Paul Krugman has a nice column today warning us that the recent record highs in the stock market indices don’t mean that happy days are here again. While I agree with much of what he says, I don’t agree with all of it, so let me try to sort out what I think is right and what I think may not be right.
Like most economists, I don’t usually have much to say about stocks. Stocks are even more susceptible than other markets to popular delusions and the madness of crowds, and stock prices generally have a lot less to do with the state of the economy or its future prospects than many people believe.
I think that’s generally right. The efficient market hypothesis (EMH) is at best misleading in positing that market prices are determined by solid fundamentals. What does it mean for fundamentals to be solid? It means that the fundamentals remain what they are independent of what people think they are. But if fundamentals themselves depend on opinions, the idea that values are determined by fundamentals is a snare and a delusion. So the fundamental idea on which the EMH is premised that there are fundamentals is itself fundamentally wrong. Fundamentals are no more than conjectures and psychologically flimsy perceptions, and individual perceptions are themselves very much influenced by how other people perceive the world and their perceptions. That’s why fads are contagious and bubbles can arise. But because fundamentals are nothing but opinions, expectations can be self-fulfilling. So it is possible for some ex ante bubbles to wind up being justified ex post, but only because expectations can be self-fulfilling.
Still, we shouldn’t completely ignore stock prices. The fact that the major averages have lately been hitting new highs — the Dow has risen 177 percent from its low point in March 2009 — is newsworthy and noteworthy. What are those Wall Street indexes telling us?
Stock prices are in fact governed by expectations, but expectations may or may not be rational, where a rational expectation is an expectation that could actually be realized in some possible state of the world.
The answer, I’d suggest, isn’t entirely positive. In fact, in some ways the stock market’s gains reflect economic weaknesses, not strengths. And understanding how that works may help us make sense of the troubling state our economy is in. . . .
The truth . . . is that there are three big points of slippage between stock prices and the success of the economy in general. First, stock prices reflect profits, not overall incomes. Second, they also reflect the availability of other investment opportunities — or the lack thereof. Finally, the relationship between stock prices and real investment that expands the economy’s capacity has gotten very tenuous.
To put this into the slightly different language of basic financial theory, stock prices reflect the expected future cash flows from owning shares of publicly traded corporations. So stock prices reflect the net value of the tangible and intangible capital assets of these corporations. The public valuations of those assets reflected in stock prices reflect expectations about the future income streams associated with those assets, but those expected future income streams must be discounted so that they can be expressed as a present value. The rate at which future income streams are discounted into the present represents what Krugman calls “the availability of other investment opportunities.” If lots of good investment opportunities are available, then future income streams will be discounted at a higher rate than if there aren’t so many good investment opportunities. In theory the discount rate at which future income streams are discounted would reflect the rate of return corresponding to the marginal investment opportunities that are on the verge of being adopted or abandoned, because they just break even. What Krugman means by the tenuous relationship between stock prices and real investment that expands the economy’ capacity will have to be considered below.
Krugman maintains that, over the past two decades, even though the economy as a whole has not done all that well, stock prices have increased a lot, because the share of capital in total GDP has increased at the expense of labor. He also points out that the low — even negative — real interest rates on government bonds are indicative of the poor opportunities now available (at the margin) to investors.
And these days those options [“for converting money today into income tomorrow”] are pretty poor, with interest rates on long-term government bonds not only very low by historical standards but zero or negative once you adjust for inflation. So investors are willing to pay a lot for future income, hence high stock prices for any given level of profits.
Two points should be noted here. First, scare talk about low interest rates causing bubbles because investors search for yield is nonsense. Even in a fundamentalist EMH universe, a deterioration of marginal investment opportunities causing a drop in the real interest rate will, for given expectations of future income streams, imply that the present value of the assets generating those streams would rise. Rising asset prices in such circumstances are totally rational, which is exactly what bubbles are not. Second, the low interest rates on long-term government bonds are not the cause of poor investment opportunities but the result of poor investment opportunities. Krugman certainly understands that, but many of his readers might not.
But why are long-term interest rates so low? As I argued in my last column, the answer is basically weakness in investment spending, despite low short-term interest rates, which suggests that those rates will have to stay low for a long time.
Again, this seems inexactly worded. Weakness in investment spending is a symptom not a cause, so we are back to where we started from. At the margin, there are no attractive investment opportunities. The mystery deepens:
This may seem, however, to present a paradox. If the private sector doesn’t see itself as having a lot of good investment opportunities, how can profits be so high? The answer, I’d suggest, is that these days profits often seem to bear little relationship to investment in new capacity. Instead, profits come from some kind of market power — brand position, the advantages of an established network, or good old-fashioned monopoly. And companies making profits from such power can simultaneously have high stock prices and little reason to spend.
