The Good News and Bad News on the Stock Market

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Written by Dean Baker   
Monday, 08 August 2011 20:11

Many of my friends have been asking me what they should make of today’s stock market plunge. I tell them to enjoy the ride. The reason is simple, stock prices are low relative to corporate earnings right now. One would be much better advised to buy and hold stock today than in the 90s when price to earnings ratios went through the roof or even in the last decade. This one is simple arithmetic – the stuff most of us learned in third grade -- but few economists seem to understand.

After-tax corporate profits were $1.398.1 billion in 2010 (National Income and Product Accounts Table 1.12, Line 15). By contrast, they were just $554.1 in 2000, less than half as much. But, at the end of 2000, after the bubble was already one third deflated, buying up all the shares in the stock market would have cost you $15,388.5 billion (Federal Reserve Board, Flow of Funds Table L. 213, line 23). By contrast, the market value of domestic corporations at the end of 2010 was only slightly higher at $17,188.7 billion. With the S&P at 1258 at the end of 2010, the market was than 10 percent higher than it is today.

Taking this together, a dollar of profits cost about 40 percent as much on the stock market today as it did at the end of 2000. If we compare it to the peak of the bubble, a dollar of profits costs about 30 percent as much.

Of course the issue is what happens going forward. This is both the good and bad news. The good news for the stock market is that workers’ bargaining power remains very weak because of the high unemployment rate. It is difficult to envision workers getting wage increases much in excess of inflation and certainly not in excess of productivity growth. That means that the profit share of income is likely to remain constant or even rise in the near-term future.

If the profit share remains constant (it is now at a record high), then investors will be getting more than 9 cents in profits for every dollar invested today. That seems like a pretty good deal. If the stock price went nowhere and firms paid out 60 percent in dividends or share buybacks (roughly the historic average), that implies a return of 5.4 percent.

This is not bad when interest rates are near zero, but of course share prices are likely to rise over any long period at least in step with the rate of growth of profits. If the economy has a very weak 2 percent real growth rate, with 2 percent inflation, and profits keep pace, then then the return on stock will be 9.4 percent annually if stock prices grow in step with profit. There does not seem a lot of downside risk in this picture.

Of course the bad news is the flip side of this story. It would be nice to see workers getting back some of the ground that they lost to corporate profits over the last two decades. However, that doesn’t seem to be in the cards. This is bad news for bulk of the population that relies on their wages for the vast majority of their income, but it is good news for people who have lots of money invested in the stock market. So, why aren’t they happy?