Arnold Kling

Are Stocks a Bargain?

Arnold Kling, Great Questions of Economics
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In the Wall Street Journal, Arthur Laffer looks at interest rates, profits, and stock prices, and concludes that stocks are a bargain.

For those who like price/earnings ratios, the conclusion is simply that stock prices are uncommonly low when compared to bond prices and properly reported corporate profits. The price of a bond in relation to its coupon is not only the inverse of that bond's yield, but is itself a price/earnings ratio. When yields on bonds fall, price/earnings ratios should rise. Given what's happened to interest rates, price/earnings ratios should also rise. But as of today, stock prices have not only not risen, they have fallen way out of line with corporate profits and the current level of interest rates.

This formula is erroneous, as was pointed out by Franco Modigliani and Richard Cohn in 1982. The ratio of profits to stock prices is a real (inflation-adjusted) magnitude. The 10-year interest rate is a nominal (unadjusted) magnitude. If we subtract expected inflation from the interest rate, we adjust the "fair market value" of stock prices higher at all times. However, the adjustment is of a larger magnitude historically than it is today.

Here is another way to get historical perspective on the stock market. Simply compare the ratio of the S&P 500 stock index to nominal Gross Domestic Product.

YearGross Domestic Product
($ billions)
S&P 500 Stock IndexRatio

For today's figures, I used first quarter GDP and the S&P 500 as of about 3:30 PM this afternoon. The ratio is below what it was in 1960, but still higher than what it was from 1970 - 1990.

The ratio of earnings to prices for the stock market today is less than 4 percent. The real rate of interest on Treasury inflation-indexed bonds is about 3.5 percent. So there is no overwhelming evidence that stocks are a screaming buy. Nonetheless, I think that there is a case to be made for a scenario in which the U.S. economy grows unusually rapidly over the next decade--Brad DeLong makes that case well. If so, then the stocks should do well. In the last couple of weeks, I have begun to shift out of bonds and into stocks. Since the end of 1996, I had been moving in the opposite direction.

Discussion Question. Does the drop in the value of the dollar suggest that it is overseas investors who are pulling out of U.S. stocks?

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