Theory and Practice in the Stock Market and Government
Isaiah Berlin was a major political philosopher of liberalism. We think he neglected, but slightly, the necessary structures of liberal democracy, starting with a common respect for its reasoned traditions and institutions. However, he captures almost exactly how people, aided by these, and with different ideas and interests, reach accommodations in the resulting marketplace. Since we are discussing political economics, we shall also show how his ideas have a nearly exact analog in the behavior of the stock market.
Dealing mainly with the extreme totalitarian doctrines of the hysterical right and the coldly intellectual former left, he was not a humorous writer. However in an essay, “Political Judgement,” he wrote:
“To be rational in any sphere, to display good judgement in it, is to apply those methods which have turned out to work best in it. What is rational in a scientist is therefore often Utopian in a historian or a politician (that is, fails to systematically to obtain the desired result), and vice versa. This pragmatic platitude entails consequences that not everyone is ready to accept. Should statesmen be scientific? Should scientists be put in authority, as Plato or Saint-Simon or H.G. Wells wanted? Equally, we might ask should gardeners be scientific, should cooks? Botany helps gardeners, laws of dietetics may help cooks, but excessive reliance on these sciences will lead them - and their clients - to their doom. The excellence of cooks and gardeners still depends today most largely upon their artistic endowment and like that of politicians, on their capacity to improvise.” 1
The Stock Market
The main idea behind value investing is that stocks have an intrinsic value, and that stocks selling below that value are possible investments. That value may be derived from a company’s balance sheet (say, book value) or from some required rate of return on dividends that ranges, for individual stocks, from 8% for stocks of low risk to 12% for stocks of greater risk. Implicit behind these ideas is that interest rates are unchanged, which may not be much of a practical problem for value investors when the economy operates in cycles ranging from four to five years, but which becomes a large problem when interest rates trend for many years, either up or down. Under these circumstances, the rates at which future dividends are discounted by the present value model – and thus the cost of capital – will also trend over many years. This, of course, is the intent of the Fed.
The question we want to ask is, “in a lower interest rate environment, what is an excessive general market level?”
In 12/20 we encountered this graph by Minack Advisors that promised some very interesting insights. We stared at the eye-candy for several minutes, and then reproduced the graph in black and white as follows:
For the years 1925-2020 it graphed the real monthly S&P 500 valuation as measured by Robert Shiller’s CAPE ratio against the long-term 10 year real treasury rate. With this trove of data, it was then possible to test the present value derived Gordon stock pricing model where:
P = D/(r-g)
D=dividend, substitute E for distributable cash
r = the required rate of return
g = the growth in dividends over time
P/E = 1/(r-g), simply
Calculating in real terms:
GDP growth = g = population growth (1925-2020) = 1.11%
Productivity growth (1950-2020 data limited) = 2.11%
Real GDP growth 3.22%, say 3%
BAA Yield Markup over 10 year treasuries = 2.00%
Equity Markup over bonds (now its about 1%) = 2.00%
Treasury Yield Markups r Calculated P/E
10% 4% 14% 9.09 *
7% 4% 11% 12.50 *
3% 4% 7% 25.00 model explodes
2% 4% 6% 33.33 model explodes
-1% 4% 3% ∞ model explodes,
* These calculations of the Gordon present value model closely track the ones in the present value rate markup model that we use. If P/E = 9.09 then the rate markup model calculates an equity return of (r) of 1.33(E/P), 14.63%. If P/E = 12.50 then the rate model calculates 10.64. Close enough. The advantage of using rates of return, rather than price, in stock market analysis is that 1/(r-g) explodes but (r-g) does not. We think that rate markups, rather than volatility or price, are the best way to analyze stocks as a long-term investment – as with bonds. So considered, the analysis is consistent across all financial assets except options and futures.
If you really want to get complicated about the similarities between the two models, the similarities are likely in the growth terms, between a general real economic growth of 3% and a growth/r term of .50 per Greenwald (2001).
We have graphed this P/E against actual stock market data and are now able to make the following conclusions. For a high real required investment return rates between 14% and 11%, and a real economic growth rate of 3%, the present model fits the data quite well. It unfortunately starts to explode around a real S&P 500 investment rate of 7%. 2
Taken by itself, this theoretical model explodes. We think that social science models are not like many natural science models, because they must be always taken in a larger context of something else. They are more like engineering. How, for instance, can we use the above graph to determine when a market is overvalued?
