Tag Archives: stock market

Irrational Exuberance

Posted on by

It’s everywhere, but most notably in the stock market and in election returns.

In the stock market, as exemplified by the S&P 500 index, there have been wild swings in the price-earnings ratio:


Derived from Robert Shiller’s data set. CAPE-10 is the cyclically adjusted price/earnings ratio, where the cyclical adjustment amounts to a 10 year average of the ratio.

In a world where stock buyers weren’t driven by irrational exuberance — and irrational pessimism — the PE ratio would follow something like a straight line. It might be a rising straight line because, as some analysts have noted, stock buyers have acquired an increasingly greater tolerance for risk-taking. But it would be close to a straight line.

The zigs and zags of the stock market are echoed in the outcomes of presidential elections:


Derived from Dave Leip’s Atlas of U.S. Presidential Elections.

To put it bluntly, almost every American who values his liberty and prosperity would in most elections have preferred the Republican candidate as the lesser of two evils. The success of Democrats testifies to the gullibility of many voters, who are swayed by — among other things — asymmetrical ideological warfare:

Leftists have the advantage of saying the kinds of things that people like to hear, especially when it comes to promising “free” stuff and visions of social perfection….

[L]eftists have another advantage: they’re ruthless. Unlike true conservatives (not Trumpsters) and most libertarians, leftists can be ruthless, unto vicious. They pull no punches; they call people names; they skirt the law — and violate it — to get what they want (e.g., Obama’s various “executive actions”); they use the law and the media to go after their ideological opponents; and on and on.

Why the difference between leftists and true conservatives? Leftists want to rearrange the world to fit their idea of perfection. They have it all figured out, and dissent from the master plan will not be tolerated. (This is very Hitleresque and Stalinesque.) Conservatives and libertarians want people to figure out for themselves how to arrange the world within the roomy confines of simple morality (don’t cheat, don’t steal, don’t murder, etc.).

The left’s ruthlessness was in full spate last year, when the election was bought and probably stolen as well.

In the same post (published on July 23, 2016), my prescience was on display:

If Trump wins in November — a very big “if” — it should be an object lesson to true conservatives and libertarians. Take the gloves off and don brass knuckles. This isn’t a contest for hockey’s Lady Byng Trophy. To change the sports metaphor, we’re in the late rounds of a brutal fight, and well behind on points. It’s time to go for the knockout.

The good news is that recent elections reflect the effects of political polarization. The swings have become less pronounced because the electorate’s “squishy center” has shrunk. The challenge before the GOP is to convince what remains of the “squishy center” that it is in their best interest to reject the anti-libertarian and anti-prosperity policies of the Democrat Party, which has become nothing more than a mouthpiece for an (anti) American brand of Hitlerism and Stalinism.

Stock Markets: The Next Victims of Totalitarian Democrats?

Posted on by

Stock prices are about due for a major correction. Consider the graph below, which I derived from statistics available here. I define a major decline as one that lasts at least 6 months and results in a real drop of at least 25 percent in the real (inflation-adjusted) price or total return of the S&P Composite Index.

When will the correction come? No one knows, though there are probably many (and varying) predictions. But I expect it to come during Biden’s one-term presidency. (I have bet the price of a Prius that it will happen before broad market indices rise much more.) And given the run-up in stock prices since the last major correction, it will be a doozy. During the correction of November 2007 to March 2009, for example, the real value of the S&P Composite Index dropped by 50 percent.

Why does that put stock markets in the cross-hairs of totalitarian Democrats? Because stock prices, volatile and emotion-driven as they can be, represent real-world feedback about the effects of government policies. The fact that stock prices continued to rise throughout Trump’s presidency — despite modest corrections in 2018 and 2020 (the latter related to COVID-19) — was seen by many observers (though not Democrats, of course) as a sign of the success of Trump’s economic policies.

The next big correction — when it comes a week, a month, or a year from now — will be seen by many as real-world feedback about the economic destructiveness of Biden’s policies. The policies in question will include new and higher taxes; heavy handed re-regulation, especially to fight “climate change”; the initiation of vast and costly programs to fight “climate change”; the destabilization of civil order through tighter controls on policing and continued laxity in controlling riot by blacks and leftists; bailouts for Blue States and cities; and increases in “social” spending, including but not limited to the subsidization of hordes of recent and new immigrants from south of the border (of the kind formerly known as illegal).

