Wall Street's
Wacky Exuberance

Cartoon ©2000, Bill Yund

This is clearly a vital question if you’re a millionaire. But the evening news would have us believe that Joan Sixpack’s financial future is also hanging in the balance.

In fact, about half of Americans have absolutely nothing riding on Wall Street. Only a small percentage of the stock market’s wealth is controlled by the millions of working Americans who do invest. Of those households that own shares, 72 percent have holdings worth less than $5,000. In contrast, the typical household has about $90,000 in real estate assets, according to the Economic Policy Institute. That means that a 5 percent change in the value of home prices has more impact on an average person’s wealth than a 50 percent change in the stock market.

Chart: © 2000, Gary Huck

All that said, some trustworthy economists are sounding an alarm about what might happen to working-class investors if the stock market did take a major dive. What’s more, they say, a major dive is pretty likely — although no one knows when.

"If the stock market collapses, rich people stand to lose the most money. If they have ten billion dollars, they might lose six of it. However, they’ll still be a billionaire," says Dean Baker of the Center for Economic and Policy Research. On the other hand, he says, "for working people, a stock market collapse — especially if it’s followed by a recession — could be disastrous." Hardest hit would be people close to retirement who were depending on their 401(K) plan to make it possible.

Even more frightening, a range of politicians — including George W. Bush and many Democrats — are so enchanted by the stock market and apparently so firmly convinced that it will never go down that they want to invest part of our Social Security fund in it. (See "Social Security Roulette, at left.) Among economists, Dean Baker is one of the harshest critics of such plans.

Baker thinks the stock market could tumble by half. And he didn’t just pull that number out of the air. In principle, he explains, stock shares are supposed to be determined by the profits companies are expecting to earn in the future. Historically, the ratio of the price of a share to corporate earnings per share has been about 15-1. Right now the so-called "price-to-earnings ratio" is, on average, closer to 30-1. (Fyi, Baker has all his 401(K) money in government bonds.)

So why haven’t we heard this stock market tip on the nightly news?

"It’s mind-boggling," says Baker. "The numbers I’m citing are widely known to economists and to anyone who follows the stock market. They’re real easy to come by. And yet, when I ask people who work on Wall Street about it, they just start uttering gibberish about the New Age and the New Economy." For politicians and central bankers, Baker believes, it’s easier to just ignore the problem and hope the crash doesn’t happen on their watch. And, he says, it’s not exactly clear what they could have done to avoid the runup anyway.

Some economists argue that the stock market’s meteoric rise over the past several years has a solid foundation. After all, they say, the economy’s fundamental numbers — strong economic growth, low inflation — are positive. But that doesn’t satisfy Baker.

"Say you’re trying to sell someone a used car that doesn’t look all that good, and asking a lot of money for it. And when the potential buyer asks you about the state of the transmission, you answer, ‘The fundamentals of the economy are good.’ What does that have to do with the question at hand?"

To double-check this alarming analysis, we turned to another noted economist. Doug Henwood of the Left Business Observer told us comfortingly that he was "generally allergic to frightening scenarios."

So what is this stuff about the price-to-earnings ratio being way off? "Oh yes. By any number of measures — including overall market valuation or the nearly two decades of spectacular stock market growth — there’s no precedent for it. It’s pretty extreme." What’s more, Henwood thinks the stock market volatility of the past few months signals the beginning of the end of the bull market.

Henwood, author of the book Wall Street: How It Works and For Whom, says that when this bull market first got its start, it made a certain kind of sense. "This all began back in the early 1980s as a result of the political victory of Reaganism. The crushing of labor and of rebellions in the third world...these things increased the profitability of capital." And those high profits — at labor’s expense — drove the stock market upward in what Henwood calls "a pretty rational reaction."

But beginning around 1995, says Henwood, the market "left the realm of reason and started levitating."

But why?

The market, notes Henwood, goes up and down based on two factors: fundamental economic conditions and psychology. "I think mob psychology really took over around 1995. That was when the public started getting involved in the stock market in a big way, and began thinking that it was a guaranteed avenue for making money — expecting 25 percent returns every year and no risk. Since then, it’s become a big cultural phenomenon and started entering people’s daily conversations."

The love affair with new technology has clearly added to the heady atmosphere. It’s nothing new for Wall Street investors to be dazzled by new technology, notes Henwood. In the early 1970s, speculation was concentrated in a few "very highly valued and glamorous stocks then called the ‘Nifty Fifty’" — companies like Polaroid and IBM. "These companies had extremely high valuations," says Henwood. "People justified the valuations because they said these companies represented the future. It was very similar to the rhetoric we’re hearing now about net stocks. The difference is, those companies were making a lot of money — the net companies aren’t."

