March 26, 2001
Dean Baker and Mark Weisbrot
Miami Herald, March 26, 2001
Millions of investors are sitting shell-shocked in the wake of the market’s recent plunge. Many have lost a large portion of their life’s savings, and with it, their hopes for their children’s education or their own retirement. The question on everyone’s mind is whether to hold or to sell.
There is no shortage of analysts urging the “hold” route. In some cases, this may make sense, but many of these same analysts were the ones that encouraged people to buy into a stock bubble in the first place. In other words, just because you play a stock analyst on TV, doesn’t mean you know anything. Having been burned once, investors would be wise to rely on their own common sense rather than this crew’s gossip.
There are some simple rules of thumb that can help in this judgment. First, over the long-term, stock prices generally rise at approximately the same rate as profits. This is true for the market as a whole and for the stock of individual companies.
The basic logic is quite simple. Other things equal, a stock with twice the earnings per share will sell for twice the price per share. This means that if the earnings of a company doubles, then we typically would expect its share price to double as well.
While we don’t know exactly how fast earnings will grow in the future, we do have some basis for informed guesses. For example, the Congressional Budget Office (CBO) — the agency that makes all the projections for the budget — expects that corporate profits will rise by an average of approximately 1 percent annually over the next decade, after adjusting for inflation.
CBO may be wrong in its prediction for profits, but its projections should at least be taken seriously. If CBO is right, then an average share of stock will rise by approximately 1 percent more than the rate of inflation each year over the next decade. While some stocks will clearly do better than the average, clearly this cannot be true for all of them. This is not Lake Wobegone, where all the children are above average.
The other part of the return from holding stock is the dividend payout. At present this averages slightly less than 2 percent a year. Adding the 2 percent dividend payout to the 1 percent growth based on the CBO profit projections gives a total return of approximately 3 percent above the rate of inflation.
By comparison, an investor can buy an inflation-indexed government bond that will provide a guaranteed return of 3.2 percent above the rate of inflation. Investors can count on this return as long as the U.S. government doesn’t go bankrupt. Holding stock that gives a lower return doesn’t seem like a very good deal. In fact, unless investors can expect a substantially higher return on stock than government bonds, it doesn’t seem worth taking the risk that the share price will fall. Historically the premium for holding stocks has been four percentage points.
The stock market is often said to be governed by the “greater fool” theory. At any point in time, stock can be sold for whatever someone is willing to pay for it. But when stocks are priced far higher than expected earnings could justify, those prices must eventually fall.
As we saw, many people were willing to pay ridiculous prices for shares of stocks that in some cases were literally worthless. Many of these shares continue to be traded at prices that are far above what would be justified by their current or future profits. Insiders who understand this are no doubt trying to unload these shares as quickly as possible.
To avoid being taken yet again, investors must ignore the advice of the analysts who say, “hold” while they try to decide for themselves whether share prices make sense. While it may help the insiders, it is a losing strategy to hold a stock that it is overvalued and on its way down.
Dean Baker and Mark Weisbrot are Co-Directors of the Center for Economic and Policy Research, in Washington, D.C.