Re: Dow 36,000

Peter C. McCluskey (pcm@rahul.net)
Fri, 1 Oct 1999 11:58:05 -0700

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. 

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