Why do profits bear only a weak relationship to investment in new capacity? Krugman suggests that the cause is that rising profits are due to the exercise of market power, firms increasing profits not by increasing output, but by restricting output to raise prices (not necessarily in absolute terms but relative to costs). This is a kind of microeconomic explanation of a macroeconomic phenomenon, which does not necessarily make it wrong, but it is a somewhat anomalous argument for a Keynesian. Be that as it may, to be credible such an argument must explain how the share of corporate profits in total income has been able to grow steadily for nearly twenty years. What would account for a steady economy-wide increase in the market power of corporations lasting for two decades?
Consider the fact that the three most valuable companies in America are Apple, Google and Microsoft. None of the three spends large sums on bricks and mortar. In fact, all three are sitting on huge reserves of cash. When interest rates go down, they don’t have much incentive to spend more on expanding their businesses; they just keep raking in earnings, and the public becomes willing to pay more for a piece of those earnings.
Krugman’s example suggests that the continuing increase in market power, if that is what has been happening, has been structural. By structural I mean that much of the growth in the economy over the past two decades has been in sectors characterized by strong network effects or aggressive enforcement of intellectual property rights. Network effects and strong intellectual property rights tend to create, enhance, and entrench market power, supporting very large gaps between prices and variable costs, which is the standard metric for identifying exercises of market power. The nature of what these companies offer consumers is such that their marginal cost of production is very low, so that reducing price and expanding output would not require a substantial increase in their demand for inputs (at least compared to other industries with higher marginal costs), but would cause a big loss of profit.
But I would suggest looking at the problem from a different perspective, using the distinction between two kinds of capital investment proposed by Ralph Hawtrey. One kind of investment is capital deepening, which involves an increase in the capital intensity of production, the idea being to reduce the cost of production by installing new or better equipment to economize on other inputs (usually labor); the other kind of investment is capital widening, which involves an increase in the scale of output but not in capital intensity, for example building a new plant or expanding an existing one. Capital deepening tends to reduce the demand for labor while capital widening tends to increase it.
More of the investment now being undertaken may be of the capital-deepening sort than has been true historically. Aside from the structural shifts mentioned above, the reduction in capital-widening investment may be the result of declining optimism by businesses in their projections about future demand for their products, making capital-widening investments seem less profitable. For the economy as a whole, a decline in optimism about future demand may turn out to be self-fulfilling. Thus, an increasing share of total investment has become capital-deepening and a declining share capital-widening. But for the economy as a whole, this self-fulfilling pessimism implies that total investment declines. The question is whether monetary (or fiscal) policy could now do anything to increase expectations of future demand sufficiently to induce an self-fulfilling increase in optimism and in capital-widening investment.
Uneasy Money 
Or simply, gross profits can be high while marginal profits can be zero or even negative, when new investments would only serve to lower existing profits. New investment is never based on past profitability but anticipation of future profits.
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“………… where a rational expectation is an expectation that could actually be realized in some possible state of the world.”
So who is to know when this pertains? It is impossible to know. So what’s the point of speculating about why financial markets have attained a particular level at a a particular time. Back in January the market was at a low – it breached a September 2015 low – was it presaging the end of civilization? Well, we’re still here and we have a new high in the DJ – the DJ having breached a string of highs in the made in the last 12 months or so. So what changed? All this only serves as fodder for financial journalists and commentators.
At any point in time there is a broad spectrum of opinion (expectations), in fact there is even contrary opinion – if this was not the case there would only be buyers or sellers. Expectations are not monolithic.
Arguments about expectations can only end up being circular.
And why drag in Hawtrey? Has the balance of capital widening to capital deepening investment changed suddenly since January?
Financial markets go up and they go down – regularly – even by the second.
