Fiscal Fitness


 

When will the market correct?

by Ron Ross

Repeatedly over the past few months I've been asked the question, "When is the market going to correct?"

The answer I give is, "To tell you the truth, I don't have the foggiest idea."

Nevertheless, it's a good question, and my answer requires some elaboration. The stock market has been on a mostly upward path now for more than two years. Everyone knows that the market has gone in the opposite direction numerous times in the past. Twelve times since World War II it has lost at least 10 percent of its value.

When the stock market does well for an extended time, it generates the feeling that it's overdue for a "correction." You hear people say that the market is overvalued or that investors are getting carried away. Federal Reserve Chairman Alan Greenspan testified before Congress that stock market prices reflect "irrational exuberance."

Greenspan might very well be right about the market. But then again, he might be totally wrong. As Harvard economist Robert Barro has observed, "One thing that never seems forecastable is the bursting of bubbles; overvalued markets are mainly obvious after the fact."

If you looked at back issues of The Wall Street Journal or other financial periodicals, you would find that no matter where the market was in the past, someone would have been proclaiming that it was overvalued and poised for a significant decline. The people who make such predictions often have atrocious track records. They confirm what I call Ross' law: a person's willingness to predict is inversely proportional to his ability to predict. You rarely see any of the past winners of the Nobel Prize for Economics making predictions.

I can't help but wonder if Greenspan has taken all his own money out of the stock market. If he believes what he's saying, that, of course, is what he should do. After it has dropped, he would put his money back into the market. I strongly suspect that Greenspan's personal money is still in the market because he's smart enough to know that such "timing" of the market almost always backfires and is not a viable long-term strategy.

There are profound reasons why the market is impossible to predict. In reality, complex and financial indicators never all point in the same direction. Right now, for example, the market is overvalued from the standpoint of its overall price/earnings ratio. This ratio is a company's stock price in relation to its annual profits. Historically, this ratio has averaged about 16 for the overall market. Today it's about 21.

On the other hand, earnings have been rising. Since that's true, the market doesn't necessarily have to fall in order for the P/E ratio to regain its historical norm. A case could also be made that the we are in a prolonged period of a higher P/E ratio. The message is ambiguous.

A stock's price and the overall level of the market reflect a consensus about countless bits of information. People do not invest in stocks expecting to lose money. Those who declare that the market is "too high" demonstrate an amazing amount of arrogance. They are saying, in effect, that there must be something wrong with anyone who continues to invest in the market.

People first decide whether to spend or invest their earnings. Then they decide where to invest -- bank accounts, real estate, stocks, bonds or gold, for example.

The question, is the stock market too high brings up another question: Relative to what? People who continue to invest in the market obviously feel that the market is not too high relative to their other investment opportunities. If you think about this relationship, you can see why low interest rates tend to stimulate the stock market.

The demand for stocks (and consequently stock prices) tends to rise when the rates of return on alternative investments fall. Of course, the opposite holds true as well. The sudden drop in the market in October 1987, for example, was triggered by a "spike" in interest rates.

Maybe there should be disclosure laws for people who make predictions. If a person had to disclose his past predictions' track record, I'm certain there would be far fewer predictions. Shame can be a powerful disincentive.


A former professor of economics, Ron Ross is a financial planner with Premier Financial Group, Eureka.


Comments? E-mail the Journal: ncjour@northcoast.com

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