Page 546 - The Principle of Economics

560 PART NINE THE REAL ECONOMY IN THE LONG RUN
IN THE NEWS
The Stock Market Boom of the 1990s
THE U.S. STOCK MARKET EXPERIENCED A quadrupling of stock prices during the 1990s. The following article tries to ex- plain this remarkable boom. It suggests that people bid up stock prices because they came to view stocks as less risky than they previously thought.
Are Stocks Overvalued? Not a Chance
BY JAMES K. GLASSMAN
AND KEVIN A. HASSETT
The Dow Jones Industrial Average has returned more than 200 percent over
the past five years, and the past three have set an all-time record. So it’s hardly surprising that many observers worry the stock market is overvalued. One of the most popular measures of valuation, the ratio of a stock’s price to its earnings per share, P/E, is close to an all-time high. The P/E of the average stock on the Dow is 22.5, meaning that it costs $22.50 to buy $1 in profits—or, conversely, that an investor’s return (earnings divided by price) is just 4.4 percent, vs. 5.9 percent for long-term Treasury bonds.
Yet Warren Buffett, chairman of Berkshire Hathaway Corp. and the most successful large-scale investor of our time, told shareholders in a March 14 letter that “there is no reason to think of stocks as generally overval- ued” as long as interest rates remain low and businesses continue to oper- ate as profitably as they have in recent years. Investors were buoyed by this statement, even though Mr. Buffett provided no analysis to back up his as- sertion.
Mr. Buffett is right—and we have the numbers and the theory to back him up. Worries about overvaluation, we be- lieve, are based on a serious and wide- spread misunderstanding of the returns and risks associated with equities. We are not so foolish as to predict the short- term course of stocks, but we are not re- luctant to state that, based on modest assumptions about interest rates and profit levels, current P/E levels give us no great concern—nor would levels as much as twice as high.
The fact is that if you hold stocks in- stead of bonds the amount of money flowing into your pockets will be higher over time. Why? Both bonds and stocks provide their owners with a flow of cash over time. For bonds, the arithmetic is simple: If you buy a $10,000 bond paying 6 percent interest today, you’ll receive $600 every year. For equities, the math is more complicated: Assume that a stock currently yields 2 percent, or $2 for each share priced at $100. Say you own 100 shares; total dividend payments are $200—much lower than for bonds.
As a starting point for an analysis of financial markets, we discuss in this sec- tion the key macroeconomic variables that measure activity in these markets. Our emphasis here is not on behavior but on accounting. Accounting refers to how var- ious numbers are defined and added up. A personal accountant might help an in- dividual add up his income and expenses. A national income accountant does the same thing for the economy as a whole. The national income accounts include, in particular, GDP and the many related statistics.
The rules of national income accounting include several important identities. Recall that an identity is an equation that must be true because of the way the vari- ables in the equation are defined. Identities are useful to keep in mind, for they clarify how different variables are related to one another. Here we consider some accounting identities that shed light on the macroeconomic role of financial markets.
SOME IMPORTANT IDENTITIES
Recall that gross domestic product (GDP) is both total income in an economy and the total expenditure on the economy’s output of goods and services. GDP