Mar

10

Shiller and SiegelThere was an article in yesterday's WSJ updating the bear v. bull debate between grad-school buddies Jeremy Siegel and Robert Shiller .

Shiller, who correctly called the 2000 stock and 2006 home price bubbles, contends the current rally has taken (his version of) stock market P/E above its long-term average, and the on-life-support real estate market will continue to drag on corporate earnings. The concern is that for some time FED/government intervention has artificially buoyed stocks above their "natural P/E"; beginning with the 1998 Russian debt default (thank you Mr. Meriwether), Y2K, 911, tech bubble bursting, and the recent credit crisis. In spite of all this help, we just ended the worst decade for stocks since 1930.

Professor Siegel counters that Shiller's P/E method is flawed, and that a version of analyst earnings estimate suggests that earnings will increase now that the credit-crisis write-downs have been taken.

Another possible explanation for a new, higher P/E regime is the transformation of investor thinking: Stocks changed from the "sucker bets" of our parents and grand-parents to the main-stream, primary investment for retirement. This is a self-fulfilling prophesy: since people associate economic well-being with the market, governments now borrow heavily to buy puts (of course someone has to pay for these, hopefully only those making more than $250,000/yr).

There is no reason embedded in nature that stocks must center about a certain P/E. They could stay higher or lower for decades without reason. One of the weakest arguments in Siegel's "Stocks for the Long Run" relates to the question of who will buy stocks as baby-boomers retire. His answer was foreign investors in developing countries -who currently look to be pretty well stocked up on American securities.

Currently the heroes of liquidity-provision are the mavens of Wall Street, who now hold the P/E levers and remain beholden to a market too big to fail.

Stefan Jovanovich comments:

I share Kim's skepticism about Professor Siegel's end-game for American securities. There is no historical evidence for the proposition that wealthy people in developing countries want to put their savings into the common stocks of the already developed/relatively declining countries. The periphery does not send capital to the center. Europeans bought American securities in the 19th century and again after WW II, when the U.S. offered superior growth prospects; those were precisely the times when Americans kept their capital at home, except, of course, for buying trips for foreign baubles. (Every time I visit the Huntington Library I find myself wondering how much the sale of Gainsboroughs for the pound; perhaps the rich in Singapore will develop a taste for the Hudson River school). The only event that could drag capital from Asia to North America would be the political collapse of China; if that were to occur, the money would be flight capital, and that would hardly be enough to cash out 50 million IRAs and 401(k)s. If the United States is going to return to the path of financial progress, like Sebastian the crab we will have to do it ourselves. It is going to take a while.

On another note, I finally understand Keynesians. You guys literally don't think balance sheets matter; it's all about the flow. But what do you do when the pipes have sprung a permanent leak? Opening the sluice gates won't help because the little water left behind the dam has to be kept so no one will worry about a drought and the Valley farmers have already used up their allotments.I have no understanding of the world of 3rd party incomes and investments - the one where the students don't pay the teachers and the money to invest is always OPM. I have not lived there in 35 years; my last brief visit was 1 year as a salaried tax lawyer before the combination of the 1976 tax reform act and my unfortunate manner got me fired. Since then, all I have known is the world of incorporated wallets. Right now in Munchkin Land investment bargains exist; but they are there precisely because the income flows are diminished. The prices have come down because the people who own the businesses do not themselves have the cash to reinvest. They simply want out. And, many of the bargains are anything but because the businesses are simply failing.

