By January 1, 1928, the stock market had risen from its trough, reached a little more than four years earlier in October 1923, at an average annual rate of 22.5 percent, for a total increase of 133 percent. By the end of 1928, it had risen by another 50 percent. During the first eight months of 1929, stocks rose another 27 percent, reaching a peak of 381 on September 3, 1929, for a total gain of 344 percent in slightly less than five years. After slipping about 10 percent during September and early October, the market collapsed, falling 6.3 percent on October 23 alone. By November 13, stocks had fallen almost 50 percent, to 198.69.

There are similarities and important differences between the behavior of the stock market and underlying economic performance during the 1990s and the 1920s. Both decades saw investment-led disinflationary recoveries of the sort that usually produces powerful stock market rallies. A combination of low and falling interest rates and improving prospects for earnings growth (resulting from falling inflation and productivity-boosting higher investment levels) creates an ideal environment to increase stock prices.

How High Is Too High?

Still, stock prices can be pushed too high in any environment. An important question facing many investors in 1996 is whether stock prices can go significantly higher. Will the paths of interest rates and prospective earnings continue to justify higher stock prices, or will investors push prices to unsustainable levels that trigger a sharp correction?

The rise of equity prices during the 1990s has been less sharp than during the 1920s boom. By January 1, 1995, the stock market had risen at an average annual rate of 11.4 percent to reach 3,600 from its trough of about 2,400, reached during October 1990 just four years and three months earlier. The total increase of 58 percent in a little more than four years was less than half the increase achieved during the 1920s over a comparable period prior to 1928. Similarly, the 37 percent increase in stock prices during 1995 was less than the 50 percent rise during 1928, although it did represent a sharper acceleration relative to the preceding four years than had occurred in 1928.

The stock market was less volatile during 1995 than it was during 1928. The sharp 15 percent drop in stock prices in November 1928 was more than reversed during December, leaving stocks at their highs of the year. The largest drops during 1995 saw prices fall around 5 percent, once in July and once in August. After consolidating during September and August, stock prices rose by about 8 percent during the last two months of the year.

An evaluation of equity market performance must be conditional on fundamentals that determine stock values. While it is impossible to predict the behavior of equity prices, it is possible to look at past behavior and ask whether it is justified relative to economic fundamentals. A careful examination of economic fundamentals during the 1920s and the 1990s suggests that the U.S. economy during the 1990s is every bit as healthy, if not more so, than it was during the 1920s. Simultaneously, the increase in equity prices over a comparable period of time is considerably less in the 1990s than it was in the 1920s.

From the October 1923 trough to the end of 1928, stock prices rose by 350 percent. From the October 1990 trough to the end of 1995, stock prices rose by less than two-thirds of that amount, or about 216 percent. If the U.S. economy during the 1990s looks as healthy or healthier than it did during the 1920s, then a continued runup in U.S. equity prices is justified by the fundamentals.

Fundamentals that determine equity prices are the behavior of and the outlook for earnings and interest rates. Earnings underpin the value of a stock, which represents a claim on those earnings. Interest rates determine the rate at which future earnings are discounted back to the present, when the price for equity prices must be determined. A given stream of earnings discounted at 10 percent is only half as valuable as the same stream of earnings discounted at 5 percent.

The level of earnings, in turn, depends on economic fundamentals that govern the growth of supply and demand and the balance between the two. The difficulty in predicting equity prices, then, is the same as the considerable difficulties attached to predicting the future outlook for the economy and interest rates. Still, the comparison of the U.S. economy in the 1920s and the 1990s is useful in gauging whether the considerable increase in stock prices already seen during the 1990s is justified by the fundamentals.

The U.S. economy during the 1920s was characterized by considerable optimism related to the satisfaction of pent-up demand after World War I and the attendant satisfaction of that demand by rapidly expanding automobile companies and other producers of consumer products. As is typically the case, the October 1923 trough in the stock market anticipated by about nine months the July 1924 trough in the economy. During the five years from 1924 to 1929, the U.S. economy performed very solidly providing the basis for strong growth of earnings, low interest rates, and higher stock prices.

During the half-decade from 1924 to 1929, the U.S. economy grew at an average annual rate of 3.4 percent. Real gross investment rose at a 5.5 percent annual rate while consumption grew steadily at a 3.0 percent annual rate. Inflation was absent, with virtually no increase in prices during the mid-1920s while the government sector was shrinking. Between 1922 and 1927, the national debt actually fell by about $5 billion, from $22.5 billion to $17.5 billion. After an export boom during World War I, the United States still managed to run a modest trade surplus just below 1.0 percent of the gross national product during the mid-1920s. Between 1923 and 1928, labor made its contribution to a sound economy with labor productivity rising at an average annual rate of 2.6 percent per year.

Close Parallels

There are some remarkably close parallels between the overall performance of the U.S. economy during the 1990s and the 1920s. The major difference probably lies with the amount of external borrowing being undertaken by the United States during the 1990s, but it remains to be seen whether this is a sign of weakness or a sign of strength. More about this later.

As in the 1920s, during the 1990s a trough of the stock market anticipated the trough in the business cycle. This time the interval was a little shorter, with the stock market trough coming in October 1990, just five months before the March 1991 trough in the U.S. business cycle. During the four and a half years after the March 1991 trough, the U.S. economy grew at an average annual rate of 2.6 percent, with consumption rising at about 2.7 percent and investment rising at an average annual rate of about 7.0 percent. Inflation, which was absent during the 1920s, rose at an average annual rate of 2.8 percent, although the inflation rate late in 1995 was about half its level at the trough of the business cycle early in 1991.

