FRBSF Economic Letter
2000-20; June 23, 2000
Evaluating the Stock Market
Since the 1980s, U.S. stock markets have soared, and stock prices now
are at levels that were unimaginable before the boom started. There has
been no shortage of speculation about the reasons for this performance.
Some claim this performance is an irrational "bubble," built
on false hopes and thin evidence, that will collapse under the weight
of reality. Others claim that the high prices may be justified by the
explosion in information technology that has transformed the way firms
do business and enhanced the prospects for strong productivity growth.
The unusual behavior of the stock market is a concern to monetary policymakers
for a variety of reasons; for instance, growing stock market wealth can
lead to an increase in consumption demand that exceeds the economy's productive
capacity. In view of these concerns, the Federal Reserve Bank of San Francisco
and the Stanford Institute for Economic Policy Research held a workshop
on April 21, 2000, to discuss five papers on the stock market. This Economic
Letter summarizes and discusses those papers.
How can we explain recent stock market valuations? Heaton and Lucas set
up an economic model to answer this question. They find that no single
explanation is adequate; instead, one needs to assume that several changes,
such as increases in portfolio diversification and market participation,
occurred roughly at the same time to increase the demand for stocks. Hall's
paper turns the question around: If stocks are reasonably valued, what
are the markets telling us? His answer is that markets are telling us
that there has been a huge increase in the quantity of organizational
capital (such as intellectual property) over this period. The two papers
coauthored by Jovanovic also try to extract information about the economy
from the behavior of the market, but they focus on what the market can
tell us about technology shocks. A key conclusion is that the arrival
of new (information-processing) technology is responsible for both the
decline in the stock market in the mid-1970s and the stock market boom
since the early 1980s. Zeira's paper suggests that while an increase in
productivity (induced by information technology) could well be behind
the recent boom in the stock market, the stock market is still capable
of overshooting its long-run value and then returning to this value with
a crash. This "boom and bust" sequence occurs because markets
tend to overestimate the extent of the productivity change while it is
going on and then are surprised when it ends. Overall, the papers at the
conference suggest that changes in technology as well as in market participation
have played a role in the market run-up in recent years, but that it is
hard to determine exactly how much of the increase is attributable to
Explaining stock prices
Heaton and Lucas point out that despite the surprising strength of the
stock market, we do not have the evidence to state definitively that stock
prices have reached levels that cannot be rationalized. We must therefore
proceed by trying to determine whether the changes in fundamentals required
to explain the observed change in stock prices appear reasonable.
In a simple model of the stock market, the price of a stock depends upon
the present value of discounted future dividends. Thus, the price of a
stock can change (a) either because the rate of expected dividend growth
changes (b) or because the rate at which future dividends are discounted
changes. Heaton and Lucas estimate that real earnings (which help determine
dividend growth) have grown at a rate of 1.4% a year over the past century,
while the real annual return on a broad-based U.S. stock index has averaged
7.3%. They calculate that the level of stock prices at the end of their
sample period (1998) can be justified if one is willing to postulate that
the growth rate of earnings has risen to 2.4%, while the required real
rate of return has fallen to 6.6%.
To determine whether changes of this magnitude can be the result of plausible
changes in economic variables, they present some exercises from a numerical
model of the economy. They consider variables that can be classified under
three broad headings: changes in stock market participation patterns,
changes in consumer preferences, and changes in earnings growth,. They
find that while no single variable explains the large change in stock
prices, assuming simultaneous changes in all three classes of variables
does. Specifically, the model "works" if one is willing to assume
that investors now have longer horizons (because of increased life expectancy),
that participation in the stock market has risen from 50% to 80%, and
that the dividend process is less volatile and, importantly, less skewed,
so that it is less likely to expose investors to extremely large losses.
The authors interpret their assumption about the less risky dividend process
as reflecting one of the benefits of diversification, which reinforces
there conclusion that the growth in mutual funds is a significant factor
in the recent performance of the market.
What the stock market may be telling us
Hall wants to establish that changes in the stock market value of the
firm largely reflect changes in the quantity of its capital and
not its price. To do so, he must find a way to decompose the market value
of the firm's capital (which can be observed in the stock market) into
the quantity of capital and its price. Note that one cannot directly observe
either the quantity of this capital or its purchase by the firm. Though
physical capital can be observed, much of organizational capital consists
of unobservables, such as ideas and the quality of employees.
Deducing the quantity of capital from the total value requires some assumptions.
Hall's assumptions about the absence of monopoly and the speed at which
the capital stock adjusts to its desired level help him find a close correlation
between changes in the value of capital and in its quantity in the data.
The recent run-up in the stock market can then be interpreted as an increase
in the amount of organizational capital in the economy.
The main conclusions from Hall's analysis of stock market data are that
the 1950s and 1960s were a period of high capital accumulation and high
productivity, as were the 1980s and the 1990s. In addition, he finds that
a substantial fraction of the capital stock was destroyed in 1973 and
1974. Hall also presents some results for capital productivity growth,
which depend upon the assumption one makes about the speed at which the
capital stock adjusts. If firms are assumed to complete 50% of the required
adjustment in one year, then the productivity of capital (over 1945 to
1998) is estimated to have increased by 18.3% per year, while if the speed
of adjustment is 6% per year, then the rate of productivity growth is
estimated to be 15.6%.
