Media panic over the stock market plunge

The most famous example of such an erratic movement was the crash in October of 1987. The market fell by more than 20 percent in a single day. There was no obvious event in the economy or politics that explained this fall, which hit markets around the world. Nor did the decline presage a recession. The economy continued to grow at a healthy pace through 1988 and 1989. It didn’t fall into a recession until June of 1990, more than two years later.

Stock is disproportionately held by the rich, with the richest 1.0 percent of families hold almost 40 percent of stock wealth held by individuals, and the top 0.5 percent of families holding almost a quarter of stock wealth.

This means that when the market rises, the rich get richer relative to everyone else. Conversely, when the market falls wealth inequality is reduced.

For most middle class people their house is their main asset. House prices have been outpacing inflation in recent years, but generally house prices increase roughly in line with the rate of inflation. It is not a good story when house prices rise more rapidly. Rapid rises in house prices mean that homeowners become wealthier, but it places houses further out of the reach of those who don’t already own a home. Furthermore, if the rise in house prices reflects the fundamentals in the housing market it means that rents are also rising. If the rise in house prices doesn’t reflect the fundamentals in the housing market then we have a bubble, as was the case in the last decade. This is also not good news.

Anyhow, it is not really plausible to tell a story where rises in housing wealth will allow the middle class reduce the wealth gap in the context of a rapidly rising stock market. It is also not plausible to tell a story of the wealth gap closing appreciably due to increased savings by low and middle class families. Suppose the bottom 100 million families increased their annual savings by $5,000. This would be a huge increase After three years they will have accumulated another $1.5 trillion in savings. In a context where total wealth is near $100 trillion, this is barely a drop in the bucket.

Much of the commentary on the drop in the stock market ignores its absolute levels. In spite of the drop, the price to earnings ratio for the stock market as a whole is still close to 20 to 1. This compares to a long-run average of close to 15 to 1. And, it is important to remember that corporate profits remain at extraordinarily high levels as a share of GDP. It is reasonable to think that a tight labor market will allow workers to get back some of the income share they lost in the weak labor market following the Great Recession. We may also hope that a Democratic Congress, and possibly a Democrat in the White House in 2021, will retake some of the tax cut that Trump gave to U.S. corporations last year.

For these reasons it is wrong to see the drop in the market as being a great buying opportunity. I don’t do market analysis for a living and am not in the habit of giving stock advice, but no one would have seen the current levels in the stock market as being low if we had not seen the run-up of the prior two years. The fact that we did see this run-up should not change our perceptions of proper market valuation.

This is important because price to earnings ratios have historically been much lower, as I just pointed out. This allowed for higher returns. The long-term average for real returns had been over 7.0 percent prior to 2000. It has been considerably lower in the last two decades, with the recent plunge putting the annual average under 4.5 percent.

This is noteworthy for two reasons. First, if we go back to the late 1990s both Democrats and Republicans thought it was a clever idea to put Social Security money in the stock market. Democrats wanted to put the Social Security trust fund in the stock market, while Republicans wanted workers to hold individual accounts that would be largely placed in the stock market. In both cases they assumed that the stock market would continue to provide 7.0 percent real returns in spite of the high price to earnings ratios that exists at that time.

I was rather lonely in arguing that these sorts of returns would not be possible. And it does make a difference. If someone invested $1,000 in the market in 1998, and got 7.0 percent real returns, their money would have increased to $3,870 in 1998 dollars. However, given the returns we have actually seen, a $1,000 invested in 1998 would only be worth $2,410 today. The gap between 7.0 percent annual returns and 4.5 percent is a big deal and it becomes even bigger over time. If we looked at it over 30 years, it would be $7,610 versus $3,750. After 40 years, $14,970 compared with $5,820.

For some reason there is little awareness of this fact. This is likely due to the fact that people do not distinguish between corporate profits, which are very high, especially after the tax cut, and the returns to shareholders. This is not a question of feeling sorry for shareholders, since the rich hold such a disproportionate share of stock wealth. It is simply a question of whether shareholders have been doing especially well in the last two decades.

More importantly, CEO pay affects pay structures throughout the economy. If CEO pay were again 20 to 30 times the pay of ordinary workers, instead of 200 to 300 times their pay, it would bring down pay at the top of the corporate hierarchy more generally. We might see the second and third tier of corporate executives getting pay in the high hundreds of thousands instead of millions. The same would be true of presidents and CEOs of universities and other non-profits.