At the first hint of a correction — perhaps even in anticipation of it — policy-makers in the Biden administration will use the power of the Treasury, the Federal Reserve, and the Securities and Exchange Commission to throttle and “guide” stock trading. This will be done in the name of economic stability, of course, but the real aim will be to prevent or minimize a major correction in stock prices that would be seen, correctly, as real-world feedback about the destructiveness of Biden’s policies.

Trump, the Coronavirus Panic, and the Stock Market

Posted on by

UPDATED 03/16/20

A writer at The Washington Post compiled a record of President Trump’s statements about COVID-19 through yesterday. Whether it is a complete and unbiased compilation I will leave to you to investigate and decide. Let’s just say that it doesn’t put Mr. Trump in a good light, which was undoubtedly the writer’s intention given the identity of his employer.

I say that the compilation doesn’t put the president in a good light because his optimism has been depicted as a manifestation of ignorance and stupidity. But — as was obvious to anyone with a modicum of common sense (i.e., not rabid reporters and other leftists who won’t let a crisis go to waste) — Mr. Trump was merely striving (in vain, it seems) to defuse the panic that the media and disloyal opposition have been intent on spreading.

The president’s declaration today of a national emergency would seem to be an admission that he had been unduly optimistic and glaringly wrong in his earlier statements. But that remains to be seen; as of now, the incidence of COVID-19 in the U.S. accounts for only a minute fraction of the populace (6/1,000,000), and the number of deaths accounts for an almost invisible fraction of the populace (2.2 percent of cases thus far). The cancellation of events and the widespread practice of self-quarantine and isolation will do much to reduce the incidence of COVID-19 from what it would otherwise had been. But it is still far too soon to know how bad it will get in the U.S.

According to the article in the Post, president made his first public comment about COVID-19 on January 22. The full effect of that statement, if there was any effect, would have been reflected in the Rasmussen Reports Presidential Tracking Poll of January 27. As it happens, Mr. Trump’s approval numbers didn’t vary much after that date until the week of February 24-28, when they jumped and then dived.

What happened during that week? Trump’s visit to India (which seemed to be a plus for him) was followed by a sharp drop in the stock market. Trump’s approval ratings haven’t changed much since February 28 (see the first graph below), despite (a) the spread of COVID-19 in the U.S., (b) panicky responses by opportunistic media types and Democrats, (c) a rising tide of closures and cancellations, (d) a brief recovery in stock prices followed by sharp declines (see the second graph below), and (e) today’s partial recovery in the wake of Trump’s declaration of emergency (again, see the second graph).

What does it all mean? Trump’s approval rating, it seems to me, is related directly to the state of the stock market, which is related directly to fears about the economic effects of COVID-19, which is driven by fears about the spread of COVID-19 throughout the world and in the U.S., in particular. That is to say, most voters are sensible enough to know that what the president says about the disease has next to no effect on its incidence, and therefore next to no effect on them, personally. But — out of long and misguided habit (driven by the media and the professoriate) — a large share of the electorate holds the president responsible for short-run changes in the state of the economy. The stock market reflects expectations about those changes, usually in an exaggerated way.

Sic semper boobus americanus.

I expect today’s jump in stock prices to show up in Monday’s Presidential Tracking Poll. UPDATE: Well, the Fed did it again, with another panicky (and probably ineffective) rate cut, which sent the market tumbling (though it’s recovering somewhat at this moment).

More Stock-Market Analysis (II)

Posted on by

Today’s trading on U.S. stock markets left the Wilshire 5000 Total Market Full-Cap index 17 percent below its September high. How low will the market go? When will it bounce back? There’s no way to know, which is the main message of “Shiller’s Folly” and “More Stock-Market Analysis“.

Herewith are three relevant exhibits based on the S&P Composite index as reconstructed by Robert Shiller (commentary follows):

In the following notes, price refers to the value of the index; real price is the inflation-adjusted value of the index; total return is the value with dividends reinvested; real total return is the inflation-adjusted value of total return.

  • The real price trend represents an annualized gain of 1.8 percent (through November 2018).
  • The real total return trend represents an annualized gain of 6.5 percent (through September 2018).
  • In month-to-month changes, real price has gone up 56 percent of the time; real total return has gone up 61 percent of the time.
  • Real price has been in a major decline about 24 percent of the time, where a major decline is defined as a real price drop of more than 25 percent over a span of at least 6 months.
  • The picture is a bit less bleak for total returns (about 20 percent of the time) because the reinvestment of dividends somewhat offsets price drops.
  • Holding a broad-market index fund is never a sure thing. Returns fluctuate wildly. Impressive real returns (e.g., 20 percent and higher) are possible in the shorter run (e.g., 5-10 years), but so are significantly negative returns. Holding a fund longer reduces the risk of a negative return while also suppressing potential gains.
  • Long-run real returns of greater than 5 percent a year are not to be scoffed at. It takes a lot of research, patience, and luck to do better than that with individual stocks and specialized mutual funds.

