Is a rising stock market a good thing?

The answer is, “usually, yes.” But the reasons why are somewhat subtle.

Some of my friends have been sharing this article by Jeff Sommer in the NYT; the article points out how well the stock market has done under the current President’s tenure. The article focuses on the Down Jones Industrial Average, a dinosaur relic of the past for measuring the stock performance (the index tracks an arbitrary and small number of companies and uses an absurd weighting scheme). But the more logical (and popular among economists) measure of stock market performance, the S&P500, has done incredibly well—up 163% since Obama’s inauguration, according to Yahoo Finance data. People like to look at how the stock market has performed under various presidents, at least partly because they think it is a measure of how well they have done on economic policy. People also like to look at how the market reacts during closely contested elections: If one party or the other unexpectedly wins the presidency or control of the House or Senate, the stock market’s reaction the next day is seen by some people as a measure of the market’s perception of the economic competence of the two parties.

In this post, I want to use just the most basic financial theory identities to show how to think through the question of when and why a rising stock market is a good thing. As I referenced above, the bottom line is that it generally is a good thing, but the reasons why are, I think, slightly more subtle than may be assumed by those who use the stock market to score political points. By exploring what, precisely, the stock market’s value represents, and why that matters, we can learn about finance and the economy, and also have more intelligent conversations about evaluating policy makers.

 

***

 

The fundamental identity of finance:

When people buy stocks, they do so in the hope of turning their spare cash today into more cash in the future. So, when we buy a stock, we’re paying for the future cash flows from that stock. Some of those cash flows could come from payouts from the company—in the form of dividends and share repurchases. And some of those could come from reselling the asset/stock to other investors (yielding a return from ‘capital appreciation’). But those other investors to whom we resell the stock will, in turn, also be hoping to profit via dividends, buybacks, and capital appreciation. All capital appreciation has to come from some other market participant being willing to pay more for the stock in the future, ad infinitum. What this means is that, even though capital appreciation is an important part of the gains that any investor can expect to make in her own lifetime, for the market as a whole, we can think of the stock valuations and prices as a function just of dividends and repurchases.*

For simplicity, let us from now on just use ‘dividends’ in place of ‘dividends and repurchases.’ Since the market values stocks for their expected future cash flows—which we are now calling ‘dividends’—it makes sense to write the price using the following simple identity:

Price = [Expected dividends] / [Some discount rate]

I am making an abuse of notation here.** But the basic concept is there in this simple notation: Price today reflects expectations for future dividends, discounted by some amount. This is an identity. It is true by virtue of how we are defining the terms: Whatever the market’s expectation of future dividends, there must be some discount rate at which those future expected dividends are being discounted that can rationalize why the market is trading the asset at the current Price.

So that’s just an identity—what can it tell us? Well, it tells us that significant*** changes in the value of stocks can come from one of two sources: Changes in expectations for future dividends and changes in discount rates. Let’s look at each of these in turn.

 

***

 

Dividends:

Dividends are just cash that firms can choose to pay out to shareholders. Legally speaking, shareholders are ‘residual claimants’ of the firm, meaning that they are entitled to be paid after the firm has met its obligations to pay contracting parties such as suppliers, debtholders, etc. This means that, to a rough approximation, the money that the firm can pay out to shareholders is determined by its profits. Empirically, dividends tend to reflect a moving average of firms’ profits over time. Profits that are not paid out to shareholders can be reinvested inside the firm. If the company’s internal reinvestments have the same rate of return as the company’s discount rate—and in economic equilibrium, they should be approximately equal, on average—then these internal reinvestments are equally valuable to shareholders as the cash payout would be. So, assuming that equality, short-term ‘payout policy’ (the choice of what fraction of profits to pay as dividends vs. reinvest) has no effect on the share value.

What does this mean? It means that, to a close approximation, we can use profits and dividends interchangeably in thinking about firm valuation. Practically speaking, the things that increase firm profits are things that increase dividends. It also means that we can change our exact identity above to an approximate identity:

Price ≈ [Expected profits] / [Some discount rate]

(Indeed, you may already know that “fundamental value” investors and analysts typically use some accounting measure of profits (such as EBITDA) or free cash flows, to value firms, rather than explicitly modeling their future dividend flows. The tight theoretical and empirical link between profits and dividends is the reason why they can do this.)

