The Stock Market Is Expensive, But Not Worringly So

Updated and superceded by April 18, 2005 post.

In an e-mail, Mom asks:

I hear two things.  One that we are advancing monetarily and that the stock market is now not overblown, the other is that it is overblown and we will pay one way or another for the deep personal debt that people have, which is considerable. [Personal info removed.] One is a positive look, the other is a pessimistic look.  I'd like the real look.  From what I hear, Greenspan is printing too much money.  Is this true.  Or even does it matter?

There are three questions wrapped up into this:  (1) Is the stock market overpriced; (2) should we be concerned about personal debt; and (3) is Greenspan printing too much money.  All three are good questions, which I have thought about.  Let's take a look at question #1 -- the stock market -- in this post.

I will use a modified Warren Buffett approach.  Warren Buffett is the second richest man in the US and by far the most successful US investor.  Using my modified approach, the stock market appears too expensive by about 15%.  This suggests that you probably shouldn't invest in the overall stock market, but that there's not much to worry about from the stock market crashing, etc.

Keep in mind the definition of investing.  An investor pays money now so that in the future he will be paid a greater amount.  The difference between this "greater amount" and what he paid orginally is called interest or return on investment, which is expressed in annual terms as a percentage of how much he originally paid.

An investor can invest his money in a number of interest-bearing assets, the least risky of which is a  long-term US government bond, which currently pays 5% per year.  Presumably, he can rest assured that the US government will always pay the interest, so investing in US government bonds is said to be "riskless".  In order for an investor to invest in a riskier asset, he requires a premium to be paid on this riskless rate.  For stocks of large US corporations, the risk premium that was required by investors since 1926 has been 5.4% per year on average (2002 SBBI).  Given this risk premium, an investor investing now would require a 10.4% return on his investment to invest in stocks for large US corporations (5% + 5.4%).  If he doesn't think he will get this return, he shouldn't invest.  The question then becomes whether or not large company stocks are likely to pay 10.4%, given the current price.

Finding out how much large company stocks are likely to pay an investor is easier than you might think, if you use a couple of solid assumptions.  First, as a measure of the combined value of large company stocks, we will use the Standard & Poors 500 Index, which includes the largest 500 publicly-traded companies in the United States, and represents about 80% of the total market value of all US companies traded on US stock markets.  The index ($spx) is at $1,035.  Second, we know how much profit the companies in the S&P 500 are making.  In 2002, core earnings were $32.93.  Let's assume that all of this profit is paid back to the investor.

Third, we know with fairly good precision how much profit 2002 would have produced if it were an average year for profitability.  Over the last 70 years, corporate activity as a percentage of our economy has stayed very stable at around 45% (it is now 47%).  So we keep that variable constant.  Further, over the last 50 years, after-tax corporate profit as a percentage of our economy as measured by GDP has ranged from 3% - 6%, and averages 4.5%.  It very rarely deviated from this range in the post-war period, as you can see from the following plot for 1929 through 2002 (NIPA Table 1.16, Line 12 divided by NIPA Table 1.1, Line 1).

In 2002, after-tax corporate profit as a percentage of GDP was 3.18%.  An average year would have yielded 4.5% in profit, or 43.4% more than it actually did.  If the S&P 500 benefitted from this upward adjustment to an average year in equal measure as the rest of corporate America, 2002 core S&P 500 earnings would have been $47.22.

Fourth, we know with fairly good precision how much this profit will grow over time.  Since corporate profit as a percentage of our economy is range-bound and corporate activity as a percentage of our economy is stable, average corporate profit will track our economic growth, which is likely to be about 5% per year -- 2% inflation and 3% real growth.

Using these assumptions in a spreadsheet, we see that an investment in these stocks is likely to earn about 9.7% per year.  That's great, right?  Well, not exactly.  As detailed above, an investor requires a 10.4% return on his investment in order to be adequately compensated for the risk that he undertakes in investing in large company stocks.  If he were to invest in the S&P 500 at these levels, he would be undercompensated for the risks that he is undertaking.  That's no good!

Anyway, you can see from this exercise that even if an investor will not earn 10.4% on his investment in large company stocks, he will earn only slightly less than that at 9.7%.  This suggests that the stock market is expensive, but not worringly so.  You could also make a reasonable argument that economic growth will be 5.5% a year (or whatever) rather than 5% a year, in which case the current S&P 500 price would be reasonable.

Sources:  Please see the underlying US corporate profits spreadsheet and S&P 500 Cash Flow spreadsheet.

The risk premium is calculated from Ibbotson Associates' 2002 Stocks, Bonds, Bills & Inflation (SBBI), page 31.  This serial is only available in print.  The geometric mean is used for both government bonds and large-company stocks.  The 2002 SBBI includes information from 1926 through 2001.  Since 2002 was another down year for the stock market, the actual risk premium figure is somewhat lower, making an investment in the S&P at these levels more reasonable.

Comments

[tso]

How did we break so quickly out of threats of deflation? And what did we do differently than Japan, who also lowered interest rates to near zero but ended up mired in a decade-long slump? (I'm making the assumption that we are out of our slump, given the latest numbers on GDP growth.)

