High Stock Prices Are Not a Policy Objective
Steve Benen has a nice overview of conservative nonsense and hypocrisy about the gyrations of the stock market. But aside from the specific question of who deserves the blame or credit for whatever, it can’t be emphasized enough what an inappropriate measure this is. Consider the chart below looking at the price/earnings ratio of the S&P 500 over time:
As you can see here, there’s a ton of variability in this metric. Some of the variation seems to be related to interest rates, but a lot of it is, as best one can tell, driven by nothing at all. It’s “animal spirits,” it’s “irrational exuberance,” it’s a mysterious x-factor. In other words, high stock market prices could reflect low interest rates, which are the result of good policy. They could also reflect good opportunities for large businesses to earn money, which would probably reflect a good economic situation, though we shouldn’t rule out the opportunity that some worthy policy initiatives might for some reason or another structurally shift opportunities away from large publicly held corporations and toward small privately held ones. And they could also just reflect speculative mania that’s not really under the control of policymakers.
What’s more, while stock price declines that are due to slow or negative economic growth are bad things, they’re mostly bad things because slow or negative growth is bad. It’s not the case that higher stock prices are systematically beneficial. Financial news is mostly consumed by people who have substantial investments, and high stock prices are beneficial for those people, which is why the financial media tends to “root” for high prices.
But this isn’t systematically true. People who don’t invest in stocks at all can afford to be indifferent to the irrational aspects of stock market fluctuations. And young people who invest in stocks through a 401(k) plan—people like me, say—actually benefit from low stock prices. As the animal spirits get low, stocks get cheaper, which means that the money we’re putting into the 401(k) winds up buying more shares. The ideal scenario for any given person is to save money when the spirits are low and then retire when they’re high. But either way, seeing it as being the president’s job to create an unsustainable speculative mania is silly.
40 Responses to “High Stock Prices Are Not a Policy Objective”
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March 15th, 2009 at 4:26 pm
Is Wall Street knocking itself out to show investors they can be trusted?
Didn’t think so.
March 15th, 2009 at 4:40 pm
WTF, Yglesias?? You seem to think that there are people who matter besides pundits and Wall Streeters. You seem to think that advancing this trend http://tinyurl.com/2ztldq isn’t the entire goal of government.
March 15th, 2009 at 4:53 pm
One of the most interesting aspects of stock prices and the stock market is that for every share sold, a share is bought. Somehow this gets left out of the discussion. That is what actually drives prices up or down. In an up market, buyers must be willing to pay more than the current price in order to induce sellers to sell.
So all the short term fluctuations are caused by new buyers coming in and previous owners getting out of a stock, usually a tiny fraction of the total number of shares gets traded, yet these sales set the price for all shares.
Long term investors should ignore this noise, but they don’t. If they followed some fundamentals, they might end up selling when the stock looked overpriced and buy it when the price seems to low. For some reason we see a lot of novice investors doing the exact opposite: they buy hot stocks and drop them once they go bad.
March 15th, 2009 at 5:13 pm
The most important thing about stocks is that 99.999999% or more when purchased, do not add capital to the economy. A newly issued stock does put capital into the company and the economy. Trading outstanding shares is economic masturbation. Speculation. So stocks are not an investment in the traditional sense of the word.
The volume of trading generating income for the exchanges and all the companies involved in the transactions. The profits or losses a tennis game among the traders.
Real investors buy bonds. Stocks are crap.
March 15th, 2009 at 5:17 pm
Idiotic. If I understand the post correctly, high stock prices don’t matter to the young (for instance), because they want high stock prices later. How this represents a significant dissent from the ideology of high stock prices, I will never know. Can we get a Marxist in here, please?
March 15th, 2009 at 5:37 pm
Trading outstanding shares is economic masturbation. Speculation. So stocks are not an investment in the traditional sense of the word.
The volume of trading generating income for the exchanges and all the companies involved in the transactions. The profits or losses a tennis game among the traders.
Real investors buy bonds. Stocks are crap.