In 1949, Benjamin Graham first published, “The Intelligent Investor,” likely one of the best investment books ever written. He wrote:
“The most realistic distinction between the investor and the speculator is found in their attitude toward stock-market movements. The speculator’s primary interest lies in anticipating and profiting from market fluctuations. The investor’s primary interest lies in acquiring and holding suitable securities at suitable prices (rates of return). Market movements are important to him in a practical sense, because they alternately create low price levels at which he would be wise to buy and high prices at which he certainly should refrain from buying and probably would be wise to sell.
“It is far from certain that the typical investor should regularly hold off buying until low market levels appear, because this may involve a long wait, very likely the loss of income (then) and the possible missing of investment opportunities. On the whole it may be better for the investor to do his stock buying whenever he has money to put in stocks, except when the general market level is much higher than can be justified by well-established standard of value.” 2
When is the market not to be added to? The first logical point to choose may be when the present value model explodes, but that is sort of abstract. The second more convincing point is shown in the second graph, where we supply context. Say we choose a point where the present value model begins to explodes and where (using the econometric OEM-ocular estimation method) the Shiller CAPE P/E resides below around 90% of the time. This conjunction of events occurs at a CAPE P/E of 25. We think this will result in a rather conservative investment policy. (We encourage you to talk with a qualified investment advisor about this, to address your unique situation.)
The Social Sciences
The graph above has a crucial feature. We have shown that the Gordon model begins to explode below a real required stock return of 7%. But in the real world, the stock market (speaking relatively) does not. Interest rates and stock returns serve their regulating function, in the bargaining process between people who provide capital and people who use it. When business is bad, expected returns are low (expected g goes down) and the P/E of the market usually goes down. When business is too good, interest rates rise (r goes up) and the P/E of the market goes down. In this slightly complicated way, markets are self-regulating; but at times no one wants to bear the social costs of waiting for this to happen. We leave it to economic research to determine when the Fed with its dual mandate of maintaining employment and controlling inflation leads or follows this process.
The Judeo-Christian religions emphasize the importance of self-regulation as well. Isaiah Berlin, who wrote that “values can clash” 3 , is a value pluralist. The Christian theologian, Reinhold Niebuhr wrote in 1949, “evil is always the assertion of self-interest without regard to the whole,” 4 or to retrieve the ideal of self-interest, “self-interest properly understood.” They transact in an open and tolerant market place of opposing ideas, aware of their own interests and the legitimate (within reason) interests of the other side. The Gordon model is unaware of this.
Which leads to the U.S. politics of the present:
U.S. politics is currently polarized, due to the contrast between a Democratic party that still acts like a traditional stabilizing political party, aggregating diverse interests, and a Republican party that currently serves the will of one unstable person, alternating between self-defeating government inaction - favoring Darwinian economic forces - and lashing out at the adverse social consequences of this, making a political cause. The following are the real causes of U.S. polarization:
1) Impersonal forces of globalization and automation, resulting in the rising economic inequality and insecurity of an increasingly disadvantaged workforce, that is losing the power to maintain its wage, pension and healthcare systems.
2) A reaction of the disadvantaged in the form of less tolerant social values that feeds back to fewer economic opportunities.
3) The resulting search for simple answers to difficult and complex social questions that favors authoritarian simplicity.
The first cause is economic. In a paper presented to the American Political Science Association in 2018, University of Michigan scholar Ronald Inglehart, noted “Conservatives argue that rising inequality doesn’t really matter. As long as a whole is growing, everyone will get richer, and we should pay no attention to rising inequality. But everyone isn’t getting richer…the safety net that once protected the American public is unraveling….Developed societies could become dystopias controlled by a small minority.”
This is not the first time that the reaction of extreme survivalist doctrines has emerged:
“The Global Great Depression – The United States was a central part of the international economic system, and its national economic disaster could not be contained. It spread across the globe. It hit particularly hard in Europe where multiple nations were indebted to the United States (due to the expenses of W.W. I; the U.S. then called these loans to stabilize its own economy)….The Great Depression also played a role in the emergence of Adolf Hitler as a viable political leader. Deteriorating economic conditions in Germany in the 1930s created an angry, frightened, and financially struggling populace open to more extreme political systems, including fascism and communism.” 5
These economic conditions were also duplicated in Japan.
