
the past bull market, a market whose unprecedented growth created stock market values
relative to their underlying earnings that were far higher than the usual historical norms.
Clearly, most people realize that there was a bubble in technology stocks, where the Nasdaq
100 (this index is dominated by tech stocks), representing the 100 largest Nasdaq stocks
traded on the Nasdaq exchange, had a total market capitalization of $5 trillion at its peak in
March of 2000; that $5 trillion value was supported by underlying earnings that amounted to
about 1/200th of that market capitalization.
In other words, the Nasdaq 100 had a PE of about 200, or about ten times historical market
norms. This incredible valuation is what is meant when people talk of a stock market bubble.
However, what is less widely acknowledged is that broader market indexes, like the S&P 500
and the Dow Jones Industrial Average, were also vastly overvalued during the same period.
At the beginning of 1995 the S&P 500 opened at 472.99. By March of 2000 the S&P 500
more than tripled, trading to its all-time high of 1552.87. Similarly, the Dow Jones Industrial
Average also more than tripled, going from 3834.40 at the beginning of 1995 to 11,722.98 at
its all-time high in January of 2000.
However, from 1995 to 2000 the underlying earnings of the S&P 500 index grew by about
63%. So while the price of the broad based index itself more than tripled at its highs, its
underlying earnings grew by about 27% as much.
This large disconnect between the growth of earnings and the growth in stock prices has not
been emphasized nearly enough.
By most historical standards, growth in earnings of about 65% would lead to a growth in
stock price by roughly an equivalent amount. The fact that both the S&P 500 and the DJIA
price levels grew by well over three times their underlying earnings suggests that these
markets were also grossly overvalued.
And that overvaluation needed to be corrected eventually.
Using a 65% growth rate in earnings as a benchmark for the growth rate in the market's
price level, one can reasonably argue that the almost 1100 point gain in the value of the S&P
500, leading to its all-time highs, would have been more accurate if it had been one third as
much.
Because of the close correlation between the S&P 500 and the DJIA, that assumption would
hold true for the DJIA as well. So instead of an almost 8000 point gain in the DJIA, maybe
something like a 3000 point gain would have reflected reality more accurately, meaning that
the DJIA probably should have traded to somewhere between 6000 and 7000 instead of
almost 12,000.
These figures aren't meant to be exact, but only show the aberrant behavior of the market
during the period from 1995 to 2000 as compared against previous historical experience.
Hence, the current bear market.
In other words, the market's downward slide is a reaction to previously unsustainable prices.
When these facts are taken into consideration, the Democratic Party's claim that this bear
market has been caused by the Bush Administration's current policies just doesn't make any
sense. And the market's fall may not be over yet.
History shows us that bear markets do not happen all at once; they take time to run their
course. While a bear market takes time to run itself out, a defining characteristic of these
down markets is that they are marked by extreme volatility as they make their way toward a
market bottom.
A good example of this volatility may be the bear market of 1973-74.
In the last two years before the major bottom of that bear market occurred, there was
unbelievably tremendous volatility.
Here is what it looked like:
In January, 1973 the Dow was at 1052; in August, 1973 it was at 850 (a down move of
about 19%). It then rallied to 988 in October, 1973 (a move of about 16%). The market then
fell to 788 in December, 1973 (a down move of about 20%).
By January, 1974 it then rallied 880 (about 12%). It then fell to 800 in February, 1974 (down
about 9%); it then rallied to 892 in March, 1974 (12%). It then fell to 796 in May, 1974
(down about 11%). The market rallied to 860 in June, 1974 (8%). Then it fell to 760 in early
July (down about 12%). Then it rallied to 806 in late July (about 6%). It fell 7% in one week
to 750 at the beginning of August; it rallied about 7% the next week to 800.
It fell about 22% in little more than a month to 628 by the middle of September. It then rallied
8% the next week to 677. It fell about 14% in two weeks to 585 by the beginning of
October. It then rallied around 15% in about ten days to 674 by the middle of October. It fell
6% in 2 weeks to 635 at the end of October. Then it rallied about 6% in two weeks to 675
by the middle of November.
Finally by the beginning of December, it fell about 14% in 4 weeks to 578, 1974, making a
market bottom.
Using these historical facts as a backdrop, the large stock market gains of the past few
trading sessions at around this price level may be strong evidence of a continuing bear
market.
The last four trading sessions ending this past Tuesday produced a gain of about 13.5%, the
largest four-day gain since October 1974; the market made lower lows by December of that
year, which marked the end of that bear market.
In addition to these latest gains, there have been three rallies of almost 20% this year.
Why these latest gains?
Some people say that the market gains this past Tuesday seemed to be propelled by the good
operating earnings news from GM, Bank of America, Citigroup, and others. Upon deeper
analysis, the good news provided by these early reports would seem to be illusory.
Here are the facts:
GM reported that pro forma earnings were $1.24 per share for the last quarter, but the
company had a net loss of over $800 million, or a loss of $1.24 per share. In addition, GM
has net pension liabilities of between $20 and $30 billion, depending on forecast assumptions.
To put this liability in perspective, GM's total net earnings over the last five years were about
$20 billion. Despite this, the market viewed the pro forma earnings news as positive and
pushed the stock's price upward.
Bank of America's earnings tripled even though revenues were flat to down in the same
period. That is not a picture that is indicative of growth.
Citigroup derived about $325 million from the profit of the sale of its HQ; its net income was
$3.92 billion vs. $3.18 billion for the prior period. The company beat estimates by a penny
and the stock gained over 13%, yet .06 of the EPS gain came from the sale of its HQ.
Without the sale of its HQ, the company would have missed its projections by .05 per share.
The sale of its HQ is not a recurring income stream. Yet the stock rallied on the news.
Fannie Mae saw a one-day up move of about 6% on Tuesday even though it reported
derivative losses of about $1.23 billion. An analyst said that this loss doesn't matter to
investors because "it's an accounting issue." Companies book the revenues when they make
money on derivative trades and it's figured into EPS and operating income calculations, but
when they have losses on the trades, they exclude the losses from operating earnings and
claim that the profits from the other underlying business are continuing to show growth in
the business's core operations. That's not consistent logic.
Unisys reported that earnings were up 300% while revenues were down 3%. Again, that's
not indicative of growth.
Motorola reported "special charges" for the 15th consecutive quarter. The total amount of the
"special charges" for the previous 14 quarters is over $11 billion. That kind of consistent
write-down doesn't indicate unusual circumstances.
It's being widely reported that United Airlines will probably file for bankruptcy.
What does this admittedly disparate data mean? It means that we may not be anywhere near
a market bottom, that's what it means.
We may not even be close; but it's not George Bush's fault.
Tom Elia is a contributing editor for The New Editor.
Paul Geary
David Rogers