During the four and a half years after the 1991 trough, government spending actually fell at about 0.6 percent per year, with sharp reductions in state and local government spending offsetting modest increases in federal government spending. Both the 1920s and the 1990s were characterized by shrinking roles of the government in the economy with a simultaneous sharp increase in private investment. As it did in the 1920s, the high level of investment during the 1990s has resulted in solid growth of labor productivity, at an average annual rate of 2.5 percent per year, almost identical to the rate of increase during the mid-1920s.

Many analysts, upon examining these data, would suggest that the Achilles' heel of the 1990s recovery relative to the 1920s is the high level of U.S. reliance on lending from abroad. During the 1920s, with a modest trade balance surplus, the United States was able modestly to increase its investments abroad. Unfortunately, a portion of those investments went to Latin America as well as to a struggling German economy. The market crashes at the end of the decade left many of those investors wishing that they had kept their funds at home.

The United States in the 1990s

During the 1990s the United States can be characterized as a country with a low savings rate and rapidly rising investment opportunities. Conversely, investment opportunities in Europe and Japan have risen less rapidly while savings rates in those countries are higher than those in the United States. Emerging markets cannot come close to absorbing the large flow of investment funds out of Japan and Europe. As a result, the United States has been a large importer of capital, the mirror image of which is a large current account deficit.

The high level of import absorption by a growing U.S. economy has kept the U.S. current account deficit, and the supply of dollars to global capital markets large at a time when a deflationary collapse of the Japanese economy has tended to keep more capital at home. In order to avoid a dangerous, self-reinforcing deflation transmission mechanism from an appreciating currency, the central bank of Japan has elected to increase its purchases of dollars as part of a reflation effort for the Japanese economy. In short, the dollar in need of support from the Bank of Japan in the process of fighting an accelerating deflation is very different from a dollar in need of support from foreign central banks when U.S. inflation is running away. The Bank of Japan's intervention is an effort to avoid exporting the dangerous Japanese deflation to global markets and should continue. Nor should it be construed as a sign of inflationary excess of the U.S. economy.

As 1996 begins, the most appealing features of the economic expansion underway in the United States are its moderate pace and the balance between supply and demand growth that has helped to extend its life while moderating inflationary pressures. The rapid growth of investment and the attendant steady increase in labor productivity has meant that nearly five years into an economic expansion the inflation rate is stable to slightly down and is distinctly below the level at the trough of the cycle early in 1991. Beyond that, the U.S. budget deficit is the lowest in the industrial world. Notwithstanding the usual year-end political posturing surrounding budget negotiations in Washington, the United States has a good chance virtually to eliminate its budget deficit over the next seven years.

An important test for financial markets will probably come early in 1996. After a rapid runup during the third quarter, U.S. demand growth has slowed considerably since September. Retail sales growth, which averaged 7.5 percent during 1994 and 3.0 percent over the past twelve months, has dropped to a 1.1 percent annual rate during the three months ending in November. Since this number is measured in current dollars, the real increase in retail sales is probably below 1.1 percent unless, as is possible, prices have actually fallen as merchants attempt to clear out excessive inventories. Falling prices and falling volumes are signs of demand weakness and too much supply.

The growth rate of final sales during the fourth quarter of 1995 will probably be about 1.5 percent, while inventory accumulation may account for another 1.5 percent, leaving total GDP growth at about 3.0 percent. The need to slow production in the face of weakening demand growth during the fourth quarter has shown up in labor markets. Employment growth during the past three months has dropped to an average monthly increase of 109,000--the 1994 average was 294,000--even allowing for some unusual seasonal factors during November that pushed up the monthly average. If inventories continue to build as they have been during the past several months while sales are stagnant or weak, the production slowdown will have to accelerate.

The slowdown in demand growth during the fourth quarter is probably sufficient to upset the balance between supply and demand growth that has characterized this cycle. Businesses, however, appear to have initiated corrections on the production side that ought to restore balance to the economy by spring. Restoration of that balance would enable continuation of moderate 2.0 to 2.5 percent growth.

Overall inflation pressures have also been well contained. The consumer price index was flat during November and rose at a 1.6 percent annual rate during the past three months, down from an annual rate of 2.6 percent. Markets were shocked by a 0.5 percent increase in the producer price index during November, but this increase was largely attributable to faulty seasonal adjustment weights for automobile prices and therefore will likely be reversed in subsequent months. Overall, inflation pressures remain muted and may become more so as the economy works through a brief period of insufficient demand growth.

The Prognosis

A broad look at the U.S. economy during the 1990s suggests that it is every bit as healthy, if not more so, than it was during the 1920s. In view of the fact that healthy economic fundamentals have produced a stock price increase of less than two-thirds that which had occurred by the end of 1928, it is reasonable to conclude that the U.S. equity market in the 1990s has not experienced the speculative excesses that appeared during the 1920s.

It is not, however, possible to say that U.S. equity prices could not correct during 1996. They could and they will if economic fundamentals, such as a period of excess demand growth and attendant rising inflationary pressures, require higher interest rates. But, in the near term, the reverse--too much supply and too little demand, along with falling inflation pressures--seems more likely. That situation, which can be corrected by lower interest rates from the Federal Reserve, suggests that 1996 will start as a good year for the stock market. While prices may not rise as rapidly as during 1995, they are unlikely to be cut in half as they were during 1929.

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