January 16, 1998

The Best of Times: A Review of the 1990s’ Market Boom

On July 16, 1997, the stock market reached historic highs when the Dow Industrial Average broke past 8000. Even after a 554.26-point (7.2 percent) correction on October 27, the Dow is performing strongly and has almost reached its previous record level. Currently around 7600, the Dow is more than 350 percent higher than it was only seven years ago when it hovered around 2200.

Despite the October 27th plunge, both pessimists—those who think the bull market is coming to an end—and optimists—those who think a bear market is years down the road—agree on one thing: The Dow’s surpassing 8000 is a remarkable event. The question, however, is, what forces are behind it?

According to some gurus, the market splurge is like "Wile E. Coyote running off a cliff while chasing the Roadrunner;" the market is churning its legs furiously, but there’s nothing beneath it. In other words, the Dow is high because stock prices are inflated way beyond fundamentally justified prices. There is no good reason for the Dow to be at 8000, and even Federal Reserve Chairman Alan Greenspan warns against "irrational exuberance," which occurs when investors look to cues from one another when buying stocks rather than basing their decisions on sound economic principles. Sooner or later, pessimists argue, the market is going to come down—with a crash.

Others say the Dow is legitimately high, particularly because the 1990s’ economy is different from that of past decades. First, corporate earnings are strong, and as long as this continues to be the case, the stock market will remain strong as well. Also, employment is high, productivity is up, and inflation is low. In fact, unemployment, which is around 5.4 percent, is below what economists traditionally consider "natural," or the level it should be when the economy is performing at its best. Furthermore, baby boomers, who make up the largest segment of the labor force, are in their prime productive years, and their capacity to generate goods and services is aided significantly by their use of advanced technology.

High employment, however, can occasionally be bad news for the stock market. When workers are in demand, employers often must increase wages to attract new employees. The more employees are paid, however, the more producers must raise the price of goods; such wage-driven inflation has devastated the market in the past.

For example, inflation is the force that killed the stock market boom in the 1970s because it led to high interest rates, which are conducive to investing in bonds—not stocks. Inflation has remained in check during the 1990s, however, because wages have remained stable, productivity has increased, and demographic and global market forces are compelling producers to keep prices low.

Economists argue that wages have remained stable for two main reasons. First, employees are hesitant to seek raises because they fear downsizing. Although in the 1990s the proportion of workers who have been laid off has not been strikingly higher than in previous years, studies show that job security is among employees’ biggest concerns.

Second, a larger share of baby boomers’ income is going towards saving and investment, not consumption. In the 1980s, boomers—who account for almost 30 percent of the total U.S. population and started turning 50 years old in 1995 (at the rate of one every seven seconds)—were known as conspicuous consumers; they saved on average just over 3 percent of their income and spent the rest. By the time boomers reach age 45, they are saving on average 23 percent of their total income. If producers want boomers to continue spending money, prices have to remain low.

In addition to stable wage rates and the boomers’ newfound taste for investing, crashing markets abroad and free trade also have tamed inflation. The recent fall of Asian markets and the subsequent fall of markets elsewhere have made foreign products less expensive compared to U.S. goods. To compete, U.S. producers must keep their prices low. In addition, free trade with countries like Mexico—where goods can be produced at much lower cost and sold in the U.S. at prices that reflect this—compels U.S. producers to refrain from raising their prices.

Regardless of whether the booming stock market is a result of just investor "exuberance," pessimists argue that the market’s climb cannot continue over time. They suggest that productivity will come to a standstill because the labor force, which grew by as much as 3.2 percent a year in the 1970s, will grow only about 0.9 percent a year in the next decade. According to the Social Security Administration, the labor force is expected to grow only 0.2 percent after the year 2020. Technology cannot make up for the declining labor force, argue pessimists, especially as boomers begin to retire in the next 15 years. Many also contend that stock values will begin a dramatic decline after 2011, when boomers start selling their retirement funds.

As for the short term, pessimists suggest that the October 27th correction is a sign of the market’s volatility; they suggest that investors who agree should begin to convert their stocks to cash to protect their investments. But optimists maintain that there is no clear evidence that a bear market is on the way; they argue that investors with a long-term horizon and steady nerves should welcome such volatility as a chance to invest further in the market—at a discount.