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Paul Krugman’s stock market advice

from Dean Baker

Paul Krugman actually did not make any predictions on the stock market, so those looking to get investment advice from everyone’s favorite Nobel Prize winning economist will be disappointed. But he did make some interesting comments on the market’s new high. Some of these are on the mark, but some could use some further elaboration.

I’ll start with what is right. First, Krugman points out that the market is horrible as a predictor of the future of the economy. The market was also at a record high in the fall of 2007. This was more than a full year after the housing bubble’s peak. At the time, house prices were falling at a rate of more than 1 percent a month, eliminating more than $200 billion of homeowner’s equity every month. Somehow the wizards of Wall Street did not realize this would cause problems for the economy. The idea that the Wall Street gang has some unique insight into the economy is more than a bit far-fetched.

The second point where Krugman is right on the money (yes, pun intended) is that the market is supposed to be giving us the value of future profits, not an assessment of the economy. This is the story if we think of the stock market acting in textbook form where all investors have perfect foresight. The news that the economy will boom over the next decade, but the profit share will plummet as workers get huge pay increases, would be expected to give us a plunging stock market. Conversely, weak growth coupled with a rising profit share should mean a rising market. Even in principle the stock market is not telling us about the future of the economy, it is telling us about the future of corporate profits.

Okay, now for a few points where Krugman’s comments could use a bit deeper analysis. 

Krugman notes the rise in profit shares in recent years and argues that this is a large part of the story of the market’s record high, along with extremely low interest rates. Actually, the profit story is a bit different than Krugman suggests.

The profit share had soared in the early days of the recovery. The before tax share of net corporate income went from a recession low of 16.9 percent of net income to 27.0 percent in the second quarter of 2014. The after-tax share peaked at 20.4 percent in the first quarter of 2012. However since then the profit share has trended downward. In the most recent quarter the before-tax profit share was 23.9 percent, while the after-tax share was 17.5 percent. This is most of the way back to the mid-1990s shares when before-tax profits were around 21.0 percent of net corporate income and after-tax shares were around 15.5 percent.

So, while profits had soared, the current market high cannot be explained by a soaring profit share. We are substantially below the peak shares from earlier in the recovery. One caution here is that the quarterly data are erratic and subject to large revisions. It is possible that this picture will look very different when the Commerce Department releases revised data later in the month.

The next issue is how we should think about a market high. If the stock market moves in step with corporate profits (i.e. the price to earnings ratio remains constant), and the profit share of GDP remains constant, then we should expect the stock market to continually reach new highs. In other words, market peaks are not like a new world record time in the mile, they are more like the tree in the backyard growing each year. They should not come as a surprise, nor be any cause for celebration.

The third point is that the stock market highs of the late 1990s were definitely not cause for celebration. The stock market was in a gigantic bubble. This was serious bad news for the economy and millions of 401(k) holders who saw their savings plummet in the crash of 2000-2002. (Yes, they should have sat tight, but a lot of people didn’t realize this and it’s not their job to be professional investors.) From the standpoint of the economy it was bad news because the crash led to a serious downturn in the labor market.

The strong wage growth of the late 1990s quickly dissipated as the labor market weakened. While the recession officially ended in December of 2001, we didn’t begin to create jobs again until the fall of 2003. We didn’t get back the jobs lost in the downturn until January of 2005. At the time, this was the longest period without net job growth since the Great Depression.

FWIW, the Clinton crew was clueless on the bubble. They wanted to put Social Security money in the stock market assuming that the real returns would average 7.0 percent annually. The actual average has been about half of this rate.

Finally, Krugman notes that the most highly valued companies in today’s market are Apple, Google, and Microsoft. Krugman points out that none of these companies “spends large sums on bricks and mortar” and all three are sitting on large cash hoards.

Both points are well taken. Investment in plant and equipment has actually been falling in recent quarters. This would be fine if the decline was offset by a boom in research and development spending, but it hasn’t been. Our great idea companies don’t have many good ideas about what to do with all of their money.