Henwood has some unlikely company in this analysis: corporate mogul Warren Buffett recently likened the runup of high-tech stocks to a "chain letter" in which early participants cash in on the gullibility of those who follow. "In the last year, the ability to monetize shareholder ignorance has never been better," he told a mortified group of investors.

In fact, says Henwood, "There’s no precedent in American financial history for this random sustained speculation in stocks that are not making any money and have no prospects of making money. In previous episodes of this sort of thing, the companies became quickly profitable and started growing like crazy. There’s just been nothing like this."

Henwood concurs with Baker’s assessment of the deeply cockeyed price-to-earnings ratio. He also notes that historically, when the market overshoots in one direction — in this case up — it goes on to overshoot in the other. Which could mean a more than 50 percent drop in the stock market.

This chart, based on analysis by economist Doug Henwood, shows the degree to which stock prices deviate from the long-term trend. Normally, stock prices have wandered between about 50 percent above the trendline and 50 percent below. This changed in 1996; now, stock prices are three times their normal value. Chart: © 2000, Gary Huck

DOOMSDAY SCENARIOS

Henwood refuses to commit to a scenario, however, doomsday or otherwise. He points out that conditions are different than in 1929, because government is a more powerful mediator of financial conditions, and we have the Fed. The stock market crash of 1987 turned out to be no great catastrophe. However, notes Henwood, "that was when only 20 or 30 percent of households were in the stock market. Now it’s over 50 percent. It’s hard to predict what would happen if masses of people discover that the stock market really can bite them hard."

Dean Baker is worried about the possibility that a stock market drop could trigger a severe recession. "Right now, people are spending money in part because of the stock market," he says. This is something economists are calling the "wealth effect," and it’s estimated to amount to about four cents on the dollar. That is, someone with $100,000 in stocks might spend an extra $4,000 a year because of that wealth.

"You can see in the data that consumption has soared and the savings rate has fallen through the floor, and the stock market seems to be an obvious explanation," says Baker. Right now, all this is pulling the economy forward — but it could also put it into reverse. "Depending on how much the market falls, there could be a very large effect — you could lose $8–$10 trillion in wealth, which could add up to losing $400 billion in annual consumption," says Baker.

Henwood is a little skeptical about the "wealth effect" idea. He thinks it’s highly unlikely that people will spend on the basis of a pension fund that they can’t touch for twenty years. On the other hand, he believes people who see the paper value of their stock market holdings rise to great heights might well be saving less, leaving them even more vulnerable if the market crashes.

POPPING MARKET BUBBLES

One thing all this means for working people is that caution is warranted.

Chart: © 2000, Gary Huck

Baker also has a structural proposal: put a tax on stock transactions. Baker is calling for imposition of a tax of .25 percentage points on each purchase or sale of a share of stock. This, he argues, would have almost no impact on anyone who holds a stock for five or ten years. But it could prove quite costly to someone who "buys at two o’clock and sells at three o’clock." This small tax might not prevent big bubbles from ever happening again, says Baker, but at least we would be treating stock market gambling more like other forms of gambling, which are heavily taxed.

Obviously, we could use the money from such a tax to provide greater security for everyone. In fact, the Labor Party has proposed a stock transaction tax as a good source of revenue for our Just Health Care plan.

To really protect workers from the vicissitudes of the market, we need a strengthened Social Security system or a public pension system that guarantees everyone a decent retirement income.

Henwood also gives a plug to defined benefit pension plans, a once popular item on the average union member’s agenda. Under a defined benefit plan, the employer commits to providing a certain number of dollars a month for workers’ retirement. These plans have been largely supplanted by either no pension plan at all or by the now familiar 401(K) and other "defined contribution plans." Here, workers and/or employers pay a set amount of money into the pension fund, but the payout depends on the state of the market when the worker retires.

"We should make the employer take the risk, not the employee," argues Henwood. "With a defined contribution plan, you get whatever’s at the end of the rainbow. If the market is high when you retire, it can be a nice amount. But if the market is low when you retire, you might be eating catfood."

Baker and Henwood both wish more working Americans would develop a skeptical attitude about the stock market — and not only because someday it will go down. The stock market mania, they believe, is having an unhealthy psychological effect.

"It gets working-class people to identify with the interests of capital," says Henwood. "It’s so seductive. People who might make a few extra bucks in their mutual fund holdings forget that they’re being asked to sacrifice their wages for thirty or forty years in order to maximize profits. The major reason the bull market has been going wild is the defeat of labor and the victory of capital — the upward shift of income and wealth and the increase in profitability, at workers’ expense. In the last few years, that’s been compounded by wacky exuberance. But there is a fundamental reason for the stock market’s climb, and it’s not something the working class should be happy about."

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