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Dangers of Extrapolation... - Grasping Reality with Both Hands

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Grasping Reality with Both Hands The Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, RealityBased, and Even-Handed Department of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 708 0467; delong@econ.berkeley.edu.

Economics 210a Weblog Archives DeLong Hot on Google DeLong Hot on Google Blogsearch August 16, 2010

Dangers of Extrapolation... Alison Schraeger writes in the Economist: Pensions: The retirement solution: If equities continue to perform the same way they have the last ten years... No, no, no, no no. No. NO! Naive straight-line extrapolation is rarely your friend. Over the past ten years... Cyclically-adjusted real earnings have grown at a rate of 2.5% per year. Stocks have paid dividends at a rate of 2.5% per year. Price-to-cyclically-adjusted earnings ratios have collapsed at an average rate of 6% per year. producing average real equity returns of -1% per year. If this were to continue for the next two decades, the S&P composite would stand in 2030 at 6 times its cyclically-adjusted earnings, which would be 56% higher than they are now. My mind, at least, boggles at the idea of an S&P Composite where the earnings yield is 17%. Brad DeLong on August 16, 2010 at 12:46 PM in Economics, Economics: Finance | Permalink

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Dangers of Extrapolation... - Grasping Reality with Both Hands

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Comments rustneversleeps said... So, what you are saying is that we shouldn't naively extrapolate historical earning rates into the future. Got it! Look, I actually do get what you are saying, but another real issue is that in retrospect many investors have concluded that the prospective equity risk premium was/is not enough at the circa 2000 price/dividend ratio. So they are/have (rationally) marked prices down to a 2.5% yield. But that still seems to assume we expect something like the 2.5% real earnings growth you used. If the next decade gradually achieves less than that, we could still get ANOTHER double whammy of downside for realized returns: Disappointing earnings and a further p/div markdown to account for even more disappointment on the risk/return tradeoff. I know that is (historically) gloomy, but my point is that there are many roads that can lead to the Rome that McCardle/Schraeger/etc. are musing about. Reply August 16, 2010 at 04:33 PM Robert Waldmann said... "Naive straight-line extrapolation" may not Alison Schraeger's friend, but it sure is one of your friends, since you paper with Andrei and 2 other co-authors about the horrible consequences of such idiocy in financial markets is cited almost as often as Noise Trader Risk in Financial Markets. Reply August 16, 2010 at 05:48 PM vtcodger said... ***My mind, at least, boggles at the idea of an S&P Composite where the earnings yield is 17%.*** Why? It happened in 1920 and again in 1932. And it no doubt seemed pretty reasonable at the time. Ah, but of course, things are different this time. No, I don't think it will happen, but that's partly because I think earnings -- if honestly reported -- would be significantly lower than is claimed and that PE ratios are therefore higher now than we think. http://delong.typepad.com/sdj/2010/08/dangers-of-extrapolation.html

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Dangers of Extrapolation... - Grasping Reality with Both Hands  

Economics 210a Weblog Archives DeLong Hot on Google DeLong Hot on Google Blogsearch August 16, 2010 The Semi-Daily Journal of Economist J. B...

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