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The Economic Costs of Fear

From Project Syndicate:

BERKELEY – The S&P stock index now yields a 7% real (inflation-adjusted) return. By contrast, the annual real interest rate on the five-year United States Treasury Inflation-Protected Security (TIPS) is -1.02%. Yes, there is a “minus” sign in front of that: if you buy the five-year TIPS, each year over the next five years the US Treasury will pay you in interest the past year’s consumer inflation rate minus 1.02%. Even the annual real interest rate on the 30-year TIPS is only 0.63% – and you run a large risk that its value will decline at some point over the next generation, implying a big loss if you need to sell it before maturity.

So, imagine that you invest $10,000 in the S&P index. This year, your share of the profits made by those companies will be $700. Now, imagine that, of that total, the companies pay out $250 in dividends (which you reinvest to buy more stock) and retain $450 in earnings to reinvest in their businesses. If the companies’ managers do their job, that reinvestment will boost the value of your shares to $10,450. Add to that the $250 of newly-bought shares, and next year the portfolio will be worth $10,700 – more if stock-market valuations rise, and less if they fall.

In fact, over any past period long enough for waves of optimism and pessimism to cancel each other out, the average earnings yield on the S&P index has been a good guide to the return on the portfolio. So, if you invest $10,000 in the S&P for the next five years, you can reasonably expect (with enormous upside and downside risks) to make about 7% per year, leaving you with a compounded profit in inflation-adjusted dollars of $4,191. If you invest $10,000 in the five-year TIPS, you can confidently expect a five-year loss of $510.

That is an extraordinary gap in the returns that you can reasonably expect. It naturally raises the question: why aren’t people moving their money from TIPS (and US Treasury bonds and other safe assets) to stocks (and other relatively risky assets)?

People have different reasons. And many people’s thinking is not terribly coherent. But there appear to be two main explanations.

First, many people are uncertain that current conditions will continue. Most economists forecast the world a year from now to look a lot like the world today, with unemployment and profit margins about the same, wages and prices on average about 1.5% higher, total production up roughly 2%, and risks on both the upside and the downside. But many investors see a substantial chance of 2008 and 2009 redux, whether triggered by a full-fledged euro crisis or by some black swan that we do not yet see, and fear that, unlike in 2008 and 2009, governments would lack the power and will to cushion the economic impact.


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