Matt Yglesias

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.

Don’t Judge the Economy By the Stock Market

I’ve complained before about the press’ habit of judging economic policy performance based on short-term stock market fluctuations. With the recent lows, this has been gaining more steam as a political talking point. Fortunately, it’s done so just as David Leonhardt put up a great non-political blog post that incidentally illustrates what a misleading line of thought this is:

For months now, we have been following the stock market’s decline here at Economix and arguing that the market was not as inexpensive as many others were arguing. Our case: Despite the enormous fall in stocks, the long-term p-e ratio — that is, the ratio based on the past 10 years of corporate earnings — was still roughly at its historical average.

But the declines over the last few weeks are starting to change the picture. I crunched some of the historical stock data kept by Robert Shiller, author of “Irrational Exuberance,” and it offers some reason for optimism. When the p-e has been between 12 and 13 over the last 125 years or so, stocks have doubled over the next decade, on average. (Adjusting for inflation, they have risen almost 50 percent.) Over all, there is pretty direct correlation between the p-e ratio and future long-term returns. For example, when the ratio has been 15 to 20, stocks have risen only about 50 percent over the next decade. When the ratio has been above 25, stocks haven’t risen much at all. [...]

In the other two great bear markets of the past century, in the 1930s and the 1980s, the p-e ratio ultimately dropped to about 6 or 7. To get to that level now, the S&P 500 would have to drop below 400, from the current 701, and the Dow Jones industrial average would need to be below 4,000. So stocks may well continue to fall. They may even still fall a fair amount.

Stock market advice aside, the political point is this. The stock market is, among other things, something that reflects the underlying state of the economy. Economic growth leads to earnings which leads to high stock prices. Recession leads to low earnings which leads to low stock prices. But there’s a substantial speculative oscillation around this long-term trend. And at any given point in time, the structural shift from a high-P/E dynamic to a low-P/E dynamic, or vice versa, can completely swamp the shifts in the underlying fundamentals. During the late 1990s, the economy was growing nicely. But the stock market was growing at a much higher rate for no particularly good reason. At the moment, the economy is doing poorly and so is the stock market. But while renewed growth might lead to a revival of stock prices, it’s also possible that we’ll undershoot the long-term average. That would be unfortunate for many people—though at the same time, probably good for someone like me who’s far from retirement and looking to add as much value as possible to my 401(k)—but I doubt it would be possible or desirable for public policy to impact it. In general, people prefer a rising market to a falling one. But there’s no particularly good reason to think that high P/E ratios serve the public interest in any systematic way.

Focus on the Fundamentals: Income, Not Investments

Felix Salmon comments on the stock market dropping below its November lows:

The fact is that prospects for the economy are much worse than they were in November. As such, it stands to reason that stock prices should be lower than they were in November: if they were much higher, and the Dow was still above 9,000, that would be the real news, since it might imply that the November lows were panic-driven rather than rational.

That’s right, but I think people’s Dow-driven anxieties point to a larger pathology that started at the policy level and has now infected the media and the general public’s understanding of how the economy works.

Historically, the route to higher living standards is higher wages and incomes. When productivity grows, and demand growth is robust enough to keep unemployment low, wages and incomes go up. Corporate profits should go up, too. All this ought to lead to assets increasing in price. If the income of people in the Boston area grows faster than the supply of houses in the Boston area, then housing in Boston is going to get more expensive. If profits grow, so will stock prices. And some people will make money off this growth in asset value. But it will be, more or less, a coincidence. The more expensive Boston area houses could lead to profits for some people who live there and want to sell their homes and move to Tampa. But for many people, it’ll make no difference—they might sell a two bedroom place and reap the benefits of homes increasing in price, but then buy a three bedroom place and suffer the consequences. And for people looking to move to Boston, the run-up in home prices is a bug, not a feature.

But ever since the 2001 recession, we haven’t really had growth in incomes. Instead, we’ve had asset-led growth. People who owned stuff already in 2001 saw the value of that stuff go up. Since they were now “richer” they were able to borrow more. And since they were able to borrow more, they were able to get more stuff. That had a similar result as if their incomes had gone up and they’d used the income to buy more stuff. But it was unsustainable. The lending based on higher asset values was based on the idea that the assets would keep going up in value. And the increase in value was driven by a combination of speculation, and buy the fact that consumption was creating economic activity. But now it’s all collapsed.

And with the collapse has come a powerful urge for action to prop the assets back up. To reinflate the housing bubble. To make the Dow go back above 10,000. But that’s all backwards. What we need is an increase in the amount of demand in the world. With, most likely, foreign countries actually being the main driver of this. And that demand can lead to jobs and income. And if people start earning more money, then soon enough asset prices will go up again. But that would be a consequence of growth, not a cause.

Time Out

Ezra Klein said this when I saw him last night, and I don’t have a good answer:

Why haven’t we simply shut down the stock market until we can draw up an appropriate recapitalization program and implement it? There would be plenty of precedent. FDR shut the markets down in 1932. Bush shut them down after 9/11. I guess it’s possible that the market would drop sharply on the day it reopened, but if the plan was sound (and given some time to build a plan — time that would be provided by a closed market — you’d have a higher chance of that), and the government had already demonstrated that sort of seriousness of purpose, it’s hard to why the markets would be more freaked out than they already are. What am I missing?

Is there a real reason here besides an ideological aversion to heavy-handed measures and a pollyanish desire to insist that everything’s all right? It seems logical enough to say that if we’re going to have an emergency intervention in the marketplace that we can take a “time out” from the stock market to give people time to put the plan together.