More Stock-Market Analysis

Posted on by

I ended “Shiller’s Folly” with the Danish proverb, it is difficult to make predictions, especially about the future.

Here’s more in that vein. Shiller uses a broad market index, the S&P Composite (S&P), which he has reconstructed back to January 1871. I keep a record of the Wilshire 5000 Full-Cap Total-Return Index (WLX), which dates back to December 1970. When dividends for stocks in the S&P index are reinvested, its performance since December 1970 is almost identical to that of the WLX:

It is a reasonable assumption that if the WLX extended back to January 1871 its track record would nearly match that of the S&P. Therefore, one might assume that past returns on the WLX are a good indicator of future returns. In fact, the relationship between successive 15-year periods is rather strong:

But that seemingly strong relationship is an artifact of the relative brevity of the track record of the WLX.  Compare the relationship in the preceding graph with the analogous one for the S&P, which goes back an additional 100 years:

The equations are almost identical — and they predict almost the same real returns for the next 15 years: about 6 percent a year. But the graph immediately above should temper one’s feeling of certainty about the long-run rate of return on a broad market index fund or a well-diversified portfolio of stocks.

Related posts:
Stocks for the Long Run?
Stocks for the Long Run? (Part II)
Bonds for the Long Run?
Much Ado about the Price-Earnings Ratio
Whither the Stock Market?
Shiller’s Folly

Shiller’s Folly

Posted on by

Robert Shiller‘s most famous (or infamous) book, is Irrational Exuberance (2000). According to the Wikipedia article about the book,

the text put forth several arguments demonstrating how the stock markets were overvalued at the time. The stock market collapse of 2000 happened the exact month of the book’s publication.

The second edition of Irrational Exuberance was published in 2005 and was updated to cover the housing bubble. Shiller wrote that the real estate bubble might soon burst, and he supported his claim by showing that median home prices were six to nine times greater than median income in some areas of the country. He also showed that home prices, when adjusted for inflation, have produced very modest returns of less than 1% per year. Housing prices peaked in 2006 and the housing bubble burst in 2007 and 2008, an event partially responsible for the Worldwide recession of 2008-2009.

However, as the Wikipedia article notes,

some economists … challenge the predictive power of Shiller’s publication. Eugene Fama, the Robert R. McCormick Distinguished Service Professor of Finance at The University of Chicago and co-recipient with Shiller of the 2013 Nobel Prize in Economics, has written that Shiller “has been consistently pessimistic about prices,”[ so given a long enough horizon, Shiller is bound to be able to claim that he has foreseen any given crisis.

(A stopped watch is right twice a day, but wrong 99.9 percent of the time if read to the nearest minute. I also predicted the collapse of 2000, but four years too soon.)

One of the tools used by Shiller is a cyclically-adjusted price-to-earnings ratio known as  CAPE-10 . It is

a valuation measure usually applied to the US S&P 500 equity market. It is defined as price divided by the average of ten [previous] years of earnings … , adjusted for inflation. As such, it is principally used to assess likely future returns from equities over timescales of 10 to 20 years, with higher than average CAPE values implying lower than average long-term annual average returns.

CAPE-10, like other economic indicators of which I know, is a crude tool:

For example, the annualized real rate of price growth for the S&P Composite Index from October 2003 to October 2018 was 4.6 percent. The value of CAPE-10 in October 2003 was 25.68. According to the equation in the graph (which includes the period from October 2003 through October 2018), the real rate of price growth should have been -0.6 percent. The actual rate is at the upper end of the wide range of uncertainty around the estimate.

Even a seemingly more robust relationship yields poor results. Consider this one:

The equation in this graph produces a slightly better but still terrible estimate: price growth of -0.2 percent over the 15 years ending in October 2018.

If you put stock (pun intended) in the kinds of relationships depicted above, you should expect real growth in the S&P Composite Index to be zero for the next 15 years — plus or minus about 6 percentage points. It’s the plus or minus that matters — a lot — and the equations don’t help you one bit.

As the Danish proverb says, it is difficult to make predictions, especially about the future.

Whither the Stock Market?

Posted on by

Drawing on the database maintained by Robert Shiller, author of Irrational Exuberance, I estimated the constant-dollar value of the S&P Composite Index (S&P) with dividends reinvested. The validity of my estimate is confirmed by comparing it with the Wilshire 5000 Total Return Index (WLX), which is based on the reinvestment of dividends in the underlying stocks:

FIGURE 1

“Real” means that the underlying values are inflation-adjusted. The indices are equated to 1 in December 1970 because that is the first month of the WLX.