Can’t companies borrow against the capitalized value of the company?
Also, while already existing stocks may not put any new money into the business (I’m not sure I understand the process well enough to be sure that you’re right about that), the owner of that stock obviously gets benefits beyond whether the shares themselves increase in value – they get dividends based on the company’s profits.
March 15th, 2009 at 5:56 pm
If financial news media is consumed by the wealthy primarily which is surely true, then can Jon Stewart stop pretending the reason poor schmucks ended up in bad mortgages was because CNBC misinformed them.
March 15th, 2009 at 6:01 pm
Don’t very large numbers of people own stocks? A lot of older people have a substantial portion of their net worth in 401k plans, IRA’s, a pension fund run by their employer (though there are fewer and fewer of those), and so forth. When stocks go down, all of these people suddenly have less money as their direct investments are worth less and the pension funds have to run to the PGIC. A lot of people suddenly find themselves having to push back retirement. But nobody has more money except the people who were shorting the market.
Also, lower stock prices are only good for young people if stocks return to their previously higher levels. Stocks starting low and staying low is no better for young investors than stocks starting high and staying high.
March 15th, 2009 at 6:05 pm
Matt, the chart is not so mysterious if one steps out of an economist’s matrix into demographics and socio-cultural trends The great run up starting in the early 1980s coincides not only with the rise of Conservatism (Reagan and all that), it is also the rise of interest and culture in the stock market on the part of baby boomers flooding into corporations that were no longer supporting old-fashioned pensions. The run up in stocks was fueled by this generational investment meme taking off. buying mutual funds became the thing one does with one’s savings: The savings if not wealth of a generation of exceptionally hard-working folks, fueled in the first place by the exceptionally strong competition among such a huge cohort, created this recent run up. I suspect something like it happened in the 20s. The market is a supply and demand mirage though, and much faster than they put it in and let it accumulate, the rush was on to get out of these great gains. Buy and Hold does not mean Buy and Hold until one is dead in a tense game of “musical shares”.
March 15th, 2009 at 6:48 pm
… but a lot of it is, as best one can tell, driven by nothing at all.
Really, these bubbles were driven by irrational exuberance? Or were they driven by highly uncertain future forecasts? Remember a stock’s inherent worth is just the present value of all future cash flows and this value is dependent on the information available. AOL circa 2000 may have looked very attractive. Once people realized it was a big waste of money it collapsed. Such is business.
Unless you have some evidence that there is some fundamental shift towards privately traded companies (why would this happen?) then the market should still best reflect our expected economic outlook. It may not be perfect but it is better than any economic report or expert opinion (which would already be reflected in the market).
March 15th, 2009 at 7:04 pm
You’re correct, it’s not the President’s job to make the stock market go up…but it’s also not the President’s job to make the stock market go down either.
The stock market is an economic variable…Certainly, it’s not the only one…but it is one of the more important ones–especially as an increasing number of people have their retirement funds tied to it.
Finally, with respect to your chart. Yes, that chart might show you that the ups and downs of the market don’t seem to be related to anything…But that chart is pretty simplistic–perhaps even more simplistic that your conclusions that you draw from it. The reality is that there are many reasons why the stock market (or rather certain types of averages) go up and down. Many of them have to do with the type of economic environment that the country is in…or, for that matter, the types of policies that are coming out of the Federal Government.
So we’re back to the President (and the Congress). It’s their job not to do things that both hurt ecomomic growth..and to some degree the stock market. For example (and this goes for the Republicans as well as the Democrats) it’s their job NOT to spend money that we don’t have and set us up for trouble down the road…Oops, too late.
March 15th, 2009 at 7:07 pm
And by the way…Is it really a mystery why the stock market is down these days? Is that based on nothing too?
March 15th, 2009 at 7:07 pm
It may not be perfect but it is better than any economic report or expert opinion (which would already be reflected in the market).
Why is it better than any expert opinion? There are obvious limits to arbitrage that can be performed by experts. So why are you so confident that such experts will employ arbitrage to fully eliminate any mispricings?
