New study says stock values now have room to rise

If economists had the equivalent of a bestseller list for their academic work, a paper by Ellen McGrattan and Edward Prescott might well qualify.

It deals with the question of whether corporate stocks are overpriced. That issue is of interest to millions of investors.

Recently, the paper has been downloaded often enough from among the many hundreds of papers carried on the website of the National Bureau of Economic Research to rank in the top 10 for popularity (Working Paper 8623 at www.nber.org).

Stock prices have tumbled for the past two years. Last year, the Standard & Poor's 500 stock index fell 13 percent, and the Nasdaq composite index 21.1 percent.

Investors wonder if prices will head south for a third year.

The paper by Ms. McGrattan, an economist at the Federal Reserve Bank of Minneapolis, and Mr. Prescott, at the University of Minnesota in Minneapolis, doesn't say the market won't tank again this year.

"The stock market is volatile," says Prescott. In the short run, the market offers a lot of risk of slumps - or booms.

But using the analysis outlined in the paper, stock prices are about 15 percent undervalued right now, he calculates.

That may be encouraging. Prescott cautions, but, in the years ahead, investors shouldn't expect the "fantastic returns" on stocks of the 1980s and 1990s. More realistic would be 4.3 percent a year on average after inflation.

"That's not bad," he says.

Of course, many, many analysts give opinions and theories on stock-market values. As veteran observers note, their predictions are often wrong.

What has prompted the excitement over the McGrattan-Prescott paper is that it explains with standard economic theory and analysis the long-term trend in average stock values.

The two authors have been invited, usually separately, to lecture at a host of business schools, the Bank of Italy, the St. Louis Fed, and to groups in Taiwan, Stockholm, and Tokyo.

To economists, the rise in the stock market in the last bull market is puzzling. Why has the return on stocks been so much higher than the return on bonds? Annual real stock returns averaged above 13 percent for 1983 through 1999. They were almost 22 percent for 1995 through 1999.

United States stock prices have increased much faster than gross domestic product (GDP), the total output of goods and services in the nation. Between 1962 and 2000, corporate-equity value relative to GDP nearly doubled. Yet the importance of debt in corporate financing hasn't changed much. Nor has the ratio of productive tangible assets (plants, machinery, offices, etc.) to output. And corporate profits as a share of GDP stands about the same now as in the early 1960s.

A number of explanations have been offered for the unprecedented rise in stock prices, none fully satisfying. Maybe investors are counting on the information revolution to boost future economic growth. Perhaps baby boomers are buying more stock for their retirement years.

Other possible explanations include less inflation, lower costs for buying and selling stocks, increased investment diversification, or just the "irrational exuberance" of investors, as Fed Chairman Alan Greenspan put it a few years ago.

McGrattan and Prescott explain stock-price shifts by noting the major changes in the American tax system. Taking these changes into account, a theoretical model produces predictions of the value of corporate equity in both 1962 and 2000 close to the actual values in those years.

What's changed is that the average marginal tax rate on corporate dividends fell from 44 percent in the 1955-62 period to 18 percent in 1987-2000.

One reason is that the highest marginal bracket among individual income-tax rates plunged from 91 percent after World War II to 33 percent in 1986. This affects the high-income people who own the bulk of stock, even today.

More important, the share of stock held by non-tax-paying entities - pension funds, individual retirement accounts, 401(k) plans, and nonprofit organizations - has increased from a few percent in 1962 to about 50 percent in 2000. In the earlier years, legal restraints in regard to prudent investing meant most pension assets were held in bonds and other liquid debt instruments. Major changes in tax law fostered the increase in stocks held by these entities.

This explanation implies that the real before-tax return on the stock market should have been about 8 percent on average in the postwar period. And it was, the authors note. Further, their theory puts the return in the years ahead at a bit more than 4 percent.

The findings also end the equity premium puzzle in the postwar period, the authors maintain.

Prescott had been "nervous" about the stock in his personal portfolio. Many analysts note the ratio of stock prices to corporate earnings is still well above 30 to 1, compared to what many regard as a "normal" 14 to 1. With the findings of his paper, he is now invested 100 percent in stocks - and relaxed about it.