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New Paradigm View for Stocks Is Bolstered

Maybe all the new-economy hype isn t just hype after all. Almost everyone agrees the revolution in information technology has probably played some part in the extraordinary valuations that stocks have reached this decade.

But figuring out how big a part has proved elusive. Skeptics look on new paradigm arguments as the sort of fuzzy-minded thinking that usually accompanies speculative bubbles in the stock market. Now, some researchers have found compelling evidence that conventional accounting understates the earning power of today s companies earning power that the stock market correctly recognizes. The research, if correct, goes a long way toward explaining how stocks, in particular of technology companies, could sensibly trade at such unprecedented multiples of earnings.

Friday, those trends were well in force. The Dow Jones Industrial Average eased 50.97 points to 11028.43. But the Nasdaq Composite Index, loaded with technology stocks, climbed 35.04 to a record 2887.06, passing its previous high of 2864.48 set on July 16. The Standard & Poor s 500-stock index, which added 4 to 1351.66, now stands at a near-record 33 times trailing earnings.

But does such a high price-to-earnings ratio mean stocks are overvalued? Earnings would be higher and P/E ratios lower if companies weren t spending so heavily on intangible assets such as research and development, software, marketing and computer training. Intangible assets fuel future profits just as surely as would a tangible asset such as a piece of equipment or a factory. But intangibles are expensed against current earnings, while tangible assets are added to the balance sheet and gradually depreciated.

This helps explain the rising value of U.S. equities. That explanation, in turn, suggests that continued strong economic growth and strong profit growth in the future are not so implausible, Leonard Nakamura, economic adviser at the Federal Reserve Bank of Philadelphia says.

Mr. Nakamura estimates that after treating R&D as regular investment and removing inflation s distorting impact on inventories and depreciation, the market s P/E ratio is only a little higher than in 1972, whereas unadjusted, it is 41% higher. Federal Reserve Chairman Alan Greenspan acknowledged two weeks ago that the economy s shift to idea-based value added, where investment is expensed immediately rather than depreciated over time, has understated earnings, although that is offset by the increased use of stock options in place of wages. But he added, It does not seem likely . . . that such [accounting] adjustments can be the central explanation of the extraordinary increase in stock prices.

Mr. Nakamura says, It could be that some proportion of what s going on now is a bubble . . . It s important not to be complacent about the stock market and think it will do this forever. On the other hand, it s important to recognize we re in fact saving and investing a lot more than it appears on the surface.

The economic establishment is beginning to accept some of these arguments but only some. The Bureau of Economic Analysis is about to change how it calculates economic output by reclassifying software purchases as investments rather than current spending, which it estimates would have boosted the level of output in 1996 by 1.5% (although the boost to output growth would be far smaller). But for now it isn t reclassifying databases, or literary or artistic works as investments, as international guidelines suggest.