The Free Market 19, no. 7 (July 2001)
As the nation’s equity markets crumbled, the question that inevitably arose was “When will stock prices stop falling?” And there was always some willing economist, journalist, politician, or other self-appointed pundit ready to take the bait.
Jeremy Siegel is one such prominent economist. Siegel is famous among stock market followers for his best-selling book, Stocks for the Long Run, which has run several editions. The book tracks equity returns going all the way back to 1802. The general premise is that stocks are the best long-term investments one can make.
In a piece that appeared in Knowledge@Wharton, titled “When will stock prices stop falling?” Siegel argued that the historical twentieth-century price-earnings ratio of the average stock in the S&P 500 was outdated and no longer valid. The historical average is about 15 compared with the current average of about 24 (well below the April 1999 peak of 36).
Siegel noted that the century-long average of 15 included such events as the Great Depression, other prolonged recessions, periods of world war, double-digit inflation, and high interest rates. As a result, Siegel makes this stunning conclusion: “You have to take out some of these real bad events. I don’t think they’re going to happen again, because we know how to avoid those.”
Granting for the moment that such long_run historical averages are even relevant, the whole point of using an average is to have some measure of central tendency and compensate for the dispersion of data. If Siegel wants to eliminate all the bad events of the century, then perhaps we should also take out some of the really good periods too, like the run-up of the 1920s that took us to the 1929 peak. Maybe we should also eliminate the bull market of the 1950s and `60s. Maybe we should also eliminate the greatest of all bull markets, the run-up in stock prices during the 1990s.
The article also points to a number of factors that should permanently change the way stocks are valued. There is the rise of mutual funds, the reduction in trading costs, and the “improved control of the economy” that will result in lower interest rates than in years gone by. These factors and others have resulted in a lower risk premium, Siegel contends, “that should permanently raise the price-earnings ratio on stocks.”
Such “new era” thinking is symptomatic during long periods of apparent prosperity. Robert Shiller, in his book, Irrational Exuberance, documents similar thinking that permeated the bull markets of the 1920s and 1950s.
The 1920s were also a time of widespread dissemination of technological innovations. The automobile was just coming into mainstream use. In 1914, there were 1.7 million registered automobiles. By 1920, there were over 8 million, and by 1929, there were over 23 million.
There was also the development of radio. In 1920, there were only three radio stations the US. By 1923, there were more than 500. Other innovations included the electrification of US households, leading to more consumer product innovations such as the vacuum cleaner.
Optimism and confidence were high, so much so that even well-respected economist Irving Fisher got caught up in the fervor when he proclaimed on the eve of the crash that stocks had reached a permanently high plateau. And yet, all of these new things and all of the confidence did not prevent the crash of 1929 and the Great Depression that followed.
In the 1950s, Shiller notes that the widespread adoption of the television set fueled so-called “new era” thinking. In 1940, only 3 percent of US families had TVs. By 1955, over 75 percent did. During this time and during the 1960s, there was also great confidence in Fed policy and the long-range planning abilities of business.
Another factor cited as contributing to the prosperity was the Baby Boom, since it was thought that this drove spending, which in turn kept the economy humming. And yet, the boom would eventually end in the severe recession of 1973-74.
Given such historical (albeit anecdotal) evidence, the economist should have no conceit in predicting the long-lasting effects of innovations propagated during the 1990s boom.
The obvious truth, seemingly often forgotten, is that no one knows when, say, the NASDAQ or the Dow will hit bottom. The equity markets price things that are inherently qualitative and that rely on predictions about the future. The resultant prices are the products of opinions. They are therefore subject to a wide range of possible values.
Or, as the great Benjamin Graham has stated: “There is room for a wide difference of informed opinion as to the proper value for a single stock or group of stocks at any time.” In addition to this factor, there is the influence of monetary policy. The Fed, the GSEs, the banks, government guarantees, and other credit enhancements-all work to inflate the money supply and set in motion the boom-bust phenomenon.
This is not to say that we can’t make reasonable value judgments -based on history, based on essential things we know, based on our own individual preferences-about whether the price of a particular stock is too rich. It is only to admit that the process of valuation is, as Mises wrote, “personal, subjective and final.” Mises noted that judgments of value are “mental acts that determine the content of a choice.” This notion of choice is important, because it leads us to question the valuation of anything that a human being cannot act on.
In Theory and History, Mises wrote: “A judgment of value is purely academic if it does not impel the man who utters it to any action. There are judgments which must remain academic because it is beyond the power of the individual to embark upon any action directed by them. . . . The significance of value judgments consists precisely in the fact that they are the springs of human action.”
Taking Mises’s definition, it seems reasonable to question whether one can even value the stock market as a whole and whether such a value would have any meaning. Individuals do not buy the market, nor could they buy the whole market. They buy and sell individual stocks. They can buy index funds, which mimic the behavior of the market, but the dollar value of these funds is still small compared to the dollars invested in equity markets as a whole. No one “buys” the market in any conventional sense.
This attempting to aggregate the market value of the stock market is similar to the error macroeconomists have long made in devising ways to measure the value of national income or other macro measurements.
As Murray Rothbard wrote, this represented “a reversion to the classic economic fallacy of dealing with the whole supply of a good as if it were relevant to individual action.” You cannot just sum up the prices of all the houses in America, for example, and say they are worth x. This figure has no meaning. No one can buy or sell the entire housing market. People can buy and sell individual homes or groups of homes.
Besides this point, the real shocker is Siegel’s contention that the really bad events are not going to happen again because “we know how to avoid those.”
Here we ask the fundamental question, as Murray Rothbard did years ago, and that is: how do we explain the cluster of errors that cause an entire economy to go into the tank? In America’s Great Depression, Rothbard critiqued a variety of explanations for the business cycle. His conclusion was that the Austrian business cycle as expounded by Ludwig von Mises was the only one that explained the recurrent cluster of errors.
Rothbard wrote: “In a purely free and unhampered market, there will be no cluster of errors, since trained entrepreneurs will not all make errors at the same time. The `boom-bust’ cycle is generated by monetary intervention in the market, specifically bank credit expansion.”
Production in a free market is driven by consumer preferences, and this production takes time. The critical role of interest rates is to allocate resources across time to meet these preferences. In a free market, as borrowers and savers interact, a sort of natural rate is achieved, constantly changing to meet the ever-shifting changes in consumer preferences.
In a hampered economy, where the Fed is tinkering with key interest rates and where there is a lack of sound money (i.e., 100-percent commodity-backed money), resources are not allocated efficiently and there are misallocations that inevitably become evident in the subsequent bust.
Siegel’s comments are not worthy of a professional economist, who should know better and who has otherwise done some fine work in the area of finance. Worse, his comments are irresponsible in that they will lead some people to believe that prosperity is bulletproof. His conclusions mask the underlying complexity of markets and further enhance the reputation of the Federal Reserve as the important pilot of the nation’s economy, despite the fact that institutions such as the Fed are themselves the source of the turbulence.
Christopher P. Mayer is a commercial lender for Provident Bank in the suburbs of Washington, D.C. (cwmayer@ provbank.com).
