hard heads soft hearts
Saturday, July 27, 2002
after quite a long time: "nagging questions about long-term stock returns"
Paul Krugman once wrote that if a non-economist has had an insight about economics, it has probably already occured to an economist/social scientist, and has likely been explored, clarified, and decisively refuted; or worse, become a standard accepted part of the canon. In that vein, I've had two "insights" which seem to me to be crucial when discussing long-term stock market returns, which *must* have been explored by some clever person or another, but which no one ever seems to talk about.
the usual explanation of long term yield is that it is = dividend yield + earnings growth + changes in P/E ("speculative yield"). Let's call this "conventional long-term yield"
Now here are my two doubts:
1) the share of the publicly traded sector as part of the economy.
If the share of publicly traded corporations rises from 50% of the economy to 75%, long term stock market returns should be higher than the "conventional long term yield". Likewise , if the share drops from 75% to 60%, long term return will be lower than the conventional model.
Now it seems to me that the publicly traded share of the economy has been rising for the recent past. (i.e. we eat more fast food, shop at WalMart instead of the corner store, etc.) Assuming that it stays constant or declines in the future, doesn't that mean we can't extrapolate future returns from the past?
In his web article Dow 36000: How silly is it? Paul Krugman wrote:
"Third, the deepest issue: today's stocks are not a claim on the earnings of the U.S. corporate sector into the indefinite future. They are a claim on the earnings of *today's corporations* into the indefinite future. That's a big difference, if you look far enough ahead: unless something terrible happens, U.S. companies will be earning a lot of money 70 years from now; but much of that money will be earned by companies that do not now exist, or at any rate are not in the Dow or even in the S&P 500"
He's right. This is a deep issue. Where can one find some deep discussion about it?
I've read "A random Walk Down Wall Street" and long chunks of "Stocks For the Long Run", which I don't remember dealing with this issue. I haven't read but intend to read someday "Irrational Exhuberance" and the new book "Triumph Of the Optimists". From the Intro to "Triumph" however, while it talks of "survivorship bias" and "adjusting for reinvestment" it does not seem to talk much about the share of the economy of the publicly traded sector.
2) "outsider (small investor) returns" versus "insider returns"
Basically, I wonder if long term returns are calculated not from the IPO price but from the price at which the stock first became publicly available.
e.g. if a stock has an IPO price of $10 but is only available to outside investors at $25. Let's say in five years it has risen to $30, is the long term return of the stock calculated as approximately 20% or as approximately 200% ?
This question may be dismissed as the artifact of the Internet bubble, but there is a larger issue: Suppose Walmart sells $100 worth of stock in its company at an IPO price of $10 and the stock appreciates to $50. Then Walmart sells a further $100 worth of stock in the company at the new IPO price of $50. Is the long term return on WalMart's stock calulated as 400% (which mixes in the returns to insiders and outsiders), or is it calculated as (100*5 + 100 - 200) / 200 = 200% (which is the return that would have been available to an outside index investor, minus the "insider returns")
I have seen *no* discussion of this issue in the context of long-term stock market returns. I have seen plenty of discussion in the context of greedy investment banks, etc. Perhaps this is what "Triumph Of the Optimists" meant by "adjusting for reinvestment" ?
I guess these nagging doubts are similar to a question I asked Paul Krugman a long time ago, namely, putting aside the issue of privatization and individual accounts, what is the appropriate model to think about the optimal asset-allocation of the Social Security Trust Funds? His reply was "Its complicated. There are questions about the effect of that large a player on the markets. But investing the trust funds in the Stock market after federal debt has been exhausted is a reasonable thing to do"
Boy those were the days, huh, when one had to imagine what to invest the trust funds in after all federal debt had been exhausted? Unfortunately, now I imagine running out of federal debt to invest in may not be one of our problems.
What motivated me to write was reading a Business Week "sound money" column that argued for stock returns of 4-6% over the next ten years (Bogle says 4-9% William Nordhaus 2-3%, Shiller "close to zero or even negative") The author (Chris Farrell) was inundated with emails like this:
"Over the past 75 years, equity appreciation has averaged about 11% annually. This is documented history.... Why would you expect the long-term future to underperform so drastically?"
I wrote this email on June 23, and sent it to three people: Paul Krugman, Andrew Tobias and Brad Delong. no reply from Krugman, Tobias replied "thanks for the email. good questions". Brad Delong replied "point #1 is important (point #2 less so). I have not seen *any* deep discussion of it. It *is* an important issue." Given how good an economist Delong is, I find that a bit scary.
Make of it what you will.