Shiller uses a cyclically adjusted price-earnings ratio (CAPE) based on the inflation-adjusted value of S&P and earnings on the constituent stocks. Specifically, he uses the current inflation-adjusted price divided by the average of inflation-adjusted earnings for the preceding 10 years. Accordingly, he calls it CAPE-10:

FIGURE 2

What is the relationship between the value of CAPE-10 for a particular month and the total return on the S&P over an extended period? Shiller’s database (which is reconstructed, of course) goes back to January 1871. January 1881 is therefore the date of his earliest CAPE-10 value. This graph shows the relationship between CAPE-10 and total returns for all 15-year periods beginning January 1881 and ending June 2018:

FIGURE 3

There’s an inverse relationship, as you would expect. But it’s a loose one because of marked shifts in the value of CAPE-10.

There’s a much tighter relationship for the “modern” financial era. I trace the beginning of this era to about 1982, when the stock market bottomed (see Figures 1 and 2) while inflation was receding from its post-World War II peak in 1980:

FIGURE 4

Here’s the relationship between CAPE-10 and real, annualized 15-year returns on the S&P since 1982:

FIGURE 5

The current value of CAPE-10 is about 32. If the relationship in Figure 5 holds true for the next 15 years, investors can expect real, annualized returns (with dividends reinvested) of 2 percent to 4 percent on broadly diversified mutual funds and stock portfolios.

Not great, you say? Well, the current real return on Baa-rated corporate bonds is about 1.5 percent. It’s less than that for Aaa-rated bonds, Treasury issues, most CDs, money-market funds, and deposit accounts. So if you’re into buy-and-hold, the stock market isn’t a bad bet. Alternatively, you can try to pick the next “big thing” — Tesla, for example.

Stagnation: ‘Tis a Tale Told by the Stock Market

Posted on by

I have just come across two articles about the shrinking number of firms listed on U.S. stock exchanges:

Kathleen Kahle and René M. Stulz, “Is the American Public Corporation in Trouble?”, Journal of Economic Perspectives, Volume 31, Number 3, Summer 2017

Michael J. Mauboussin, Dan Callahan, and Darius Majd, “The Incredible Shrinking Universe of Stocks: The Causes and Consequences of Fewer U.S. Equities“, Credit Suisse, Global Financial Strategies, March 22, 2017

I will refer to the first article as K&S and the second article as MC&M. (Despite the publication dates, K&S predates MC&M.) The articles tell this tale:

  • From the mid-1970s to the mid-1990s, the number of listed companies rose sharply.
  • Since the min-1990s, the number of listed companies has dropped sharply.
  • The declining number of listed companies has been accompanied by consolidation within many industries and — among the surviving firms — greater size, higher profits, bigger payouts to shareholders, and higher average market capitalization (market value of outstanding shares).

Here are some relevant observations from K&S:

If consolidation has nothing to do with being a public firm, we should see the total number of firms decreasing, whether firms are public or private. We don’t. The United States has become an economy dominated by service industries, and so a good way to demonstrate this is to look at the service industries. Even though the number of firms in the service industries increases by 30 percent from 1995 to 2014 and employment increases by 240 percent, the number of public firms falls by 38 percent. A similar evolution occurs in the finance industry, in which the number of firms increases by 18.7 percent from 1995 to 2014, but over the same time the number of listed firms falls by 42.3 percent. Further, … the propensity of firms to be listed … falls across all firm-size categories when size is measured by employment….

The drop in the propensity to be listed suggests that there is a problem with being a public firm…. In the United States, corporate law is governed by state of incorporation, but public firms are subject to federal securities laws. As a result, Congress can regulate public firms in ways that it cannot regulate private firms….

Our data show that the fraction of small public firms has dropped dramatically…. [T]he drop in initial public offerings is particularly acute among small firms. Why are public markets no longer welcoming for small firms?… [R]esearch and development investments have become more important. Generally, R&D is financed with some form of equity rather than debt, at least in early stages before a firm has accumulated lucrative patents. Raising equity in public markets to fund R&D can be difficult. Investors want to know what they invest in, but the more a firm discloses, the more it becomes at risk of providing ammunition to its competitors. As a result, R&D-intensive firms may be better off raising equity privately from investors who then have large stakes….

