On Sun, 26 Sep 1999 21:46:12 -0700 hal@finney.org writes:
> My reasoning may not have been quite right, but this new analysis
> does suggest that investors are underestimating future growth
> possibilities. And in a way they are being conservative. They assume
that growth will tail off after 50 years (apparently in order to avoid
deriving my
> result of infinite valuations). If we instead factor in the
possibility
> for tremendous future INCREASES in growth due to the new technologies
we
> often talk about, then even DJIA 36,000 looks small.
>
> I'd like to hear what our more economically sophisticated members
> think of this argument.
>
> Hal
Stocks always compete with other investments which are not stocks, so stocks are valued in comparison with other investments. Any investment, whether it is a stock or something else such as a bond, real estate, a machine, or a collectible item is valued in terms of the expected return of the investment over time. The time horizon varies from one investor to another, but typically it's about 30 years for a so-called 'long-term investor', though that long-term investor may change investments numerous times during the nominal 30 year period.
The concept of 'expected return' is complicated by risk and reward. US Treasury bonds, for example, are thought to have practically no risk of default, so the expected return of those bonds in nominal terms is easy to calculate. But those bonds do carry risk and potential reward from a change in value due to fluctuation in current interest rates and changes in the purchasing power of the dollar.
The expected return of any specific investment cannot be predicted with much certainty, and any such prediction is less certain for the far future than for the near future. That is why mutual funds and other methods of diversified investment are so popular. Consider a zero coupon bond which has a 1% lifetime probablity of complete default which is sold to yield 6% per year compounded annually. Then consider a zero coupon bond which has a 50% lifetime probablity of complete default which is sold to yield 18% per year compounded annually. Mathematically the 18% bond is is the better investment, since its risk-adjusted return is about half again greater than that of the 6% bond. But the 18% bond would only appeal to a gambler, not a conservative investor. But if a mutual fund were to invest in a widely diversified portfolio of such 18% bonds, then investors in the fund would be able to get a 9% compounded annual return with almost perfect safety.
Risk can be considered in two aspects, short-term and long-term. According to commentary I have seen on the 'Dow 36,000' book, the book points out that history shows that a diversified portfolio of stocks is no more risky over the long term than bonds, but that stocks have a much higher return than bonds over the long term. That, I think, is the basis for the claim that stocks are undervalued, even though PE ratios are historically high.
The other argument that stock PEs should be higher than bond price/yield ratios is based on the idea that stock earnings can grow (including because of improved technology), whereas the bonds' earnings are rather limited. The argument is somewhat persuasive, but I think it has 3 flaws. 1) The stocks which investors hold now do not include any of the future stocks which will rise dramatically due to technology advances, 2) a stock which falls to zero is most likely a permanent loss which imposes an ongoing opportunity cost forever, and 3) short term fluctuations are in fact not ignored by the average investor, and have, and will, cause a tendency to shy away from stocks.
Investors' moods are important to prices. When investors are optimistic about stocks, they will bid up prices, and when they are pessimistic about stocks, prices will be depressed. The Dow Jones Industrial Average fell almost 90% from the high in 1929 to the low in 1932. It is hard to imagine how the high levels in 1929 and the low levels in 1932 can be explained by rational analysis.
Ron Kean
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