Stock Market in Historical Perspective and Equity Risk Premium Paper Assignment: Grinold Kroner Model (100 words) First, some review: E(Re)=[D0(1+g)/(V0)

Stock Market in Historical Perspective and Equity Risk Premium Paper Assignment: Grinold Kroner Model (100 words)

First, some review:

E(Re)=[D0(1+g)/(V0)] + g =[D1/(P0)] +g

In the above equation, we make a simple modification to the infinite period dividend discount model,[Po=D1/k-g], to solve for the expected return on the market (thus we can forecast the price next year). In words, the price now equals the dividend next year divided by the required return less growth. The above equations just solves for k. k is the same as E(Re) in the above equation. Sometimes we call it expected return, or sometimes we call it required return. Same thing. If we have the price of a stock, or an index value, and an estimate for next year dividend and growth we can estimate the expected(required return) on the market. One way to estimate growth is using [retention rate x ROE].

Next, we can look at the infinite period dividend discount model.. Po=D1/k-g…and divided both sides by earnings to provide some theoretical basis for the PE ratio. The PE ratio is a measure of relative value and shows the value, or multiple, the investors are willing to pay to own a share of the earnings:

Pi/E1 = (D1/E1)/(k-g)

Shiller discusses the PE ratio measured with 10 year inflation adjusted numbers. Our next step is to come up with another way to forecast for the market, using some of these ideas. The associated reading with this assignment discusses the Grinold Kroner Model:

Answer the question: What is your forecast for the equity risk Premium?

EX:For forecasting equity risk premium, we have to look at technical indicators alongside macroeconomic variables. Technical indicators show us business cycle peaks and how they relate to the decline in equity risk premium, while macroeconomic trends show us cyclical troughs and the rise in equity risk premium near these. Technical indicators are statistically important values while some examples of macroeconomic variables are dividend yields, price earnings ratios, inflation, and volatility of stock prices.

