<SPECIAL FEATURE>
January 21, 1999

Eyes on the Press

Forbes
"D" on Deflation and History.
A Gentlemen's "C" on Long-Term Investing

Issue Date: September 21, 1998
Cover Headline: ""Is it Armageddon... or October 1987 revisited?"

Forbes highlighted commentary from the insufferable international gadabout Steve Hanke, who told readers to establish a "good-sized hedge" against the market by moving "a hefty dose" of assets into money market funds, Treasury bills, and Treasury bonds. That was consistent with the rest of the magazine's main coverage. The answer to the cover headline was "No... and No" -- neither apocalyptic nor particularly reassuring. Still, the editors opted "to lean to the cautious view" that while this wasn't the beginning of a worldwide depression, neither was it a "great buying opportunity." Well, at least they were half right.

This relatively bearish conclusion depended on a 200-year chart showing the market's historical after-inflation total return of 6.8% a year. Produced by well-known market historian Jeremy Siegel, the chart showed that whereas stocks were supposedly undervalued after the crash of '87, they were still overvalued in September, even after the market's sell-off. Siegel figured the Dow was "30% above its long-term trend."

Indeed, Siegel was quoted as saying, "It's the big break. It's an overvalued market with no momentum." Which sure sounded like, "Get out!" It was a strange comment coming from a guy who once wrote, "There is no compelling reason for long-term investors to significantly reduce their stockholdings, no matter how high the market seems."

The editors wouldn't go so far as endorsing Siegel's apocalyptic vision, but they concluded that "the deflation danger in 1998 is very real." A companion piece argued that there was a 75% chance that deflationary forces would bring about a U.S. recession by the end of 1999. Each of the ensuing main articles simply assumed that the market was still overvalued.

All of this would have been interesting except for a few major problems. First, it hardly makes sense to extrapolate fair value for any leading index of stocks from historical returns of all stocks, as Siegel and Forbes did. One reason the indexes do so well so often is because they are continually updated to include America's very best companies.

Second, Siegel's most famous work (which showed how the supposedly overvalued Nifty Fifty growth stocks of 1972 actually weren't overvalued) offers ample evidence for disputing his argument here. The market is supposed to discount future growth, so high valuations may simply be projecting tremendous future profits. Arguing that historical returns should serve as some sort of fixed governor on current equity values seems as stupid as the economists' so-called NAIRU (the non-accelerating inflation rate of unemployment), which was supposed to be 6% but has happily been well below that for 2 years. Forbes (and Siegel) simply misused history, turning mindlessly to data that was readily accessible rather than to data that is actually relevant for gauging the value of businesses.

Perhaps even worse, Forbes devoted an entire article to what it calls the "D" word without showing any evidence that the so-called deflationary forces it highlighted will actually cause broad deflation much less lead to the profit squeeze it bemoaned. As writers Robert Lenzner and Carrie Coolidge rightly pointed out (and then ignored), "Some prices still rise, but others are dropping." That could be why the Producer Price Index still shows mild inflation (which they also noted, but ignored).

While I have to give Forbes points for recognizing that low interest rates "translate naturally" into higher P/Es, I have to take away points for its writers' failure to recognize that lower interest rates also cut corporate interest payments while pumping up consumers' disposable income. Both ameliorate some of the profit squeeze caused by flat or falling prices. Moreover, Forbes said nothing at all about the impact of productivity gains on profits. So again, lots of talk about stock valuations, but most of it misleading.

The magazine's resident money manager/commentators generally did much better. Laszlo Birinyi said, "Stay the course: the bull is stunned but not dead" as part of a stick-to-your-strategy message. His stock picks -- including America Online <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AOL)") else Response.Write("(NYSE: AOL)") end if %>, Gap <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GPS)") else Response.Write("(NYSE: GPS)") end if %> and Home Depot <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HD)") else Response.Write("(NYSE: HD)") end if %> -- were also terrific. Kenneth Fisher offered a similar message, saying he thought this was "a correction in a bull market" and to stick with the large cap stocks. Martin Sosnoff apparently has read his Siegel better than Siegel himself because he argued for sticking with growth stocks like Cisco <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CSCO)") else Response.Write("(NYSE: CSCO)") end if %>, Microsoft <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MSFT)") else Response.Write("(NYSE: MSFT)") end if %>, and Pfizer <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PFE)") else Response.Write("(NYSE: PFE)") end if %>.

Robert Salomon also saw the trouble as a "correction," but argued wrongly (so far) that index funds wouldn't fare well in the near future. David Dreman, well, was as wrong as he usually is. "We are in a bear market at best, and if we are not lucky it may be a crash... [G]et defensive now by tossing out your most speculative stocks. Yes, I mean America Online or Yahoo!" Okay, David, sure thing. Hey, isn't that Alan Abelson at the door.

Next: Eyes on Newsweek