http://www.dismal.com/thoughts/th_mz_022900.stm

"Stock Prices in the Long Run By Mark Zandi

GDP posted a whopping gain near 7% in the fourth quarter of last year and a gain of over 4% for the year as a whole. Driving this growth is voracious consumer spending, as households purchase anything and everything.

The current pace of growth can no longer be sustained as imports surge and businesses stretch already exceedingly tight labor markets in an effort to increase output to meet the insatiable demand. The nation's current account deficit is hemorrhaging and the jobless rate has never been lower save when the military was a large and rapidly expanding employer during the Korean and Vietnam wars.

Consumers are spending well beyond the healthy growth in their incomes. As such, the personal saving rate continues to plunge and household liabilities are expanding at a double-digit pace.

Behind consumers' appetite to spend is their surging wealth. Approximately one-half of households own stocks and two-thirds own homes, and the values of both assets have soared since the mid-1990s. Average household net worth is up over $100,000 in the past five years. Extraordinarily confident consumers are thus spending nearly every penny of cash they can muster from their income, capital gains and borrowings. This is the wealth effect, and it is in full swing as it is adding an estimated one-percentage point to the economy's per annum growth.

The wealth effect could very well cause the economy to overheat. For the economy to throttle back to a pace that will not ignite accelerating labor costs and broader inflation, the wealth effect must fade. Federal Reserve Board Chairman Alan Greenspan argued in recent Congressional testimony that for this to happen, asset values should ultimately increase no faster than household incomes. For stock investors who have become conditioned to expect 20%-plus annual gains, this is a terrifying thought. In the long run (meant here to describe the length of time necessary for the impact of the vagaries of the business cycle to be ironed out) personal income growth is expected to be just over 5% per annum.

At first blush, the Chairman's claim appears inconsistent with history. Since World War II, personal incomes have risen by less than 8% per annum while stock returns as measured by the sum of the growth in the S&P 500 and the average dividend yield have been closer to 13%. Remember, however, Greenspan is talking about all household assets, including housing, consumer durables, various fixed income assets, as well as stocks. Indeed, the value of all household assets has risen by some 8% per annum since World War II.

There is also a simple theoretical justification to believe that the long-run growth in asset values will mirror the growth in household incomes. Household incomes will ultimately grow at a pace equal to GDP growth. If incomes rise more slowly than GDP, then businesses will take a bigger piece of the economic pie through increased corporate profits. Vice-versa, if incomes rise more quickly than GDP, then business profitability will suffer. The share of the economy's output that goes to households and businesses can and does vary, but the share going into households' pockets or to businesses' coffers cannot and will not rise or fall for very long. The growth in asset values must also ultimately mirror GDP growth. After all, the value of the economy's assets is ultimately determined by the value of what those assets can produce as measured by the economy's GDP.

The long-run outlook for stock price returns is not as dour as implied by the expectation of only 5%-plus per annum household income growth. Stock returns should be greater than returns for the average asset since stocks are riskier than the average asset. When investors buy most fixed income assets, for example, they know with a level of certainty they will get their principal back. Moreover, they get a fixed interest payment year in and year out over the life of the bond. An investment in a home or a consumer durable such as a vehicle is even more certain as much of the return is in the form of housing and other services regularly consumed over the life of that asset. Stocks are much less of a sure thing, and as such, stock returns should be greater than the return on most assets. The difference between stock returns and the return on other assets is the so-called equity risk premium.

It just so happens that the equity risk premium is approximately equal to the rate of inflation. At least that is how it works in theory after making a few simplifying assumptions, and how it has actually worked out historically. Given that long-run consumer price inflation is expected to average 2.5% per annum (this is the Federal Reserve's seeming target for CPI inflation), the equity risk premium should be 2.5%. Total long-run stock returns should therefore be just shy of 8% per annum, equal to the sum of expected household income growth of over 5% and an equity risk premium of 2.5%.

There are certain circumstances in which asset and stock values can achieve higher returns over an extended period than as implied by the growth in household incomes. It can be argued that, at least to some degree, is what has happened since the mid-1990s. The business cycle is less pronounced than in the past, suggesting that the return on assets is also more stable, and thus their value should be enhanced relative to household incomes. It can also be argued strongly, however, that at least part of the extraordinary growth in asset values in recent years is due to increased speculation and leverage. It is thus no more likely that asset and stock returns will outpace the expected long-run growth in household incomes in the next few years than it is likely that they will fail to measure up.

Stock investors are clearly having a difficult time buying into this outlook. The longer that they fail to recognize that they should only anticipate at most high single-digit returns, however, the more aggressive the Fed will have to become, and the greater the risk that, at least for a while, even these modest gains will appear optimistic."

-- Ken Decker (kcdecker@worldnet.att.net), March 06, 2000

Answers

I am simple-minded. As far as I can make out, the current "value" of financial assets can only flow in two directions. Either it will flow into real assets and inflate their value or today's paper assets will be discounted from present levels and lose value.

Any thoughts, Ken?

-- Brian McLaughlin (brianm@ims.com), March 06, 2000.

A topical link:

CNNfn Poll:
How high will the Nasdag go?

-- Tim (pixmo@pixelquest.com), March 06, 2000.