For forecasting the equity risk premium, one can apply the Grinold-Kroner model. The Grinold-Kroner model is a model that forecasts the equity risk premium by subtracting the change in outstanding shares from the dividend yield, and adding inflation, the market or firm’s growth rate, plus the change in PE multiple. One. The Stock Market in Historical Perspective
When Alan Greenspan, then Chair of the Federal Reserve Board, used the term irrational
exuberance to describe the behavior of stock market investors, the world fixated on those
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words. He spoke at a black-tie dinner in Washington, D.C., on December 5, 1996, and the
televised speech was followed the world over. As soon as he uttered these words, stock markets
dropped precipitously. In Japan, the Nikkei index dropped 3.2%; in Hong Kong, the Hang Seng
dropped 2.9%; and in Germany, the DAX dropped 4%. In London, the FTSE 100 was down 4%
at one point during the day, and in the United States, the next morning, the Dow Jones Industrial
Average was down 2.3% near the beginning of trading. The sharp reaction of the markets all over
the world to those two words in the middle of a staid and unremarkable speech seemed absurd.
This event made for an amusing story about the craziness of markets, a story that was told for a
time around the world.
The amusing story was forgotten as time went by, but not the words irrational exuberance,
which were referred to again and again. Greenspan did not coin the phrase irrational exuberance,
but he did cause it to be attached to a view about the instability of speculative markets. The chain
of stock market events caused by his uttering these words made the words seem descriptive of
essential reality. Gradually they became Greenspan’s most famous quote—a catch phrase for
everyone who follows the market.
Why do people still refer so much to irrational exuberance years later? I believe that the words
have become a useful name for the kind of social phenomenon that perceptive people saw with
their own eyes happening in the 1990s, and that in fact, it appears, has happened again and again
in history, when markets have been bid up to unusually high and unsustainable levels under the
influence of market psychology.
Many perceptive people were remarking, as the great surge in the stock market of the 1990s
continued, that there was something palpably irrational in the air, and yet the nature of the
irrationality was subtle. There was not the kind of investor euphoria or madness described by
some storytellers, who chronicled earlier speculative excesses like the stock market boom of the
1920s. Perhaps those storytellers were embellishing the story. Irrational exuberance is not that
crazy. The once-popular terms speculative mania or speculative orgy seemed too strong to
describe what we were going through in the 1990s. It was more like the kind of bad judgment we
all remember having made at some point in our lives when our enthusiasm got the best of us.
Irrational exuberance seems a very descriptive term for what happens in markets when they get
out of line.
Irrational exuberance is the psychological basis of a speculative bubble. I define a speculative
bubble as a situation in which news of price increases spurs investor enthusiasm, which spreads
by psychological contagion from person to person, and, in the process, amplifies stories that
might justify the price increase and brings in a larger and larger class of investors, who, despite
doubts about the real value of the investment, are drawn to it partly through envy of others’
successes and partly through a gambler’s excitement. We will explore the various elements of
this definition of a bubble throughout this book.
Greenspan’s “irrational exuberance” speech in 1996 came during the biggest historical example
to date of a speculative upsurge in the U.S. stock market. The Dow Jones Industrial Average
(from here on, the Dow for short) stood at around 3,600 in early 1994. By March 1999, it passed
10,000 for the first time. The Dow peaked at 11,722.98 in January 14, 2000, just two weeks after
the start of the new millennium. The market had tripled in five years. Other stock price indices
peaked a couple of months later. The real (inflation-corrected) Dow did not reach this level again
until 2014, and, as of this writing, the real Standard & Poor’s 500 index has still not quite
returned to its 2000 level. It is curious that this peak of the Dow (as well as other indices)
occurred in close proximity to the end of the celebration of the new millennium—it was as if the
celebration itself was part of what had propelled the market, and the hangover afterward had
brought it back down.
Figure 1.1 shows the monthly real (corrected for inflation using the Consumer Price Index)
Standard and Poor’s (S&P) Composite Stock Price Index, a more comprehensive index of stock
market prices than the Dow, based, since 1957, on 500 stocks rather than just the 30 stocks that
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are used to compute the Dow. Inflation correction was used here because the overall level of
prices has been very unstable over parts of this period (the government printed a lot of money,
which pushed all prices up) so that the uncorrected numbers would give a misleading impression
of the real increase in the stock market. The stock prices are shown from 1871 through 2014
(upper curve), along with the total earnings (corporate profits per share) that the corporations that
comprise the index made
in doing their businesses (lower curve) for the same years.
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Figure 1.1
U.S. Stock Prices and Earnings, 1871–2014
Real (inflation-corrected) S&P Composite Stock Price Index, monthly, January 1871 through
June 2014 (upper curve), and real S&P Composite earnings (lower curve), January 1871 to
March 2014. Source: Author’s calculations using data from S&P Statistical Service; U.S. Bureau
of Labor Statistics; Cowles and associates, Common Stock Indexes; and Warren and Pearson,
Gold and Prices. See also note 3.
This stock market chart is unusual: most long-term plots of stock prices are not this long term,
and most are done in nominal terms, without inflation correction. On this chart, the magnitude of
the boom beginning in 1982 and peaking in 2000 stands out especially well. It is a unique event
in history.
The 2000 Millennium Boom peak in world stock prices was followed by the Ownership-Society
Boom, 2003–7, which I have named after a slogan used by George Bush in his 2004 presidential
campaign. This peak was followed by the world financial crisis in 2008–9. Starting in 2009, after
the crisis lessened, there was another major upswing in world stock markets, which I will call the
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New- Normal Boom, after a phrase popularized by Bill Gross, then of PIMCO, in 2009. The