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I like your critique of EMH, but I think in practice the dismissal of stocks as a leading indicator is overblown, especially by Krugman here. Here is a post with a graph of the second derivative of total stock market returns and weekly earnings, which seems to have a pretty regular relationship, with a slight lag on weekly earnings. This sort of dismissal leads policy makers to ignore one of our best leading indicators of economic trends.
http://idiosyncraticwhisk.blogspot.com/2015/08/we-are-100.html
Also, domestic operating profits are quite level as a proportion of national income over time. There just isn’t any modern precedent for claiming that corporate+proprietor income will move outside of a very narrow range. Here’s a post with a graph on that. To top it off, I think his link goes to a measure of total corporate profit, not domestic profit, so he’s mixing denominators. He’s just wrong on this point. Profits are back up to where they were in the 50s and 60s because leverage was low then, too.
http://idiosyncraticwhisk.blogspot.com/2016/06/housing-part-157-we-cant-win.html
The reason corporate profits are high is mainly because corporations have massively deleveraged, relative to market value, so income is going to equity instead of debt, which goes with what you are saying about the relationship between interest rates, risk taking, and leverage. Firms aren’t leveraging up on cheap debt.
Further, US firms get an increasing amount of revenue from foreign operations. That affects corporate earnings and values in a way that has little to do with domestic economic politics. There is a significant trade of capital where foreign savers push capital into US fixed income and US corporations earn high profits on foreign investments. This is a huge factor that has to be accounted for when talking about domestic incomes.
I’d add one additional factor that affects perceptions. The shift of the return of capital from dividends to stock buybacks causes an upward drift in stock indexes like the S&P500 and Dow Jones index of about 2% per year. This adds up to a lot over time. And, for someone comparing market peaks or comparing stock indexes over time to GDP growth, can greatly distort perception. The return of capital (income) has ranged around 5% per year for a loooong time. As an income source, this overwhelms shifts in real stock prices. Some of this happens to be accounted for as capital gains today, because of buybacks, but its the same old return of capital.
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Well done.
I was surprised there was no mention of stagnant wages. As a kid, I remember business magazines reporting growth in regional income, so I learned that businesses chase paychecks. When the paychecks stop growing, all that is left is arbitrage and zero sum gaming. That’s my mishegas.
Having read this, I dug up one of my favorite articles on “rational expectations”:
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“But I would suggest looking at the problem from a different perspective, using the distinction between two kinds of capital investment …”
The book value of Apple’s equity (which is a measure of Apple’s net investment) is roughly $ 120 billion.
It’s current market value is roughly $ 540 billion.
How would you interpret the difference?
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It’s a bit muddier than the numbers I indicated above.
E.g.
Apple’s “fixed investments” are only about $ 25 billion, plus some inventory assets. A lot of financial assets as opposed to “real” investment otherwise.
But the general question remains – about how you would interpret the bulk of the market capitalization compared to the stock of much lower accumulated real investment on the balance sheet.
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Underlying this may be a resource constraint, but to see this in a monetized economy you have to distinguish between investments that produce a stream of monetary earnings and those that merely increase human welfare. A lot of the “investment” of the last three decades has been in monetizing public assets (schools, universities, parks, parking meters, government expertise in IT). Why? Because the comparable money-earning investments are not there. The US has a major need to invest in infrastructure repair and climate change mitigation, but these do not earn money. So money concentrates on the smaller pool of remaining earning opportunities.
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Well nice post but…why low investment? Dudes there are glutes in everything from steel to autos to commodities to potash to clothes to tech gadgetry. Why invest?
Name one industry anywhere straining to meet demand.
Demand? Did someone say demand?
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Stock prices, profit, and other self-fulfilling idiocies
Comment on David Glasner on ‘Stock Prices, the Economy and Self-Fulfilling Prophecies’
You quote Paul Krugman saying:* “The truth . . . is that there are three big points of slippage between stock prices and the success of the economy in general. First, stock prices reflect profits, not overall incomes. “
And, elaborating this point: “This may seem, however, to present a paradox. If the private sector doesn’t see itself as having a lot of good investment opportunities, how can profits be so high? The answer, I’d suggest, is that these days profits often seem to bear little relationship to investment in new capacity. Instead, profits come from some kind of market power — brand position, the advantages of an established network, or good old-fashioned monopoly.”
Obviously, economists do not really understand what profit is and where it ultimately comes from. As the Palgrave Dictionary summarizes: “A satisfactory theory of profits is still elusive.” (Desai, 2008, p. 10). Or, as Mirowski put it “… one of the most convoluted and muddled areas in economic theory: the theory of profit.” (1986, p. 234)
So, in effect Krugman, Glasner and the blogging rest tries to explain stock market valuation as a reflection of profit expectations without having any idea of what profit is. What the general public cannot see is that this abysmal scientific blunder is all-pervasive and that the representative economist does not understand the pivotal phenomenon of his subject matter.
Alone for this reason, the whole discussion about stock market valuation and efficient markets is vacuous. The root cause of why the profit theory is false lies in the fallacy of composition, that is, economists take propositions which are true for a single firm and generalize them for the economy as a whole (2013).
