Barack Obama's Irrational Exuberance

Label it the "Irrational Pessimism" speech. In a peppery presentation to the Brookings Institution, White House economic adviser Lawrence Summers did his best to prove that Mr. Market has it all wrong, that the 25 percent drop in stocks since Election Day represents a) an irrational mispricing of risk, rather than b) an accurate assessment of an economy slipping into mini-depression, or even c) a reasoned vote of "no confidence" in Obamanomics.

Like an investment strategist calming jittery clients, Summers pointed out that the battered Dow Jones industrial average, adjusted for inflation, now stands at 1966 levels. That was a time when America was far less wealthy and technologically advanced. He reassuringly concluded that the current situation "may be regarded by some as the sale of the century." All in all, a more potent argument than the one given by President Obama who recently offered that stocks are "potentially a good deal" given big declines in "profit and earnings ratios," mysterious metrics, one would assume, that are close cousins of price-earnings ratios.

Yet Summers' crude comparison refers only to the Dow's price level. It doesn't include dividends, traditionally a large source of total returns (indeed, the entire source from 1887 through 1978, according to Ibbotson Associates) to equity portfolios. Four decades of investment wealth have not been erased. But point taken; the stock market may be reflecting a level of "irrational pessimism." Still, as Lord Keynes famously said, "The markets can stay irrational longer than you can stay liquid." The terrible 1981-82 recession, for example, actually pushed the inflation-adjusted Dow below its 1900 level.

Of course, investors a generation ago then had the good fortune to face years of falling tax rates, falling energy prices and falling inflation. Folks today are more likely to see all three zooming higher. American investors back then also benefited from a powerful V-shaped recovery. The economy surged 4.5 percent in 1983, 7.2 percent in 1984. The current White House economic forecast expects a solid sequel: after a 1.2 percent GDP drop this year, 3.2 percent GDP growth in 2010, 4.0 percent in 2011 and 4.6 percent in 2012. If so, Summer's bullish "sale of the century" call might be spot on.

But probably not. The Wall Street consensus is a 5 percent GDP decline in the first quarter. If that's roughly correct, the economy would have to start growing at a brisk 3.5 percent clip for the remaining three quarters of 2009 to match the White House mark. And while the official Obama economic advisers are cheery, not so unofficial adviser Warren Buffett. In his dour letter to Berkshire Hathaway shareholders, Buffett wrote that "the economy will be in shambles throughout 2009 -- and, for that matter, probably well beyond." Such an anemic outcome would also be more typical of how economies perform after banking crises. An analysis by the Cleveland Federal Reserve Bank concludes such shocks frequently have "negative long-term effects on the economy, such as slow growth, high interest rates, and lower living standards."

None of this makes a compelling case for equities. Too bad. It's often misunderstood, though surely not by Summers, just how important the stock market has become for the real economy today, not just retirement portfolios tomorrow. The long bull market enabled Americans to save less and spend more. A permanent shift away from stocks means Americans would need to shovel greater gobs of money into lower-yielding-but-safer assets and consume less. There's also a political risk: The White House has highlighted another clear marker for how Americans (and GOP campaign ad meisters) should judge its policies. If portfolios stay sickly, impatient voters might wonder if was not Mr. Market but Mr. Obama who, in the end, had it all wrong.