The date was Dec. 5, 1996. The scene was the ballroom of the Washington Hilton Hotel. The speaker was Alan Greenspan, the chairman of the Federal Reserve Board, keeper of the nation's money. He had been droning on for 45 minutes with an address on the 83-year history of the Fed, and much of the audience of 2,000, at this annual dinner of the American Enterprise Institute, was starting to nod off. Then, suddenly, out of the blue, Greenspan said that he was worried about "irrational exuberance" in the stock market. A few people caught it; most (me, included) did not.
But the markets did. The next day, the Dow Jones Industrial Average opened 200 points lower. It quickly recovered, however, and resumed its upward climb.
Only a few weeks before Greenspan gave that speech, two Ivy League economists, Robert Shiller of Yale and John Campbell of Harvard, told the Fed in a confidential session that they were worried that stocks were vastly overvalued and would fall by 50 percent or more. At the time, the Dow stood at 6,437. If you had heeded the warnings of Campbell and Shiller and Greenspan, you would have missed an increase of about 70 percent, including dividends -- despite the decline in the Dow in recent weeks.
It was the Greenspan speech that got me thinking: If Alan Greenspan believes that the only reason the market has been rising is that investors are "irrational," then I needed to get to work. There must be a more sensible way to explain why the Dow had climbed from 777 in 1982 to a level which at that time was nearly 10 times as high and that today is more than 12 times as high -- an increase of a factor of 20, including dividends.
So, with my colleague Kevin Hassett, an economist at AEI, I got to work. In March 1998, Kevin and I published our initial findings. A book, "Dow 36,000," followed late in 1999. We argued in our book that stocks were undervalued, that the rise in the market since the early 1980s was completely rational and that it would continue until the Dow got to around 36,000 -- about four times its level at the time we wrote the book. At that point, stocks would at last be fully valued and returns would level off.
As you can imagine, this theory was very controversial when it first appeared and is probably even more controversial today. Still, Kevin and I have not wavered in our belief that stocks are cheap and that investors -- if they do the right thing -- should profit handsomely.
Doing the right thing means buying diversified portfolios of stocks in excellent companies with solid track records and holding them for the long term (five years or more). In our book, we highlighted 15 such companies (there are hundreds more), and they have, in general, performed very well. Our poster child for Dow 36,000 was Tootsie Roll Industries, maker of those chewy chocolate logs (as well as Junior Mints, etc.) which has risen more than 40 percent. But diversification is key, and we urged readers not to load up on technology stocks but to buy financials, utilities, energy and consumer goods as well -- using such vehicles as mutual funds and new instruments like Folios, which are packages of stocks put together by professionals but managed by investors themselves.
History shows that stocks return twice as much as bonds but carry the same level of risk -- when both are held for the long term. In the short run, stocks are extremely risky, but in the long run that risk, or volatility, drops off sharply. For example, the worst 20-year period in history for stocks produced a gain of more than 20 percent, after accounting for inflation. The worst 20-year period for bonds produced a loss, after inflation, of more than 60 percent.
Investors have been waking up to this truth about stocks. Far from being irrational, they have become more rational. Even Greenspan himself has changed his mind. In speeches over the past year he has recognized the crux of our book -- the decline of what is called the equity risk premium -- as the primary reason for the 20-fold increase in share values.
But there is a wild card -- one that, frankly, we did not take into account in our book. It is that politicians, after decades of reducing their involvement in the free-market activity of business, would begin aggressively to intervene again. That is what began to happen in the closing years of the Clinton administration.
For a long time, high technology had been a kind of enterprise zone -- in Jack Kemp's excellent phrase. It was an area of low taxes and low regulation, pretty much beyond the radar range of politicians. That's changed. The key event was the Justice Department's antitrust suit against Microsoft -- and, more important, its decision last year to seek a breakup of the company.
Microsoft is the symbol and substance of the high-tech revolution -- a process that in 10 years has brought the price of a computer, adjusted for quality, down by 90 percent. Computers have become cheaper than TV sets, and a majority of Americans now use the Internet, to their benefit. But the Clinton Administration's attack on Microsoft, instigated by the company's competitors, had a depressive effect not only on that company but on high technology in general. It was no coincidence that the Nasdaq began its 60 percent decline just when the government moved for a Microsoft breakup.
Around the same time, local governments intervened on behalf of content providers that demanded that it fix rates and conditions for their access to cable Internet connections. The local Bell operating companies then tried to get government to take action to thwart their feisty broadband competitors. Governors and big retailers teamed up to try to tax Internet transactions. Plaintiffs' lawyers, with help from attorneys general, focused on high tech as their next target of opportunity -- after tobacco and handguns. And self-styled consumer groups, also with government help, began to go after online firms for privacy encroachments.
All of these steps dampened the enthusiasm of investors for e-commerce, and no wonder. Coupled with tripling oil prices, aggressive rate increases by the Fed, these government interventions are helping produce what I have called a "regulatory recession."
How bad is it?