The correct profit theory follows from the analysis of the pure consumption economy which is the most elementary case (2011). From this analysis follows:
― The business sector’s revenues can only be greater than costs if, in the simplest of all possible cases, consumption expenditures are greater than wage income.
― Overall profit does neither depend upon the agents’ personal qualities, motives, their ideas about what profit is, nor on profit maximizing behavior. Overall monetary profit is NOT explainable by subjective factors but is OBJECTIVELY given by the Profit Law which can be tested in principle by summing up what is in the cash boxes or on the bank accounts.
― In order that profit comes into existence for the first time in the pure consumption economy the household sector must run a deficit at least in one period. This presupposes the existence of a credit creating entity.
― Profit is, in the simplest case, determined by the increase and decrease of household sector’s debt. There is a close relation between profit/loss and the expansion/contraction of credit for the economy as a whole.
― Wage income is the factor remuneration of labor input. Profit is NOT a factor income. Since capital is nonexistent in the pure consumption economy profit is not functionally attributable to capital.
― There is NO relation at all between profit, capital, marginal or average productivity.
― Profit has no real counterpart in the form of a piece of the output cake. Profit has a monetary counterpart. In a real exchange economy profit does not exist.
― The existence and magnitude of overall profit does not depend on the ownership of the firms that comprise the business sector. The Profit Law holds for a capitalist and communist economy alike.
― The value of output is, in the general case, different from the sum of factor incomes. This is the defining property of the monetary economy.
― Profit is a factor-independent residual and qualitatively different from wage income. Therefore, it is an elementary mistake to maintain that total income is the sum of wages and profits.
― There is NO antagonism between total wages and total profits, and the distribution of consumption good output has nothing at all to do with profit.
― Innovation and efficiency are IRRELEVANT for the profit of the business sector as a WHOLE. It is a logical mistake to trivially generalize what can be observed in an individual firm. The same holds for monopoly power. These factor affect the DISTRIBUTION of profit among firms but NOT the overall volume.
All this follows from the elementary case of the pure consumption economy. The Profit Law for the investment economy reads: Qm =Yd+I-Sm (2014, p. 8, eq. (18)). Legend: Qm: monetary profit, Yd distributed profit, Sm: monetary saving, I investment expenditure. The Profit Law gets a bit more complex when foreign trade and government is included.
In the last decades overall (= world) profit has been driven by the growth in Asia (= high I), by dissaving, i.e. the growth of private debt mainly in the USA, by the growth of public debt worldwide, and by high profit distribution mainly in the USA. Overall profit has been distributed between the countries via export surpluses/deficits.
Roughly speaking, as accumulation (= I) slows down in China/Asia and the developing regions overall world-profit goes down, then overall profit distribution goes down, then again profit goes down, then investment goes down again, and so on. Rising unemployment and falling wages ACCELERATE the downward spiral (2015). The market economy is NOT self-correcting.
Does this matter for stock valution? Not much, as long as the central banks stand ready to stabilize the stock markets. This is what the market participants have observed in the past and expect for the future, independent of the performance of the real economy. This is where the disconnect of overall profit and overall stock market valuation comes from.
Egmont Kakarot-Handtke
References
Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume
(Eds.), The New Palgrave Dictionary of Economics Online, pages 1–11. Palgrave Macmillan, 2nd edition. URL http://www.dictionaryofeconomics.com/article?id=pde2008_P000213
Kakarot-Handtke, E. (2011). The Emergence of Profit and Interest in the Monetary Circuit. SSRN Working Paper Series, 1973952: 1–22. URL http://ssrn.com/abstract=1973952.
Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL http://ssrn.com/abstract=2207598.
Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792.
Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2624350.
Mirowski, P. (1986). Mathematical Formalism and Economic Explanation. In
P. Mirowski (Ed.), The Reconstruction of Economic Theory, pages 179–240. Boston, MA, Dordrecht, Lancaster: Kluwer-Nijhoff.
* See ‘Bull Market Blues’ http://www.nytimes.com/2016/07/15/opinion/
bull-market-blues.html?action=click&pgtype=Homepage&clickSource=
story-heading&module=opinion-c-col-right-region®ion=opinion-c-col-right-region&WT.
nav=opinion-c-col-right-region&_r=0
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“…scare talk about low interest rates causing bubbles because investors search for yield is nonsense. ”
No-one has mentioned crazy QE. QE was designed to kick start the real economy. All it did was push up prices of fixed interest assets which then had money move into equities and property. Investors did chase yield, driving up equity prices, to the point where balance sheet book values far exceed market values – not an unusual situation anyway, but now more extreme given the big push into equities.