“Japan was hit especially hard (by the Great Depression). With practically no natural resources, the nation had to import oil, iron, steel, and other commodities to keep its industry and military forces alive. But to buy these things, it had to export goods for sale abroad. This became harder to do in the early 1930s as nation after nation, including the U.S. raised tariffs (taxes on imports) to protect their own struggling industries. As Japan’s economy grew worse, the county became more aggressive. One way Japan could gain greater access to raw materials and markets was to increase the amount of territory under Japanese control….” 6
The lesson here is that Democracy has unraveled before due to economic conditions. Democracy is not about just flags and slogans; it must reform itself to deliver the goods, a better life for all. This is the advantage of Democracy, unlike dictatorships, it can more easily reform itself; but it has to start. In the democratic political system, there is an implicit bargain that the chosen political elite has to keep things running well. At the moment, that requires good leadership.
In the 19th century, Karl Marx thought that he had discovered the key to history, class conflict solely motivated by inevitable growing economic inequality. His too materialistic view of the world was stymied by national facts. The Communist International, seeking to promote wide economic class conflict, was perpetually stymied by the recalcitrant nationalisms of the Americans, French, British and Germans. The Marxist message took root only in the deeply shocked developing world, whose traditional cultures were also under siege by war and by the solvent of market capitalism.
But in the 2020 presidential election, voters in the 9/10 states with the highest household income voted for Joseph Biden and (precisely) voters in the 9/10 states with the lowest household income voted for Donald Trump. In his paper, Professor Inglehart notes in the graph below that in the Western democracies (between 1900-2010) the top decile’s share of national income has increased greatly since 1970, especially in the United States.
The second graph shows that voters in the Western democracies (between 1946-2015) have become increasingly authoritarian as economic inequality has increased.
These two graphs together correspond to Karl Marx’s economic interpretation of history.
But there is much more happening at the level of individuals. Professor Inglehart notes that there is a difference between people who voted on 2016 for Hillary Clinton and Donald Trump. This difference is cultural.
In 1977, he hypothesized “…throughout advanced industrial societies, peoples’ value priorities were shifting from ‘materialist goals, which emphasize economic and physical security, toward ‘postmaterialist’ goals, which emphasize self-expression and the quality of life....A massive body of evidence demonstrates that an intergenerational shift has been taking place in the predicted direction.” 7
Fast forward a few decades, and this picture has become more complicated. In the current paper, he writes, “Economic growth has continued since 1975, but in high-income countries virtually all of the gains have gone to the top….This has fueled support for xenophobic populist authoritarian movements such as British exit from the European Union, France’s Nation Front and Donald Trump’s takeover of the Republican Party. Cultural backlash explains why given individuals support xenophobic populist authoritarian movements – but declining existential security explains why support for these movements is greater now than it was thirty years ago. In the field of values, there is struggle between groups espousing Materialist values and Postmaterialist values, or in sociological terms between (timely) “Period Effects” and “Age Cohort Effects,” (values held by different generations).
Surprisingly, at the individual level, traditional economic variables such as age, education and household income all explained only one percent of the variance in how people voted in 2016. “Cultural cleavages dominate the standard demographic variables.”
Table 1. Excerpt Predicting the 2016 Presidential Vote
Independent Variable: Explanatory Power
Voted in 2012 for Barrack Obama High
Materialist/Postmaterialist 12 Item Index Medium (added effect)
Age, Education, Household Income Low
Model R2=.64 (significant for political research), n=1,182 cases
This analysis indicates that voter behavior in the 2016 election was even more polarized than in 2012 – for obvious reasons. It is much easier to destroy trust than to build it. This analysis also suggests that government programs can deal effectively with more direct economic issues, rather than more difficult cultural issues. It is more important to give all voters a justified sense of hope that tomorrow will be better. A study of what was or was not effective during the New Deal (such as the TVA), allowing for different times, might be useful.
Professor Inglehart concludes, “It took decades for the industrial working class to become literate, cognitively mobilized and organized as an effective political force. But today’s knowledge societies already have highly-educated publics who are accustomed to thinking for themselves. A large share of the 99 percent is articulate and have political skills….
“A large share of the public is angry – and it should be. Government is not working on their behalf. Growing resources are available, but government intervention will be required to reallocate some of these resources to create jobs that (unlike automation) required a human touch, in health care, pre-school education, infrastructure, environmental protection, research and development, care of the elderly, and the arts and humanities. Developing well-designed programs to attain this goal will be a crucial task for social scientists and policy-makers in coming years.”