Hall's paper provides an interesting way of looking at the recent movements
in the market. However, as DeLong points out in his discussion, the paper
replaces one puzzle with another. Instead of having to explain why prices
are so volatile, we now have to explain why productivity is so volatile:
Hall's estimates of productivity range from 8% in 1960s, to 2% in 1970s,
to 17% in 1990s; over the last five years, his estimate of annual productivity
growth has averaged 24%!
Technology shocks and the stock market
The papers by Hobijn and Jovanovic and by Jovanovic and Rousseau are
concerned with the effect of technology shocks on the stock market. The
key idea underlying these papers is that a major technical innovation
lowers the value of existing firms, causing a reduction in the value of
the stock market that will persist until shares in the new firms that
can use the new technology make their way to the market.
In the first paper this hypothesis is used to explain both the decline
in the stock market in the early 1970s and its rise since the mid-1980s.
According to the authors, new technology¼or information about new technology¼arrived
in 1973 (more loosely, over the 1968²1974 period). The key event was the
invention of the microprocessor; prior to this, computers were too expensive
and cumbersome for most businesses. Such revolutions favor new firms for
a number of reasons. For one thing, old firms have old capital (both physical
and human), whose value will be diminished by the technological change.
Established firms are more likely to resist change as well; and they may
not have the skills needed to adopt new technology. As a consequence,
the introduction of new technology would cause the value of existing firms
to fall. New firms cannot immediately compensate for the resulting decline
in the stock market, because they will not be in a position to issue tradable
securities. Only after these firms have done IPOs will the value of the
new technology be reflected in the market.
The authors then present different kinds of evidence in support of their
hypothesis. For instance, they show that most of the increase in stock
market capitalization relative to GDP since 1985 represents an increase
in the value of new firms. Firms that were already in existence in 1972
lost about half their value (relative to GDP) in the early 1970s and never
The paper by Jovanovic and Rousseau presents a further development of
these ideas. Using a data set that spans 1895-1995, the authors examine
how changes in the value of a firm are related to changes in the economy's
technology. The two big technological changes they focus on are the spread
of electricity around the turn of the century and the explosion in information
technology in our own era. They find some notable parallels between the
two episodes. For instance, the ratio of market capitalization to GDP
dropped after the introduction of electric power just as it did prior
to the widespread adoption of computers. However, the market recovered
with a longer lag in the first case because it was harder for new firms
to enter at that time (since markets were not as developed). Similarly,
the recovery period (around the early 1920s) was marked by an unusually
large number of new firms entering the stock market, just what has happened
in the current boom.
Information and the stock market
Zeira's paper provides another link between technological change and
stock market fluctuations, one that involves learning by stock market
participants. To understand his argument, assume that there is some sort
of technological breakthrough that will lead to an increase in the level
of productivity and profits; however, no one knows by exactly how much.
In the simplest framework, one can imagine individuals observing an increase
in dividends paid by the firm and then trying to estimate how long this
growth will persist. Recall that an (unexpected) increase in dividends
causes stock prices to go up; thus, the longer that dividends are expected
to grow, the more prices will be bid up. Uncertainty about the length
of this period (which is equivalent to uncertainty about how much dividends
will increase) is the key element in Zeira's argument. One way to think
of this uncertainty is to imagine that different people have different
beliefs about the length of this period. Most of the time, when dividends
stop growing, some people will be disappointed, and will immediately reduce
their estimate of the value of the stock. Consequently, stock prices will
come crashing down.
Technological change is not the only possible trigger for booms and crashes
in this model. Zeira points out that one can get a similar boom and bust
sequence following financial liberalization, when the number of participants
in the market (and therefore the demand for stocks) goes up, but no one
knows the extent of the increase. Thus, the basic requirement is that
there be some fundamental change in the economy, the duration or extent
of which is unknown in advance. Stock prices move around (sometimes violently)
as people learn about this change.
Zeira's model has some interesting features and implications. Note first
that the increase in prices begins in response to an improvement in fundamentals.
One fact that is consistent with this hypothesis is that post-crash prices
often remain above levels that prevailed before the boom. This would be
hard to explain if manias and panics were the key reason for swings in
the stock market. An interesting implication of this model is that an
economy may experience more booms and crashes during periods of rapid
technical progress than it does during periods of moderate growth.
The papers and comments are available in pdf format at http://www.frbsf.org/economics/conferences/000421/index.html
DeLong, Bradford. 2000. "Comments
on Hall, on Hobijn and Jovanovic, and on Jovanovic and Rousseau."
http://econ161.berkeley.edu/TotW/stock_market_comment.html. Accessed June
Hall, Robert E. 2000. "The
Stock Market and Capital Accumulation." http://www.stanford.edu/~rehall/SMCA-d%205-12-00.pdf.
Accessed June 12, 2000.
Heaton, John, and Deborah Lucas. 1999. "Stock
Prices and Fundamentals." http://www.kellogg.nwu.edu/faculty/heaton/research/macroannual.pdf.
Accessed June 12, 2000.
Hobijn, Bart, and Boyan Jovanovic. 2000. "The Information Technology
Revolution and the Stock Market: Preliminary Evidence." Mimeo. New
Jovanovic, Boyan, and Peter L. Rousseau. 2000. "Vintage Organization
Capital." Mimeo. New York University.
Zeira, Joseph. 1999. "Informational Overshooting, Booms and Crashes."
Journal of Monetary Economics 43(1) pp. 237-257.
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