You know the stock market is in for a major downdraft when people start writing books with titles like "Dow 36,000." The Atlantic Monthly, ordinarily a prudent journal, has given upwards of 10,000 words and its September cover to promote the giddy new book by James Glassman and Kevin Hassett, which contends that the Dow should be at 36,000 right now. Not to be outdone, the current issue of Wired magazine insists that the new, high-tech economy justifies a Dow of around 50,000. And -- what the heck -- a new book by Charles W. Kadlec sees the Dow going to 100,000. A million, anyone?
David Dodd, co-author of the classic text on securities analysis, once observed that the four most dangerous words in the English language are "This time it's different." But it isn't. The economic fundamentals can support stock price growth in excess of economic growth for only so long. Well before the e-commerce economy, stock touts and crackpot theorists were promoting manias and bubbles that were literally too good to be true.
Glassman and Hassett base their argument on the large divergence between the returns on bonds and stocks. In a heroic leap, they assert that stocks are just as safe as bonds, because if you wait long enough, their value eventually recovers from downturns. Therefore, to equalize the return on stocks with the return on bonds, the Dow should be at 36,000.
There are two big flaws in this analysis. For one thing, risk-averse investors take lower returns on bonds because they can get their money out. Contrary to Glassman and Hassett, a stock is not a bond. A certificate of deposit or Treasury bond yields about a 6 percent guaranteed return (around 4 percent after inflation). Stocks, by contrast, are paying a current dividend yield averaging only 1.5 percent -- but a total return of more than 20 percent because of the raging bull market.
People keep buying stocks only because they expect capital appreciation to provide high returns. The long-term total return on stocks (dividends plus capital gains) has been consistently around 7 percent for two centuries. The return on stocks can temporarily exceed that average for a time, but not forever. The first phase of the decade-long stock run-up was justified by disinflation. As inflation came down, a given yield could support a higher share price. More run-up was justified by rising growth and profits. But today more and more of the inflated Dow is pure bubble.
Alas, an economy that grows at 4 percent a year cannot indefinitely sustain 20 percent annual growth in share prices. A key personage who has noticed this problem is one Alan Greenspan. In a major address last week, Greenspan declared that in addition to tracking rising prices in goods and services, the Federal Reserve would begin worrying about precarious rates of increase in "asset values" -- in other words, stocks. So even if investors are irrational, stocks will not keep rising at 20 percent per year -- because the Fed will not let them.
That policy shift, in turn, is very likely to bring about a stock-market correction, since it will change investors' expectations. Taking some air out of the inflated stock market now, rather than picking up after a crash later, is sensible policy. But it would be a shame if Greenspan used a blunt instrument -- interest rates -- which would temper the stock market by chilling the real economy.
The Fed has two finer instruments to use on the financial economy. First, it can tighten margin requirements, to discourage borrowing to buy stocks. Currently, investors can borrow up to 50 percent. According to an analysis by economist Jane D'Arista of the Financial Markets Center, the ratio of margin debt to gross domestic product has quadrupled in a decade. D'Arista reports that the financial market's share of total borrowing also has soared from one-quarter of all borrowing a decade ago to more than half today.
Another instrument in Greenspan's tool kit is the power to require banks to set aside additional funds when they lend to brokerage houses and investment bankers. In 1979, then-Fed chairman Paul Volcker imposed such a temporary reserve requirement of 3 percent. If Greenspan can prevent stock euphoria from turning into crash without needlessly sandbagging the real productive economy, he is a true genius. In the meantime, as the 70th anniversary of the Great Crash approaches and weird millennial prophecies abound, keep your hands on your wallets.
Robert Kuttner is co-editor of the American Prospect.