Dear Jim,
All right, you’ve convinced me. You aren’t kidding about 36,000. But I’m still puzzled.
I don’t have much trouble with the first part of your argument, which concerns the “risk premium” on equities. You say equities have been safer than bonds over the long term. It’s true this is odd, because for decades the stock market has priced equities to deliver a higher return than bonds, as if compensating investors for a risk that doesn’t exist. At last, you say, the market is waking up to this. That’s why equity prices are rising. They should keep rising, you reckon, until they reach a point where the return on equities and bonds is the same. So far, I understand you.
It’s when you move on to the second stage, and work out what this equalizing price will be, that you lose me. Only when the Dow is 36,000 and the profit-to-equity ratio is 100, you reckon, will sensible investors no longer prefer stocks to bonds. This calculation must be wrong, but let’s come back to that in a minute. First, a word on the risk premium.
I agree it’s an anomaly. A key question is whether the historic premium was a straightforward error or a reflection of some intelligible but unexplained investor preference. If it’s the first, as you say, then the mistake might be corrected all of a sudden, and the implications for the stock market would be big (but not, I emphasize, 36,000 big). If it’s the second, then it’s economists–not investors–who need to think harder. Perhaps it’s both, but I would definitely not dismiss the second kind of explanation. (Suppose, as the economist Richard Thaler has argued, that investors are more upset by their losses than they are pleased by their gains. That would make them wary of the stock market, where the risk of short-term losses is great, leading them to demand a premium despite the market’s long-term safety. Sounds plausible.)
Anyway, the premium has had a long history (hardly to be compared with the junk-bond episode), and investors probably noticed that the risk of long-term loss was small even before you came along to point it out. I’d be cautious about saying the premium has had its day.
But what I find really odd about your argument is this: Anybody who believes the risk premium has gone for good should find today’s dizzy market about fairly valued, not vastly undervalued, as you do. At a P/E of 25, the market is yielding 4 percent. This, of course, is a real yield, because earnings rise with inflation. The corresponding yield on government bonds is about 6 percent, less, say, 2 percent for inflation, which is roughly 4 percent. In other words, there is no risk premium in this market. I expect one to reappear in due course, so I see the market as dangerous and expensive in the short term. I might be wrong about that. But if I thought the right premium was zero, as you argue, I would only think the market was now about where it should be–not that it’s undervalued by a factor of four.
How then do you get to this zany valuation? Through a cash-flow calculation which seems to assume that companies can simultaneously pay their earnings out as dividends and reinvest them in the business in order to grow. Real (as opposed to nominal) growth in earnings doesn’t come from nowhere, as your calculation assumes. It comes from investment, and if that investment is financed out of retained earnings, the growth of dividends is correspondingly reduced. As I expect you noticed, Jeremy Siegel from Wharton (whose book on equities over the long term seemed to set you off on this track) explained this in a letter to the Wall Street Journal last month. “[Your] analysis contains a serious flaw which vastly overstates the value of stocks,” he said. “[The] greatest danger for the market today stems from unrealistic expectations of what stocks can earn. In no way can the high stock returns of the past five years or even the past 15 years persist.” I agree.
Sincerely,
Clive
