How to Think About the Stock Market

Against the Gods: The Remarkable Story of Risk

by Peter L. Bernstein
Wiley, 383 pp., $27.95

It Was a Very Good Year: Extraordinary Moments in Stock Market History

by Martin S. Fridson
Wiley, 244 pp., $29.95

Security Analysis: The Classic 1934 Edition

by Benjamin Graham and David Dodd
McGraw-Hill, 725 pp., $50.00

A Random Walk Down Wall Street

by Burton G. Malkiel. sixth edition
Norton, 522 pp., $15.95 (paper)

What Works on Wall Street

by James P. O'Shaughnessy. revised edition
McGraw-Hill, 366 pp., $29.95

Stocks for the Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies

by Jeremy J. Siegel
McGraw-Hill, 301 pp., $29.95

Advances in Behavioral Finance

edited by Richard H. Thaler
Russell Sage Foundation, 597 pp., $19.95 (paper)

The Intelligent Investor

by Benjamin Graham, with introduction and appendix by Warren Buffett. fourth revised edition
Harper Business, 340 pp., $30.00

Are stocks overvalued? Federal Reserve Board Chairman Alan Greenspan raised the issue most famously in December 1996 when he said he was worried about “irrational exuberance” in the stock market.1 At that time, the Dow Jones Industrial Average,2 the oldest and most popular index of stock prices, was about 6500. It is now over 9000, and Greenspan has backed off from making comments while other government officials have chimed in. Treasury Secretary Robert Rubin suggested in early May that investors use more “rigor” in evaluating their investments. A day later, Alice Rivlin, vice-chairwoman of the Fed, said that she saw “cause for concern about the values in the stock market,” but added, “That doesn’t necessarily mean it’s a bubble.” Between the comments by Greenspan and Rivlin, the financial press has kept the question of overvaluation alive, particularly as stock prices have reached new heights—7000, 8000, 9000.

It is hardly surprising that people are worried about stock prices because they have been rising so rapidly for such a long time. Despite setbacks in 1987 and 1990, stock prices have increased more than ninefold since 1982, when the Dow was less than 1000. Just the current phase of the upswing, which began in October 1990 with the index slightly above 2000, is considered the longest “bull market” in history (see Figure 1 on page 24, which also shows that when the long-term record of the Dow is drawn on a ratio scale which gives the same weight to equal proportional changes in the index, then the current rise in stock prices is less dramatic when it is compared to the pattern during several earlier periods). As a result of the sustained run-up in stock prices, total returns (i.e., dividends plus capital gains) on the stocks in the S&P 500, a more representative market index than the Dow, have averaged about 18 percent a year in the 1980s and 1990s, compared to about 11 percent between 1926 and 1980.

The rise in stock prices has been driven largely by improvements in the economy, principally rising corporate profits, falling inflation, and falling interest rates. Profits of the companies in the S&P 500 index more than doubled between 1982 and 1996, growing more than 6 percent a year on average. But because share prices rose even more rapidly, the price of stocks relative to a dollar of earnings (the price/ earnings, or P/E, ratio) also rose, from about 8 times earnings to more than 20; it is now about 24, roughly 50 percent above its long-term average of approximately 16 (see Figure 2 on page 24). Earnings growth and the rise of the P/E ratio to only its average level account for about two thirds of the rise in stock prices from 1982 to 1996. Investors have bid up stock prices even further because they anticipate growth in earnings to continue, and because interest rates have fallen sharply since the early 1980s, making investments in stocks even more attractive than in bonds.

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