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The US stock market and the global economic crisis

Published online by Cambridge University Press:  26 March 2020

Sushil B. Wadhwani
Sushil B. Wadhwani*
Affiliation:
Tudor Investment Corporation
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Abstract

The question whether the US equity market is overvalued is important from a policy perspective because a significant derating could interact adversely with the realisation of risks of recession. A simple dividend based model suggests that the market is two or three times overvalued. Allowing for stock buybacks, takeovers for cash and temporary unsustainable earnings growth leave the market overvalued by 20–30 per cent. The ‘New Economy’ view that recessions are things of the past and that technical change justifies permanently higher earnings growth is implausible. An influential argument that the traditional premium earned by equities over bonds is too high is itself theoretically special. Similarly the recent relationship between US inflation and the risk premium has not held at other times and places, while the fact that most wealth is held by middle-aged people with limited time horizons supports a larger premium. Our best guess is that the current premium is 1.7 per cent p.a. which is near the lower end of the historical range although equity investors do not appear to be prepared for lower returns in the face of the possibility of global recession in the next 12–18 months. The risk that a US market adjustment might aggravate such a recession in the US itself is a basis for reconsidering central banks' disregard of asset prices in setting monetary policy.

Type
Articles
Information
National Institute Economic Review , Volume 167 , January 1999 , pp. 86 - 105
Copyright
Copyright © 1999 National Institute of Economic and Social Research

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Footnotes

The views in this article are entirely personal, and in no way reflect the opinions or positions of the Tudor Group. This article could not have been written without the help received from Brian Bell. I am also appreciative of the comments received from members of the Clare Group, Olivier Blanchard, Richard Brealey, Mark Heffernan, John Macfarlane, Mahmood Pradhan, Andrew Smithers, Paul Tudor Jones and John Vickers. Of course, the usual caveat applies. The article assumes that the S&P500 = 1150.

The Review is pleased to give hospitality to CLARE Group articles, but is not necessarily in agreement with the views expressed; responsibility for these rests with the authors. Members of the CLARE Group are M.J. Artis, T. Besley, A.J.C. Britton, W.A. Brown, W.J. Carlin, J.S. Flemming, C.A.E. Goodhart, J.A. Kay, R.C.O. Matthews, D.K. Miles, M.H. Miller, P.M. Oppenheimer, M.V. Posner, W.B. Reddaway, J.R. Sargent, M.Fg. Scott, P. Seabright, Z.A. Silberston, S. Wadhwani and M. Weale.

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