But there is another point worth noting about the Big Three. All three are companies that depend to a large extent on government-granted monopolies in the form of patent and copyright protection. We have made these protections much stronger and longer over the last four decades through a variety of laws and trade agreements.

Of course the point of these protections is to give an incentive for innovation and creative work. But in a period where we are supposedly troubled by an upward redistribution from people who work for a living to people who “own” the technology, perhaps we should not be giving those people ever stronger claims to ownership of technology. (Yes, this involves the Trans-Pacific Partnership, among other policies.)

Anyhow, perhaps our leading economists will one day take note of this issue. It took a long time to notice that we had an $8 trillion housing bubble and that yes, it could be a problem. But let’s hope our economists is learning.

  1. July 15, 2016 at 7:10 pm

    Perhaps high valuations in tech reflect future monopolistic market power. A significant fraction of these companies’ assets is user accounts, through which they can sell advertising, communications, software, entertainment, delivered goods, in the future banking, transportation, etc.

    Market power translates to profits, but later. So if a company keeps the same expected profits for the next 10 years but also greatly consolidates its market power, that’ll mean more profits in years 11+. The “attention monopolies” of the internet are piling up market power and effectively lengthening years over which their price/earnings ratio is estimated.

  2. jlegge
    July 16, 2016 at 10:44 am

    Share prices reflect a combination of speculative/bubble effects and a pseudo-rational calculation based on forecast earnings, some blend of historic and forecast growth, and historic price volatility. Their present level, in the face of very slow growth, reflects traders’ belief that such productivity gains as there are will be fully captured in corporate profits and real wages will continue to decline.

    The more aware stock market operators like Nick Hanauer recognise that these trends can’t continue indefinitely: http://www.politico.com/magazine/story/2014/06/the-pitchforks-are-coming-for-us-plutocrats-108014

  3. July 16, 2016 at 5:24 pm

    Stock prices, profit, and other self-fulfilling idiocies
    Comment on Dean Baker on Paul Krugman’s stock market advice’

    Paul Krugman says:* “The truth . . . is that there are three big points of slippage between stock prices and the success of the economy in general. First, stock prices reflect profits, not overall incomes. “

    And, elaborating this point: “This may seem, however, to present a paradox. If the private sector doesn’t see itself as having a lot of good investment opportunities, how can profits be so high? The answer, I’d suggest, is that these days profits often seem to bear little relationship to investment in new capacity. Instead, profits come from some kind of market power — brand position, the advantages of an established network, or good old-fashioned monopoly.”

    Obviously, economists do not really understand what profit is and where it ultimately comes from. As the Palgrave Dictionary summarizes: “A satisfactory theory of profits is still elusive.” (Desai, 2008, p. 10). Or, as Mirowski put it “… one of the most convoluted and muddled areas in economic theory: the theory of profit.” (1986, p. 234)

    So, in effect Krugman and the blogging rest tries to explain stock market valuation as a reflection of profit expectations without having any idea of what profit is. What the general public cannot see is that this abysmal scientific blunder is all-pervasive and that the representative economist does not understand the pivotal phenomenon of his subject matter.

    Alone for this reason, the whole discussion about stock market valuation and efficient markets is vacuous. The root cause of why the profit theory is false lies in the fallacy of composition, that is, economists take propositions which are true for a single firm and generalize them for the economy as a whole (2013).

    The correct profit theory follows from the analysis of the pure consumption economy which is the most elementary case (2011). From this analysis follows:

    ― The business sector’s revenues can only be greater than costs if, in the simplest of all possible cases, consumption expenditures are greater than wage income.

    ― Overall profit does neither depend upon the agents’ personal qualities, motives, their ideas about what profit is, nor on profit maximizing behavior. Overall monetary profit is NOT explainable by subjective factors but is OBJECTIVELY given by the Profit Law which can be tested in principle by summing up what is in the cash boxes or on the bank accounts.

    ― In order that profit comes into existence for the first time in the pure consumption economy the household sector must run a deficit at least in one period. This presupposes the existence of a credit creating entity.

    ― Profit is, in the simplest case, determined by the increase and decrease of household sector’s debt. There is a close relation between profit/loss and the expansion/contraction of credit for the economy as a whole.

