Andrew Smithers
Published in: World Economics • Vol. 25 • No. 4 • October–December 2024
Key Points
- The stationarity of the stock market’s value (q) and the mean reversion of its real return are its most obvious and exceptional characteristics.
- These characteristics allow the cost of capital to be calculated, and the results are incompatible with the consensus growth model. The Stock Market Model (SMM) includes these features. It is testable and robust when tested; it is therefore the model used in this paper.
- The ex post identity of investment and savings requires an ex post identity of the flow of savings available to finance the equity and debt proportions of new investment. This identity pulls q to fair value.
- Only temporary fluctuations in q around fair value are possible because net issues of equity will either depress net worth, relative to share prices, if q is above fair value, or boost it, if it is below.
- Changes in nominal corporate bond yields, profit margins and household liquidity cause fluctuations in q. Sustained misevaluations of the stock market require continuing changes in at least one of these three variables.
- Changes in these variables, which depend partly on endogenous political decisions, cannot be predicted, but past changes in q can be explained by their past fluctuations.
- The current prolonged excessive level of q has been driven by a rise in household liquidity, in response to the current secular liquidity trap. A similar experience in the 1930s ended in 1937 with the second worst recession in US history.
- Changes in corporate bond yields explain 7 of the past 10 major bull and bear phases of the stock market. One of these three exceptions is the current bull market, which depends on the rise in household liquidity.
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