Thinking About The Stock Market (written about 2000)

Well over one hundred years ago, Charles MacKay published a book titled "Extraordinary Popular Delusions and the Madness of Crowds and Confusion of Confusiones". The book is still being published, which attests to its insight. Even a casual reading should convince you that the current stock market will go down in history as one of the great bubbles. In case MacKay's treatise is not enough to convince you, here's more to think about.

The stock market has more than tripled in recent years. Sales and profits are up, but by nowhere near as much. Financial valuation ratios, such as price/book and price/earnings ratios have skyrocketed. For example, the S&P500 index's price/book and price/earnings ratios are about 5 and 30, respectively. Can this divergence from historical levels be justified?

According to the stock valuation theory taught in graduate business schools, a stock's value stems from its ability to throw off cash. In particular, a high price/book or price/earnings ratio is justified only to the extent that the company will be able to earn unusually high profits on its investments (abnormal profits).

Assume that the S&P500's risk is such that investors require a 10% expected return on their investment (If you want to use a higher number, the implications will be worse.). Suppose the index's return on equity is 10% and its growth rate is 0% annually. Then the theory says that the index should sell at a price/book ratio of 1.0 and a price/earnings ratio of 10.0. These two numbers are not far off the S&P500's long-term historical averages. They imply that the market should be selling for well under half its current price.

Leave the index's return on equity assumption at 10%. Posit a growth rate of 20% annually for the first ten years and then let its growth rate decline one percentage point per year until it reaches 5% in year 25. Thereafter, let the growth rate be 5% annually. Make no mistake, this is a wildly optimistic growth rate forecast. The index's fair price/book and price/earnings ratios still are only 1.0 and 10.0, respectively. Growth alone does not bestow value. Betcha that was a surprise.

Now, keep the optimistic growth forecast, but increase the forecast return on equity to 20% for the first ten years with a decline of one percentage point per year until it reaches 10% in year 20. Thereafter, let return on equity be 10%. Make no mistake, this is a wildly optimistic profitability forecast. Now, the index's fair price/book and price/earnings ratios are about 3.6 and 17.8, respectively. This illustrates that abnormal profitability is required to justify high valuation ratios. However, even this wildly optimistic forecast of growth and profitability implies a fair price for the S&P500 about 30% below its current level.

Let's apply this theory to the internet retail stocks, like Amazon.com.
Relatively cheap talent is available to set up and run web sites, and to handle operations, i.e., ordering and delivering merchandise, and inventory management. Thus, this industry has essentially no barrier to entry.

A low barrier to entry fosters competition. This has happened in the Internet store industry. Barnes and Noble was able to compete with Amazon.com in the Internet book business as soon as it made economic sense. Neither Internet store has been competitive in books for some time. Other, smaller, Internet book stores undercut them regularly.

The availability of shopping "bots" that locate the Internet stores selling the merchandise you want at the lowest price has created, for the first time, the economist's dream of the perfectly competitive market. A fundamental characteristic of a perfectly competitive market is the absence of abnormal profitability. Thus, it is unrealistic to think that the Amazon.coms of the world will ever be unusually profitable. If so, Internet retailers' current valuation ratios never will be justified.

Even if my analysis is right, it does not imply a market crash. Valuation ratios can decline because prices come down, earnings and book values rise, or a combination of the two. Personally, I'm hoping for a really big crash, because it's so exciting.