The stock market

[Louis Proyect <lnp3@xxxxxxxxx>]

NY REVIEW OF BOOKS

August 10, 2000

All Too Human
JEFF MADRICK

Irrational Exuberance
by Robert J. Shiller
296 pages, $27.95 (hardcover)
published by Princeton University Press
(order book)

A Random Walk Down Wall Street
by Burton G. Malkiel
499 pages, $16.95 (paperback)
published by Norton

Stocks for the Long Run
by Jeremy J. Siegel
301 pages, $29.95 (hardcover)
published by McGraw-Hill

Dow 36,000
by James K. Glassman and Kevin A. Hassett
294 pages, $25.00 (hardcover)
published by Times Books

Famous First Bubbles
by Peter M. Garber
163 pages, $24.95 (hardcover)
published by MIT Press

Devil Take the Hindmost: A History of Financial Speculation
by Edward Chancellor
386 pages, #$25.00 (hardcover)
published by Farrar, Straus and Giroux

Social Security: The Phony Crisis
by Dean Baker and Mark Weisbrot
175 pages, $22.00 (hardcover)
published by University of Chicago Press

On Money and Markets: A Wall Street Memoir
by Henry Kaufman
388 pages, $24.95 (hardcover)
published by McGraw-Hill

To most observers of the ups and downs of today's stock market, it defies
common sense when eminent economists assert that the stock market works
according to logical principles. But most economists believe just that.
According to generally accepted economic theory, stocks have a true or
intrinsic value.

This value is based on several factors, the first of which is a company's
dividends. In the long run, a shareholder who holds on to a company's stock
can extract a certain cash value from it only when the management returns
profits in the form of dividends to its owners. Today, of course, investors
buy many stocks, such as Microsoft and Cisco Systems, that do not pay
dividends. These companies are growing so rapidly that they continuously
reinvest their profits in new products, research, and expanding productive
capacity, and investors generally believe their stock prices will rise as
they generate more profits. But eventually, even these companies, or so it
is presumed, will begin to pay out part of their earnings in the form of
dividends as their businesses mature. If Microsoft, for example, retained
all its earnings even as its core businesses grew more slowly or stagnated,
investors might sell the stock. If they were to hold on to the stock, they
might demand some of those earnings in the form of dividends so that they
might invest elsewhere (even though they would have to pay taxes at
ordinary rates on dividends rather than lower capital gains rates on a
rising stock price).

General Electric, for example, is a widely admired and fast-growing
company, which no longer mostly makes electric turbines but also owns,
among other businesses, a large credit company as well as NBC. But it is
also a mature company which prudently pays about half of its profits to
investors in the form of dividends-fifty-five cents a share, a little more
than 1 percent of its recent stock price. For the economist, the value of
GE's stock depends on future dividends. When analysts devise mathematical
models to determine the value of GE's stock, they usually assume that
dividends will grow at about the same rate as profits. Because future
dividends are so closely related to profits, if the outlook for profits
falls, investors should pay less for stocks.

Money also has a time value, however, and this second factor significantly
affects the current valuation of a stock. You will not pay a dollar today
for a dollar in dividends twenty years from now because you can earn
interest income on today's dollar. Therefore, when interest rates rise,
stock prices will usually fall because dividends to be received in the
future will be worth relatively less. (Rising interest rates may also
reduce corporate profits, because the cost of borrowing rises.) When
interest rates rise, investors will usually pay less for stocks because
they can earn more on their money from interest in bonds. A stock price can
be seen theoretically as based on the value of estimated dividends
discounted for the level of interest rates. When that discount is made, the
result is called the "present value" of the dividends, and this determines
the true value of the stock. (This method of assessing stock is called the
"dividend discount model.")

Full article at: http://www.nybooks.com/nyrev/WWWfeatdisplay.cgi?20000810038R


Louis Proyect

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