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News :: Miscellaneous |
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Hold On While I Sell |
Current rating: 0 |
by Dean Baker and Mark Weisbrot
(No verified email address) |
27 Mar 2001
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Millions of investors are sitting shell-shocked in the wake of the market's recent plunge. Many have lost a large portion of their life's savings, and with it, their hopes for their children's education or their own retirement. The question on everyone's mind is whether to hold or to sell. |
There is no shortage of analysts urging the
"hold" route. In some cases, this may make sense,
but many of these same analysts were the ones
that encouraged people to buy into a stock bubble
in the first place. In other words, just because you
play a stock analyst on TV, doesn't mean you
know anything. Having been burned once,
investors would be wise to rely on their own
common sense rather than this crew's gossip.
There are some simple rules of thumb that
can help in this judgement. First, over the long-
term, stock prices generally rise at approximately
the same rate as profits. This is true for the market
as a whole and for the stock of individual
companies.
The basic logic is quite simple. Other
things equal, a stock with twice the earnings per
share will sell for twice the price per share. This
means that if the earnings of a company doubles,
then we typically would expect its share price to
double as well.
While we don't know exactly how fast
earnings will grow in the future, we do have some
basis for informed guesses. For example, the
Congressional Budget Office (CBO) -- the agency
that makes all the projections for the budget --
expects that corporate profits will rise by an
average of approximately 1 percent annually over
the next decade, after adjusting for inflation.
CBO may be wrong in its prediction for
profits, but its projections should at least be taken
seriously. If CBO is right, then an average share
of stock will rise by approximately 1 percent more
than the rate of inflation each year over the next
decade. While some stocks will clearly do better
than the average, clearly this cannot be true for all
of them. This is not Lake Wobegone, where all
the children are above average.
The other part of the return from holding
stock is the dividend payout. At present this
averages slightly less than 2 percent a year.
Adding the 2 percent dividend payout to the 1
percent growth based on the CBO profit
projections gives a total return of approximately 3
percent above the rate of inflation.
By comparison, an investor can buy an
inflation-indexed government bond that will
provide a guaranteed return of 3.2 percent above
the rate of inflation. Investors can count on this
return as long as the U.S. government doesn't go
bankrupt. Holding stock that gives a lower return
doesn't seem like a very good deal. In fact, unless
investors can expect a substantially higher return
on stock than government bonds, it doesn't seem
worth taking the risk that the share price will fall.
Historically the premium for holding stocks has
been four percentage points.
The stock market is often said to be
governed by the "greater fool" theory. At any
point in time, stock can be sold for whatever
someone is willing to pay for it. But when stocks
are priced far higher than expected earnings could
justify, those prices must eventually fall.
As we saw, many people were willing to
pay ridiculous prices for shares of stocks that in
some cases were literally worthless. Many of
these shares continue to be traded at prices that
are far above what would be justified by their
current or future profits. Insiders who understand
this are no doubt trying to unload these shares as
quickly as possible.
To avoid being taken yet again, investors
must ignore the advice of the analysts who say,
"hold" while they try to decide for themselves
whether share prices make sense. While it may
help the insiders, it is a losing strategy to hold a
stock that it is overvalued and on its way down.
Dean Baker and Mark Weisbrot are co-directors
of the Center for Economic and Policy Research,
in Washington, D.C. (www.cepr.net), and co-
authors of Social Security: the Phony Crisis
(2000, University of Chicago Press). |
See also:
www.cepr.net
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