In December 1996 when Federal Reserve chairman Alan Greenspan used the term irrational exuberance in a speech at the American Enterprise Institute's annual Boyer Award dinner, he was referring to the bursting of the Japanese equity bubble six years earlier. It is possible to stretch Greenspan's intention out of context to suggest that he was contemplating the possibility that irrational exuberance would grip U.S. equity markets. However, at the time, earnings forecasts and interest rates, the inputs to the most basic model of equity valuation, a model employed by the Fed, indicated that the American stock market was slightly below fair value.

A little more than three years later, in March 2000, at the peak of the U.S. stock market bubble, the S&P 500 Index reached a level where it was 65 percent overvalued based on the usual criteria. More strikingly, the extraordinary level of stocks early in 2000 was three standard deviations above where one would expect it to be given generous, and retrospectively questionable, earnings forecasts and interest rates.

Stocks after "Irrational Exuberance"

Leading up to Chairman Greenspan's testimony to Congress on July 16 and 17 on the state of the economy, speculation abounded about what term he might use to characterize the behavior of stock prices in today's market. Terms like "irrational pessimism" that were bandied about suggest that the sharp drop in stock prices has been somehow based on irrational behavior. Rather than characterize stock prices, Chairman Greenspan chose to focus on the behavior of corporate managers and auditors whose behavior he described as having been driven by "infectious greed." This choice of words was both surprising and counterproductive. It was surprising because the Fed chairman's testimony was expected to be an effort to bolster confidence in the American economy. While the chairman's characterization of the outlook for the economy was perhaps excessively generous and bullish in blaming lower stock prices on a few corporate bad actors, he seemed to overlook the well-known link that runs from financial markets to real economic behavior. Rapidly falling stocks cut wealth, employment, and consumer confidence, and the economy suffers. Why would a Fed chairman, almost out of ammunition to fight a further slowdown of the economy, want to help weaken the economy further?

The other counterproductive part of the "infectious greed" characterization is the suggestion that greed and hence misleading or, worse, fraudulent earnings reports are going to continue because infections have a way of spreading. Indeed, we have not seen the last revelations about irregularities attached to the preparation and auditing of earnings reports of leading corporations. Yet to emphasize the infectious nature of greed as an explanation for the weak performance of the stock market is an unhelpful thing for the Fed chairman to do. CEOs of America's largest corporations are already facing an August 14 deadline imposed by the Securities and Exchange Commission, by which time they must be willing to accept personal responsibility for the accuracy of their earnings reports or admit that they cannot do so, thereby compounding further the current uncertainty attached to the corporate earnings outlook in the United States.

If "irrational exuberance" was a poor description of the state of the U.S. equity market in December 1996, and "infectious greed" was a regrettable characterization of the forces driving stock prices down in the summer of 2002, what ought the chairman to have said in July? My suggestion to describe the state of the U.S. equity market this summer is rational saturninity. The mood of investors is certainly saturnine, that is, gloomy, and, given the behavior of stock prices in past post-bubble periods, it is probably rational for investors to be gloomy.

Fundamentals Are Hurting Stocks

Over the past several months, news stories have focused on irregularities and outright fraud contained in earnings reports as the reason for falling stock prices. Little attention has been paid to the possibility that, based on fundamentals, stock prices are quite close to those that would reflect rational saturninity. With the major determinants of stock prices--interest rates and expected earnings--at their mid-July levels, the S&P typically would have been about 18 percent above its actual level at that time. That level was just within a normal range--one standard deviation--of fair value based on a simple model for valuing stocks like the one the Fed uses.

Revelations of fraudulent accounting practices do make earnings reports more suspect than usual. Surely increased risk must reduce the amounts investors are willing to pay for shares. In fact, 18 percent seems a modest discount on share prices, one that reflects rational saturninity on the part of investors given the elevated risks associated with doubts about earnings reports.

The stock market has been falling also because of a poor earnings outlook even adjusted for uncertainty about the quality of earnings reports. The U.S. economy, the ultimate determinant of earnings, is slowing with last winter's 6 percent growth having dropped to 2 percent. The pickup in investment that Alan Greenspan has suggested will be necessary for a sustainable recovery will not be undertaken by corporate leaders fearful of legislation emerging from a Congress that is seeking scapegoats for the $7 trillion of household wealth erased so far in the stock market. The bounce in profits earlier this year was tied to lower labor costs resulting from layoffs. Widespread cost cutting to enhance profitability is a negative-sum game since it cuts demand growth, pricing power, and profits. The absence of employment growth during the second quarter will probably be followed by a subsequent fall in employment growth as firms enter another round of layoffs in an effort to preserve profitability in markets where demand and pricing power are weak.

