Stocks show Greenspan's approach was sound

November 19, 2006|By Jay Hancock | Jay Hancock,Sun Columnist

It was not a judgment. It was a question, posed in the manner of Socrates, who said, "I know nothing except the fact of my ignorance."

But Alan Greenspan's musing about the stock market a decade ago seemed close enough to truth to become the T-shirt slogan for the 1990s.

"How do we know," the maestro wondered in late 1996, "when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the last decade?"

Irrational Exuberance became the title of a hit book on financial insanity. The New York Times printed the phrase almost once a week, on average, between late 1996 and early 2000, when stocks began falling and temporarily wiping out $7 trillion in wealth. Greenspan himself seemed to become addled by irrationality, fueling the boom with easy money and suggesting that markets know best.

But U.S. stocks are having the last word. That is making conventional wisdom about the 1990s - that it was mostly money down the drain for shareholders - seem not so rational, either.

Many of the lunatics who bought stocks last decade have done very well indeed if they diversified, held on, kept buying through the decline and could afford to wait for the rebound, which is the only way to be in the market.

Greenspan spoke on Dec. 5, 1996, in an evening speech at the American Enterprise Institute. If on that day you had sunk $1,000 into, say, the T. Rowe Price mutual fund that tracks the S&P 500 stock index, your money would have earned an average of 7.9 percent a year and would be worth more than $2,100 today.

That wasn't so irrational, now, was it? Over 10 years your investment would have outpaced bonds, money-market funds, bank deposits, even high-flying gold. Even, in many places, residential real estate.

Had you bought two years later, in late 1998, after stocks had soared even more, you still would have earned 2.8 percent a year, on average. That's a little better than inflation.

And it's not like your little patch of the S&P 500, up nearly 15 percent this year, would be overpriced today. (That's hard to say about gold and real estate.) At 18 times profits and 2.8 times book value, the S&P 500 is priced close to its long-term average. Not only would you have earned 7.9 percent annually since 1996; you'd be in decent shape for further gains.

The upshot: The fundamental theory for the 1990s "buy" signal has been vindicated.

With the exception of investors in Toys.com and similarly crazy Internet firms, people who bought stocks because they expected economic changes to breed big profit gains were as logical as Mr. Spock for most of the decade.

Yes, irrationality eventually showed up, and it tainted the whole era.

At around 1,400, today's S&P 500 is still below its 2000 peak. The Nasdaq index, home a few years ago to publicly traded companies with no revenue, let alone earnings, is less than half its 2000 top. Anybody who held onto Enron or WorldCom lost everything.

But the nuttiness that occurred was a misapplication of essentially sound thinking. Buying the S&P 500 was a good idea, but not at 35 times profits in 1999. Investing in technology was smart, but not at $400 a share in companies with no profits. The 1999 foam should not obscure the beer underneath.

Greenspan's "irrational exuberance" question came early. The initial public offering for Netscape, the starting gun of the stock boom, occurred the previous year. The Dow was at 6,500; the S&P 500 at 750.

History has shown that the query was sincere. Stocks had risen sharply in 1996, and while Greenspan believed that key economic changes might justify the levitation, he also worried about a potential crash. He soon went with the first thought, that stocks were worth what investors were paying, and let the economy blow steam out its ears.

As it turns out, the economic changes of the 1990s were indeed revolutionary. Computers and the Internet enabled huge productivity gains, which helped double corporate profits in the past decade.

How do we know when irrational exuberance has unduly escalated asset values? It's extremely difficult, and those in the market should invest only for the long term. But the U.S. stock market seems to have redeemed much of the 1990s' promise. That may be vindication for Greenspan, as well.

jay.hancock@baltsun.com

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