What Happened to the Bull Market

Unless long-term interest rates drop further, aggregate price-to-earnings ratios are about as high as they can possibly be. By the time NASDAQ reached its peak in the recent bull market, many financial commentators had begun to accept the idea that stock market valuations were no longer driven solely by the traditional economic factors: earnings growth, inflation, and interest rates. Instead, they suggested, new factors--such as structural changes in the economy, new rules of economics, and the value of intangible assets and brands -- justified the lofty stock prices. Today those valuations seem ludicrous, though the fundamental question remains: has the market changed what it factors into share values? Using a simple model based on changes in earnings, inflation, and interest rates, we found that the traditional factors alone explain most of the medium- and long-term movement in the SP only a small portion could be assigned to the amazing run-up in the Internet and high-tech sectors, which, some investors came to believe, had rewritten classical theories of how markets behave. Yet the plunge in the prices of a few megacapitalization stocks did play a major role in driving the markets down. Between January 1, 1980, and December 31, 1999, the S&P 500 index rose to 1,469, from 108, representing a compound annual growth rate of almost 14 percent (excluding dividends). In the 19 months that followed, from January 1, 2000, to July 31, 2001, the S&P 500 fell to 1,211. We identified three factors responsible for almost all of the change in the index. The first two--growth in earnings and changes in interest rates and inflation--are precisely the factors that would traditionally have been expected to drive share prices. The third is the temporary and somewhat irrational emergence of megacap stocks. [1] Together, these three factors account for over 80 percent of the run-up in stocks from 1980 to 1999 (Exhibit 1). The retreat in the value of megacap stocks accounts for over 60 percent of the decline in the market from January 2000 through July 2001. Consider earnings growth. From 1980 to 1999, forecast earnings per share for the S&P 500 rose to $56, from $15. If the forward price-to-earnings ratio [2] of the 1980 S&P 500 had remained constant over that time, earnings growth alone would have boosted the index by 302 points. This annual growth in earnings of 6.9 percent (3.2 percent in real terms) isn't exceptional, since the nominal US gross domestic product grew by 6.6 percent over the same period. As a result, corporate profits remained a relatively constant share of overall GDP. Simultaneously, interest rates in the United States were falling dramatically, along with inflation. Long-term US-government bond yields peaked at nearly 15 percent in 1981 and then fell, more or less steadily, to 5.7 percent by 1999. Falling interest rates reduced the cost of capital for corporations, thereby enabling them to earn a larger premium as well as generating higher values for stocks. …