Greenspan’s Words Go to Work, but His Question Lingers

Federal Reserve Board Chairman Alan Greenspan got what he wanted, if what he wanted was to take some of the air out of the stock market balloon.

Since Greenspan on Dec. 5 uttered his now-famous line about possible “irrational exuberance� in markets--and it was a question he posed, not a statement of fact--the Dow Jones industrial average has lost 2%, bringing its decline from its Nov. 25 record high to 3.7% as of last Friday.

And Coca-Cola, arguably one of the most overvalued stocks in the Dow, has fallen 11% from its recent peak.

The declines may not seem like much, given that the Dow is still up 23% this year. Yet the market’s mood is definitely a little more sober today than it was in November. A weekly survey of investment newsletters nationwide by Investors Intelligence found that the percentage that are bullish tumbled to 50.9% last week from 56% a week earlier, no doubt in large part because of Greenspan’s comment.

Indeed, it’s hard to have a conversation with a portfolio manager or trader without the discussion turning to the issue of market speculation: How much of it is going on? Who’s doing it? How crazy are these stock prices?

Walt Disney Co. didn’t help matters last week, because under the topic heading “irrational exuberance� one would have to include exiting Disney President Michael Ovitz’s rumored $90-million severance package. All that just for cleaning out a desk?

But gauging ostensibly “irrational� behavior on the part of investors in general is a far more difficult trick. Greenspan didn’t even try to answer his own question, though when the Fed board meets on Tuesday, the topic is likely to come up again.

What Greenspan implied, of course, is that stock prices might be too high and that investors might therefore want to ease off rather than risk paying prices that will seem foolish later.

Yet there are plenty of Wall Street pros who will defend current share values as quite rational. One of the market’s best-known bulls, investment strategist Abby J. Cohen at Goldman, Sachs & Co. in New York, insists that “U.S. share prices are now roughly at fair value based on . . . our models linked to both interest rates and inflation.�

Cohen pegs the price-to-earnings ratio of the average blue-chip stock at about 16 now, based on her 1997 earnings estimate for the Standard & Poor’s index of 500 major stocks. Other analysts have lower earnings expectations, but most figure the S&P;’s 1997 P/E is in the 16 to 20 range.

Cohen sees nothing unusually exuberant about these valuations. With annualized consumer inflation in the 3% range, she notes that blue-chip stock P/Es are normal or below normal, given that they have been as high as the 18 to 20 range during similar periods of low inflation historically.

Similarly, the argument goes that there’s nothing absurd about stock price levels relative to current interest rates.

But what Greenspan was hinting, not even all that subtly, is that interest rates may well be higher someday if the global economy picks up speed. If rates rise, the path of least resistance for stocks will be down. So the higher share prices go, the greater the potential market “adjustment� if Greenspan & Co. boost rates.

If measuring the market’s speculative pitch was as simple as looking at underlying earnings and interest rates, the worst one could say is that Wall Street is at risk if corporate earnings decline or rates move up. But that’s not a particularly novel statement.

The bigger concern is that speculation--as opposed to true, well-thought-out long-term investing--might be much more prevalent than is apparent in P/E ratios or stocks’ values compared with interest rates. The danger: If raw speculation is excessive enough, any market reaction to changes in earnings or interest rates could far exceed what would rationally be expected.

But how to measure the gross level of speculation? It is, of course, unmeasurable. Still, some veteran Wall Street analysts say the simple question to ask is whether too many investors are surrendering all caution, believing either that stocks will never fall dramatically, that their stocks will never fall dramatically, or that they will be emotionally and financially able to handle a decline of any magnitude.

Richard Eakle, at market research firm Eakle Associates in Fair Haven, N.J., argues that one sign of decreasing caution is the low level of cash reserves held by stock mutual funds: The average fund had just 6.2% of assets in cash as of Oct. 31 (the latest reading), a 20-year low. Minimal reserves imply a lack of fear on the part of fund managers.

Eakle also points out that belief in stocks’ supremacy among investments is now spreading even to institutions that have long had a much more risk-averse attitude. Indiana voters, he noted, just approved allowing state funds to be invested in stocks, for the first time since the Civil War.

Finally, there is the worrisome issue of leverage--buying stocks on credit. We know that margin debt at brokerages, the officially reported sum of money that individuals have borrowed and used to buy securities, is near a record high. But it’s the margin debt that we don’t know about that is of greatest concern: How many Americans are maxing out their 401(k) stock fund contributions (and therefore taking a big pay cut), then living off credit cards?

It may be that Greenspan, in raising the issue of “irrational exuberance,� is thinking about all of the above. Yet he does not, and cannot, suggest what Americans should do. Stop saving for retirement? Time it--get out of the market now and jump back in when there is less exuberance? Take Ovitz’s job at Disney and wait for the severance package?

For most investors, there is no alternative to being in stocks, and permanently. The challenge is to be personally realistic about risk, return and your ability to cope when exuberance inevitably gives way to a painful bear market.

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Visible Margin Debt

Margin debt--the sum investors have collectively borrowed to buy stocks on credit--has soared to record levels this year. This chart reflects official margin borrowings, as tracked by the New York Stock Exchange. What is unknown is unofficial margin debt--as when people boost investments while living off their credit cards. Margin debt, in billions of dollars, quarterly data plus Oct. 31

Oct. $88.7*

* latest data

Source: New York Stock Exchange