So, all that said, what are the implications? The bottom line is that one reason why stock prices increase is that expectations for future profits increase.

Is it a good thing when that happens? The answer is, I think, mostly yes. Usually, if market participants expect firm profits as a whole to grow, it’s because they’ve become more optimistic about consumer spending—and the things that tend to drive consumer spending, employment and GDP, tend to correlate with better outcomes in life for people as a whole.

But there could be some special circumstances when increased corporate profitability could be a bad thing. Suppose that some new policy were adopted that protected incumbent firms from competition by innovative startups. Since S&P500 firms are, by definition, large firms, expectations for their future profitability would, in this thought experiment, increase. The value of the S&P500 would increase, even as consumers would be hurt, and the value of privately-held and small-cap startups would decrease. Or, suppose that some new law were passed that greatly extended various patent protections. Assuming that S&P500 firms are net suppliers of patents, their profits would benefit, while the effects on consumers and the economy as a whole would be more ambiguous. Thus, if we used the value of the S&P500 as our summary statistic of economic well-being, we would be misled. In some policy circles, people draw a distinction between being “pro-business” and being “pro-market,” and this thought experiment captures one of the ways in which there can be a difference. Various types of policies could benefit certain corporations’ profits while being bad for the economy as a whole.

So the bottom line is that increases in the value of the stock market that are driven by what economists call “cash flow news” are usually, but not always, indicative of good news for the economy as a whole. It turns out that news about macro variables that will affect consumer spending (which tends to affect all firms in all industries) tend to swamp news about, say, legislation that will protect one industry or another from competition, etc. So most changes in expectations for corporate profitability reflect good news. But it’s worth remembering that this doesn’t always have to be the case.

 

***

 

Discount rates:

Discount rates capture the fact that, even if I expect some stock to pay me $100, on average, next year, I’m not willing to pay $100 for it today. There are two reasons for this: First, even if I expect it to pay $100, there’s some uncertainty—some probability that it could pay more or less—and most of us are risk averse and thus willing to pay less than the average payoff. Second, it has traditionally been asserted (though the era of negative interest rates may be casting doubt on this) that there is a time value of money, such that even riskless future cash flows are discounted in the present. For the purposes of this question—since risk-free interest rates have been low and stable for the past 8 years—the first factor is most important. Let’s leave aside the time value of money for now.

What will determine by how much I discount a risky payoff of $100? Necessarily, the two things that will determine that are (1) the riskiness of the payoff, i.e., how widely dispersed are the possible outcomes are around my expectation (e.g., does it pay $50 vs. $150 with probability .5 each, or does it pay $0 vs. $200 with probability .5 each?), and (2) my attitudes towards that risk, how risk-averse or risk-seeking I am.

So what this means is that the other major source of changes in the value of the stock market is changes in discount rates, driven by changes in perceptions of riskiness as well as attitudes towards risk.

The prevailing consensus in modern finance is that most major aggregate (that is, market-wide) changes in the value of stocks are driven by ‘discount rate news’ rather than ‘cash flow news’—that is, changes in perceptions and attitudes towards risk. (Note that discount rate means the same thing as [required] rate of return, expected return, etc. All these terms can be used interchangeably, but I think that ‘discount rate’ is the most intuitive in the context of valuation.)

Is it a good thing, per se, when discount rates decrease—i.e., when perceptions of risk and aversion to risk decrease?

I actually think this is a tough philosophical question. Normatively, how can we say what our preferences and attitudes towards risk should be? Moreover, is it even possible to say how we should perceive the amount of risk that there is? Presumably, in judging changes in perceived riskiness, we would want to separate true riskiness from inaccurate perceptions of riskiness. Perhaps we think it is good when true riskiness decreases, and good when an inaccurately high perception of riskiness decreases to a correct perception—but that it is not good when the perception of riskiness becomes inaccurately low. But how do we make such a distinction between the truth and the perception? Indeed, in a deterministic world, it’s unclear what it even means to talk about the true riskiness!

