February 04, 2005
The CEA Forecasts a *Big* Stock Market Crash
For the past several years U.S. stock prices have averaged something like 60 times dividends--a very high multiple compared to the normal 25-30 or so found in U.S. experience. There are three theories as to what is going on: (i) the equity premium has fallen substantially, and so returns on stocks will average significantly less than the 6.5% per year of the past; (ii) economic growth is about to accelerate, and be noticeably faster than standard models suggest; and (iii) the stock market is about to crash.
The fact that economists are forced to choose from among these three options--for there is no fourth way out--has interesting implications for Council of Economic Advisors, "Three Questions About Social Security," February 4, 2005. That memo denies that the equity premium has fallen. It denies that future growth will be fast. And so we have the CEA forecasting a stock market crash.
The forecast is implicit. But it is very real. With a bounded price-earnings ratio and a bounded share of profits in GDP, stock market capital gains over the long run are equal on average to earnings growth, and the earnings growth on a stock index averages one annual percentage point less than real GDP growth.
The CEA assumes the Social Security Administration's long-run forecast of real GDP growth:
economic growth will average only 1.9% per year in the future
And it states that this rate of real GDP growth is not incompatible with real stock returns of 6.5% per year:
The Social Security Trustees estimate future stock returns of 6.5% per year.... This premium [return] is consistent with long-run historical experience and is low relative to the experience of the last seventy-five years.... The Actuaries’ projection of a 6.5% real stock return is thus consistent both with other professional assessments and with historical investment returns. The Trustees predict that economic growth will slow primarily because of slower population growth. Slower population growth need not imply lower stock returns....
Although short-run movements in growth can affect stock market returns, there is no necessary connection between stock returns and economic growth in the long run. Long-run economic growth is determined by productivity growth and labor force growth here in the United States, while stock market returns are determined by the overall cost of capital in the global economy and by the return investors require to bear the risk that comes with equity ownership. There is no reason to believe that slowing population growth in the United States would significantly lower the cost of capital... or the premium required by stock investors.
But how do you make up this 6.5% per year real return? We know that overall growth in corporate earnings for the companies whose stocks make up the index will get us 0.9% per year (1.9% GDP and profit growth minus a 1% wedge because a goodly share of profits are earned by young companies not yet in the index). We know that stock buybacks by companies will get us an extra 1.0% per year or so. That leaves 4.6% per year required by "the cost of capital... [and] the premium required by stock investors." That 4.6% per year must come from dividends, and that means that stock prices must on average be 1/4.6%, or 21.7 times dividends.
What are stocks today? They are priced at 60 times dividends.
When the CEA writes that "the stock return and economic growth assumptions [of the Bush administration] are not inconsistent," it is leaving out the logical next sentence. The logical next sentence is: "They are consistent if stock prices fall by more than three-fifths: from 60 down to 22 times current dividend levels."
I know that if I were working at the CEA, I would tell my political masters to reconsider if they instructed me to produce an analysis that had as an implication a 60 percent fall in the stock market. I don't know whether the CEA didn't think through what a 6.5% per year long-run return means for average price-dividend multiples; thought it through, went back to its political masters, and was unable to influence them; or is once again engaged in passive resistance.
Posted by DeLong at February 4, 2005 04:16 PM