CommentsCommentsCreated 6/15/1998
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J. Bradford DeLong
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My remarks at an economic consultants' meeting called by the Board of Governors of the Federal Reserve on June 15, 1998.
Let me begin by saying that I am not sure that I disagree with what Jeremy Siegel has just said--and I certainly do not disagree with Joseph Lakonishok. But it seems to me that I would best advance the discussion if I were to lay out the set-theoretic complement to the arguments that have been expressed so far.
It is very possible that the equity premium--the higher rate of return demanded on stocks than on bonds--has fallen. The high rates of return required on equities over the past century have puzzled generations of economists. It may really be the case that investors as a group have "wised up"--have realized that they underpriced stocks, and that old valuation patterns made stocks an irresistible investment opportunity from any rational risk/return perspective.
There is, however, reason to be skeptical. We don't see any signs of a reduced equity premium in Japan, or the rest of Asia, or Mexico, or Latin America. We don't see as much of a sign of a reduced equity premium in Europe. Other equity markets outside the U.S. are offering very attractive bargains if the equity premium has fallen. Yet U.S. investors do not seem to be moving in large numbers to take advantage of them. And investors who are sophisticated enough to recognize that they should requie a lower risk premium should also be abelt to recognize opportunities outside of the U.S.
So I find myself thinking of who is in the market, of the ecology that produces market participants. I find myself thinking of Jeffrey Vinik of Fidelity, promoted to perhaps the best asset management job in the world--head of the Magellen Fund--only to lose the job rapidly because the market seemed high to him and he kept a considerable share of his portfolio out of equities. The lesson has been learned. If you are fully invested, and thus if your returns match those of your fully invested peers among asset managers, you probably keep your job. If you bet that the market is overvalued and are not proven right by a near-immediate decline in the stock market, you lose your job.
Over the past five years the normal operation of turnover in asset managers had given us a stock market run by optimists--by those who have been fully invested and perhaps leveraged even though prices appear by standard measures to be relatively high.
It has also created a broader climate of opinion in which stock market columnists for the Washington Post can complain that because people have been worrying about stock-market overvaluation for three years, in which "the Dow has risen by 110 percent," that "warnings about the market being overvalued are, frankly, getting a little old."
Now we can dismiss such comments by the likes of a James Glassman as the not very well informed views of someone who doesn't understand the stock market: someone who is hopelessly confused about what a dividend yield is and how it differs from an earnings yield. But we can dismiss such stupid opinions only if they are not backed by a lot of stupid money--only if we are confident that there are enough rational risk/return investors to offset the purchases now (and sales later) of the Glassmans and those who listen to them.
So what happens next? Three possibilities:
- First, nothing happens. Jeremy Siegel is right, and the equity premium has declined by a lot, and the market is now--roughly--fairly priced.
- Second, the optimists who now run our stock market are real optimists: they will keep on buying and holding stocks no matter what returns are because they always expect the best. In this case optimists will be disappointed as earnings growth fails to meet their expectations, but there will be no sharp break in prices--hence nothing to greatly concern the Federal Reserve. There will be the standard deadweight losses produced by overvaluation: the financial economy will be sending the wrong price signals to savers and investors. But the stock market channels a sufficiently small proportion of net investment that these losses cannot be very large.
- Third, our optimists who are our asset managers today may not be optimists but rather trend chasers: people who tend to buy what has risen, and sell what has fallen. In this case the future of the stock market contains a significant probability of a substantial and rapid decline, analogous to the decline in the Japanese stock market that started in the late 1980s. In this case...
Professor
of Economics J. Bradford DeLong, 601 Evans Hall, #3880
University of California at Berkeley
Berkeley, CA 94720-3880
(510) 643-4027 phone (510) 642-6615 fax
delong@econ.berkeley.edu
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