There are several additional potential explanations for why small firms are staying out of public markets… First, public markets have become dominated by institutional investors…. Investing in really small firms is unattractive for institutional investors, because they cannot easily invest in a small firm on a scale that works for them. As a result, small firms receive less attention and less support from financial institutions. This makes being public less valuable for these firms. Second, developments in financial intermediation and regulatory changes have made it easier to raise funds as a private firm. Private equity and venture capital firms have grown to provide funding and other services to private firms. The internet has reduced search costs for firms searching for investors. As a result, private firms have come to have relatively easier access to funding.

… According to [the economies of scope] hypothesis, small firms have become less profitable and less able to grow on a stand-alone basis, but are more profitable as part of a larger organization that enables them to scale up quickly and efficiently. Thus, small firms are better off selling themselves to a large organization that can bring a product to market faster and realize economies of scope. This dynamic arises partly because it has become important to get big quickly as technological innovation has accelerated. Globalization also means that firms must be able to access global markets quickly. Further, network and platform effects can make it more advantageous for small firms to take advantage of these effects by being acquired. This hypothesis is consistent with our evidence that the fraction of exchange-listed firms with losses has increased and that average cash flows for smaller firms have dropped…. [M]any mergers do involve small firms, so small firms do indeed choose to be acquired rather than grow as public firms.

The increased concentration we document could also make it harder for small firms to succeed on their own, as large established firms are more entrenched and more dominant….

[Gerald] Davis … argues [in The Vanishing American Corporation] that it has become easier to put a new product on the market without hard assets…. When all the pieces necessary to produce a product can be outsourced and rented, a firm can bring a product to market without large capital requirements. Hence, the firm does not need to go public to raise vast amounts of equity to acquire the fixed assets necessary for production… Ford’s largest production facility in the 1940s, the River Rouge complex, employed more than 100,000 workers at its peak. Of today’s largest US firms, only Amazon has substantially more employees than that complex at its peak. With this evolution, there is no point in going public, except to enable owners to cash out.

These explanations imply that there are fewer public firms both because it has become harder to succeed as a public firm and also because the benefits of being public have fallen. As a result, firms are acquired rather than growing organically. This process results in fewer thriving small public firms that challenge larger firms and eventually succeed in becoming large. A possible downside of this evolution is that larger firms may be able to worry less about competition, can become more set in their ways, and do not have to innovate and invest as much as they would with more youthful competition. Further, small firms are not as ambitious and often choose the path of being acquired rather than succeeding in public markets. With these possible explanations, the developments we document can be costly, leading to less investment, less growth, and less dynamism.

This is all consistent with the creeping stagnation of the U.S. economy, as it collapses under the weight of government spending and regulation:

The Stock Market 15 Years from Now

Posted on by

I won’t bore you with a bunch of tables and graphs. I’ll just tell you that I’ve played around with inflation-adjusted stock-market indices (the Wilshire 5000 Total Return and the S&P Composite), and have discovered the following:

  • Internal relationships (future performance vs. prior performance) suggest that 15 years from now real stock prices will have risen at a compounded annual rate of +5 to +10 percent.
  • External relationships (future performance vs. current AAA corporate bond rate) suggest that 15 years from now real stock prices will have dropped at a compounded annual rate of about -5 percent.

The second result is based on a positive long-run relationship between the bond rate and stock-market performance. Why would there be such a relationship if an interest-rate hike usually causes stock prices to drop? Well, that’s a short-run phenomenon. But over the long run, higher interest rates mean more demand for money, which means that companies are making investments to generate higher profits. And over a period of sufficient length, like 15 years, those higher profits are realized and reflected in stock prices.

In sum, low interest rates signal sluggish business activity. Interest rates are at historically low levels, and have remained stubbornly low for a simple reason. It’s not just that inflation is low. It’s also that the demand for money is weak because the regulatory regime makes it more increasingly difficult and unprofitable for businesses to form and expand.

I see no hope for true regulatory reform, which would involve the beheading of almost every government bureaucrat in the United States. Therefore, my bet is on negative stock-market performance over the next 15 years — and beyond.

It can happen here if it can happen in Japan, where the Nikkei 225 index stands at 42 percent of its nominal level on December 1, 1989. Adjusted for inflation, the index probably has dropped about 75 percent in 27 years, which is a real  decline of -5 percent a year.

*     *     *

Related reading: Jon Hilsenrath, “Yellen Points to Slow Growth and Low Rates in the Long Run,” The Wall Street Journal, June 21, 2016

Related posts:
Economic Growth Since World War II (with links to many more related posts)
Bonds for the Long Run?
Why Are Interest Rates So Low?