news media have shown a tendency since 2000 to dramatize the “new records” set in stock
markets in 2007 and 2014. But, in fact, these post-2000 booms were not record setting. The
biggest-ever upswing in the real (inflation- corrected) U.S. stock market was from July 1982 to
August 2000, when the market went up 7.7-fold, dwarfing the 5.2-fold upswing from December
1920 to September 1929, and also dwarfing the 5.1-fold upswing from June 1949 to December
1968. The upswings from 2003 to 2007 (1.5-fold) and from 2009 to 2014 (2.3-fold) are mild by
comparison. For the purpose of understanding irrational exuberance, I will emphasize the 1982–
2000 Millennium Boom, particularly its later years, when this exuberance became most palpable.
The stock market increase from 1994 (when the real stock market had already more than doubled
since 1982) to 2000 could not obviously be justified in any reasonable terms. Basic economic
indicators did not come close to tripling. Over the same interval, U.S. gross domestic product
rose less than 40%, and corporate profits rose less than 60%, and that from a temporary
recession-depressed base. Viewed in the light of these figures, the stock price increase appears
unwarranted.
Large stock price increases occurred in many countries at around the same time, and the peaks in
the stock markets were often roughly simultaneous in many countries in early 2000. Figure 1.2
shows the paths of stock prices for ten countries and for the world as a whole from 1995 to 2014.
As can be seen from Figure 1.2, between 1995 and 2000 the real stock market valuations of
Brazil, France, China, and Germany roughly tripled, while that of the United Kingdom roughly
doubled. In 1999, the year before the peak, real stock price increases averaged 58% over the ten
countries shown in Figure 1.2. The prices of all countries went up sharply in 1999; in fact, the
smallest increase, occurring in the United Kingdom, was still an impressive 16%. Stock markets
in Asia (Hong Kong, Indonesia, Japan, Malaysia, Singapore, and South Korea) and Latin
America (Chile and Mexico) also made astounding gains in 1999. It was a truly spectacular
worldwide stock market boom.
The end of the 2000 boom brought stock markets down across much of the world by 2003, as
can be seen in Figure 1.2. Once again, the next boom, peaking in late 2007 or early 2008, had
huge impacts over much of the world. After that, the world slipped into the most serious
recession since the Great Depression of the 1930s, economic growth rates faltered, and the postbubble weakness of the world economy continued for years after. Despite the weakness of the
world economy, the third stock market boom that began around 2009 affected many countries.
Looking back to Figure 1.1, which shows a longer history for the S&P Index, we can see how
differently the market behaved up to 2000 compared with the long past. The spiking of prices in
the years 1982 through 2000 was most remarkable: the price index looks like a rocket taking off
through the top of the chart, only to sputter and crash. This—the largest stock market boom ever
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—may be referred to as the Millennium Boom or, now that it is over, the Millennium Bubble.
Figure 1.2
Real Stock Prices in Ten Countries and the World, January 1995–July 2014
Monthly closing prices in Brazil (Bovespa), China (SE Shang Composite), France (CAC),
Germany (DAX), India (Sensex), Japan (Nikkei), Korea (KOSPI), Mexico (Mexbol), United
Kingdom (FTSE 100), the United States (NASDAQ Composite), and the Morgan-Stanley
Capital International All Country World Index, all deflated by the monthly Consumer Price Index
for the currency, all rescaled to January 1995 = 100. Source: Bloomberg and International
Monetary Fund International Financial Statistics (1999).
The boom and crash in the stock market in the years after 1994 are clearly related to the behavior
of earnings. As can be seen in Figure 1.1, S&P Composite earnings grew very fast in the late
1990s before they crashed after 2000, rose again until 2007, utterly crashed in 2009, and then
rose with the market. Earnings seem to have been oscillating around a slow, steady growth path
that has persisted for over a century.
Inspection of Figure 1.1 should make it clear that nothing like the Millennium Boom had ever
happened before in the entire stock market history since 1871. There was of course the famous
stock run-up of the 1920s, culminating in the 1929 crash. Figure 1.1 reveals this boom as a cuspshaped price pattern for those years. If one corrects for the market’s smaller scale then, one
recognizes that this episode in the 1920s does somewhat resemble the recent stock market
increase, but it is the only historical episode that comes even close to being comparable.
Price Relative to Earnings
Figure 1.3 shows the cyclically adjusted price-earnings ratio (CAPE), that is, the real (inflationcorrected) S&P Composite Index divided by the ten-year moving average of real earnings on the
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index. The points shown reflect monthly data from January 1881 to June 2014. The priceearnings ratio is a measure of how expensive the market is relative to an objective measure of the
ability of corporations to earn profits. John Campbell and I originally defined CAPE using the
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ten-year average, along lines proposed by Benjamin Graham and David Dodd in 1934.
The ten-year average smooths out such events as the temporary burst of earnings during World
War I, the temporary decline in earnings during World War II, and the frequent boosts and
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declines that we see due to the business cycle. Note again that there was an enormous spike
after 1997, when the ratio rose until it hit 47.2 intraday on March 24, 2000. Price-earnings ratios
by this measure had never been so high. The closest parallel was September 1929, when the ratio
hit 32.6.
In 2000 earnings were quite high in comparison with the Graham and Dodd measure of long-run
earnings, but nothing here was startlingly out of the ordinary. What was extraordinary in 2000
was the behavior of price (as also seen in Figure 1.1), not earnings.
Part of the explanation for the remarkable price behavior between 1990 and 2000 may have to do
with the unusual behavior of corporations’ profits as reflected in their earnings reports. Many
observers remarked then that earnings growth in the five-year period ending in 1997 was
extraordinary: real S&P Composite earnings more than doubled over this interval, and such a
rapid five- year growth of real earnings had not occurred for nearly half a century. But 1992
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marked the end of a recession during which earnings were temporarily depressed. Similar
increases in earnings growth following periods of depressed earnings from recession or
