Technology stocks have had the stuffing knocked out of them, earnings warnings are appearing in sector after sector, and even the Dow is hovering close to a bear market.

Wall Street analysts, desperate to re-ignite a bull market and save their jobs, have fallen back on their next line of defense: It is reasonable for price earnings ratios to be above their historic average because stocks are less risky now.

Like most analysts’ theories this one, too, needs to be examined closely.

For a start, if you’re invested in the big companies that make up the Standard and Poor’s Index, maybe you shouldn’t be. The Standard and Poor’s 500 Index is up 75 percent since April 1, 1996, which itself was a level at which the market was already close to “irrational exuberance.” The Russell 2000 Index, of the 2,000 smaller companies of the top 3,000 companies in the United States, is up only 32 percent. That in itself is food for thought because it suggests large-capitalization stocks have undergone an excessive run-up in value similar to the “Nifty Fifty” effect of 1972-1973.

But the main reason for skepticism about today’s stock prices is that the Standard and Poor’s 500 index is still trading at a level of more than 20 times trailing earnings compared with a historic average of 14 times. Since earnings are now expected to be lower in the first quarter than in the fourth quarter of 2000, it requires a considerable leap of faith to believe that risks are so very much lower than they have been.

One argument for higher stock prices, of course, is that productivity growth is now higher, thus justifying higher earnings multiples. But as discussed in this column a few weeks ago, when adjustment is made for the huge surge in capital investment in 1996-2000, this is quite simply a myth. Total factor productivity, in fact, grew rather more slowly in 1992-1998 than in the previous economic cycle of 1982-1988, hence there is no support here for a rise in valuations above the long term average.

Analysts also make the argument that interest rates are lower, therefore stock prices should be higher. This would be true if real (inflation adjusted) interest rates had in fact dropped over the last several years. However, a drop in nominal interest rates that is not reflected in real interest rates simply reflects a decline in inflation; since the earnings of non-financial stocks are linked to real prices, not nominal prices, this should simply reduce the assumed growth rate of nominal earnings by the same amount as the reduction in nominal interest rates, thus having no net effect.

In fact, the current yield on inflation-indexed long term Treasury bonds, at just over 3.5 percent, is around 50 basis points (0.5 percent) higher than the historical average, real risk-free yield of around 3 percent. One would expect this in a country such as the United States, which has a negative savings rate, and which has to pull in capital from abroad at a rate of $400 billion per annum because of the payments deficit.

However, if real interest rates are higher than the long-term average, this should lead one to expect stock prices to be lower, not higher than their historical average.

We thus come back to Wall Street’s last line of defense — risk.

The “weak” form of this thesis was propounded in 1989, before the last recession. It states that because inventories are now much better controlled than they were historically, through IT advances, therefore a recession will be shallower and shorter than the historical average since there will be far less inventory overhang needing to be liquidated. In that recession, the theory seemed to work — inventory overhang was a less serious problem than in previous downturns.

Naturally, this time around, the advent of B2B commerce across the Internet has led analysts to wax rapturous over the possibilities of minute-by-minute inventory management, such that one would be surprised if a single unit of excess inventory were present at any point in the supply chain. In fact, the inventory to sales ratio in the fourth quarter of 2000 was already up to 1.37 months, suggesting that inventory controls were not quite as watertight as had been claimed.

Nevertheless, the cost of excess inventory needing to be worked off is likely to be less this time round than in previous recessions, provided the recession is a shallow one. Of course, if the recession is deep, then final goods inventories will still pile up, since consumers are not yet automated in the same way as business, and hence can decide to stop buying without telling the nation’s inventory management systems.

However, bloated inventories are not the only thing that can cause recessions. Two other factors that loom particularly large at present are the U.S. balance of payments deficit, running at historically record levels of over $400 billion per annum, and the U.S. savings rate, running at a historically unprecedented nadir of minus 1.3 percent.

Taking the Panglossian view, the necessary correction to these two factors could to an extent cancel itself out. The U.S. consumer needs to save an extra 10 percent of gross domestic product in order to replace his day trading losses, and, presto chango, the foreign consumer could buy an extra 5 percent of gross domestic product worth of U.S. goods in order to zero out the balance of payments deficit. Compromise both figures at 7.5 percent, and the whole thing goes like clockwork, with the consumer saving 6.2 percent of GDP (not enough, but it’ll have to do) and the U.S. balance of payments running a surplus of 2.5 percent of GDP (destabilizing in the other direction in the long run, but hey, who’s counting).

All this requires is for a world government to force foreign consumers to buy $750 billion of U.S. goods more per annum!

Absent this supremely Keynesian solution, assuming U.S. consumers reduced their consumption of foreign goods pro rata to their total consumption, or about $175 billion, U.S. exports, based on 2000 figures, would have to rise by $575 billion on their current base of $1,097 billion, or 53 percent. Gee, I guess that means the dollar might have to drop a bit to accommodate this.

In other words, the U.S. economy can stabilize itself only at the cost of a huge recession or a 40-50 percent drop in the dollar. Anybody who thinks either of those two events would leave no trace on stock prices is an optimist more extreme than those who bought the Pets.com IPO in February last year.

Apart from purely economic risks, there are war and terrorism risks to think about. Of course, the Cold War’s over. That means those nasty communists, Mikhail Gorbachev and Deng Xiaoping, have been replaced by those nice social democrats, Vladimir Putin and (soon) Hu Jintao.

Feel safer yet?

Then of course, there are the traditional “rogue states” of Iraq, North Korea, Iran etc. Since 1998, there has been nothing to stop Iraq developing nuclear weaponry. Meanwhile North Korea has developed a very satisfactory medium range missile. Of course in practice a nation with a nuclear bomb can always deliver it the old fashioned way — by freighter sailing into New York Harbor.

Let us not forget also the possibilities of bio-terrorism. The U.K., blasted by unexpected outbreaks of BSE and foot-and-mouth disease, has only a marginal effect on the world economy these days.

But while it may be conspiracy-theorist to suppose that every outbreak of disease is caused by bio-terrorism, it is certainly very optimistic to conclude that none of them are.

None of these risks existed in 1929. Neither the Stalin of 1929 nor Chiang kai-shek represented a threat to the Western economy while Hitler, who did represent such a threat, had obtained only 12 seats in the Reichstag at the most recent election. Each individual risk of these modern nightmares may be remote but surely their combination should reduce price-earnings ratios at least as much as modern inventory control raises them.

It’s a risky world. We may yet discover in the next few years that it’s a very risky world. And the market P/E ratio should reflect this, running say at about 12 times compared to the historic average of 14 times and the current 20 times. This means that the market, as represented by the S&P500 Index, should drop another 40 percent, to around 680 from its current level of 1140.

Oh, and one more thing. We haven’t even considered the effect of a possible decline in earnings. Of course, such a thing is impossible. As Herbert Hoover said, we are, after all, on a Permanent Plateau of Prosperity.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

This article originally appeared on United Press International.