Why do stock prices rise so persistently over the decades? The bottom line is that over the long run, stock price-to-earnings ratios, and hence their inverse, earnings-to-stock price ratios, have no discernible trend going back to at least 1890. The equity yield peaked in 1949 at 16 percent and ranges between 5 percent and 10 percent for most years.

The reason for this relative historical stability is that these ratios are tied to interest rates that reflect our inbred stable time preference. (Interest rates, after all, in the fifth century B.C. were similar to those of modern times. I know of no other “time series” that has exhibited such stability.) Corporate earnings are tied to gross corporate product, or more generally, GDP. But GDP over the long run can be reasonably proxied by the product of the civilian labor force, productivity, and, since 1933, inflation—all of which have persistently grown. Thus, earnings per share and stock prices rise with nominal GDP. Implicit in these relationships is that common stocks, in addition to being an investment in corporate performance, act as a hedge against inflation as well. Since 1921, for example, nominal stock prices have risen by 6.4 percent annually, the product of a 2.5 percent annual inflation rate (in prices of core personal consumption expenditures) and a 3.8 percent annual rate of increase in inflation-adjusted earnings.

The equity risk premium, calculated as the earnings yield less the yield on long-term government bonds, is a measure of the compensation spread that investors require to hold equity rather than riskless bonds. It is often used to assess the degree of risk perceived in holding equities.

These data recommend an investment strategy of concentrating purchases when equity premiums are in the upper bound of their range (that is, when stocks become “cheap” relative to their earnings and to bonds). Such mechanical trading strategies, if rigorously followed, displace “intuition” or “gut” trading, which demonstrably is biased by fear and hence is rarely as successful as buy and hold. Even experienced investors and/or speculators have difficulty in overcoming our ingrained aversion to risk, which is a far more emotionally gripping propensity than its obverse, euphoria. Panic selling is an integral part of any bear market. But panic buying, excluding short covering, is rarely evident during bull markets. As the data show, the rate of price increase in bull markets tends to be importantly less than the average pace of decline in bear markets.

The degree of fear and euphoria is measured reasonably well by yield spreads, both with respect to credit risks and maturity. The longer the expected life of a prospective investment, the more uncertain the return and hence the greater the rate of discount applied to income from such assets. Disregarding credit risk, that discount rate should reflect the riskless yield of government bonds of the same maturity. And the difference between the yield on thirty five-year Treasury obligation and that on a thirty-year Treasury obligation indicates how severely discounting increases with maturity. (The five-year maturity is long enough to eliminate expected business cycle fluctuations.)

Fear plays an especially dominant role for investors with modest means. The risk-averse small investor confronts the bias of a gambler who has a small stake and knows if he loses it, he is out of business. His appetite for risk taking is limited. It is only when an investor’s stake is large that he, or she, can suffer substantial losses with relative equanimity. In addition, an investor with large accumulated capital has the resources to disregard periodic market crashes, and indeed usually employs such opportunities to build up his or her stock portfolio.

The obvious question is why, granted the longer-term outlook, all investors don’t subscribe to the buy and hold philosophy of stock price investment. After all, “real” stock prices rise over the long run. If we look at a time series of “real” stock prices going back about a century and a half, we see that a buy-and-hold strategy would undoubtedly pay off over the long run.

But the answer is that it goes against human nature to buy and hold because fear is a more dominant force than euphoria. Fear and euphoria are not symmetrical. History demonstrates that human beings are more prone to respond to fear than euphoria. And so investment decisions are driven not entirely by rational behavior, but rather are subject to the forces of human nature.

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Dr. Alan Greenspan

Dr. Alan Greenspan

Alan Greenspan served five terms as chairman of the Board of Governors of the Federal Reserve System from August 11, 1987, when he was first appointed by President Ronald Reagan. His last term ended on January 31, 2006. He was...
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