Monday, 25 November 2013

How High Can Stocks Go? - Part 1

Keynes, who was a successful investor as well as economist, wrote that markets can remain irrational longer than most people can remain solvent. On Friday, the Dow Jones 30 Index finished over 16,000. Markets are significantly higher for the year, and for the last few months have been hitting new all-time highs, week after week. As usual, in such conditions, the business channels continue to cheer on the rallies, whilst claiming to only report the facts. They and the market bulls proclaim that despite such rises, markets remain fairly valued, or at best only a bit frothy. Yet, on many measures such as Tobin's Q, or the Cyclically Adjusted Price Earnings, markets are at levels they have only ever been at during times when there have been crashes. But, that has been true for months now. In 1996, Alan Greenspan proclaimed that markets exhibited “irrational exuberance”, but it was another 4 years, until 2000, before they crashed. From around 2003, the UK property market was judged to be in a bubble, yet it was not until 2008 that it crashed, and even then it quickly bubbled up again as mortgage rates were slashed. So, how high can stocks go?

Logically, the value of a share should be equal to what it is a share of, that is the value of the company. That is basically what Tobin's Q measures. It is a ratio of the total value of the shares in a company compared to the cost of replacing the capital employed by the company. That measure can then be extended across all shares traded to determine whether markets are above or below a fair value. 

The point from where global stock markets, and particularly the US stock markets, began to rise substantially is 1982. Yet, its clear that the rise in the value of these markets has little or nothing to do with the growth of economic activity, and, therefore, of productive capital in the period after that. In fact, that is not unusual. Periods of stock price appreciation have frequently accompanied periods of sluggish economic growth, and vice versa, for reasons I will explain later.

US GDP rose by 848% between 1950 and 1980, from $294 billion to $2788 billion. Between 1980 and 2000, it rose from $2788 billion to $9951 billion, a rise of 257%. Between 2000 and 2012, it rose to $15094 billion, a rise of 51.68%. I have chosen these dates because they are the closest I can get to periods of the Long Wave, i.e. 1949 – 74 (boom), 1974-1999 (downturn), 1999 – (boom).

For a fair comparison, I have looked at the compound increase per annum for each period. For the first period it is 7.79%, and 6.57% and 3.53% for the further two. Because, these periods do not properly coincide with the Long Wave, I'd suggest that they underestimate the higher growth in the first period compared to the second. They include the period of the second slump between 1974 and 1980 – US GDP fell 14.4% between Q4 1973 and Q2 1975 alone - and that the figure for the period after 2000, reflects the effect of the relative decline of the US, and the effect of the recession after 2008, on what is still only the first half of the boom phase.  In addition, these figures are nominal values.  Given that inflation was generally low in the first period, and last period, but high in the second period, this also flatters the real growth between 1980 -2000.  I will look at real rates of growth later.

However, the point here is to compare these figures for economic growth, which can also be used as a proxy for the growth of capital value in the economy, against what happened with the stock markets. For the first period, the Dow Jones Index rose from 200 to 824 in 1980, to 11723 in 2000, and to 13593 in 2012. In terms of annual compound growth this is then, 4.83%, 14.2%, and 1.24%. In other words, between 1980 and 2000, the Dow Jones Index rose by three times as much on an annualised basis, as it did in the high growth post war boom period from 1950 to 1980.

The low figures for 2000 to 2012, reflects the effect of the 2000 Stock Market Crash. I started compiling this data a year ago, but during that time, the Dow has risen from 13593, to now over 16000, a rise of 18%. Factoring that in would then give an annualised figure around 3% for the period. So, although there is a general belief that bubbles have been blown up in financial markets over the last 10 years, the data here suggests that the period when these asset price bubbles were inflated was, in fact, the 1980's and 90's. The money printing of the last 10 years, despite being of astronomical proportions, seems to have been much less effective in that regard, and has only served to keep already inflated asset prices inflated. The same picture is seen for other markets.

For the S&P 500. it rose from 16.93 to 107.94, to 1469.25, to 1379.32 over the same period. That is compound annual rates of 6.37, 13.95 and - 0.53 respectively. Last week it closed at 1805, which gives an approximate rise since 2000 of 1.5% p.a.

Forward To Part 2

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