A Ho-Hum Look at Wall Street
Jude Wanniski
October 7, 1993


The stock market continues its steady upward creep, the long market remains steady, and gold hovers around $350. The barrage of bear warnings about market corrections has diminished for the moment, replaced by ho-hum, wait-and-see, trading-range commentary. Meanwhile, we've taken another look at the warning raised a few weeks ago that the stock market has entered a speculative period, with "bubble" potential. Remember, this was based on Price/Earnings ratios seemingly bloated, as well as ordinary odd-lot schmoes coming into the market, bidding up equities because they can't make ends meet on what they get from money-market funds. We took a quick look at the earnings and market value of the top U.S. corporations. The calculations give no support to the notion of a speculative bubble. Instead, they tend to confirm our view that the Fed has wrung much of the monetary risk out of holding financial assets, allowing the market to absorb a higher level of risk.

If the market were rising as the result of a speculative bubble fueled by low interest rates, one would expect to see market valuations unhinged from fundamentals such as profitability. In such a speculative market environment, profits as a percentage of stock value would be extremely low as share prices rise regardless of a company's actual earnings power. In a speculative bubble, certainly this percentage -- essentially a rate of return measuring earnings per dollar of capital value (the inverse of a price-earnings ratio) -- would be below a standard, low-risk market discount rate, i.e., the five-year T-bill. The evidence does not support such a conclusion.

We looked at the 44 most profitable U.S. companies listed in the September 24 Wall Street Journal table of "The World's 100 Largest Public Companies." The table listed the companies in order of market value as of June 30. Only three of the top 10 most valuable companies on the chart were U.S. firms, six were Japanese. However, eight of the top 10 most profitable companies were American. These companies had an Earnings/Price ratio averaging 6.4%. This represents a premium of 1.63% on the 4.81% five-year interest rate on that date. For the 44 profitable U.S. companies listed -- four unprofitable companies were eliminated from our analysis:  Ford, GM, IBM and Sears -- this average rate was 5.32%, a premium of 0.51%.

Obviously, this is just a quick and dirty calculation in what could be a fruitful avenue for further study. We may take a look at what this E/P ratio looks like in a broader sample of companies, what it shows for low-cap stocks, and how it has changed over time in response to interest rate fluctuations and market conditions. Nevertheless, even this back-of-the-envelope sort of analysis is fairly convincing in refuting the idea of a speculative bubble. Instead, it suggests that the Fed's success in bringing down interest rates and inflation is, on balance, encouraging investors to seek higher returns in more risky -- though not speculative -- equity instruments.

Stocks and bonds will continue to move together as long as there is no further negative fiscal surprise to the economy. The President's health care plan would, if enacted as is, sharply increase the risk to capital, and would overwhelm the benefits of sound money and low interest rates. This would "decouple" the two markets, with stocks going south. We continue to believe there is much less threat from health care than meets the eye. If the health care "crisis" was manufactured to begin with, as we've always thought, an artificial momentum cannot be sustained over the time it will take to get it into law. Think of the Clinton Plan as a block of ice, melting down drip by drip, with Hillary Rodham Clinton determined to get it enacted before it shrinks to an ice cube. The legislative process is such that unless there is a genuine crisis atmosphere at the grass roots, which we don't see, health care reform may not come to a final vote until 1995, with a new Congress that is likely to be more Republican.

Grace-Marie Arnett, a health-care policy expert in Washington who is now advising some key Republicans, has boiled down the essentials of the debate to two questions: 1) To what degree will Americans accept government compulsion?; 2) If it is assumed that the American people want to undertake an obligation to provide health care for all Americans, what are the limits -- ranging from simple catastrophic insurance to comprehensive care, a full a la carte menu of organ transplants -- and how are we going to realistically pay for this care? The Clinton plan clearly is the most compulsory, while the GOP plan of Sen. John Chafee of Rhode Island is much less so. The GOP center of gravity is already moving away from the Chafee plan toward the plan of Sen. Phil Gramm of Texas. For example, Senate Minority Leader Bob Dole had been a prime sponsor of the Chafee plan and is now talking of the need to pull together the best elements of all the plans, including Gramm's. Yet another plan of Sen. Don Nichols [R-Okla.] may have the most palatable blend of freedom and coverage, says Arnett. Sen. Bob Bennett [R-Utah], a successful entrepreneur prior to his election last November, has been asked by Dole to vet all the plans kicking around in assessing their impact on small, new, or yet unborn businesses. Bennett, a Chafee sponsor, is now also a Gramm sponsor. The situation is becoming very fluid and so is Mr. Clinton's block of ice.

The Administration, meanwhile, is resigned to living with an economic expansion that is not really capable of cutting into the unemployment rate. The European heads of state are in the same boat, agreeing among each other that since there is not much that can be done to fuel economic expansion that would slice into high unemployment rates everywhere, let's everyone sit back and patiently wait for the business cycle to right itself. Japan is an exception. The U.S. government in particular has been encouraging the new Tokyo government to cut high marginal income tax rates. This advice is coming from Treasury Undersecretary Larry Summers, who we have identified as one of the bad guys behind "shock therapy" in Russia and Eastern Europe. When it comes to income tax rates, Summers has been influenced by the work of fellow Harvard economists Martin Feldstein and Fed Governor Larry Lindsay, who have satisfied him that rates above, say, 40%, really are counter-productive. Japan's more important problem, though, is its high capital gains tax on real property, which keeps it frozen. Lowering the top income tax rates would provide some relief, but eliminating the capgains tax on real property would provide a great deal. As far as we can tell, there is no discussion in the government along these lines.

In Mexico, we were surprised this week when the Salinas government announced its new economic program without mentioning capital gains. There were adjustments in the lower income tax brackets, taking several million low-income workers off the tax rolls, and some okay adjustments in corporate taxation. We've since been reassured that when the formal budget is published November 1, all financial transactions will be exempt from capital gains taxation -- as has been the case for equities traded on the Bolsa, Mexico City's stock exchange. This will give a welcome boost to capital formation in Mexico, helping create a bottom-up dynamic that will eventually lift more of Mexico's vast underground sector into the formal, tax-paying economy. Our hat goes off to Finance Minister Pedro Aspe, who has been maneuvering for three years to get this done. The surface news on NAFTA is still not all that encouraging, with House Majority Leader Richard Gephardt working feverishly against it. There is, though, still a sense in Washington that it will pull through. Robert Novak reports this week that "the smart money" is on NAFTA. A vote could come as early as November 17.

P.S. ON SOMALIA: Read Prof. George Ayittey's op-ed in today's Wall Street Journal. He's right on. So is Jesse Jackson: We should take the ransom off the head of General Aidid, the most capable and popular political leader in the country, a fellow who wanted to be friends until our inept diplomats decided he was a "war lord." If there is to be nation building in Somalia, it should be around a popular, capable leader. Sending in more troops to hunt this guy down is reminiscent of Waco.