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All Too Human

A Random Walk Down Wall Street

by Burton G. Malkiel
Norton, 499 pp., $16.95 (paper)

Stocks for the Long Run

by Jeremy J. Siegel
McGraw-Hill, 301 pp., $29.95

Dow 36,000

by James K. Glassman, by Kevin A. Hassett
Times Books, 294 pp., $25.00

Famous First Bubbles

by Peter M. Garber
MIT Press, 163 pp., $24.95

Social Security: The Phony Crisis

by Dean Baker, by Mark Weisbrot
University of Chicago Press, 175 pp., $22.00

On Money and Markets: A Wall Street Memoir

by Henry Kaufman
McGraw-Hill, 388 pp., $24.95

1.

To most observers of the ups and downs of today’s stock market, it defies common sense when eminent economists assert that the stock market works according to logical principles. But most economists believe just that. According to generally accepted economic theory, stocks have a true or intrinsic value.

This value is based on several factors, the first of which is a company’s dividends. In the long run, a shareholder who holds on to a company’s stock can extract a certain cash value from it only when the management returns profits in the form of dividends to its owners. Today, of course, investors buy many stocks, such as Microsoft and Cisco Systems, that do not pay dividends. These companies are growing so rapidly that they continuously reinvest their profits in new products, research, and expanding productive capacity, and investors generally believe their stock prices will rise as they generate more profits. But eventually, even these companies, or so it is presumed, will begin to pay out part of their earnings in the form of dividends as their businesses mature. If Microsoft, for example, retained all its earnings even as its core businesses grew more slowly or stagnated, investors might sell the stock. If they were to hold on to the stock, they might demand some of those earnings in the form of dividends so that they might invest elsewhere (even though they would have to pay taxes at ordinary rates on dividends rather than lower capital gains rates on a rising stock price).

General Electric, for example, is a widely admired and fast-growing company, which no longer mostly makes electric turbines but also owns, among other businesses, a large credit company as well as NBC. But it is also a mature company which prudently pays about half of its profits to investors in the form of dividends—fifty-five cents a share, a little more than 1 percent of its recent stock price. For the economist, the value of GE’s stock depends on future dividends. When analysts devise mathematical models to determine the value of GE’s stock, they usually assume that dividends will grow at about the same rate as profits. Because future dividends are so closely related to profits, if the outlook for profits falls, investors should pay less for stocks.

Money also has a time value, however, and this second factor significantly affects the current valuation of a stock. You will not pay a dollar today for a dollar in dividends twenty years from now because you can earn interest income on today’s dollar. Therefore, when interest rates rise, stock prices will usually fall because dividends to be received in the future will be worth relatively less. (Rising interest rates may also reduce corporate profits, because the cost of borrowing rises.) When interest rates rise, investors will usually pay less for stocks because they can earn more on their money from interest in bonds. A stock price can be seen theoretically as based on the value of estimated dividends discounted for the level of interest rates. When that discount is made, the result is called the “present value” of the dividends, and this determines the true value of the stock. (This method of assessing stock is called the “dividend discount model.”)

A third factor in estimating intrinsic value is the uncertainty of future estimates of dividends. The prospects for some companies, such as those with new businesses, are more difficult to forecast than for others. Similarly, some companies’ dividends or earnings will be affected more by the unforeseeable fluctuations of the economy, the dollar, or interest rates than other companies’. The more uncertain the outlook for a company’s profits and dividends, the lower will be its intrinsic value.

The uncertainty of future profits and dividends, it may seem, leaves a particularly wide margin for error in the evaluation of stock prices. But even so, many and perhaps most economists believe that stock prices usually reflect a reasonable estimate of a company’s future performance, and that stock prices deviate from this intrinsic value only temporarily. It is not necessary, moreover, that most investors be right about stock prices. A relative handful of well-informed investors will sell or buy stocks if their prices are irrationally driven too high or too low. In fact, so “efficiently” do these investors gather and evaluate new information that it is extremely difficult for one well-informed investor to have an advantage over others.

