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The current average price-to-earnings ratio of stocks is still far above the historic average, so we should not be surprised that there is a stock bubble and that it burst, explains PERI economist Robert Pollin

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SHARMINI PERIES: It’s The Real News Network. I’m Sharmini Peries coming to you from Baltimore. At the State of the Union Address last week President Trump boasted about the high stock markets as an indication that his economic policies were working and strengthening the economy. But then days later the stock markets took the greatest plunge in a single day and it slid further the following days. The situation has of course stabilized now but the concern over what happened lingers. In the panel discussion here at The Real News Network shortly after Trump’s State of the Union Address Bob Pollin called it. By that I mean he predicted that the stock markets would not continue to rise because some fundamental economic principles were not in sync. Let’s listen.
ROBERT POLLIN: … have not repealed the laws of economics that have been going on for hundreds of years. This stock market will not be sustained and when the stock price collapses then we will see how sustainable the Trump policies are.
SHARMINI PERIES: Indeed just two days later the markets took a big dive so we invited Bob back into the show to discuss this latest development with the markets. Bob Pollin as you know is a distinguished Professor of Economics and Co-Director of the Political Economy Research Institute at the University of Massachusetts Amherst. I thank you so much for joining us Bob.
ROBERT POLLIN: Thank you very much for having me on Sharmini.
SHARMINI PERIES: All right Bob, let’s begin with you elaborating on the point you were trying to make there. The price to earnings ratio being so high that the only way to generate profit from the stock market is through speculation. Explain that a little bit further and how it drives prices up and then what caused the plunge.
ROBERT POLLIN: Well the price to earnings ratio is a standard indicator of the relationship between how much you have to pay to get a dollar of profit by buying a company. If we think of it as not this big complicated stock market thing, we’re just like you’re trying to buy into a business, how much are you willing to pay in order to get a hundred dollars of profit out of the company. That’s basically what the price to earnings ration is.
Now if you look at the price to earnings ratio today in the stock market, and this is an average so it doesn’t apply to every single business but if you look at it in terms of the Standard and Poor 500 broad indicator people are paying the average stock price today and will get a return, a profit of 2.2%. That tells you that the prices that people are paying are way too high relative to the profit they’re going to earn and that means that the market is unsustainable. The historic average for this price to earnings ratio would generate an average rate of profit of between six and seven percent.
People are not going to stand for a 2.2% return once they realize that that’s what they’re buying into. The only thing that sustains the market at this incredibly high, historically high level is this perception that somehow it is just going to keep going up. Because it’s gone up before, it’s going to keep going up. These are called bubbles or manias and we’ve had these over and over again historically. We didn’t have as many of them when we actually regulated the stock market, the financial markets, but we’re back in a largely unregulated finical market so we’re back having this kind of bubble.
What happened over the past week and actually today the market is going back down again. I don’t know how far it’s going to drop today but we are definitely not going to sustain a stock market where the average price to earnings ratio gets you a 2.2% return. Nobody will buy into it.
SHARMINI PERIES: Right. Now, if these ups and downs are somewhat normal or what Leo Panitch calls in and out of crises in the market, if this is normal will the lower price that’s there now make the stock market more attractive and people will invest more?
ROBERT POLLIN: Well we have, the price to earnings ratio is still way too high. We had three or four days of decline. There may be some people who think, “Oh, well it declined 4% so I’ll buy in now because it’s just going to keep going back up.” I think those people are going to be cruelly disappointed over time. The market just doesn’t … The only way the market has room to go up at all is if you squeeze workers and cut wages severely or you squeeze, you take out taxes and so the companies get to keep a higher share of their profits.
Now we did get the tax cut and that is certainly contributing to these, this bubble in the stock market but again, there’s just only so much room you can get. I mean people aren’t going to invest in the company for no return. After you’ve gotten the tax cut then where’s the room there? Oh well, we could try to push wages down and that is a lot of the concern that prompted, and this was in the front page of the New York Times last Saturday, that the immediate cause of concern in the stock market was the job report that said that worker’s wages had gone up.
Now as we talked about it on, after the State of the Union worker’s wages, non-supervisory worker’s wages had gone up a whole four cents on average. Basically no increase at all. Even that alone was enough to rattle the market. The markets are very fragile. They think, we’ve repealed the laws of economics, the stock market can just go up forever because maybe because we have Trump cheerleading it on and of course people want it to go up and wanting it to go up makes it go up a little bit temporarily but it’s going to come down and we’re going to be … I don’t know how fast it’s going to come down but the trend over time is going to have to be down.
SHARMINI PERIES: Right. And Bob, how do you tell the difference between what optimists and the business media this call of correction and an actual crash about to happen and happening?
ROBERT POLLIN: Well, you know a crash, we had a crash in 1987. There was a 20% decline in a matter of a day and a half. We haven’t gotten there yet. It could happen. There’s plenty of room for 20% decline but again, in 1987 the market was overvalued. We had the crash and we didn’t have a severe recession. So whether or not we also have the recession will have to depend on other factors, not just the stock market. The stock market itself, the reason we focused on it after Trump’s speech was because Trump is so onto it and he is so focused on keeping it high, the stock market is going to come down. There’s only so much you can squeeze workers wages. Workers got a tiny tiny raise and to push it back down would be extremely hard at this point.
