Are Stock Prices Driven by Irrational Exuberance

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Are Stock Prices Driven by Irrational Exuberance?

• A. Caveats I speak for myself.
• B. Purpose To provide one explanation for the
  Chairmans comments on the markets value.

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C. Historical Perspective

• 1. Average real annual returns 7.6.
• 2. Average real bond returns 2.0.
• 3. 30 annual fluctuations in stock prices are
  not uncommon.
• 4. Stock returns may be poor for long periods.
• a) The market lost 50 of its value in
  1972-1973.
• b) Bonds outperformed stocks from 1967-1982.

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D. What Determines the Price Of Stocks?

• 1. Expected dividends and prices in the future.
• 2. The definition of return is
• a) Assume constant dividend growth. (We dont
  need this.)
• b) Assume constant stock returns. (We dont need
  this.)
• c) Assume that the present value of a stock very
  far in the future is very small. Then

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D. What Determines the Price Of Stocks?

• 4. Higher prices today are associated with a
  higher growth rate of dividends or lower stock
  returns in the future.
• 5. This requires no economic theory. It comes
  from the definition of return.

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E. Do historical levels of dividend growth
stock returns justify current prices? (Lets
use earnings instead of dividends.) 1.
Historical average dividend growth and stock
returns imply a P/E ratio of 17.4. 2. The
August 1997 P/E ratio was 23.25 the market is
34 overvalued.
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• F. What levels of dividend growth or stock
  returns justify the current P/E ratio of 23?
• 1. Dividend growth could rise from 1.75 to
  3.2.
• 2. Stock returns could fall from 7.6 to 6.2.

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G. How big are these changes in dividend growth
and returns? 1. Dividends would double every 22
years instead of every 40 year. Is this
realistic? 2. Wealth would be 50 higher after
30 years with the higher stock returns. This
affects consumption, savings and investment.
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H. What are the consequences of the decline in
stock returns to 6.2? 1. People become much less
wealthy, consumption declines significantly. 2.
Savings for college or retirement have to go way
up. 3. Firms will invest much less. 4. A stock
market crash may interfere with the Federal
Reserves pursuit of price stability and a
pro-growth environment. I. What can or should be
done about it? 1. Not clear. Investors may bear
some or most of the consequences of their own
mistakes.
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THE END