From: Peter C. McCluskey (pcm@rahul.net)
Date: Fri Oct 01 1999 - 12:58:05 MDT
rhanson@gmu.edu (Robin Hanson) writes:
>At 09:46 PM 9/26/1999 -0700, Hal F. wrote:
>>A very interesting article is available online from Atlantic Monthly
>>at http://www.theAtlantic.com/atlantic/issues/current/9909dow.htm.
>>...
>>The authors analyze stock market prices using basic techniques of
>>expected income stream and also risk premiums, and conclude that
>>stocks are actually extremely UNDERvalued today (and always have been).
>>By their model the Dow ought to be running at 36,000 or even more.
>>...
>>I'd like to hear what our more economically sophisticated members think
>>of this argument.
>
>Their argument isn't silly or wrong. But they could easily be wrong
>nonetheless about where the Dow will be anytime soon.
They start with a serious analysis, but some parts of their claims
strike me as silly.
For instance, they say:
To believe that the market is overvalued, you have to believe that the
risk premium, once irrationally so large and getting rationally small,
will become irrationally large again.
Ignoring the hypothesis that stocks are overvalued because earnings/dividend
forecasts are too high, I see two reasons to suspect that a rational
investor might think the risk premium is currently too small.
1) Stocks ought to become riskier as p/e's rise and dividend yields drop.
Their arguments appear to depend on this being insignificant. I suspect
any reasonable analysis of how stock price volatility has historically
been higher when dividend yields are low, or almost any theoretical analysis,
will imply that stocks are much riskier now than the historical average.
My gut feeling is that investors are irrationally ignoring this.
2) Bonds may have been been abnormally risky over the period the authors
use to estimate the risk. The transition from metallic currency to fiat
currency has produced some significant bouts of inflation. It doesn't
seem irrational to hypothesize that this source of risk has diminished
as currency markets have developed to discipline central banks.
>Standard models have trouble explaining current large risk premia. So
>either it is due to something we don't understand, or it is irrational
>and will eventually go away. If you want to bet it will go away soon,
>why go buy stocks. If you want to bet that it won't go away soon,
>go sell them.
The hypothesis that it will go away soon doesn't imply you should just
buy stocks. It implies you should also sell short bonds, as the change
could happen entirely by an increase in interest rates.
The most striking feature of their conclusions is that it implies that
there should be an incredible reward to creating new companies. 36000
on the DJIA implies that companies are worth about 20 times the capital
apparently required to create them. This seems to imply either that there
are much larger costs that don't get accounted as book value than economic
analysis normally assumes, or there are returns to putting capital into
creating new companies approaching 1900% that people are irrationally(?)
ignoring. This would seem to hint that it is more likely that interest
rates are too low than that stocks are too low.
P.S. - I'm currently betting the market will go down over the next month
or two, but wouldn't be surprised if the bull market resumes this winter
and continues until the baby boomers retire.
-- ------------------------------------------------------------------------ Peter McCluskey | Critmail (http://crit.org/critmail.html): http://www.rahul.net/pcm | Accept nothing less to archive your mailing list
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