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.