Tuesday, December 30, 2003

Profits, returns, and labour

Brad DeLong points to a good article by Bill Nordhaus. They are both correct, the capital that went into dot-coms generated no returns for its owners, any rent was taken by employees (through fun work environments and high salaries) and consumers (through great new services that were usually for free). But the investment in capital stock was very real, and that stock is still around, boosting productivity (remember, capital and labor are complements).

After losing their shirts when the bubble popped, investors have demanded performance from their capital (namely, they want companies to stop screwing around and start throwing up some real profit). This has increased earnings, but not enough to justify the current price/earnings ratio in the stock markets, which continues to be historically high even though prices have collapsed post-bubble while earnings have risen.

A buddy of mine from Chicago (PhD program) thinks it is because the equity risk premium has fallen. Jeremy Siegel wrote a book called "Stocks for the Long Run" where he demonstrated that, over the long run (30 years), stocks outperform bonds even on a risk adjusted basis. This outperformance, which should not really exist in an efficient market, was called "the equity risk premium" and there have been all sorts of papers trying to explain it away. Historically, it's been about 5%-10% (IIRC), and now it seems to have become 0%. People still have money in stocks even though the prices have fallen, not because they think the prices are undervalued (historically, they are not) but because they believe that holding equities is a good strategy in the long run. If they believe that, then there is no more equity risk premium and the current, high price/earnings ratio is actually correct and stable. This also means that the returns to equity holders is going to be lower than it has been historically, it may be more like a real 1%-3% instead of 3%-6%. But hey -- where else are you going to stick your money?

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