That, combined with the likely further extension of confiscatory regulation, makes any current investment here in California very much of a dodgy proposition. The risk of loss seems much, much greater than the reward. If there is to be new investment, it will have to come because we greedheads think we can make money, not because we have a positive cash flow. Until we can see a prospect for profit at the prices for capital assets, the flows will go into the bank to wait. Those businesses that have access to bank and government credit may, indeed, be recovering; but few, if any, small businesses and non-government employee customers are. Their own income prospects are lousy, and their balance sheets are under water. Hayek would blame all this on the past nationalization of credit and money. (Cf. Good Money, Vol. I and II). That, and the prospect of having the government tax more of the flow is only encouraging people to look for ways to camouflage their wealth. Someone - it may have been Jim Farley but I can't find the precise source - said about Joseph Kennedy, Sr. that "he was the only guy I knew in 1932 who could buy something without having to sell something else." The Kennedy political tradition may be dead, but the bootlegger legacy is alive and growing.

Kim thought Siegel was being naïve in expecting that new capital to be invested in America from abroad to buy out the retiring geezers like me. I agree, but God only knows; perhaps Brazilians will acquire a taste for windfarms in Tornado Alley. What we do know is that growth in real wages is a pure function of increased investment. Workers who get to play with newer, more expensive machines make more money because things and services can be provided better, cheaper and faster. I don't like the term capitalism, but one should give Marx his due. He did understand what was at stake. The money and credit and assets held by competitive enterprises - what he would define as "das capital" - are the only chips in the game. If the capital stock is diminished, the holders of cash who are able to invest at 6 or 8 x present earnings will probably make money; but they will be doing it at a time when the workers will be making less - as they did in the decade after the 1982 bottom. (Marx would say it was BECAUSE the new investors were making more money; and even if he was wrong about the causality, he was right about the coincidence; workers' wages do not increase dramatically while capital stock is being rebuilt. They have to wait their turn.)

What we also know is that a world of lower stock prices is one in which profits have declined and the prospect for future earnings has grown less cheery. Those situations usually do present opportunities for future gain but only if someone has "das capital". Andrew Carnegie said that, if you have a choice between losing the factories and losing the people, you want to lose the factories because, with the people you can build a better factory. Being a 19th century primitive, Carnegie presumed that a prudent businessman always had a stash of money - what used to be known as a reserve - whose value was not subject to confiscation or abolition by the government. Carnegie also presumed that he and other prudent businessman would use the cash to pay the workers their wages while the new, better factory was getting up and running. What was different in the past was that there was a stock of private capital willing to speculate after a factory had burned down or the market had crashed.

The question that Kim raised– and for which there is still no apparent answer - is where will that real cash come from now? The diminished future can only be a Grand Bargain after private savings are restored. Until then, it is likely to be a Grand Fail with both the young and the old getting far less than they expect. "Other than that, Mrs. Lincoln, how did you like the play?" 

Phil McDonnell writes:

One important aspect of this discussion is to look at the required level of stock prices. To this end it is helpful to consider that there is a large store of wealth in the world which must be invested somewhere. Right now Real Estate is in the dog house so people are dis-investing in that area. But bonds and stocks are relatively close substitutes with comparable liquidity.

Thus the required yield on stocks is simply the reciprocal of the P/E ratio. To be competitive stocks must yield something comparable to and competitive with bonds. But bonds yields are remarkably low now largely through Fed intervention. So stock P/E ratios can go quite high and still remain competitive with the historically low yield of bonds.

Alston Mabry comments:

Perhaps Dr Siegel's thesis will be supported by a new paradigm that dispenses with the connection between "American" and "securities", i.e., is Coca-Cola really just an "American" stock? Or Exxon-Mobil? Or Microsoft? Or many smaller US-based companies whose business is actually global in scope? Or think about the large foreign companies that are a big part of daily trading volume here and also part of most/all retirement accounts. Increasingly, it may be that boomers are selling their holdings into a more and more homogeous global market.

from the WSJ article:

"They say they've been chewing over the issue during vacations together at the New Jersey shore."

One shudders to think of the reality-tv-show possibilities….

Rocky Humbert comments:

An alternative way to look at this issue is to consider whether one's ownership of equities is an investment based on an assessment of future earnings and dividends — or a speculation based on a greater-fool theory.

