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Are Stock Prices Driven by Irrational Exuberance?

Are Stock Prices Driven by Irrational Exuberance?. A. Caveats: I speak for myself. B. Purpose: To provide one explanation for the Chairman’s comments on the market’s value. C. Historical Perspective. 1. Average real annual returns = 7.6%. 2. Average real bond returns = 2.0%.

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Are Stock Prices Driven by Irrational Exuberance?

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  1. Are Stock Prices Driven by Irrational Exuberance? • A. Caveats: I speak for myself. • B. Purpose: To provide one explanation for the Chairman’s comments on the market’s value.

  2. C. Historical Perspective • 1. Average real annual returns = 7.6%. • 2. Average real bond returns = 2.0%. • 3. 30% annual fluctuations in stock prices are not uncommon. • 4. Stock returns may be poor for long periods. • a) The market lost 50% of its value in 1972-1973. • b) Bonds outperformed stocks from 1967-1982.

  3. D. What Determines the Price Of Stocks? • 1. Expected dividends and prices in the future. • 2. The definition of return is • a) Assume constant dividend growth. (We don’t need this.) • b) Assume constant stock returns. (We don’t need this.) • c) Assume that the present value of a stock very far in the future is very small. Then:

  4. D. What Determines the Price Of Stocks? • 4. Higher prices today are associated with a higher growth rate of dividends or lower stock returns in the future. • 5. This requires no economic theory. It comes from the definition of return.

  5. E. Do historical levels of dividend growth & stock returns justify current prices? • (Let’s use earnings instead of dividends.) • 1. Historical average dividend growth and stock returns imply a P/E ratio of 17.4. • 2. The August 1997 P/E ratio was 23.25; the market is 34% overvalued.

  6. F. What levels of dividend growth or stock returns justify the current P/E ratio of 23? • 1. Dividend growth could rise from 1.75% to 3.2%. • 2. Stock returns could fall from 7.6% to 6.2%.

  7. G. How big are these changes in dividend growth and returns? • 1. Dividends would double every 22 years instead of every 40 year. • Is this realistic? • 2. Wealth would be 50% higher after 30 years with the higher stock returns. • This affects consumption, savings and investment.

  8. H. What are the consequences of the decline in stock returns to 6.2%? • 1. People become much less wealthy, consumption declines significantly. • 2. Savings for college or retirement have to go way up. • 3. Firms will invest much less. • 4. A stock market crash may interfere with the Federal Reserve’s pursuit of price stability and a pro-growth environment. • I. What can or should be done about it? • 1. Not clear. Investors may bear some or most of the consequences of their own mistakes.

  9. THE END

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