Saturday, January 22, 2005

# Posted 5:27 PM by Ariel David Adesnik  

OUT-EXPERTING THE EXPERTS: I don't know much about economics, so I am a little bit surprised at my ability to spot an apparent flaw in Paul Krugman's economic logic. Krugman's political logic may have less value than a junk bond, but you figure he'd get his economics right. In Friday's column, Krugman tells us to
Remember the disclaimer that mutual funds are obliged to include in their ads: "past performance is no guarantee of future results."

Fifty years ago most people, remembering 1929, were afraid of the stock market. As a result, those who did buy stocks got to buy them cheap: on average, the value of a company's stock was only about 13 times that company's profits. Because stocks were cheap, they yielded high returns in dividends and capital gains.

But high returns always get competed away, once people know about them: stocks are no longer cheap. Today, the value of a typical company's stock is more than 20 times its profits. The more you pay for an asset, the lower the rate of return you can expect to earn. That's why even Jeremy Siegel, whose "Stocks for the Long Run" is often cited by those who favor stocks over bonds, has conceded that "returns on stocks over bonds won't be as large as in the past."
Krugman may be right that stocks are now overpriced and thus can no longer provide the historic returns of the 1990s. That is plausible.

But fear of another Great Depression didn't always make stocks a good investment. If memory serves, there was a lot of hype about stocks, especially blue chips, in the early 1970s. But the price of those stocks promptly fell and the market stagnated for the rest of the decade. Clearly, something more complex was going on here. By the same token, something more complex than low prices was probably responsible for stock market growth in the 80's and 90's.

Since all of this is way out of my area of expertise, I wouldn't surprised if there is some fundamental flaw in my analysis that I have failed to recognize. With any luck, some of you (presumably including AG) will be able to point out the error of my ways. But until then, I will enjoy some tentative schadenfreude.
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