To quote Keynes: "Most of these [professional investors and speculators] are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the public. They are concerned, not with what an investment is really worth to a man who buys it "for keeps," but with what the market will value it at, under the influence of mass psychology, three months or a year hence." Source: Keynes "General Theory," Harcourt,Brace & World 1965 ed. pg 155

This quote is reminiscent to statements made by a certain gentleman from Omaha, whose company has now outperformed the S&P-500 for the past 1, 3, 5, 10, 20 years…

Stefan Jovanovich adds:

The gentleman from Omaha has an easy standard of comparison. If you apply the average tax rate of the S&P companies to Berkshire's past 20 years' earnings, the company's book value drops by roughly 1/3rd. Never mind being a specialist in a bull market; in my next life I want to come back as the owner of an insurance company who is on a first-name basis with the Secretary of the Treasury.

I hate to trash what was once part of Dad's backlist, but Keynes' presumption about what is in the minds of investors and speculators is the truth only because it is theory that has won the academic beauty contest. It has been the most fashionable theory going since neo-Marxism trumped all else (note the reference to "mass psychology"), but it no more likely to be the truth than any other guess about something that is unknown and unknowable.

"The man of system is apt to be very wise to his own conceit. He seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board." - Adam Smith

Tyler McClellan writes:

I don't understand the relevance of any of the above. There are complicated ways in which falling stock prices affect on economic growth and even more complicated steps through which this transmission affects corporate profits.

But surely other than these effects, we don't care about the price of the capital stock. We care about the return to the capital stock at the given price of transfer. If the profits don't decline, so what if the old transfer the assets to the young at 12x or 15x, excepting of course the old.

Considering the IRR of social security has gone from high 30s for the first generation to slightly negative in mine, I can assure you that we need not worry about the "misfortune of the old". Social security is a flippant example, but the fact is empirically undeniable, the current generation of old people have benefitted from the most massive transfer of wealth to them from the young the world has ever seen. The baby boomers will do materially better than breaking even at current projections (driven almost completely by medicare), and the next generation will do substantially worse.

Its astounding to me that we allow the "old" to impart their wisdom to the "young". Now of course the young will benefit in the non-taxed sectors. If no one in Westchester's children can afford their parents houses, then in aggregate the houses must go down in price. This is a benefit to the children, just as lower stock prices with the same future earnings are a benefit to the young.

I call this the Grand Bargain, either we eliminate the entitlements and the asset prices can stay high, or we pay the entitlements and the asset prices fall. I'm not sure which is preferable.

I am basically a doctrinaire Keynesian, although I'm not sure what analytic work such a concept does or does not perform.

I would simply say that the process you outlined in the below is actually quite different than where you began. You seem to argue on the one hand that the businesses wont reinvest because they don't have any cash flow and then in the second that they wont reinvest the surplus cash flow because they are not confident in future X, Y, or Z.

As you can see those are mutually incompatible facts. Keynes believed that because changing expectations of the future largely effect plans reliant on the far future (such as investment), that in times of panic one should create investment to make use of the excess demanded savings, specifically when the excess of demanded savings was sufficient to make lower interest rates incapable of increasing the demand to invest sufficiently to absorb this excess savings.

Expectations of the future are a source of current period aggregate demand. Changing expectations of the future where everyone wants to invest less than he wants to save (which by the way savings is a flow of income as you correctly identify further down in you argument), can only be accomplished by destroying enough income such that the savings is not actually produced. There cannot be more savings than investment. There is no way to store money, there is no flow of savings that is not spent. That is to say, all savings is spent, just some of it is spent on investment.

I suspect you agree with the above and simply doubt that the way to get people to demand greater investment is to do it for them, and that rather we should provide future tax clarity, lower regulation, jump through hoops… fine, and I don't particularly disagree, but you will see that the fundamental insight remains. With no demand to invest, we cannot fulfill the demand to save. Period, end of story.


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