March 15th, 2009 at 7:14 pm
The Obama Administration: Working tirelessly to better Matt’s retirement by driving down stock prices now!
March 15th, 2009 at 7:21 pm
Is it really a mystery why the stock market is down these days? Is that based on nothing too?
No, but it goes deeper than you think. Before Obama was even elected commodities tanked, the price of space aboard bulk naval shipping cratered. Every last indicator out there suggested a massive global contraction in demand. Not just Wall St. but the entire global manufacturing sector voted with their feet to order massively less in case Obama could raise the marginal tax rate by a few percentage points in a few years and add another percentage point to the U.S debt to GDP ratio.
March 15th, 2009 at 7:21 pm
That’s how smart the markets are, they knew beforehand that there *would* be a stimulus bill to counteract the downward cycle that…ah fuck, I give up.
March 15th, 2009 at 7:32 pm
I am mortified to say I agree with Ed the Smithie…until his last paragraph, which reassured me that I’m not insane and can still spot disagreements when I have to.
All things being equal, we’d rather have high stock prices than low ones, because of what Ed says. It’s just not as important for people not currently in retirement as is commonly claimed.
March 15th, 2009 at 7:39 pm
Most of us go don’t out the door in the morning into an economy — we go out into a society. And not even most FINE people go out the door into a market. They go out into an economy.
The number of people who actually go out the door into a market in the morning wouldn’t populate Wisconsin.
March 15th, 2009 at 7:43 pm
Matt’s point appears to be that stock prices can serve as an indicator of the health of the economy, but they themselves are not the same thing as the health of the economy. So trying to improve the economy by raising stock prices is rather similar to trying to warm up a room with a thermometer in it by breathing on the thermometer. You make it look as if it is warmer, but you have not actually significantly warmed the room.
The only problem here is that Matt fails to realize that the same is true of GDP. GDP is not the economy but an indicator; you can increase GDP by producing things regardless of whether or not anyone wants what you produce. That’s the central flaw of Keynesianism; building tanks so that you can sink them in the ocean adds to GDP, so they think that it improves the economy, even though you are wasting resources on things that have no effect (or a negative effect) of people’s quality of life.
March 15th, 2009 at 8:10 pm
“As you can see here, there’s a ton of variability in this metric. Some of the variation seems to be related to interest rates, but a lot of it is, as best one can tell, driven by nothing at all. It’s “animal spirits,” it’s “irrational exuberance,” it’s a mysterious x-factor.”
The “mysterious x-factor” is multiple compression and expansion. In general, the longer a secular bear market lasts, the more earnings multiples get compressed, and the longer a secular bull market lasts, the more earnings multiples expand. The correlation with interest rates doesn’t hold if you go back more than a few decades, e.g., we had low interest rates and low P/Es in 1950, at the tail end of the secular bear market that followed the Crash. See the chart by Vitaliy Katsenelson* that accompanies this post, “Stocks for the (Very) Long Run”
*Katsenelson uses the term secular “range-bound” market (abbreviated as R/B) on that chart to describe what most would consider a secular bear market.
March 15th, 2009 at 8:22 pm
So why are you so confident that such experts will employ arbitrage to fully eliminate any mispricings?
I don’t. The only way that would be possible is if the expert’s opinion was perceived as certain. Otherwise, you won’t have absolute arbitrage. Instead investors will take advantage of what the expert says as far as they feel it is correct. You could say but what if the expert is ignored (think of Dean Baker). Well an expert is only as valuable as the people who listen and trust him (with or without a market).
What the stock market does is effectively create a weighted value of expert opinion based on our collective assumptions of their worth.
March 15th, 2009 at 8:29 pm
What the stock market does is effectively create a weighted value of expert opinion based on our collective assumptions of their worth.
Right, but that’s not what you said, you said:
It may not be perfect but it is better than any economic report or expert opinion (which would already be reflected in the market).
