No one who is not utterly preoccupied with Brexit can have missed the dramatic downturn in the markets this week.
But it’s an ill wind etc. The downturn gives us a chance to evaluate two important theories about the market. The first is Shiller’s idea (which won him a Nobel prize) that income is more stable than capital. That is, the market value of a portfolio goes all over the place, but dividend payments don’t. Shiller discovered this by an elegant method that valued stocks on an ex post basis using future dividend streams. I.e. go back to 1950 (say) look at all the dividends that were going to be paid, then present value them using 1950s long term market discount rates. Then do the same for 1951 and so on. How would changes in the ex post present value compare to the ex ante value given by the market ?
It turned out, using some elegant mathematics, that the ex ante value was much more volatile than the ex post one. Another way of saying it is that dividend income is, or should be, more stable than the volatile stock prices.
Well let’s hope so. The thing about the market is that you can be entirely convinced by the rational aspects of the theory, but when it comes to seeing those red numbers, theory and rationality disappear out of the window. So far, dividends have been pretty stable for a long time, but who knows?
The second idea is that markets ‘demand’ a premium for taking on risk. That idea underlies the logic of Mark Carney’s letter to Sir John Vickers, which I briefly discussed here. The empirical evidence for that used to be strong, and I shall produce some charts on that later, but for now it should be noted that the premium seems to have disappeared since the high of the dotcom boom in the late 1990s. No charts necessary: we know the FTSE was around 6,700 at the end of the 1990s, we know (sadly) that it is the same level now. Hence the only growth has been that provided by dividends, which are generally less (until recently) than long term interest rates.
I promise a chart or two later on, but you can already see it’s going to be a close call.