Economics Reporting Review MAKING SENSE OF THE MARKET'S NOSE DIVE Week of March 10 - March 16 By Dean Baker The stock market plunge was the major economic story of the week, and the newspapers struggled to make sense of it. While some of the reporting provided helpful insights into the thinking of investors, there was a remarkable reluctance to seriously evaluate the evidence of a bubble, and to assess the proper valuation of the market. While no one can say exactly what the proper price for the stock market should be, given a projected path for profit growth, it is fairly easy to set some range of reasonable values. Policy-makers routinely use projections of profit growth in other areas. Most importantly, the budget projections include a forecast of profit growth to provide a basis for projections of corporate income tax receipts. Reporters frequently use these budget projections in their stories, regarding them as serious numbers. This implies that they are using the profit projections from Congressional Budget Office (CBO) that form the basis of a significant portion of the revenue projections. The CBO currently projects that real (inflation adjusted) profits will rise by an average of approximately 1.0 percent annually over the next decade. Since over the long-term stocks cannot consistently rise more rapidly than corporate profits, the CBO profit numbers imply that real stock prices will rise by approximately 1.0 percent annually. The current dividend yield on stocks is approximately 2.0 percent, which implies a total return of 3 percent (1 percent capital gains plus 2 percent dividend yield). Since a completely safe inflation-indexed government bond pays a 3.3 percent real return, unless investors are willing to hold stock that pays them a lower return than a government bond, stocks remain significantly over-valued. The only way for stocks to provide a reasonable premium over government bonds (historically it has been 4.0 percentage points) is for stock prices to fall so that the dividend yield rises. If stock prices fell by 50 percent, then the dividend yield would double from 2.0 to 4.0 percent (the dollar value of dividend payments would not change), restoring some of the historic premium of stocks compared to bonds. This sort of simple analysis was altogether absent from the discussion of the market in the paper this week. In fact, one Washington Post article justified current stock prices by reporting that profits should rise by 10-15 percent annually over the next decade (7-12 percent in real terms). This would imply the largest redistribution from wages to profits that the nation has ever experienced. If it proved true, real wages would be far lower in 2011 than they are today. (From www.tompaine.com) Louis Proyect Marxism mailing list: http://www.marxmail.org
