Explaining Stock Market Prices by Laura Davidson

Letter 1:

From: N
Sent: Tuesday, April 03, 2018 2:13 AM
To: Walter Block ;
Subject: Stock Prices

Why do stock prices systemically go up? The S and P 500 has been going up slowly but steadily for many decades. What determines stock price is either dividend payments or reinvestment for the purpose of increasing future dividend payments – in other words, the profit margin. Now, you wouldn’t necessarily think that profit margins would go up over time, just as some businesses become more successful over time, other businesses fail. You might expect them to counterbalance each other. Stock market growth doesn’t logically necessarily have any connection to economic growth.

Now I looked at the statistics and profit margins have steadily been going up over time. This suggests to me that the economy has been steadily becoming less competitive over time. A few examples would be the expansion of newish natural digital monopolies or oligopolies like Google for search engines, Apple with iMessage, and Uber for rides. Before Uber I’m sure there must have been thousands of more taxi companies around the country (even with taxi licensing). I looked at the data and it is indeed true that the plurality of the economic growth in the economy is from these newish digital technologies. Now, there may be other reasons for the lack of competitiveness such as increased trade restrictions in the form of tariffs or occupational licensure. Do any of ya’ll know if either of those have been trending up or down over time? If I’m right about this it would suggest that if other people haven’t figured this out as well that if we start to see the amount of economic growth going to digital technology natural monopolies go down or we see trade restrictions being lifted we could theoretically predict a ceteris paribus decrease in economic growth. Thanks, N

Letter 2:

On Apr 6, 2018, at 2:15 PM, Walter Block wrote:

Dear N:

I’m copying on this my friend and many times co author (and sometimes intellectual debating partner) Laura Davidson, who is one of my gurus on macro. Her recent paper deals with the stock market, so I expect she’ll be able to shed some light on your question.

Dear Laura:

N is an excellent student of mine. Would you please respond to his question?

Best regards,

Walter

Walter E. Block, Ph.D.
Harold E. Wirth Eminent Scholar Endowed Chair and Professor of Economics
Loyola University New Orleans
6363 St. Charles Avenue, Box 15, Miller Hall 318
New Orleans, LA 70118
wblock@loyno.edu

Letter 3:

From: Laura Davidson [mailto:davidsonlaura@hotmail.com]
Sent: Tuesday, April 10, 2018 12:58 PM
To:
Subject: Re: Stock Prices

Dear N,

How are you? I’d like to try to answer your question:

Suppose we lived in an unchanging world of complete certainty. How would stocks be priced?
The price per share of any given firm would reflect the total value of all the assets of that firm. The assets would be priced according to the capitalized value of the expected future returns discounted to the present. Since neither the assets nor the returns would change, and since they would be known with absolute certainty, the share price could be calculated easily as the proportionate share of the total value of all the assets. And it would never change. Dividends to shareholders would be equivalent to the return the firm makes (cost of the product less price of the factors with just enough funds retained to maintain the present value of the fixed assets.) The dividends would equal the market rate of interest, which would equal the natural rate, which would equal the pure rate of interest as governed by the social time preference. There would be no entrepreneurial profit or loss, and no speculation.

But in the real world there is constant change and a good deal of uncertainty. While the present discounted value of a firm’s assets is a good starting point for share valuation, the share price has to take into account the fact that the fortunes of the firm might change due to exogenous events. In other words, any share price is likely to vary according to how entrepreneurs appraise future profits or losses, and how the firm’s capitalized value is likely to change as a consequence. For example, if the firm has a developed a new technology which is forecast to generate greater profits in the future, then the share price is likely to rise, ceteris paribus. If demand for the product is forecast to increase, which would raise the product’s selling price, or if new resources are discovered which lowers the cost of the factors such that future returns will be higher, then this too increases the firm’s value and the share price. From a long term perspective, share prices in general also rise if the social time preference falls, because this means increased investment, and subsequent growth in the economy as a whole. However, one has to take into account the fact that when we talk about rising share prices, we mean real values. And share prices in general can rise in real terms without increasing nominally, particularly in a growing economy in which there is little or no monetary inflation. Conversely, real share prices could fall even if nominal share prices rise dramatically, as might occur during a hyperinflation, for example.

As far as the actions of the firm are concerned, we mean the actions of the shareholders, at least from an economic point of view, because they are the owners, and ultimately dictate what the managers may do. The firm can increase investment by retaining more of the earnings, in which case the capitalized value and the share price increase, ceteris paribus, but there are fewer funds available to pay dividends. Or it can increase dividends while reducing investment. In this case, shareholders receive greater income for themselves but the capital value of the firm and hence the share price will be relatively less, ceteris paribus. This is contrary to popular financial theories which claim dividend growth always results in an increased share price. The reality is that increased dividends usually reflect a successful enterprise, which is why the share price might rise as well, but it’s not true that the former is the cause of the latter, ceteris paribus.

One final note: In a world of government intervention, there can be a lot of speculation in the market. I talk about this in my paper (attached with this email). In the free market, speculation is not a bad thing. It’s simply a form of entrepreneurship. And with respect to stocks, it means the share price of an individual firm is thought to be either undervalued or overvalued, as discussed earlier. But in an economy of violent intervention — and by violent intervention I mean any government action which interferes with the free market — speculation can occur with respect to stocks as a whole. This is when you get large market moves, as occur for example, when the Fed changes interest rates, or when the government enacts certain policies, particularly those that increase uncertainty. It’s a mass psychological phenomenon. And it can result in large-scale error.

So, in general, stock market growth does indeed correspond to economic growth, because it reflects a steady increase in the overall amount of capital goods in the economy over extended periods of time. (Who would argue that the economy is not more advanced now than say a hundred years ago?) However, the stock market is buffeted by all sorts of exogenous events, and in particular by government intervention, which means the trajectory of the stock market is never linear or smooth.

Best regards,

Laura Davidson

Letter 4:

Dear Laura:

The only “problem” I have with your brilliant (as usual) writing is that so few people will see this important contribution to our profession, unless I do something about it.

So, unless I hear otherwise from you, I’m gonna blog this correspondence on LRC, keeping N anonymous, as is my practice. Ok?

Best regards,

Walter

Walter E. Block, Ph.D.
Harold E. Wirth Eminent Scholar Endowed Chair and Professor of Economics
Loyola University New Orleans
6363 St. Charles Avenue, Box 15, Miller Hall 318
New Orleans, LA 70118
wblock@loyno.edu

Letter 5:

Walter, Yes, no problem.
Laura

Letter 6:

On Apr 10, 2018, at 1:37 PM, N wrote:

That is a brilliant explanation of the stock market, my question is answered. Thank you.

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7:17 pm on April 11, 2018