Economists and the Stock Market

Brad DeLong put together some talking points about the stock market. These are some basic, mainstream ideas, including the fact that historical price/earnings ratios tend to be low, indicating a risk premium that is higher than many economic models suggest is appropriate. (One exception is the "rational beliefs equilibrium" explanation given by Mordecai Kurz.)

One of DeLong's readers said that the fact that stock prices historically have not behaved as the models might predict is an indictment of the economics profession. However, I think this is another instance of the late Herbert Stein's observation that although economists know little, non-economists know even less.

Concerning the stock market, suppose that someone chooses to get into the stock market whenever it appears that the earnings/price ratio on stocks is above the long-term real interest rate and to get out of the market when the long-term real interest rate appears to be higher. That is suppose, that you invested as if the risk premium ought to be zero, instead of its historical values. This rule would have paid off extremely well. Throughout most of the past 100 years, it would have kept you in stocks, which earned a high rate of return. However, it would have caused you to sell well before the peak of stock prices two years ago, and it certainly would have kept you out of the Internet Bubble.

In contrast, the average investor (by definition) earned inferior returns by having too little invested in stocks for many years and then over-investing in stocks at their peak.

Economists, who have a reasonable model of the fair valuation of stock prices, do not know very much, in that we do not have a way to predict market sentiment. However, non-economists, who do not use rational valuation models, know even less.

Discussion Question. Do you think that, compared to the average investor, economists were more or less likely to buy Internet stocks in 1999?