Is the market nuts? Financial economists generally assume that investors are rational. Researchers today, however, have some answers in behavioral psychology that can explain real estate bubbles and stock market crashes.
One example is our attitudes towards risk. The pain of loss is often much greater than the joy of gain. Investors will only take more risk when they have already made good gains; leading to bubbles. The same can be said when prices go down. They will stop taking risks as they take on more losses.
Another example is in our beliefs about probabilities. Policymakers and investors alike are too conservative and slow to update their beliefs. If we see gains, we expect them going forward. If we see losses, we expect them going forward as well.
Rephrasing a popular quote from the dot-com era, we may now be in a time of Irrational Despondency.
Stock market investors have irrationally sold off stocks and bought bonds because they are no longer willing to take risk. They may have overestimated the probability of economic recession and large-scale bankruptcies.
Is the stock market response to slowing global economic conditions rational? Yes, a 40 percent drop in value of stocks is consistent with only a small change in the forecasted growth rate of earnings. To explain this financial economists use the discounted cash-flow method of stock valuation.
The return on a stock reflects the return from both dividend yield and expected growth of earnings. Dividends are cash distributions from the corporation to its owners and are normally paid every quarter. The dividend yield is calculated by dividing the current annual dividend by the last price at which the stock traded.
If there is no growth in the company the dividend yield is constant. This may be true if all the earnings of the corporation were paid out to shareholders. Most corporations, however, reinvest earnings in order to pursue new business opportunities and maintain their existing operations (some corporations do not pay dividends at all).
Thus, the return on an investment in common stock comes from cash dividends and expected future growth in these dividends due to increases in earnings. Suppose that the company’s stock is currently selling for $20 and the company is expected to increase its $1 annual dividend 5 percent each year. The expected rate of return in this case is 10 percent ($1/$20 + 5% = 10 percent).
Applying this model to the overall market today shows the current situation is consistent with just a slightly lower expected growth rate. At its height in October 2007, the S&P 500 index was worth approximately $153 per share, with dividends per share of $2.30. This is a 1.5 percent dividend yield ($2.30/$153). If we assume investors wanted a 10 percent long return they must have expected 8.5 percent growth.
Today the S&P sells for about $85 per share. Some corporations have cut dividends but the total is relatively constant. If we then hold that the long-run expected return is still 10 percent, the current dividend yield of 2.7 percent ($2.30/$85) suggests investors have dropped their expected growth rate to 7.3 percent.
This is completely logical given that the average annual nominal rate of growth in the U.S. economy is 7 percent over the last 60 years. Therefore, investors still have reasonable expectations for future value of the company earnings. What has spooked everyone is just how rapidly this change in expectations occurred.
Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.