Monday, April 17, 2006

Equity Premia, or Is the Premise Valid?

by Ken Houghton

Brad DeLong declares that "Stocks Have Been an Extraordinarily Good Investment," and goes on to ask "Why?"

Channeling George Bernard Shaw as played by JFK (a role for which I am not fit--though I'm not certain Christopher Walken was, either), I ask your indulgence as we take a step back, borrow a picture from Burton G. Malkiel (it was on page 257 of a previous edition), and "look at the evidence":

The first thing to notice is that the returns in the current range of the stock market are far from "extraordinary" in an environment with 4.75% Fed Funds. The "extraordinary" returns came from Price Earnings Ratios well below 15 times current--not forward--earnings.

The other thing to note is that, of those historic returns, a large portion of them came from dividends. Now, I'm as fond of dividends as the next man (at a 15% tax rate, I'm fonder of them than I am working on a dollar-for-dollar basis), but the reality is that dividends have declined over time, as has (and will, as DeLong noted in quoting Shiller about a year ago) the absolute return of the market:
[Shiller's paper] uses historical returns from 1871-2004 .... This sample has an average real stock market return of 6.8% annually, slightly above the 6.5% annual return assumed by the Social Security actuaries....

The United States economy and stock market performed extremely well over the last century. Many factors suggest this lucky experience is not likely to be repeated: most analysts project slower GDP growth in the next century, the risk premium required for investing in equities may have diminished, and the P-E ratio is very high by historical standards.

The Wall Street Journal recently surveyed 10 leading financial economists, the median projection for the stock market real rate of return in this survey was 4.6% above inflation.

A decline from 6.8% to 4.6%--just under 1/3 of the real gain--is not to be taken lightly. (If anything, Malkiel's graphic above implies an even greater decline.)

Additionally--a reason to which I alluded earlier--investment income is not required to work as hard as it was in earlier times. If I care about after-tax income (and, having written my annual check to the state of New Jersey to cover dividend income and capital gains taxes, I do today more than many others), it is much easier to accept a lower absolute return when the tax rate is reduced.

Continued on Next Rock...
Just to make sure that I'm on the same page (I'm brushing away a year's baby-related sleep deprivation!), is this consistent with the Krugman/DeLong/Baker implication that one way to get a future period of sustained "high" returns on equities is to have equity prices crash between now and then?
It dovetails well with that, yes.

Think more "general survey about wehy we have a stock market and what it's purpose should be" rather than a prediction of what the market will or would need to do--but the result won't surprise you, unless it does me as well.
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