The question is what will happen to equity markets when interest rates begin to rise? Presumably they will begin to rise once the economy is buoyant and performing strongly and inflation clearly a problem again. How equity markets perform will depend on the balance between interest rises and increases in corporate earnings.
There’s an old Street saw to the effect that bull markets climb a wall of worry.
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There is a perfectly rational explanation for stock prices increasing after a long period of stagnation. Money supply growth, which had been falling since January 14, has been rising since February 2016.
See the graph on http://www.philipji.com/item/2016-07-09/the-fall-in-us-money-growth-reverses-after-two-years
The reason, I suspect, is that negative interest rates in Europe and Japan has led to greater interest in US assets, As long as the Fed does not neutralise money inflows by selling bonds, the trend is likely to continue.
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David,
“To put this into the slightly different language of basic financial theory, stock prices reflect the expected future cash flows from owning shares of publicly traded corporations. So stock prices reflect the net value of the tangible and intangible capital assets of these corporations.”
That is incorrect. The market value for the total liabilities (equity and debt) of a company reflect the expected future cash flows from owning the debt and equity of publicly traded companies.
In a low interest rate environment what is left unexplained by the efficient market hypothesis is why the equity market capitalization for publicly traded companies continues to expand.
It’s one thing to say that returns on equity are inversely proportional to the risk free rate of return – a lower risk free rate means people will pay more for an existing quantity of stocks (higher prices).
It’s quite another to say that companies will issue (sell more) stocks in a low interest rate environment.
If equity is more expensive for a company to issue than debt, then why hasn’t the market capitalization for the Dow and SP500 collapsed even as stock prices have risen?
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Lord, You are describing the situation, the challenge is to explain it.
Henry, Grumpy as ever. Stock prices are a reflection of expectations, so you can’t talk about how stock prices are changing without relating them somehow to expectations. Expectations are just that, expectations, not fundamentals, so I don’t see what you are complaining about. Hawtrey was not mentioned (certainly not dragged) to explain why stock prices are changing, but to explain why historically high stock prices are not generating a wave of new investment.
Kevin, I wouldn’t dismiss stock prices as a leading indicator. In fact my paper on the Fisher Effect under Deflationary Expectations was an attempt to show that stock prices were a leading indicator, though certainly an imperfect one. Your point about buy-backs seems very well taken, but it’s also a reflection of the lack of investment opportunities. If corporations thought that they could invest free capital more profitably than they going market rate of return they would be using those funds internally rather than giving it back to stockholders.
Kaleberg, Thanks. I think it’s hard to make sense of stagnant wages, because there has been a lot of turnover and job switching in the labor market over the past few years, making meaningful comparisons of wages over time very difficult.
JKH, I would say the difference reflects the market’s capitalization of Apple’s market power and the market’s confidence that Apple will continue to introduce profitable new products.
Peter, The infrastructure investments you are talking about are only indirectly reflected in share prices. My ownership of some company’s stock does not give me a claim on any public infrastructure, but that infrastructure may well affect the profitability of a particular company.
Benjamin, Thanks, I see your point, I think. I thought I was making a similar one.
Egmont, Thanks for sharing.
Henry, Actually, interest rates have been falling since QE stopped.
Phillip, Well, according to you, shouldn’t stock prices elsewhere have been falling as US stock prices rose?
Frank, We seem to be working with different definitions.
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“Henry, Grumpy as ever.”
Yep. I am grumpy, therefore I am.
” Expectations are just that, expectations, not fundamentals, so I don’t see what you are complaining about”
You’re not complaining about my complaining are you?
The point I was trying to make, not very successfully it appears, was that while expectations matter, the state of the markets are not necessarily an indication of where they lie or where they’re about to go. Expectations are volatile, markets are volatile – wait five minutes and markets are heading in a different direction. I can’t see the point about making a fuss about a particular level at which the market has attained. The most significant thing for me is that the Dow has breached a string of highs going back twelve months – technically interesting.
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Henry, I don’t think that we can explain all fluctuations in the stock market. But I do think, and I have done some empirical work that seems to support my thinking, that prices and asset prices, under certain conditions, are positively correlated with inflation expectations. Other researchers have found that stock prices are positively correlated with consumer confidence (though the causation might run in either direction). So there may be situations in which rising or falling stock prices can be explained by deeper factors or convey information about general economic conditions. I don’t think that that is such an outlandish claim.
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