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Bye Bye, Miss American Pie

by J. Orlin Grabbe

Some people think the time to sell is when everyone else is selling. That the time to get out of stocks is when stocks are being dumped, the market is falling, and execution prices are terrible. That the finest strategy for self- preservation is to make a mad rush for the door once the theater has caught fire. After all, they are then doing the "right thing". They are "financially correct", and their actions are reinforced by current articles in the Wall Street Journal, Money Magazine, and commentators on CNBC.

Such people are called Lemmings.

It has been three weeks since I posted "Sell Stocks Now" on the Internet, on September 15. These have been three weeks of steady or modestly rising prices for most of the major stock averages. For those individuals with millions of dollars in invested in stocks, or institutions with billions, the intervening time has provided a perfect environment for liquidation of stock assets, and conversion to other forms of wealth.

Well, the grace period is over, and the time for lemmings is at hand. Of course the lemmings have also been around these past few weeks, rushing to buy more shares of stock, pulled forward by Dow visions of 6000, 7000, and onward to 10,000! But much like the bankrupt Credit Lyonnais, the lemmings will soon be seeking salvation from their government, and seeking to dump on someone else's shoulders the consequences of their own actions. It's all part of the recent "no-regrets" theory of finance, whereby if a financial contract or asset turns sour, you sue the institution that sold it to you, claiming you were "victimized". (If the reverse happens, and you win, you then explain to everyone what a brilliant investor or financial manager you are.)

It's the same cry-baby mentality evidenced by corporations which have suffered losses on their interest-rate swaps. When the swap generates a positive cash flow, the corporate treasurer is a hero. When the swap generates a negative cash flow, the board of directors yells "fraud" and sues the bank. The simplest concepts of risk management and responsibility have been tossed out the window. After all, we are all supposed to become billionaires in Bill Clinton's Go-Go 90s--pockets flush with cash, and the booze and lines of coke waiting in the limo bar.

Are stocks over-valued? Let's do some back of the envelope calculations. Stocks have historically yielded about 5 percentage points higher in dividend payouts and share buy- backs than interest payments on bonds. This is considered a risk premium for the uncertainty inherent in owning stocks as compared to the fixed payments promised by bond covenants. If we add 5 percent to the recent yield of about 7 percent on long-term U.S. treasury securities, we obtain a stock yield of about 12 percent. That is the return that stock owners would ordinarily require.

But in the year 1995, dividends and stock buy-backs for publicly traded companies was about $157 billion. The stock market value of these same firms is currently about $7.2 trillion. This implies a return of about 2.18 percent--more than five times smaller than it should be.

For stocks to rise to a 12 percent yield would require the value of traded companies to fall to about $1.3 trillion. This value, $1.3 trillion, is about 18 percent of the current market value of $7.2 trillion. If we apply this ratio to the Dow Jones Industrial Average of about 6000 (although in truth the Dow is not really representative of the market as a whole), we obtain a projected Dow of 1090. (That is, $157 billion/.12 = $1.30833 trillion. Then 1.30833/7.2 =.1817. Finally. 6000 x .1817 = 1090.)

Of course, the relationships could hold in other ways without the stock market falling. Dividends and stock buy- backs could increase to $864 billion in 1996 and subsequent years. Fat chance. Or bond yields could fall to negative 3 percent. Fat chance again. Or bond yields could fall to zero and the risk premium on stocks fall to 2 percent, and the Dow could stay at around 6000. I seriously doubt it. Or bond yields could fall to zero and the risk premium on stocks fall to 1 percent, and the Dow could rise to 13,000! Think like this, and you are a lemming.

Something is going to give. In equilibrium (that is, after the shit has hit the fan), all of these numbers and relationships will have changed. But one thing is for sure: stock prices are going to be a lot lower than they are now.

And the screams of the infants will be heard throughout the land.

October 7, 1996
Web Page: http://www.aci.net/kalliste/