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December 8, 2004
The End of the Equity Premium?
This strikes me as a serious challenge to supporters of Social Security reform involving personal accounts. The problem, in a nutshell is this:
Price to earnings ratios have historically been about 15. Today, they are over 20. By definition, that means there's about four cents of corporate earnings for every dollar of equities. That means that in the short term, investors can expect to get dividends of at most 5%, and probably less, as corporations typically retain some of their earnings.
Now, the return on any stock investment is equal to dividends plus capital appreciation. That means that in order to achieve the 7% return generally touted by proponents of privatization, stocks prices must see real price increases of at least 3-4% in order to add up to a total return of 7%.
Here's the catch: the Social Security trustees, in their scoring of various reform proposals, are apparently assuming real corporate earnings growth of 1.4%. But if stock prices are growing at 3.5%, while earnings are growing at 1.4%, that means that the P/E ratio will continue to increase, and will do so pretty rapidly. That, in turn, will mean that dividends will be shrinking as a percentage of market capitalization, which will make it even harder for overall returns to stay at 7%. Hence, the argument runs, stocks can't average 7% real returns in the long run.
I can think of a few plausible responses. One is that the market might currently be over-valued. In the most extreme scenario, if stocks dropped by 25% next year, that would bring the P/E ratio closer to historical levels, and make possible annual dividends above 5%. Of course, predicting a 25% stock market correction would be political suicide for a politician promoting personal accounts, but it would allow historical rates of return to continue.
Another response is that there's something fishy about conflating the earnings growth of individual companies with the earnings growth of the market as a whole. Companies entering and leaving the market could affect aggregate earnings (by increasing the number of companies that are counted) without affecting the earnings of individual companies. I'm not sure how to think about that issue, though.
A third possibility is that the trustees are just wrong. Maybe earnings growth will be substantially higher than 1.4%. DeLong pounces on that possibility as evidence that Social Security isn't as doomed as we say it is. I'm not sure: benefits are indexed to wage growth, so a higher growth rate would mean that we have to pay out higher benefits too. But if that is what's going on, the trustees should really do some alternative models with higher growth rates to see how it affects the scoring of different plans. Maybe they have-- I don't really follow their reports.
Finally, it's possible that the return on equities really will be lower in the future. Maybe the much-discussed equity premium is going to shrink, and the return on stocks will be closer to the return on less risky investments. A bidding-up of equity prices is precisely how you would expect the equity premium to disappear. Maybe investors have finally figured out that blue chip stocks aren't as risky as they thought, and have bid up their price as a result.
I'm not sure what to think here. Interestingly, Nobel Laureate Ed Prescott, who first identified the equity premium puzzle, supports personal accounts. So at least one person a lot smarter and more knowledgable than me thinks this it's a good idea.
Posted by Tim Lee at December 8, 2004 12:42 PM
Comments
I have wondered about the equity risk premium myself for a while now. There are at least two important related factors that need to be considered:
1) The expected rate of inflation
2) Interest rates (i.e. the risk-free rate)
Both inflation and interest rates have steadily declined over the last 20 years or so. A lower risk free rate means less discounting of future cash-flows (dividends), and hence a higher present stock value. Perhaps the increased P/E ratio merely indicates that people are forecasting lower inflation, or fleeing into equities because treasuries are returning so little.
It is a complex issue...
Posted by: Jo Janssens at December 8, 2004 2:46 PM
Arnold Kling writes:
The stock market scenario is one in which the return on investment greatly exceeds the growth rate of the economy. Typically, the economy is assumed to grow at 2 percent per year, but the stock market is predicted to provide returns of 7 percent per year. This disparity is expected to last for fifty years or more.
To see the flaw in the stock market scenario, start with the algebraic fact that the ratio of the value of common stocks (P) to the total economic output of the country (Y) is the product of the price-earnings ratio of the stock market as a whole (P/E) and the share of corporate profits in economic output (E/Y). That is,
P/Y = (P/E)(E/Y)
If stock prices grow at 7 percent per year while the economy grows at 2 percent per year, then the ratio of stock prices to GDP (P/Y) fifty years from now will be more than ten times what it is today. How could that happen?
If the price-earnings ratio of the stock market (P/E) stays constant, then in order for P/Y to increase tenfold, the ratio of earnings to GDP (E/Y) has to increase tenfold. However, corporate profits are over 10 percent of national output today, so that if the ratio increases by tenfold, then corporate profits will be more than 100 percent of national output. That is impossible.
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Posted by: Lane at December 9, 2004 1:33 PM
P/E of 15, 20%? I think you mean simply 15 and 20. P/E is the cost of a stock divided by its annual increase in value, low is good.
Posted by: adfklj at December 22, 2004 1:45 AM
Yeah, you're right, I shouldn't have put percent signs after the P/E ratios. That's been fixed.
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