Sunday, October 29, 2006

Gross Returns

I know most liberals would like to ignore good economic news in the weeks running up to the election, but to pretend like to economy has been anything but remarkably strong is absurd.

Daniel Gross, in Slate, tries to take Republicans to task for touting the Dow Jones record highs as they prepare for November elections. His article is not exactly false, but it is a complete non sequitur. The stock market does not equal the economy. They often move in step, but the market has many influences that go beyond the strength of the American economy.

If he wants to argue that the economy is not doing well he should, instead he launches into an academic debate about the market not doing as well as Republicans would have us believe (although his argument there is pretty weak too). Since Gross doesn't make an economic argument I'll just show where his analysis comes up short regarding the stock market.

Gross first argues that the Dow Jones index is not representative of the market as a whole and this is certainly true. He goes on to argue that the S&P 500 index is more representative of the entire stock market and 10% off its March 2000 highs. Again this is true, but hardly indicative of the current economic environment. Does Gross actually believe the stock market in March 2000 fairly represented the economic fundamentals of its time and the market's intrinsic value? Is the March 2000 high a proper baseline for judging the current market?

There are two factors that determine market capitalization: current earnings and expected growth. Of the two, earnings are a much better reflection of the economy and earnings have never been better. The chart below, which is adjusted for inflation, shows just how much earnings have grown over the past six years:

S&P 500 EPS - Inflation Adjusted


Overall, earnings per share have grown 74% since 2000. Now let us take a look at how those earnings translated into market caps.

Currently the S&P 500, at 1335 on September 30, 2006, is trading about 17 times earnings, close to its historical average. The index ended its highest quarter on March 30, 2000, at 1498 and it traded just over 34 times full year earnings. If we used that multiple with today's earnings it would give us S&P index of 2700! Of course we wouldn't use that multiple because it was an historical anomaly. Which is the exact reason why we wouldn't want to use it as a baseline for looking at the market today.

Go back to 2000 and ask yourself why the market was overvaluing future growth. There were plenty of reasons: big increases in productivity, low inflation, the tech stock boom. But I don't think you can discount the fact the press was writing about the economy under a Democratic President. And if the NY Times wasn't writing about homeless people shitting gold nuggets under Clinton it's only because the media doesn't write about homeless people under Democratic Presidents.

It's also misleading to suggest that because many sectors are off their 2000 highs that investors haven't fared well the past few years. Unless you're a poor sap who put all their money in the market in March 2000, you would have made much money before and after the S&P reached its peak. The S&P 500 is currently up 65% since reaching the nadir of its current cycle in September 2002.

Finally, I have to mention the ridiculous swipe Gross takes at George Will, even having the gall to call his column absurd. Gross writes:

Take a gander at George Will's absurd column last week. "Economic hypochondria is also bred by news media that consider the phrase 'good news' an oxymoron," he wrote, "even as the U.S. economy, which has performed better than any other major industrial economy since 2001, drives the Dow to record highs." Next, Will pooh-poohed high oil prices, noting "the recent 20 percent decline of the cost of a barrel of oil, from a nominal record of $78.40 (which, adjusting for inflation, was well below the 1980 peak of $92 in 2006 dollars)." Got that? Will celebrates the record nominal high in stock prices but urges readers to focus on the real price of oil.

I'm no fan of George Will, he's a Cubs fan and wears a bow-tie for crying out loud. But there is nothing peculiar or misleading about his column. It's hardly customary to make inflationary adjustments to market indexes outside the academy, and doing so here would have done little to change the substance of Will's argument that the U.S. economy has performed better than its industrial peers.

However, oil is commonly adjusted for inflation, as it should with the central role it plays in the American economy. Gross goes on:

By mixing and matching real and nominal, Will could just as easily have argued that oil is more expensive than it has ever been, while the Dow is barely at the level it reached in 1999. If Democrats controlled the levers of power, he'd be making precisely that argument.

This is just wrong, as he is basically calling Will a hack. But I think he doth protest too much. George Will's bonafides stand on their own as he has earned a reputation as a partisan but honest pundit. The irony is that Gross accuses Will of such hackery in a column in which he so eagerly displays it himself.