Why is the weighted opinion better than any individual opinion? Let’s say there’s one really smart guy who has the best estimated of the expected value of the future cash flows, and a bunch of monkeys throwing darts at a dartboard. Why is the market estimate better than the smart guy’s estimate?
Answer: it’s not… unless the smart guy is able to completely exploit arbitrage opportunities. Which is transparently not true in the real world: the market can stay irrational longer than you can stay solvent, fund managers face principal-agent difficulties, and so on.
March 15th, 2009 at 8:36 pm
Asset price increases were how we were all, well many of us, were going to gain comfortable wealth. Stocks thus became the new savings through the 80’s and 90’s. After the dotcom crash it was houses which were going to do the trick. Not that stocks disappeared. After the March 2003 low they percolated in the background reaching a new all time high on the DOW and S&P in 07.
Asset price increases above GDP growth are a manifestation of inflation. It does not represent real wealth. Inflation being a monetary phenomenon. Two generations of Americans know asset inflation as the only road to wealth, save perhaps being an entertainer. If most are not wealthy through asset inflation most think they could be. The absolute belief that some other bubbles will form, in fact have to form for the system to work is almost universal. It is a fools dream.
To chase it the US government will now borrow 4 to 6 trillion dollars over the next two years and guarantee asset prices with 20 or 40 or 100 trillion dollars worth of promises. The Fed will print untold trillion dollars more. That can keep the hope alive. Until the Treasury is no longer able to borrow of if the dollar crashes, or both. Then the piper will be paid.
At some points along the way there will be echo bubbles in stocks as the asset inflation dream is rekindled.
March 15th, 2009 at 9:36 pm
That meaning of that graph would be more accessible if the price/earnings part were replaced with earnings/price in %. That way the two curves would represent directly comparable quantities- the immediate return on $100 per year.
March 15th, 2009 at 10:20 pm
Let’s say there’s one really smart guy who has the best estimated of the expected value of the future cash flows, and a bunch of monkeys throwing darts at a dartboard.
If every stock were efficiently priced by the smart guy and monkeys entered the market randomly buying stocks I don’t see how this would create inefficiency. Markets don’t become inefficient simply because the amount of capital in them increases.
What Matt and Shiller are saying is monkeys enter in groups and leave in groups creating these booms and busts. Perhaps there is a herd mentality/irrational behaviour but I would argue it is more reflective of our collective assumptions about the state of the economy. Remember what the experts were saying in 2003 or what they were saying in 2000. Sure you have contrarians who retrospectively seem all the wiser but think about the expert consensus at the time.
March 15th, 2009 at 10:46 pm
There is only going to be so much economic production available to divide up over any given future period, and so the real question is just what is your relative realizable share of that production during the period in which you are going to be withdrawing income from your assets.
I would argue that increased savings funding increased investment can increase the amount of economic production available to divide up in the future.
March 15th, 2009 at 10:55 pm
Matt:
Didn’t you get your latest talking points from the White House? Claiming the Dow Jones average doesn’t matter is so seven days ago. This is no time for excuses. Now, you’re supposed to say that last week’s bull market proves the correctitude of the Obama Administration’s policies.
We have always been at war with Eurasia.
March 15th, 2009 at 11:15 pm
Perhaps there is a herd mentality/irrational behaviour but I would argue it is more reflective of our collective assumptions about the state of the economy. Remember what the experts were saying in 2003 or what they were saying in 2000. Sure you have contrarians who retrospectively seem all the wiser but think about the expert consensus at the time.
The expert consensus was something like “look the market is simply a reflection of the expert consensus, and we can’t do any better than that.” Do you see anything circular with this reasoning?
You’re not arguing that the market estimate is the best we can do, you’re simply asserting it.
March 16th, 2009 at 12:16 am
Steve Sailer Says:
March 15th, 2009 at 7:14 pm
The Obama Administration: Working tirelessly to better Matt’s retirement by driving down stock prices now!
========================================================
Well it is ALL about Matt, isn’t it?
