The Stock Market

Dear Clive,

       You misrepresent my case and then claim that I make mistakes that I don’t. Let’s go through your two points one at a time:
       1) You say that I overstate earnings growth (and dividend growth) by looking only at aggregate numbers, rather than per-share numbers. This is flat wrong. The 5 percent real growth I cited last time is for earnings per share, accounting fully for dilutions. This sharp growth in earnings (well ahead of gross domestic product growth) may be something of a puzzle, but it is a fact.
       2) You say that I claim that earnings are the appropriate measure of “cash flow” for the annuity calculation made by my colleague Kevin Hassett, a former Federal Reserve senior economist, and me. In fact, I never made such a claim. I said that dividends are probably a lower bound for cash flow to investors and that official earnings are probably an upper bound.
       You seem to think that dividends are the “correct” measure, but clearly that can’t be right. Microsoft pays no dividends. Do you really believe that Microsoft needs to invest all its cash flow in the business in order to maintain a static level of profits? By reinvesting in the business, Microsoft raises its profits and the price of its stock, to the benefit of shareholders–who will cash in when Microsoft is acquired, when it decides at last to issue dividends, or when the shareholders sell.
       But let’s accept your definition of cash flow as dividends only. Let me now go through my argument again, in a way that should show any sober person that the market is not overvalued:
       Real dividends alone have grown–on a per-share basis–much faster than the economy as a whole for many years (real earnings have grown even faster, but forget that). Consider, just as one example, General Electric Co., the largest-capitalization stock in America. Its dividends have been rising over the past five years at a real rate of more than 9 percent.
       Now, let’s assume that real dividends will grow at less than half their recent rate–at 2.1 percent (which is our assumption for GDP growth). Assume that inflation is 2.8 percent. Then the yield that would equalize the cash flow between stocks (dividends only) and bonds would be 1 percent.
       Currently, the yield on the Standard & Poor’s 500 Stock Index is 1.43 percent; on the Dow, 1.64 percent. When you adjust for stock repurchases, the yield for the broad market is about 2 percent. Thus, to equalize the present value between expected dividend payments to stockholders and expected interest payments to bondholders, the market should be roughly 50 percent to 100 percent higher. Using the outer bound (reported earnings), the market should be 300 percent higher, as I explained in my last message.
       Are we really in a bubble economy, as your cover story put it, with a bubble stock market?
       As for the economy, you think it’s running on hot dollars from the Fed. That’s nonsense. In fact, the most likely Federal Reserve move from here is down (after all, T bills are paying a real return of 3.7 percent!).
       As for the stock market: A bubble exists when valuations are not supported by rational expectations. Over the long term, I consider fully rational: a) a risk premium of zero; b) real profit growth of 2.1 percent and inflation of 2.8 percent; and c) interest rates roughly where they are today or a little higher.
       More cautious than you, I would be willing to call something a bubble only if reasonable present-value calculations based on parameters like the ones above could not produce a market value in the range of the current one. I have heard no sensible case that contradicts our parameters.
       Now, what bubble did you have in mind?