Rational saturninity would suggest that falling stock markets are signaling legitimate concerns about the prospects for the economy and corporate earnings. Beyond the normal weakness of demand growth that has characterized this entire "recovery" there are other reasons that economic weakness and weakness of stock prices will persist in this post-bubble environment.

First, there is the capacity recycling problem. When companies such as WorldCom fail, the bankruptcy procedures usually involve bundling up and selling equipment at sharply reduced prices. Purchasers of such assets can then offer services in the industry at prices below prevailing levels and still earn an attractive rate of return on the reorganized entity. This is good for consumers, but for existing producers the cost basis is higher and the competition from failed and reorganized entities is devastating.

Can Real Estate Replace Stocks?

Much has been made of the notion that the wealth lost in the stock market is being replaced in the real estate market. This is not true. Household net worth has dropped from about $43 trillion early in 2000 to approximately $36 trillion in mid-2002. That 16 percent reduction in the wealth of American households includes the appreciation of real estate values. The $7 trillion of wealth loss is equal to a full year's disposable income for all American households combined.

If we recall the behavior in Japan's post-bubble environment in the early 1990s, our real estate "boom" is not consoling. The Fed's sharp reduction in interest rates, aimed at reigniting investment spending, has instead sustained a shift by some households from investment in stocks to investment in real estate. More buying of real estate has been encouraged by low interest rates and households have taken more debt onto their balance sheets in order to upgrade primary residences and acquire second homes. House prices are above normal levels both relative to household income and residential rents, and that suggests that prices are being paid for housing because of expected increases in its price rather than based on attractive rates of return from rents.

The problem with the housing boomlet is that it is conditional on continued sustainable growth of the economy. The big risk is that the persistent and large drop in household net worth exacerbated by the recent sharp drop in equity prices will reduce demand growth and thereby intensify the downward pressure on profits and employment as firms attempt to maintain margins by further cutting labor costs.

Stock Market Faces Further Problems

As usual, the efforts of government to "reassure" investors about corporate behavior have been largely counterproductive. A spate of new laws prescribing prison terms for corporate managers whose earnings reports can be shown to be misleading will discourage legitimate risktaking. Congress is in the process of legislating a negative supply shock to the U.S. economy that will penalize the global competitiveness of U.S. firms. The correct approach over the past decade would have been more vigilance under existing law on the part of regulators and more attention to the deficiencies of earnings reports on the part of investors.

The stock market has been levitating on fumes rising from the wreckage of a twenty-year bull market nurtured by a huge expansion of resources devoted to selling stocks to the public. By early 2000, just before the NASDAQ (below 1,300 as this Outlook goes to press) crested at 5,100, the American public, and later the public worldwide, was absolutely sold on the idea that it had to own stocks. The truth is that no one has to own stocks and no one should own them unless they understand a good deal about what determines their value.

If today's rational saturninity, which implies lower stock prices, turns into irrational saturninity, as it usually does in a post-bubble environment, stocks will fall further by another 20 percent or more to levels that would be extraordinarily low by normal standards of valuation. In this century's two post-bubble environments--the 1930s in the United States and the 1990s in Japan--investors went from expecting 20 percent a year returns in the stock market to being primarily concerned about the preservation of assets.

Government Bond Prices Will Rise

Rational saturninity that drives investors toward a primary focus on wealth preservation rather than wealth enhancement usually produces a run into government bonds that sharply depresses yields. In both the United States in the 1930s and Japan in the 1990s, four to five years after stock market peaks the preoccupation with wealth preservation drove yields on government bonds to extraordinarily low levels--to below 2.5 percent in the United States in the latter half of the 1930s and as low as half that in Japan in recent years. It should be noted that this extraordinary boom in the prices of government securities, accompanied by far lower yields, occurred while the supply of such securities was rising rapidly due to rising government deficits associated with fiscal efforts to end depressions.

Government bond prices can rise in the face of sharply increased supply when investors become attracted to the notion that the principal of their investment in bonds is guaranteed by the government. After seeing stock prices fall more than 50 percent in many cases, investors become less interested in the rate of return on assets and more interested in being assured that the amount of money originally invested will be returned in the future.

Perhaps investors, driven by rational saturninity and a desire to preserve wealth, can do themselves a favor by purchasing long-term government bonds in the United States and Europe, which currently yield well over 4.5 percent. That return, coupled with some possible price appreciation of the bonds as yields move lower, looks like a much better bet than jumping back into the stock market.

John H. Makin is a resident scholar at the American Enterprise Institute.