RETIREMENT PUZZLE I LIKE THE WAY YOU WORK IT, NO DIVIDENDS The last decade or so has thrown down a challenge to a variety of conventional economic theories. One difficulty with economics is that it’s not a model of anything permanent, but ultimately a model of human behaviour. In physics, whether everyone believes something or no-one does has no impact on its truth or falsehood. In economics, if enough- or if the relevant- people believe in a theory and act accordingly, that can make it true. If enough stockholders believe a stock will fall, and either sell it or short it, the price will fall. It may become a good value stock as a result, and reward those who hold it or buy it, but the price will fall. That means economic theories are vulnerable to regime change in a way that gravity isn’t, which makes it harder to test. One theory in vogue now is that stocks have performed well recently and valuations appear high because rates are low. The idea is that future value- ultimately, future dividends -should be discounted less heavily. It’s plausible and coherent- but is it true? We know there should be some one-directional effects because lowering rates has been used as a policy tool after crashes, alongside stimulus packages. That is, equity crashes may now make rates falling more likely. But do lower rates drive higher equity prices? The simplest test is to look at correlations, and it’s not very strong. The correlation since 1994 between US 10y government rates and the S&P 500 has been 14%. High rates might indicate strong growth environments, which would appear to be a stronger factor. Even if we look rolling correlations, the trendline is actually the other way around, albeit with a lot of noise. So are higher rates good for equities?
page 22