[Dominic Schmelzer]

Daniel, that was a perfect evaluation and answer to the question on whether the stock market is overpriced or not *at the moment*. Using this formula should certainly aide one building up his long-term investments, and I can only say "respect" to the clairity of your explanation.

Both what Mom and tso are asking, probably as are most people thinking about the "big questions" in the economy, is where the bus is going to take us and whether we've got control of what is going on. We want to know whether the situation is going to be better or worse in, say, two years - not whether the stock market is properly priced at the moment.

All I can say here is, "all hail Harry S. Dent!" who predicted that the '90s were going to be years of rapid expansion and that the '00s were going to be likewise very positive for the US. Why? Because we have the right people (the baby boomers) at the right age (peak of births was 1957-1961, meaning that the bulk is presently just turning 45), doing what they usually do in this stage of life - spend lots of money. The US has consumers buying big things, spending more money than they ever have, driving an already consumer-oriented economy to new hights. This situation is *not* deflationary, at least not yet. If we were to consider the timing, this situation will change in 3 to 4 years as this group of people leaves the age of peak spending, which will truly create a comparable deflationary environment which Japan experienced in the '90s and which it should be leaving about now. Btw, Japan's economic development was predicted by Dent in 1992 (if I remember correctly) based only on demographics.

We hardly need to look at the High Priest Greenspan to wonder what's going on. Looking at demographics, innovation and social structures will get us much further.

[Daniel Schmelzer]

I don't agree with the assessment that we will have a comparable deflationary environment to Japan of the 90s. For one, Japan had larger swings in population among different age groups. Also, Japan allowed more dangerous economic imbalances to build up over the course of the 80s than the US has during the 90s and 0s, even though the US imbalances are substantial.

Perhaps I will go more into this in more detail in a future post, but discounting Greenspan's importance in the economy isn't a wise thing to do, since he and his cohorts control one of the law of gravity in the economic world -- interest rates. Even an Austrian school economist would allow that they can distort interest rates, if not set them outright.

[Dominic Schmelzer]

please view my posting at kondratiev-et-al.blogspot.com.

[Dominic Schmelzer]

Sorry.
The link is: kondratievetal.blogspot.com .

[ts]

Compelling. I'd never heard that Japan had a demographic problem but then I'm not that well-versed on Japan. I just figured the Japanese were "too good" at saving, and that their culture became deflationary as a result.

I played the "demographic angle" with respect to the US stock market much to my regret. I figured that baby boomers wouldn't start retiring enmasse until 2010. So they wouldn't begin pulling their money out of the stock market until 2007 (since they want to retire as soon as possible and stocks are the only way to get there fast - I counted on their greed). So I figured that the market would be bullet-proof until around 2007. Valuations were crazy, but boomers had no where else to put their money.

Obviously the moral of the story is that valuations matter.

[Daniel Schmelzer]

Yes, valuations do matter, since they imply expectations of future economic growth. Keeping in mind that economic growth equals productivity growth plus labor supply growth, only about 1/3rd of the future economic growth picture in the US is made up of demographic factors (2% trend economic growth plus 1% labor supply growth).

From an investor's viewpoint, this is where demographics begins and ends, since if retirees are pulling their money out of funds, then valuations should be lower and investments more lucrative. It is important not to double-count the demographic impact, otherwise you will start thinking that demographics is the only thing that matters.

[Dominic]

Yes, valuations do matter. But they do not dictate even mid-term stock prices, although they are important. They even say less about the timing of big stock market movements. This is the lesson we learn from every bubble. Dow (of Dow-Jones), for instance, warned that the markets were far overpriced and could collapse at any moment in the spring of 1927. He was only a year and a half (and many index points) off!

Daniel, your supply-orriented definition of economic growth is just that. But where are the consumers? If you look at my comments on demographics, you will notice that I am dealing with the demand side of the equation, the side that Chicago has forgotten during the past sixty years of healthy increases in (also demographically generated) demand. What happens when productivity rises and demand falls? What does Chicago say to that? Would this not be a definition of the non-monetary development at the end of the 1920's?

Btw, I'm very interested in what you have to say about personal debt. I've never seen it as more than a secondary factor. Perhaps I'm wrong.

[Dominc]

Btw, who is the Austrian School? Schumpeter?

[Court Johnson]

Interesting...but the stock market is the sum total of "herding". Expectations, fear, and greed, drive stock prices. As market prices increase, more investors assume greater risk fearing the loss of return if they don't invest. Tops can be predicted by New highs relative to new lows (individual issues) and trading days with large swings in the common indices. Obviously, as markets become overextended investors are fearful of losing their gains and are willing to sell. Fear becomes the driver; usually triggered by and outside event.

[Daniel Schmelzer]

Yes, in the short term, the market has an aspect of herding. However, in the long-term the market acts as a scale with fairly high precision. That's why investors can make money in the market over the long term, even if the market is full of speculators.

[Dominic Schmelzer]

well said.

[denisdof2]

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