If we could make such a distinction, between true riskiness and perceived riskiness, then it would seem that decreases in discount rates driven by decreases in true riskiness were a good thing. If the future path of GDP, consumer spending, and thus corporate profits, all become more reliable, and less risky, that would be desirable. But if discount rates decrease, we can never know if the economy truly became less risky, or the market fallaciously perceives it as less risky. In the end, if the economy continues to do well, low discount rates will be proclaimed, ex post, to have been justified; if not, then the previous market  high will be proclaimed, ex post, to have been an obvious bubble. But we can never know with certainty ex ante.

When the current president took office in 2009, the U.S. was still amid a major and largely unprecedented financial crisis. The low stock market valuations at the time likely reflected general macroeconomic pessimism—expectations that corporate profits might be low for some time—but also, more significantly, very high discount rates, reflecting uncertainty (perceptions of riskiness) and risk aversion. There could be a mix of institutional reasons (e.g., interlocking financial constraints) and psychological reasons for it, but the current academic finance literature is in agreement that discount rates/expected returns/required rates of return tend to be very high during recessions. It’s no surprise when the stock market bounces back from a recession low. The value of the stock market goes so low in recessions precisely because those are the time periods in which investors are most sensitive to downside risks—and that very fact, in turn, makes the stock market cheap, and thus likely to bounce back.

So the performance of the stock market over the past 8 years would seem to reflect two separate periods: First, a resolution of the extreme uncertainty of the financial crisis, which allowed discount rates to go from being very high to moderate. Most people would say that the smooth resolution of the financial crisis and its fear and uncertainty was a good thing. And second, the period of the last several years, in which decreased perceptions of and aversion to riskiness (themselves, in turn, influenced by monetary policy) allowed discount rates to go from being moderate to being very, very low. Are these very low discount rates a good thing?

We don’t know, and we won’t know, until it’s too late.  🙂

 

***

 

Conclusion:

Significant*** changes in the value of stocks are driven by changes in (i.) expectations for corporate profits and (ii.) discount rates. Increases in expectations for corporate profitability usually, but not always, reflect good economic news. Decreases in discount rates could reflect a desirable decrease in fear and uncertainty, but might also reflect fallacious overconfidence and risk tolerance. To find out whether today’s very low discount rates are a good thing, you’ll just have to wait and see.

 

 

______________________________________________________________________________

* Somewhat technically, for any positive discount rate, the discounting of the ‘terminal value’ of the asset will asymptote to zero as time increases.

** In reality, since dividends are paid out over many future periods, and since discount rates can vary between periods, I should really have t-subscripts, and an infinite summand symbol. Also, depending on what notation you prefer, you can write the discount rate as the thing you multiply cash flows by (something like .94), or as the thing you divide them by (something like 1.05). We also have flexibility with whether to write the divisor as [discount rate] or as [1 + discount rate]. My goal is to focus on putting the high-level concepts in English, so my apologies if I irritate some precise readers, or those who have been previously exposed to one notation or the other.

***Technically, where I write ‘significant,’ it should be ‘unexpected,’ to reflect the fact that, in the theoretical absence of news, the stock market would still be expected to increase by its expected rate of return.

The Debt Bias: Or, how good reforms do bad things to good people

I’ve been reading a lot of economic commentary and analysis around two things lately: (1) is, naturally, the negotiations surrounding the “fiscal cliff,” and (2) is Prof. Anas Admati’s argument that the best financial reform we could undertake would be to require banks to have a higher equity ratio (that is, to finance more of their assets through stock and less through debt, reducing their leverage). I hope to write at greater length about (2) in the future, but, for now, suffice it to say that both of these things center on the “debt bias” in the U.S. tax-code, a bias which piqued my interest and so which, after a little research, I should like to tell you about.