Rarely, however, have the movements of the stock market tested the validity of this thesis as they do today. It is hard to open the financial pages of the newspapers and avoid a discussion about whether there is a speculative “bubble” in stock prices that is about to burst. Compared to earnings and dividends, stock prices on average have in fact never been higher, and rarely have they risen so far so fast. A broad measure of stocks, the Standard & Poor’s 500 index, has tripled since the 1990s after tripling in the preceding dozen years. The average “price- earning multiple” of the S&P 500—the prices of all the stocks in the index divided by their earnings per share—recently stood at thirty compared to a former high of only twenty. The Nasdaq index of stocks, which is mostly dominated by high-technology companies such as Intel and Sun Microsystems, has risen by nearly six times since the mid-1990s, and it almost doubled in 1999 alone. Many individual stocks are trading at price-earnings multiples of more than one hundred, levels that are almost unknown for any but start-up companies. Relative newcomers such as America Online and Yahoo are now valued at well more than General Motors or American Express.

Even more disturbing to the proponents of “market efficiency” is the recent volatility of stocks. To take only one example, last March the Nasdaq had climbed to above 5,000, a record high. Within a few weeks it fell to roughly 3,300. It is surely difficult to make a case that the intrinsic value of the companies that make up the index declined by nearly 35 percent on average in only a few weeks. (In the October 1987 market crash, stocks fell by more than 20 percent in a single day.) The outlook for future earnings did not suddenly change by more than one third in March and April. Interest rates did indeed rise early this year, but not nearly so much as to drive down the value of the Nasdaq stocks in a matter of weeks by some 35 percent.

In fact, there has probably not been a more volatile period for stocks in post-World War II history. The Nasdaq index has fluctuated by more than 5 percent in a single day several times this year. Major stocks, such as Cisco Systems and Oracle, have fallen by 5 to 10 percent in morning trading only to regain all the losses in the afternoon. Securities such as stock options, which give investors the right to buy or sell stocks within a restricted period of time, have never fluctuated as much in price before.

In view of such constant changes, the claim that the stock market reflects logical behavior increasingly seems to defy common sense, whatever economists may say. Stock prices clearly reflect the hopes, frustrations, greed, and fear of the millions of investors who now own stocks. Hundreds of millions of shares trade hands each day; millions of individual decisions are made. In recent years, good economic news has dominated bad, and few investors have experienced extensive losses. To many, today’s stock market euphoria can be seen as an expression of one of the human species’ most frequent conditions, overconfidence. Why should stock prices, so subject to human foible and fantasies of wealth, generally reflect the true value of companies?

In Irrational Exuberance Robert J. Shiller, a Yale economist and long-time researcher into the vagaries of financial markets, contends that common sense may be right after all. He even implies that stock prices may rarely reflect companies’ true values. Although Shiller’s book is informative and well argued, what is particularly important about it is that a respected economist has written it.

Shiller makes three central points. If history is at all an appropriate guide, the rise in profits in the 1990s, though rapid, cannot justify the rise in stock prices. “No price action quite like this has ever happened before in US stock market history,” he writes. Stock prices rose far more rapidly than corporate profits in the 1990s, leaving price-earnings multiples, as noted, at record levels. Profits rose even more rapidly in the 1920s and stock prices did not rise as much. Profits grew about as rapidly in the 1990s as they did in three other periods: following the depression of the 1890s; following the Great Depression of the 1930s; and after World War II; but stock prices rose more slowly in those years than they did in the 1990s.

A second important point is that stock prices time and again significantly overestimate or underestimate the actual “present value” of future dividends—which, as we have seen, is considered the basis of the true value of a stock. Since we know the level of dividends going back to the late 1800s, Shiller computes the present value of actual future dividends (discounted for the time value of money) for more than a hundred years. In fact stock prices gyrated widely compared to the steady rise in the present value of dividends. In the 1920s, for example, the S&P composite index increased by more than 400 percent but the present value of dividends increased by only about 16 percent. In the 1930s, the S&P composite index fell by more than 80 percent but the present value of dividends fell by only 3 percent. Shiller thus clearly shows that stock prices regularly overreact to economic expansions and contractions as well as to the proliferation of new technologies.

Shiller’s third important point is that there is a largely psychological herd effect in the stock market. Higher stock prices encourage people to invest and therefore to bid prices still higher. Another round of higher prices encourages still more stock buying, and so on. Investors may become more confident; they may become accustomed to the higher level of prices; and increasingly they are investing their winnings so they may take bigger risks. No matter the underlying value of the companies, Shiller believes the herd effect has driven today’s stock prices to unjustifiable levels.

To make clear just how bold Shiller’s contentions are, one has to understand how strongly the academic case for market efficiency has been made. Most economists allow for the possibility that stock prices will temporarily overshoot the mark. But for the most part, they argue that these deviations in the stock market will not persist because, as noted, there are enough well-informed investors to push prices back to sensible levels.

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