by Archie M. Richards, Jr., CFP^®
July 22, 2002

In the July 15, 2002 issue of The Wall Street Journal,a highly respected economist, Arthur Laffer, presented an analysis showing that stock prices are likely to rise smartly.

Imagine you're an investment banker who engages in initial public offerings (referred to as IPOs). It's your job to bring the stocks of privately-held corporations to the market, making them available for ownership by the public.

For the initial sale of a stock to the public, the price must be determined by you. The price has to be related to the company's profits, but it should be larger than those profits.

You decide to use an evaluation method often used by investment bankers. You divide the latest annual profit by the current interest rate on 10-year Treasury bonds. Assuming a profit of 50 cents a share and an interest rate of 5 percent, the price at which you'd offer the stock to the public would be $10 a share (the $.50 profit divided by the .05 interest rate). This is called "capitalizing" the profit.

Now assume you are asked to arrange an initial public offering for the entire U.S. economy. (This would give you a nice day's pay.)

You turn to the Bureau of Economic Analysis (www.bea.doc.gov), part of the Department of Commerce. The BEA employs scores of professionals to determine U.S. corporate profits from the tax returns of five million U.S. corporations. The staff members adjust the figures for differences in reporting methods and eliminate financial flim-flam as best they can. (Only about 15 thousand corporations are publicly traded. The rest of the five million are owned privately.)

For the latest period, the annual pre-tax U.S. corporate profits were $644 billion.

(Government legislators are prone to complain about "outrageous" corporate profits. $644 billion seems like a lot, but government expenditures are almost five times larger. Profits are what make the economy grow, benefiting everyone. It's the government spending that's outrageous.)

Back to our story. We've got pre-tax U.S. profits of $644 billion. The average daily interest rate on 10-year Treasuries is about 4.6 percent. Dividing $644 billion by 0.046 gives capitalized corporate profits of $14 trillion. (I'll leave it to you to figure out how many shares of the U.S. economy to sell in your IPO, to arrive at a per-share price.)

Economist Arthur Laffer calculated the capitalized corporate profits in this manner for the 32 years from 1970 to the present. He plotted the numbers on a chart. On the same chart he also plotted the S&P 500 Index, which reflect the price trends of the 500 largest publicly-held U.S. stocks.

For most of the 32 years, both the capitalized corporate profits and the S&P 500 Index rose approximately together.

The biggest divergence took place in the late-1970s, when gas lines, high tax rates, high inflation, and high interest rates suppressed stock prices. Capitalized corporate profits at that time forged ahead of the S&P.

For the sixteen years from 1982 to 1998, both indexes rose sharply, with the capitalized corporate profits generally leading the way and the stock market playing catch-up.

For the two years from 1999 to 2001, the trends reversed. Stock prices moved ahead, and the capitalized corporate profits declined. Stock prices were too high.

Perhaps you've noticed that they've come down a bit.

The capitalized corporate profits are again in the lead. The S&P 500 would have to gain about 50 percent to catch up. Laffer calls this a buying opportunity.

A 50 percent gain in the Dow would bring it to about 13,000. An advance of this magnitude will certainly occur over time. Make sure you're on board for the ride.

For family history purposes, Charles asks what $200 in 1857 would be worth now. (The answer is $3,788.) Such information is available on www.westegg.com/inflation. In 144 years, the buying power of the dollar fell by 19 times. This is an annual compound rate of decline of 2.06 percent.