Let me start out with some econ for poets. Suppose you’re a business and you want to make a big expansion–setting up lots of new stores, opening a new R&D facility, etc.–that will cost you $1 billion.  Unless you have a lot of cash on hand (which you probably shouldn’t–it would have been wasteful to have just accumulated it) there are two ways you could fund this expansion. One, you could issue more shares in your company (that is, sell more stock to the public)–this is equity. Or, two, you could get a loan from a bank to do this–this is debt. Which option should you choose? Well, naturally, you should choose whichever one is cheaper–technically, whichever funding option’s obligations have a lower net present discounted value (the debt’s obligations being interest and principle, and the equity’s obligation being a share of profits and ownership). In reality, which one will be cheaper? Well, theoretically, since these two instruments are both providing the same good–financing–they should be about equally expensive. Think about it: if interest rates were relatively high, meaning that debt was more expensive than equity, firms would rush to issue more shares, which would reduce stock prices by increasing their supply, and eschew bank loans, which would force banks to lower their ‘prices’ (their interest rates), until the two became equally expensive. So in a perfect market, equity and debt should be about equally expensive for companies, and companies would make their financing decisions as follows:  they would fund their activities through equity if they thought that their shares were slightly overpriced, and through debt if they thought their shares were relatively underpriced.

Now, we’ve just done some typical Econ 101 theory above, about an ideal market. But in the real world corporate financing decisions are distorted. One major distortion is the U.S. tax code, which includes a deduction for interest payments on debt. The tax code does not include a deduction from dividend payments to shareholders. To the contrary, corporate profits returned to shareholders are taxed twice: once as corporate profits (just before they have been returned to shareholders), and again as capital gains (once they are in the shareholders’ hands). What does this do? Well, it gives companies a strong “debt bias” relative to the ideal market we laid out above. Because the obligations they incur from debt-financing in fact reduce their tax burdens, corporations are incentivized to rely relatively more heavily on debt, and less on equity.

Why is this a problem? Well, it isn’t always, necessarily, a problem for everyone. Indeed, if you’re a shareholder of a firm that has really great growth prospects for the future, you should be happy with debt-financing–this “leverage” means that you will get a higher share of whatever is left over once debt-obligations are paid off, than if your share had been diluted by the issuance of more equity. But the problems are twofold. First, in general, we as a society want companies to devote their analysis to trying figure out, and their energies to trying to meet, our needs as we express them in the marketplace–not make their decisions based on how best to game the tax code.  But, second, debt becomes a very big, very tangible problem during an economic downturn, when it can cause a credit crunch, a massive financial crisis, and thence a recession/depression, as you may have heard. We often hear debt analogized to “leverage,” because it makes the good times better for companies’ owners (shareholders) and the bad times worse. Consider this super simplified model of a firm buying one asset in one year, with a 2% interest rate: If you’ve financed a $100 million asset through $50m of equity and $50m of debt (a debt-equity ratio of 1 to 1), if the value of that asset suddenly declines to $85m, you’re still easily okay–you can pay back your creditors their $51m, and still have $34m left, which is now the value of your shareholders’ stake, a loss of $16m for them. But if you financed that through $10m of equity and $90m of debt (a debt-equity ratio/leverage of 9 to 1), the same decline in the asset’s value will bankrupt you: You owe creditors more than you have, and so your shares are worth less than nothing, and you have to enter bankruptcy. If you get the conceptual gist here, you can probably also see how, in good times, when firms are making high profits, “leverage” (a high debt-equity ratio) can increase the profits that are returned to shareholders. (But, and this is a bit technical, it does not technically increase shareholder value, because the leverage makes the expected return-on-equity riskier.) It also makes it much easier for firms to slip into bankruptcy when the times are not as good as they had predicted.

