by Archie M. Richards, Jr., CFP^®
October 1, 2001

Market commentators have been saying that stock prices remain vulnerable because price-earnings ratios are still above their long-term average. In a recent Wall Street Journal article, Professor Burton G. Malkiel says they're wrong.

First, let's nail down the vocab. If the price of a stock is $40, and the company's earnings per share for the year are $2, the price/earnings ratio (PE) is 20. The price is twenty times greater than the year's earnings. If the annual earnings stayed the same year after year (which they don't), the buyer would have to wait twenty years for the cumulative earnings to equal the up-front price.

Author of A Random Walk Down Wall Street, Burton Malkiel is a professor of economics at Princeton and all-around market expert. I deem anyone a market expert who recommends buying and holding stocks, but Mr. Malkiel is a cut above the crowd.

Over the long term, stock prices have averaged 15 times earnings. With PEs now in the low-20s, many commentators expect further declines.

Anything can happen in the short term, says Malkiel, but the market is fairly valued now. Here's why:

• PE ratios fall below average when long-term interest rates rise. Rise they did in the early-80s, drawing money out of stocks into bonds.

• PE ratios also fall below average during period of high inflation. Rapid inflation makes investment planning more difficult and raises the risk that the Fed will clamp down on the money supply, as indeed it did twenty years ago.

But with interest rates and the rate of inflation both now low, Malkiel believes that the market is valued fairly.

As to terrorism, Dr. Malkiel analyzed previous shocks, such as the Gulf War, the 1987 crash, the Cambodia bombing, and others. The market declines were temporary in all cases. "Investors who make an emotional decision to sell during times of crisis," he writes, "are unlikely to derive any benefit."

Finally, Malkiel notes that many companies today are focusing investor attention on "pro forma" earnings, which omit expenses that are considered to be "special" or "nonrecurring." Companies treat lots of bad stuff as special or nonrecurring expenses, causing pro forma earnings to overstate actual earnings.

But this kind of misreporting, Malkiel finds, has been even more extreme in other years. He considers the quality of earnings to be better today, for example, than they were in the early-1970s and early-1990s.

History tells us, says Professor Malkiel, "that anyone who sells stocks today in the hope of getting back in at just the right time is likely to be making a large and costly mistake."

Amen, brother. But there's a fly in the ointment.

This column has expressed the belief that the world's stock markets will benefit greatly from extraordinary technological advances, generally improving U.S. monetary policies, and the growing belief among world voters that big government causes more harm then good. The column has said that the coming bull market will proceed more rapidly, over the next ten or twenty years, than the 12-percent annually compounded growth that stocks have enjoyed since World War II.

But a study for Congress based on two decades of data calls this view into question. Among other things, the study showed that stock prices fall when federal spending increases faster than the nation's total output.

From 1994 to 1999, federal spending declined as a percentage of total output. Sure enough, the market rose rapidly during those years.

But in the past year or two, even before the infamous September 11, a federal surplus induced Congress to gleefully turn up the spending spigot.

Awareness that the size of government is beginning to grow faster than the economy probably contributed to the market's recent drop. Moreover, the urgency to increase federal expenses for homeland security will spur the growth of total federal spending all the faster.

I doubt that the market will fall even more than it already has. In any event, don't sell. Don't ever sell in an effort to time the market. The chances of being wrong are too great. But I no longer believe that the market will bounce up rapidly, at least not until the U.S. government simmers down.

Do you like bull markets? More than ever, we need term limits on the U.S. Congress!