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http://bnarchives.yorku.ca/262/02/20...risis_3_ds.htm
This is a potentially major point: If confidence in the system is replaced by fear, then there is no possibility of reflation of an equity bubble because stock prices will closely adhere to actual earnings.
This puts the EJ S&P --> 500/600 call into greater focus: his assertion was that the failure of the economy to return to bubble levels - as evidenced by still rising unemployment, misallocation of capital, etc etc as well as by the ending of short term government distortions of the market - will show up as a failure to return to peak earnings levels much less growth going forward.
This is a potentially major point: If confidence in the system is replaced by fear, then there is no possibility of reflation of an equity bubble because stock prices will closely adhere to actual earnings.
This puts the EJ S&P --> 500/600 call into greater focus: his assertion was that the failure of the economy to return to bubble levels - as evidenced by still rising unemployment, misallocation of capital, etc etc as well as by the ending of short term government distortions of the market - will show up as a failure to return to peak earnings levels much less growth going forward.
According to the sacred annals of modern finance, formalized a century ago by Irving Fisher and popularized during the Great Depression by Benjamin Graham and David Dodd, asset prices are forward looking: “The value of a common stock,” dictate Graham and Dodd in their 1934 immortal doorstopper, “depends entirely upon what it will earn in the future.” [Note 5]
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Theorists of finance don’t consider this loose association problematic. On the contrary, they see it as fully consistent with their basic model. According to this model, investors price an asset by discounting the future profits the asset is expected to generate. In this ritual, investors set the price of the asset—say a share of Microsoft—as equal to the ratio between what they expect Microsoft’s future profits to be on the one hand, and the rate of return they wish those profits to represent on the other. For instance, if investors expect ownership of a Microsoft share to generate a perpetual profit stream of $100 annually, and if they want this stream to represent a 20% rate of return, then they would be willing to pay for the share (or demand to be paid) a price of $500 (=$100/0.2). [Note 8]
Obviously, prices set in this manner should bear little or no relationship to the current level of profit. There are three reasons for the dissociation.
First, since the price is determined on the basis of future earnings, there is no inherent reason for it to be correlated with profits that have already been earned. And that is just for starters. Note that future earnings, by their very nature, cannot be known with certainty and are forever conjectural. For this reason, investors discount not the profits they will earn, but the profits they expect to earn. In the case of Microsoft above, for example, investors can easily misjudge the perpetual future flow of earnings per share to be $50 or $400, instead of the eventual $100; this error will in turn cause them to price the company’s stock at $250 or $2000, respectively (=50/0.2 or 400/0.2); and since profit expectations are rather open ended, the effect is to further widen the disparity between price on the one hand and current earnings on the other.
Second, a given level of expected earnings can generate any number of asset prices, depending on the discount rate of return. For instance, if the discount rate for Microsoft in our example were 10% (rather than 20%), the stock price would double to $1,000 (=$100/0.1). Now, the discount rate changes constantly—partly because of variations in the overall rate of interest and partly in response to changing perceptions of risk specific to the particular equity in question. And since in and of themselves these changes are unrelated to current earnings, the effect is to further reduce the correlation.
Finally, investors are not always able to follow the rituals of finance with sufficient precision. Regardless of how hard they try, their computations are constantly thrown off by various market “imperfections,” government “intervention” and other such diseases; and sometimes, particularly when the investors get excited, the calculations can even become “irrational,” god forbid. Now, since neither the miscalculations nor the irrationality are correlated with current profits, the result is to loosen the fit even more.
So if we adhere to the scriptures of finance, we should expect to see no systematic association between equity prices and current profits. And given that most investors obey the scriptures—including the allowed imperfections and irrationalities—their actions tend to validate the “theory.”
But not always.
Looking Backward
Figure 2 shows two clear exceptions to the rule: the first occurred during the 1930s, the second during the 2000s. In both periods, which the chart shadows for easier visualization, equity prices moved together—and tightly so—with current earnings.
Needless to say, this tight correlation is a gross violation of conventional, forward-looking finance. In fact, the violation is far worse than it seems.
Note that, despite their name, monthly earnings per share represent profits that were earned not during the current month, but during the previous twelve months. This measurement convention means that, during the 1930s, and again during the 2000s, investors committed a cardinal sin. They priced assets based not on future earnings, and not even on current earnings, but on past earnings!
...
Theorists of finance don’t consider this loose association problematic. On the contrary, they see it as fully consistent with their basic model. According to this model, investors price an asset by discounting the future profits the asset is expected to generate. In this ritual, investors set the price of the asset—say a share of Microsoft—as equal to the ratio between what they expect Microsoft’s future profits to be on the one hand, and the rate of return they wish those profits to represent on the other. For instance, if investors expect ownership of a Microsoft share to generate a perpetual profit stream of $100 annually, and if they want this stream to represent a 20% rate of return, then they would be willing to pay for the share (or demand to be paid) a price of $500 (=$100/0.2). [Note 8]
Obviously, prices set in this manner should bear little or no relationship to the current level of profit. There are three reasons for the dissociation.
First, since the price is determined on the basis of future earnings, there is no inherent reason for it to be correlated with profits that have already been earned. And that is just for starters. Note that future earnings, by their very nature, cannot be known with certainty and are forever conjectural. For this reason, investors discount not the profits they will earn, but the profits they expect to earn. In the case of Microsoft above, for example, investors can easily misjudge the perpetual future flow of earnings per share to be $50 or $400, instead of the eventual $100; this error will in turn cause them to price the company’s stock at $250 or $2000, respectively (=50/0.2 or 400/0.2); and since profit expectations are rather open ended, the effect is to further widen the disparity between price on the one hand and current earnings on the other.
Second, a given level of expected earnings can generate any number of asset prices, depending on the discount rate of return. For instance, if the discount rate for Microsoft in our example were 10% (rather than 20%), the stock price would double to $1,000 (=$100/0.1). Now, the discount rate changes constantly—partly because of variations in the overall rate of interest and partly in response to changing perceptions of risk specific to the particular equity in question. And since in and of themselves these changes are unrelated to current earnings, the effect is to further reduce the correlation.
Finally, investors are not always able to follow the rituals of finance with sufficient precision. Regardless of how hard they try, their computations are constantly thrown off by various market “imperfections,” government “intervention” and other such diseases; and sometimes, particularly when the investors get excited, the calculations can even become “irrational,” god forbid. Now, since neither the miscalculations nor the irrationality are correlated with current profits, the result is to loosen the fit even more.
So if we adhere to the scriptures of finance, we should expect to see no systematic association between equity prices and current profits. And given that most investors obey the scriptures—including the allowed imperfections and irrationalities—their actions tend to validate the “theory.”
But not always.
Looking Backward
Figure 2 shows two clear exceptions to the rule: the first occurred during the 1930s, the second during the 2000s. In both periods, which the chart shadows for easier visualization, equity prices moved together—and tightly so—with current earnings.
Needless to say, this tight correlation is a gross violation of conventional, forward-looking finance. In fact, the violation is far worse than it seems.
Note that, despite their name, monthly earnings per share represent profits that were earned not during the current month, but during the previous twelve months. This measurement convention means that, during the 1930s, and again during the 2000s, investors committed a cardinal sin. They priced assets based not on future earnings, and not even on current earnings, but on past earnings!
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