So what, then, is the problem with leverage if it just helps shareholders on the upside, and hurts them or causes bankruptcy on the downside? Why should I care if I’m not a major shareholder, or involved in any way with a highly-levered firm? Or if I am a shareholder, shouldn’t I be okay with this as long as I have a diversified portfolio that is collectively non-risky? The problem is that, during a credit crunch and financial crisis, bankruptcy is contagious. That is, when a highly-levered firm (which could itself be a bank–see my upcoming post on Admati) can no longer meet its obligations and enters bankruptcy, it is failing to pay out a cash flow that a bank had been depending on to finance its own activities. So that can send that bank into bankruptcy, or leave it unable to roll over the debt of another firm, sending that firm into bankruptcy. This is basically what a “credit crunch” is–everybody being so indebted to everyone else, that a small economic downturn can cause a string of interlocking insolvencies–and this is pretty much the story of what has happened in the economy from 2007-present. If companies had had less debt, and financed more of their activities with equity, an economic downturn would have caused their shareholders to take an unpleasant hit, but it would not cause this contagious domino-effect of insolvency.

A lot of what I’ve written about firms is also true of people, except for the fact that we people don’t really have the option (yet) of getting outside equity-financing (though some are proposing to equity-finance college loans–more on this later). For example, we humans have a mortgage-interest deduction, which provides us an incentive to take out relatively larger mortgages on our homes. There are a couple of problems with this. First, since the real-estate market is in reality largely an arms-race to get into the best school district possible, people generally buy the most expensive house they can afford, and so, according to many economists, the economic value of the mortgage-interest deduction is simply capitalized in higher home prices–i.e., in the aggregate, it doesn’t provide any easing of financial burdens to homeowners at all. Second, it distorts the market for buying vs. renting property–and there’s no particularly compelling reason to do that. And third, and most importantly, as we, again, saw in the financial crisis, more debt makes it easier for you to get wiped out by even small changes in the value of your assets. Suppose bad employment prospects have made it difficult for you to make your mortgage payments–if, in addition, the value of your house has declined, leaving you “underwater,” you won’t be able to refinance your house, and so you’ll default. That will reduce the cash flow to the bank that is entitled to them which, in turn, can cause Lehman… You get the picture. So personal bankruptcies, just like company bankruptcies, are contagious, and they become likelier and more harmful the more debt we all have.

***

I hope that you, gentle reader, do not spend as much time reading economics commentary as I do (because then what use would I be to you?), but one thing I’ve noticed is that almost all econ-theory minded people want to get rid of all of these distortions. Everyone seems to agree that the ideal tax reform involve lower rates, while getting rid of loopholes and deductions, such that we can actually raise more revenue, while imposing fewer distortions on the marketplace. There’s a consensus among them. But if there’s a consensus, why can’t we get some policy and legal changes done? The answer, of course, is “vested interests.” But that term sounds mean, and derogatory, and, more importantly, it understates the difficulty of our challenge.

Because, in this case, the term ‘vested interests’ doesn’t just mean super-rich super-evil tobacco lobbyists, or some such fun-to-hate villain, but actually literally means your mom and dad. Even if your mom and dad have already finished paying off the mortgage on your house, getting rid of the mortgage-interest deduction would hurt them, because it would reduce the sale-value of their house, because it would hurt the real-estate market as a whole (since new buyers won’t get such large mortgages if they can’t write them off). And the same goes for the corporate interest deduction–if we eliminated it, a lot of medium-size firms would  lose a lot of money when they can no longer write off the interest on bonds they issued a decade or two ago. And the same goes for a lot of other loopholes:  if we get rid of the federal deduction of state income taxes, medium-high-income people in high-tax states are going to get badly hurt. All of these people were, when they made these decisions, responding rationally to the incentives our public polices had put in place. They formed rational expectations for the future based off of those expectations. They were good people doing the right thing, in the circumstances and policy landscape that they were presented with, and now the policy changes that we are proposing are going to hurt them and disrupt the life path that the old policies had led them to expect. These people are, quite justly, going to be very upset if their representatives do it.

This is why reform is hard. 

Nonetheless, I’ll reiterate that we really should do the right thing and eliminate these distortions and tax loopholes if we can. It would obviously be wrong to leave bad policies in place forever. But the longer we leave them in place, the more and more good, rational, reasonable people build their lives around those policies, making them even more costly to be rid of in the future. So the very best time to take the plunge is right away.