March 16th, 2009 at 1:22 am
The P/E ratio is a rather bad tool to use because earnings are subject to manipulation, along with the complication of dealing with ratio against some direct measure. When talking about stocks it is best to use price. Here is the total stock market capitalization vs GDP.
http://i2.cdn.turner.com/money/2009/02/03/magazines/fortune/buffet_metric.fortune/wide_chart.gif
A somewhat positive picture one might say. Depending upon how much the economy shrinks and if we overshoot to the downside. Then too one might guess the next bull market is about 20 years away.
March 16th, 2009 at 7:16 am
I’m interested on your post. It’s good. Have any more information about it? or any information on attracting money? thanks.
March 16th, 2009 at 7:59 am
Well, I guess Rapier got to it before I did, but Matt, what’s the advantage of P/E to long-term interest rates over a simplified total market cap versus GDP (or in Rapier’s link, as a percentage of GNP)?
Cheers.
March 16th, 2009 at 8:39 am
Rich,
You’re not insane. You’re just being honest.
As for the reasons why the market is going down now…That wasn’t a veiled reference to the Obama administration (although there is certainly some truth to the notion that his economic policies are not exactly popular on Wall Street). We’ve got banks that are tanking and are unable to lend. Credit is more scarce and there’s uncertainty about the depth of the problem, or how long its going to take to repair (fix itself)…That translates into folks, rightly, taking less risk with their money (i.e. putting it under their mattresses). Once that risk subsides…The stock market will, ON AVERAGE, rise…Just like it has for more than 100 years.
March 16th, 2009 at 11:26 am
tomj nailed it way back at #3.
“One of the most interesting aspects of stock prices and the stock market is that for every share sold, a share is bought. Somehow this gets left out of the discussion. That is what actually drives prices up or down. In an up market, buyers must be willing to pay more than the current price in order to induce sellers to sell.”
I’d take that observation several steps further. Long-term investors buy stocks because they believe that the value of a stock portfolio will rise, in the long run, by more than the value of bonds or money sitting in a bank account. And this has generally been true. But the reason that share values rise, in a bull market, is because the amount of money invested in the market increases and each new investor is willing to pay a higher price than the last. So it’s in every investor’s best interest to get more and more people to invest in the stock market over time. Not quite a Ponzi scheme, but it’s definitely a pyramidal scheme.
This is why CNBC is more of an infomercial for stock market investment than a reporting source. This is why wealthy conservatives want to invest social security in the stock market. The incentive pressures all push toward getting more people to invest. It certainly pushes stock pickers like Cramer to urge people to buy stocks he’s already bought. But on a more systemic level, it pushes everyone to bring in the next generation of rubes to invest in mutual funds and such in order to make sure those shares keep selling at higher and higher prices in ways that have no tangible connection to what the businesses in question are actually doing.
Sure, it’s in the best interest of long-term investors for everyone to put their money in equity funds, not to speculate heavily on individual stocks and increase market volatility.
But is it really in the best interest of the general public for everyone’s financial well-being to be tied up in a scheme to inflate the value of the market far beyond the level of currency inflation, and invest in ways that bear little relationship to the health of individual companies, of which the stocks supposedly represent ownership shares?
I’m starting to think not.
March 16th, 2009 at 12:25 pm
“Which is not to say people never encourage asset price inflation for their own selfish reasons. But you don’t need for there to be asset price inflation in order for stocks to provide a higher return than bonds or cash.”
Fair enough.
However, I think the point remains that the expectation of inflation in share values is the primary driving force behind large-scale middle class investment in the stock market, as opposed to previous eras when most people made more conservative investments and left the stock market to the professionals.
March 23rd, 2009 at 8:05 am
Great…
April 6th, 2009 at 12:46 pm
Well said, finally a good report on this stuff
April 9th, 2009 at 8:44 am
Not that I’m totally impressed, but this is a lot more than I expected when I stumpled upon a link on SU telling that the info is awesome. Thanks.
April 10th, 2009 at 10:37 am
FANTASTIC!
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