depression have happened before. In fact, there was more than a quadrupling of real earnings
from 1921 to 1926 as the economy emerged from the severe recession of 1921 into the
prosperous Roaring Twenties. Real earnings doubled during the five-year periods following the
depression of the 1890s, the Great Depression of the 1930s, and World War II.
It was tempting for observers in 2000, at the peak of the market, to extrapolate this earnings
growth and to believe that some fundamental changes in the economy had produced a new
higher growth trend in earnings. Certainly, expansive talk about the new millennium at the time
encouraged such a story. But it would have been more reasonable, judging from the cyclical
behavior of earnings throughout history, to predict a reversal of such earnings growth.
Figure 1.3
U.S. Cyclically Adjusted Price-Earnings Ratio (CAPE) and Interest Rates, 1881–2014
Price-earnings ratio, monthly, January 1881 to June 2014. Numerator: real (inflation-corrected)
S&P Composite Stock Price Index. Denominator: moving average over preceding ten years of
real S&P Composite earnings. Years of peaks are indicated. Source: Author’s calculations using
data shown in Figure 1.1. Interest rate is the yield of long-term U.S. government bonds
(nominal), January 1881 to June 2014 (author’s splicing of two historical long-term interest rate
series). See also note 7.
The bust in corporate profits between 2000 and 2001, the biggest drop in profits in percentage
terms since 1920–21, is certainly part of the story about the drop in the market. This drop
certainly diminished support for the notion that the new high-tech economy was infallible. But
there is a question of how to interpret the drop in earnings. As we shall discuss in Chapter 5, the
drop in earnings could be seen in many dimensions, and in part, as just an indirect consequence
of the changes in investor psychology that produced the decline in the market. Part of the crash
in earnings after 2000 was also just a technical accounting reaction to the stock price decline,
since companies were required by accounting rules to deduct from earnings the impairment in
value of some of their stock market holdings, holdings that were far reduced in value after the
crash in the stock market.
Other Periods of High Price Relative to Earnings
There have been three earlier times when the price-earnings ratio as shown in Figure 1.3 attained
high values, though never as high as the 2000 value. The first time was in June 1901, when the
price-earnings ratio reached a high of 25.2. This might be called the “Twentieth Century Peak,”
since it came around the time of the celebration of the new century. (The advent of the twentieth
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century was celebrated on January 1, 1901, not January 1, 1900.) This peak occurred as the
aftermath of a doubling of real earnings within five years, following the U.S. economy’s
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emergence from the depression of the 1890s. The 1901 peak in the price-earnings ratio
occurred after a sudden spike in the ratio, which took place between July 1900 and June 1901, an
increase of 43% in eleven months. A turn- of-the-century optimism appeared—associated with
expansive talk about a prosperous and high-tech future.
After 1901, there was no pronounced immediate downtrend in real prices, but for the next
decade, prices bounced around or just below the 1901 level and then fell. By June 1920, the
stock market had lost 67% of its June 1901 real value. The average real return in the stock
market (including dividends) was 3.4% a year in the five years following June 1901, barely
above the real interest rate. The average real return (including dividends) was 4.4% a year in the
ten years following June 1901, 3.1% a year in the fifteen years following June 1901, and −0.2% a
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year in the twenty years following June 1901. These returns are lower than we generally
expect from the stock market, though had one held on into the 1920s, returns would have
improved dramatically.
The second instance of a high price-earnings ratio occurred in September 1929, the high point of
the market in the 1920s and the second-highest ratio of all time. After the spectacular bull market
of the 1920s, the ratio attained a value of 32.6. As we all know, the market tumbled from this
high, with a real drop in the S&P Index of 80.6% by June 1932. The decline in real value was
profound and long- lasting. The real S&P Composite Index did not return to its September 1929
value until December 1958. The average real return in the stock market (including dividends)
was −13.1% a year for the five years following September 1929, −1.4% a year for the next ten
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years, −0.5% a year for the next fifteen years, and 0.4% a year for the next twenty years.
The third instance of a high price-earnings ratio occurred in January 1966, when the ratio as
shown in Figure 1.3 reached a local maximum of 24.1. We might call this the “Kennedy-Johnson
Peak,” drawing as it did on the prestige and charisma of President John Kennedy and the help of
his vice-president and successor, Lyndon Johnson. This peak came after a dramatic bull market
and after a five-year real price surge of 52% from May 1960. This surge, which took the priceearnings ratio to its local maximum, corresponded to a surge in real earnings of 36%. The market
reacted to this earnings growth as if it expected the growth to continue, but of course it did not.
Real earnings increased little in the next decade. Real prices bounced around near their January
1966 peak, surpassing it somewhat in 1968, then falling sharply back after 1973. Real stock
prices were down 56% from their January 1966 value by December 1974 and would not be back
up to the January 1966 level until May 1992. The average real return in the stock market
(including dividends) was −2.6% a year for the five years following January 1966, −1.8% a year
for the next ten years, −0.5% a year for the next fifteen years, and 1.9% a year for the next
twenty years.
We see evidence in these past episodes of temporarily high price that irrational exuberance is not
a new thing, and that such episodes do not end well. The high CAPE—higher than any peaks
save 1929, 2000, and 2007 as of this writing in 2014—warrants some concern, though we do not
yet know the aftermath of this time. We will return to a discussion of the predictive power of the
price-earnings ratio in Chapter 11.
Worries about Irrational Exuberance
As reflected in the first edition of this book, in 2000 I thought that most people I met, from all
walks of life, were puzzled over the apparently high levels of the stock market. It seemed that
they were unsure whether the market levels made any sense, or whether they were indeed the
res…
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