Wall Street Is Right


Wall Street Is Right

Investors know that previous recessions have never held down the U.S. economy for long.

It's as if we're living in two different worlds. Consumer confidence is faltering, unemployment is up, and real estate is still in shambles. Yet stocks have been surging to new recovery highs.

Who is right, Wall Street or Main Street? I'll put my money on what is happening in the stock market.

The recent bear market was vicious. From its high in October 2007 to its low in March of this year, Standard & Poor's 500-stock index lost 55%. You have to go back to the 1932 bear market, the worst in history, to witness a steeper decline.

This time, stocks collapsed because investors feared an economic catastrophe: Banks were nearly bankrupt, credit markets weren't functioning, and housing was in free-fall. Many people began to talk seriously about taking money out of the bank and stuffing it in the mattress. Stock prices reflected a doomsday scenario.

But nearly a year later, investors are rightfully convinced that a catastrophe was averted. No depositors have lost their money, the flood of firms declaring bankruptcy has been stanched, economic indicators are showing signs of life, and emerging markets have bounced back smartly.


What this means is that investors believe the downturn won't morph into a second Great Depression. Depending on which measures you look at, the current recession is either the worst since World War II or since the early 1980s. No matter the outcome of the statistical debate, the pain Americans are experiencing today is real and intense. Even so, investors know that previous recessions have never held down the U.S. economy for long.

Stocks on the rise. If investors see a recovery, it's a significant indicator for the economy. That's because stock prices depend only modestly on company earnings during the coming year; they're far more dependent on earnings further down the road. To see how the numbers work, consider that the historical average price-earnings ratio for a stock is about 15. That means investors pay an average of 15 times current annual earnings to buy shares of a company.

Certainly, if you knew that a company would be out of business after one year, you'd pay only one times earnings. The fact that the market is willing to pay 15 times as much, on average, means that only one-fifteenth, or 6.7%, of the value of the company is based on earnings expected over the next 12 months, while 93.3% is based on earnings beyond one year.

Analysts expect that taken together, the firms in the S&P 500 will earn only about $54 per share this year. With the index fluctuating around 1000, that is a hefty price-earnings multiple of 19, modestly expensive by historical standards. But this is a recession year. Earnings for 2010 are projected to be $73 per share. Furthermore, investors are betting that the economy will not only recover but also surpass its previous 12-month earnings peak of $91, reached in June 2007.


Two powerful forces could push stock prices even higher: the trillions of dollars sitting in money-market funds earning close to 0% interest and the cost-cutting moves companies have undertaken. Money-market depositors will eventually seek higher returns in the stock market, and cost-cutting will boost earnings once the economy recovers. Even a falling dollar is a bullish sign because most large U.S. firms record significant sales overseas. Rising prices in foreign currencies mean more dollars -- and more profits -- when the proceeds are converted into greenbacks.

The stock market isn't always right. But whenever it has rallied vigorously from a bear-market low, an economic recovery has always been in the offing. Main Street is not wrong in believing that the current economy is bad. But Wall Street is focused on the long run, and the positive signs are now too numerous to ignore.

Columnist Jeremy J. Siegel is a professor at the university of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.