SHARMINI PERIES: Right, and speaking of wages, now wages rose 2.9% apparently for this year. How much of an indication is that because people were speculating that the price, the wage price hike and in addition to that the possibility of interest rates going up partly due to the changing of the guard in the federal reserve kind of caused people to pull out of the market. Do you agree with that and if not why?
ROBERT POLLIN: Well, you know I think there’s a lot of truth in that. I think there’s some truth in the change from Janet Yellen to Powell affecting the market. Maybe unsettling the market. Though if anything Powell is going to be more favorable around issues of regulation. Janet Yellen was relatively tough on Wall Street and believing in financial regulations. But, the issue is when you have a relatively low unemployment rate, and we can come back to that but we do have a relatively, the official unemployment rate is 4.1% and we do have some indication of wages going up because at low unemployment workers get more bargaining power because they can quit the job that they have go for a better job, which they can’t do when it’s high unemployment.
So, that’s a concern. That’s good for workers by the way. Workers getting raises, having jobs, having some options, that’s good. It’s just not good for capital. It’s not good for profitability because the higher wages will cut into profits. Now I want to say about the labor market, these wage increases are very very modest. They’re in the framework of the long trajectory of labor market. Average wages are still lower than they were in 1971, 45 years ago, whereas productivity has doubled. Secondly, and even though the official unemployment rate is 4.1%, the official broader rate, which includes people who can’t get full time jobs who want full time jobs, that’s double. That’s 8%.
And on top of that we have people having dropped out of the labor force, which is another six million people. If we added all those up we’re more at an unemployment rate at something like 10%. This is the best, this is the best conditions. We are, in real genuine terms we’re very very far from a full employment economy but the problem from the business standpoint is that we’re at a point in which workers seem to start getting a little bargaining power and that means they think, the businesses think well that’s going to cut into my profit margin and therefore I’m going to have to raise my prices to defend my profit margin. That’s what causes inflammation.
By the way, worker’s wages do not cause inflation. Rising wages do not directly cause inflation. Inflation means businesses raise their prices. Businesses are just trying to defend their profit margins. They are not accepting workers having a bigger share of the overall pie.
SHARMINI PERIES: And Bob, also one thing that you said in the panel discussion is that if the stock prices were to fall we’ll see how sustainable Trump’s policies really are. What did you mean by that?
ROBERT POLLIN: Well, I mean Trump is touting the success of the economy based very significantly on the stock market. But once you have this prop that’s holding up this Trump image collapse the confidence that people have that well Trump may be crazy but hey, the stock market’s doing great. Once we have, Trump is really crazy and he can’t even sustain the stock market, well I think that is going to create an unraveling politically and confidence in Trump. On top of that people will say, “Well, you know the market was in a bubble situation all along. How come we didn’t realize that? How come the Trump administration didn’t do anything about it?” And those are the things I think we have to look forward to.
SHARMINI PERIES: Right. And finally Bob, there is this question of crypto currency, which apparently contributed to this fall of the stock market. If, according to the Business Press of course, if speculative money flows from the stock market to bit coin and other crypto coins can this explain what we are seeing now? Does it have any effect on it?
ROBERT POLLIN: Well, you know this is a big area of a bubble. You know the crypto currencies have no basis whatsoever. They have no value whatsoever. Except that people think they have value. Somehow they got the idea that these crypto currencies have increasing, rapidly increasing value just because people think they do. Once that confidence stops, once people realize there is no relationship in the value of this crypto currency and what you can buy with the crypto currency, then that market will also collapse.
This is the history of capitalism. This has been the history of capitalism for 300 years. The only time we had a modulation on this kind of bubble formation as a regular occurrence in capitalism was in the period immediately after the Great Depression and World War II because we had the tremendous Wall Street crash and then we had regulations. We had regulations that worked reasonably well for 30 years. And other than that we will always have bubbles and financial markets and that’s what crypto currency phenomenon is and that’s what the stock market phenomenon is.
SHARMINI PERIES: All right Bob. I thank you so much for joining us today and we are going to have a second segment with you so do tune in. We’re going to talk about the current budget in Washington.
ROBERT POLLIN: Okay, great. Thank you Sharmini.
SHARMINI PERIES: And thank you for joining us here on The Real News Network.

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Robert Pollin is Professor of Economics at the University of Massachusetts in Amherst. He is the founding co-Director of the Political Economy Research Institute (PERI). His research centers on macroeconomics, conditions for low-wage workers in the US and globally, the analysis of financial markets, and the economics of building a clean-energy economy in the US. His latest book is Back to Full Employment. Other books include: A Measure of Fairness: the Economics of Living Wages and Minimum Wages in the United States, and Contours of Descent: US Economic Fractures and the Landscape of Global Austerity.