In This Market, a Lot Is Riding on Complacency

“Stock prices have reached what looks like a permanently high plateau.�

-- Irving Fisher, Yale economics professor,

just before the 1929 market crash

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People have chuckled about poor Irv Fisher’s famous quote for 70 years now. What a sap, to utter something so ludicrous!

But how many millions of Irving Fishers silently stroll on Wall Street today--believing, if not professing, that the U.S. stock market finally is all but immune to a severe and long-lasting downturn?

To put it another way: What happened to all the talk in recent years about a looming market crash? You hardly hear the C-word anymore in polite market conversation.

The bulls seem as much in control of the U.S. market as ever. Indeed, the percentage of investment newsletter writers who are bullish on stocks is about 58% now--hovering just under the 12-year high reached in early June, according to Investors Intelligence, which polls the newsletters weekly.

Yet by some of the most common measures, the blue-chip stocks that comprise the bulk of the market (in dollar terms) are more drastically overvalued than at any time in modern history.

Federal Reserve Board Chairman Alan Greenspan’s own favorite market valuation formula, which measures blue-chip stock prices and expected corporate earnings against the yield on 10-year U.S. Treasury notes, says the market is currently more than 40% overvalued.

That’s higher even than the 34% overvaluation reading in September 1987--just before that year’s market crash, notes Deutsche Bank economist Edward Yardeni, who regularly monitors Greenspan’s formula.

Wall Street, however, hardly seems perturbed. There were more people worried about a deep market dive a year ago, two years ago, even three years ago, when stock prices were much lower and valuations far less troubling, judged historically.

“There is an unbelievable level of complacency� among investors, says Arnold Kaufman, veteran editor of Standard & Poor’s Corp.’s Outlook market newsletter in New York.

Of course, nothing says that the market must obey anyone’s pricing models. But Greenspan’s model at least implies that if stocks were to move closer to “fair� value, a lot of paper wealth would disappear.

Why, though, should that occur? Abby J. Cohen, the Goldman, Sachs & Co. investment strategist who is perhaps Wall Street’s best-known bull, has popularized the notion that the U.S. economy is a nearly impervious “supertanker�--a description that would seem to fit the stock market as well.

Look what we’ve survived over the last few years: the Asian economic crisis, Russia’s economic collapse, a slump in U.S. corporate earnings, last fall’s horrendous global deflation/depression scare, a presidential impeachment and, most recently, the Kosovo crisis.

In the worst of it, U.S. blue-chip stocks overall suffered no more than a 20% decline from their highs, and even that didn’t last very long.

If recent events couldn’t trigger a market crash on the order of 1987’s 36% drop or 1929’s nearly 50% loss, why worry about one now--with corporate earnings rising again, Asia’s economy on the mend and interest in the U.S. market finally broadening to include smaller stocks?

True, Greenspan’s intent to raise short-term interest rates, a virtual certainty at this week’s Fed meeting, has troubled Wall Street lately. But the stock market’s ability to largely shrug off even this says that investors are far more comfortable with the devil they know (an inflation-vigilant Fed) than the devil they don’t (last year’s perceived deflation threat).

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Surely, if the Fed overdoes it, triggering a recession instead of simply slowing the economy, then the urge to sell stocks might very well become overwhelming, Wall Street’s bulls concede.

Barring that, many pros say a decline of more than 20% in the broad market from these levels could only be triggered by “some kind of unexpected shock,� as Charles Crane, chief investment strategist at $60-billion Key Asset Management in Cleveland, puts it.

In years past, however, allowing for that potential shock kept some people from fully loading up on stocks or from paying super-high prices relative to per-share earnings. That’s what is different today: There appears to be far less of an allowance for the unanticipated.

As S&P;’s Kaufman notes, this eight-year bull market has beaten the odds for so long, people understandably can’t imagine that the money machine will ever stop.

“I felt more uncomfortable two or three years ago, when we first sailed into uncharted territory� in terms of price-to-earnings valuations, he says.

Now, as with anything else, the abnormal begins to feel more normal the longer you endure (or enjoy) it. Two weeks ago, Kaufman raised the percentage of stocks in his recommended portfolio to 60% from 55%, cutting cash to 5% and keeping bonds at 35%.

The relatively few vocal bears continue to remind us that these valuations aren’t normal and that the farther out of whack they get, the greater the risk of ultimate ruin.

Yet many of the bears have been wrong for so long, “we can barely stand the sound of our own skeptical voices,� says James Grant, editor of Grant’s Interest Rate Observer newsletter in New York and one of the market’s leading pessimists since 1995. “Repetition doesn’t enhance the appeal of an idea that just doesn’t seem to work.�

Interestingly, though, if fewer U.S. investors and analysts are willing to challenge the unspoken trust in a “permanently high plateau� for U.S. stocks today, that is not the case among many foreign investors, some Wall Streeters say.

“The words ‘crash’ and ‘stock market bubble’ are firmly lodged in the first paragraph� of many foreigners’ discussions of the U.S. market, Crane says.

That’s especially true of the Japanese. “They see all the same fingerprints� that were on their own market 10 years ago--before it lost 60% of its value in less than three years.

In 1989, stocks in Japan were the most richly valued in the world, reflecting a national sense of economic invincibility and massive investment by individuals.

In so many ways, of course, America in 1999 is not Japan in 1989. Most important, ours is not a rigid society bound by 1,000-year-old traditions, nor is our government micromanaging our economy in the way Japan’s bureaucracy has since World War II.

But on one important level, Grant points out similarities that should be unsettling even to those who don’t share his downbeat views.

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In the U.S. Internet stock mania, “people are rewarding companies that are behaving very much like companies in Japan behaved 10 years ago,� he says.

That is, money is being poured into Net companies that are investing heavily in infrastructure, hiring aggressively, fighting tooth and nail for market share and bending over backward to please customers--�everything except earning a net profit for shareholders,� Grant says.

A “permanently high plateau� for the market, he says, is indeed possible “if capitalism stops working--if it stops allocating resources to their most profitable use.�

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Times Senior Markets Editor Tom Petruno can be reached at [email protected].