    ― Wage income is the factor remuneration of labor input. Profit is NOT a factor income. Since capital is nonexistent in the pure consumption economy profit is not functionally attributable to capital.

    ― There is NO relation at all between profit, capital, marginal or average productivity.

    ― Profit has no real counterpart in the form of a piece of the output cake. Profit has a monetary counterpart. In a real exchange economy profit does not exist.

    ― The existence and magnitude of overall profit does not depend on the ownership of the firms that comprise the business sector. The Profit Law holds for a capitalist and communist economy alike.

    ― The value of output is, in the general case, different from the sum of factor incomes. This is the defining property of the monetary economy.

    ― Profit is a factor-independent residual and qualitatively different from wage income. Therefore, it is an elementary mistake to maintain that total income is the sum of wages and profits.

    ― There is NO antagonism between total wages and total profits, and the distribution of consumption good output has nothing at all to do with profit.

    ― Innovation and efficiency are IRRELEVANT for the profit of the business sector as a WHOLE. It is a logical mistake to trivially generalize what can be observed in an individual firm. The same holds for monopoly power. These factor affect the DISTRIBUTION of profit among firms but NOT the overall volume.

    All this follows from the elementary case of the pure consumption economy. The Profit Law for the investment economy reads: Qm =Yd+I-Sm (2014, p. 8, eq. (18)). Legend: Qm: monetary profit, Yd distributed profit, Sm: monetary saving, I investment expenditure. The Profit Law gets a bit more complex when foreign trade and government is included.

    In the last decades overall (= world) profit has been driven by the growth in Asia (= high I), by dissaving, i.e. the growth of private debt mainly in the USA, by the growth of public debt worldwide, and by high profit distribution mainly in the USA. Overall profit has been distributed between the countries via export surpluses/deficits.

    Roughly speaking, as accumulation (= I) slows down in China/Asia and the developing regions overall world-profit goes down, then overall profit distribution goes down, then again profit goes down, then investment goes down again, and so on. Rising unemployment and falling wages ACCELERATE the downward spiral (2015). The market economy is NOT self-correcting.

    Does this matter for stock valution? Not much, as long as the central banks stand ready to stabilize the stock markets. This is what the market participants have observed in the past and expect for the future, independent of the performance of the real economy. This is where the disconnect of overall profit and overall stock market valuation comes from.

    Egmont Kakarot-Handtke

    References
    Desai, M. (2008). Profit and Profit Theory. In S. N. Durlauf, and L. E. Blume (Eds.), The New Palgrave Dictionary of Economics Online, pages 1–11. Palgrave Macmillan, 2nd edition. URL http://www.dictionaryofeconomics.com/article?id=pde2008_P000213.
    Kakarot-Handtke, E. (2011). The Emergence of Profit and Interest in the Monetary Circuit. SSRN Working Paper Series, 1973952: 1–22. URL
    http://ssrn.com/abstract=1973952.
    Kakarot-Handtke, E. (2013). Confused Confusers: How to Stop Thinking Like an Economist and Start Thinking Like a Scientist. SSRN Working Paper Series, 2207598: 1–16. URL http://ssrn.com/abstract=2207598.
    Kakarot-Handtke, E. (2014). The Three Fatal Mistakes of Yesterday Economics: Profit, I=S, Employment. SSRN Working Paper Series, 2489792: 1–13. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2489792.
    Kakarot-Handtke, E. (2015). Major Defects of the Market Economy. SSRN Working Paper Series, 2624350: 1–40. URL
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2624350
    Mirowski, P. (1986). Mathematical Formalism and Economic Explanation. In P. Mirowski (Ed.), The Reconstruction of Economic Theory, pages 179–240. Boston, MA, Dordrecht, Lancaster: Kluwer-Nijhoff.

    * See ‘Bull Market Blues’ http://www.nytimes.com/2016/07/15/opinion/
    bull-market-blues.html?action=click&pgtype=Homepage&clickSource=
    story-heading&module=opinion-c-col-right-region&region=opinion-c-col-right-region&WT.
    nav=opinion-c-col-right-region&_r=0

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