Vice President and Economist, Federal Reserve Bank of Boston. The author thanks Richard Brauman for his very helpful research assistance.
The price of equity has soared during the past five years--the value of the Standard & Poor's index of 500 stocks, for example, tripled between December 1994 and December 1999, rising an average 25 percent annually. This rapid appreciation of equities, at a pace more than double previous postwar experience, has stoked concerns that stocks' prices might have risen too far, too fast. These concerns became more pressing as the values of equities rose much more rapidly than earnings during 1998 and early 1999, lifting stocks' prices to record highs relative to their earnings.
Although many indexes of stocks' prices continued to rise sharply in 1998 and 1999, fewer stocks contributed to this performance, perhaps signifying cracks in the foundation of the current bull market. During these years, the market became more narrow as the running count of stocks whose prices were rising fell behind that for stocks whose prices were dropping. In 1999, the prices of just over half the stocks constituting the S&P 500 fell. For many companies, a bear market seemingly had begun.
This article reviews the valuation of the equities constituting the S&P 500 index between 1968 and 1999. Although the ranks of the winners thinned and the gap separating the performance of the winners from laggers increased, the value of most equities remained high by historical standards. Even though prices for many companies' stocks fell, they fell from very high levels, and they remained high relative to earnings across the S&P 500.
Despite the disparity in the performance of equities in 1999, the relatively high value of the S&P 500 index that prevailed through the fall of 2000 reflected shareholders' optimistic view of earnings in coming years. This optimism might be the market's principal weakness. For companies' earnings to support the current valuation of equity, the economy must grow unusually rapidly for the next decade and beyond. Its potential rate of growth in coming years would need to be as much as one and one-half times its previous post-World War II average. Although recent experience suggests that potential growth has increased significantly, this evidence does not yet confirm that growth has increased sufficiently or will last long enough to pay the expected dividends.
The first section of this article analyzes the recent performance of the stocks that constitute the S&P 500, comparing the distribution of the annual rates of appreciation of the stocks, their price-earnings ratios, and forecasts of the growth of their earnings. The second section analyzes the price-earnings ratio for the S&P 500, describing the contribution of shareholders' required rates of return, the expected growth of earnings, and the growth of the economy to the valuation of the 500. The final section concludes the article.
I. The Wings of Hope
The strong performance of some popular indexes of stocks' prices masked a growing weakness in the prices of many companies' stocks in 1998 and 1999. In this regard, the stock market seems to have become more narrow. From 1994 to 1999, Standard & Poor's index of prices of 500 stocks rose, on average, 25 percent annually. During each of the first three years of this run, the prices of two-thirds of these stocks rose more than 10 percent, which was the average annual increase in the index since the end of World War II. After 1997, however, the performances of the stocks that constitute the index varied more substantially. During 1999, the prices of more than one-half of the 500 stocks fell, even as the index rose 20 percent, and fewer stocks accounted for a larger share of the increase in the total market value of the S&P 500. Nevertheless, in spite of this apparent weakness, …