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The Flight to Quality: Project Syndicate

Forecasting U.S. Stock Returns


Neil Hume of FT Alphaville directs us to Jim Reid of Deutsche Bank:

A century-long look at the US equity market: If you are a market historian, you have to decide whether the 1900-[to]-end-1994 best fit line was vaguely the correct basis for a long-term trend of equity prices or whether you believe something changed fundamentally in the mid-1990s in a positive manner (earnings?, the economy?, EM?) that permanently elevated the price level of Western equity markets. If you don’t believe that anything really changed from the mid-1990s (maybe only debt levels?) then the Dow at 10,000 still historically looks a bit stretched....

What we would say is that after the 1929 crash, markets took until 1954 to get back to their pre-crash levels. Also after the 1966 peak (Dow 995 in Feb 1966), the Dow only permanently crossed 1000 for the last time on 17th December 1982. So the market hovered around 1000 for nearly 17 years. This is stunning given its a period in which the price level (as determined by CPI) tripled in the US. Given that Western equity markets were approaching their most overvalued point in history when the Dow first traded through 10,000, one would have to bet against history to suggest that we can permanently leave current levels behind anytime soon. Interestingly in a high inflation world the Dow crossed 900 97 times between 1965 and 1982, and crossed 1000 65 times between 1972 and 1982. Since 1999 we haven’t had inflation to ease the adjustment as the overall CPI price level is only a third higher...

Five comments:

  1. Yes, the evidence that the market centers on round numbers for the DJIA (and not for other indices) for generations is strongly suggestive, albeit not fully compelling.

  2. In the early 1990s dividend yields fell substantially as firms began pumping more money out to shareholders via share buy-backs. You would expect that to lift the trend of the DJIA even without any other changes.

  3. The late 1980s-early 1990s were also the period where it became apparent that there had been a shift not just in the post-tax but in the pre-tax distribution of income in the U.S. away from labor and toward capital. You would expect that to lift the trend of the DJIA even without any other changes.

  4. The 1990s were also the period that saw the North Atlantic core lose its effective monopoly over the location of high-value manufacturing. Even without any shifts in the U.S. income distribution, the ability to have your stuff made by low-wage workers in Mumbai or Shenzhen would be likely to lift profits and thus the trend in the DJIA even without any other changes.

  5. It's hard to see there being a large, permanent wedge between average real stock returns on the one hand and average earnings yields on the other. With trend earnings on the DJIA somewhere around 600 and with Treasury rates as low as they are, it's hard to argue that U.S. stocks will be outperformed by other asset classes over any even moderately long horizon.