What should stocks cost?

As you may have heard, US stocks are expensive. You may even think you know what that means. Personally, I have no idea.

I buy organic milk. Organic milk costs more than milk from corn-fed antibiotic cows. In other words, it’s “more expensive.”

I buy t-shirts made by union workers in downtown Los Angeles. They cost more than t-shirts made in Southeast Asian child labor mills. They’re “more expensive.”

But when I buy US stocks by making contributions to the Vanguard 500 fund I hold in my IRA, I don’t know what the point of comparison is supposed to be. You can tell me the Russian stock market has a lower price/earnings ratio than the US stock market, but Apple isn’t listed on the Russian stock market; it’s listed on the US stock market. You can tell me that the price/earnings ratio of the US stock market used to be lower than it is today. But I don’t live back then, so I can’t pay the historical low price, or even the historical average price, for US stocks. The only price I can pay is today’s price. Is today’s price “expensive?” Compared to what?

Stocks, flows and stocks

Say you happened to enter the workforce in March, 2009, and started directing monthly contributions into an IRA invested entirely in the Vanguard Total Stock Market Index Fund. Every single one of those purchases in the last 8 years has been “expensive” compared to your original purchase: you’ve received fewer shares per dollar contributed to the fund. Why would anyone pay $58.19 for a share that’s identical to the one they used to pay $16.43 for?

That being the case, you might arrive at a sensible conclusion: “there’s no way I’m paying that much for a mutual fund share that I used to be able to buy for $16.43. I’m not going to buy a single share more until the price falls to something more sensible.”

But that leaves you with an obvious dilemma: all those other lunatics are willing to pay you $58.19 each for shares you purchased starting at $16.43. If you’re not willing to pay such a ridiculously inflated price, and are waiting for prices to fall, why not unload your shares now and hold onto the cash, “dry powder” for when the market finally comes to its senses?

What should stocks cost?

There is a very fashionable line of inquiry that asserts that the historical average Shiller CAPE ratio of “about 15” is a kind of dividing line between an “expensive” and a “cheap” stock market. Does that mean stocks should cost 15 times their inflation-adjusted 10-year average earnings? I don’t know anyone who would agree with that. For one, it means any company that has run a loss on average over the last 10 years is worthless. Whatever you think about Amazon’s business model, clearly the warehouses, technology, and patents they own aren’t worth nothing.

You’re free to say that I’m being ridiculous, and that while an individual company’s “correct” share price can’t be calculated so mechanically, the correct price of an entire market can be, averaged as it is across so many different companies.

But if it’s ridiculous to use such a mechanical calculation for an individual stock, it’s equally ridiculous to use it for the stock market as a whole, which is of course composed entirely of those individual stocks.

Why own stocks?

No one would ask “how much should a car cost?” without first asking “do I need to buy a car?” No one would ask “how much should a coffee machine cost?” without first asking “do I need a coffee machine?” But plenty of people are willing to ask “how much should stocks cost?” without first asking “do I need to own stocks?”

The reason I own stocks is in order to have a broadly diversified, inflation-protected income stream denominated in my home currency. Stocks will not make me rich (nothing will make me rich), but owning a very broad swathe of US stocks will give me access to the overall profits of the publicly-traded US economy.

Publicly-traded securities are a weird thing to own if you have other options

The great democratization of the stock market in the latter half of the 20th century, spurred on by the adoption and growth of 401(k) and IRA accounts, has obscured a much older and more fundamental truth: people invest in securities when they are out of other things to buy.

After all, cobblers did not historically own stocks: they owned shoe stores. Blacksmiths did not own stocks: they owned smithies. Even lawyers didn’t own stocks: they owned law firms. The idea that ordinary people, and even professionals, should own stocks instead of investing in themselves or their businesses is a relatively new phenomenon.

That’s worth remembering when deciding whether to buy stocks or not, however much stocks cost. If you have credit card debt accruing 21% interest, you should pay it off before buying stocks no matter how cheap stocks are. If you have a business idea that needs capital, you should pour capital into it before buying stocks.

Of course, most people today don’t own their own businesses. They’re employees, they’re paid a more-or-less fixed wage, and they have to decide how to save their excess income. My point is that when determining what to do with that excess income, the past performance of a given market is largely, if not entirely, irrelevant. You should decide whether or not you need to own stocks before the question of whether stocks are “expensive” or not can even begin to become relevant.

Demographics, inflows and outflows

Finally, I want to mention a topic that some people seem to believe has unusual explanatory powers: the question of demographics and market flows. The simplest version of this theory goes that aging Americans today, who have accumulated a vast treasure trove of assets, will begin to sell off those assets as they enter and proceed through retirement, forcing down asset prices and crushing the US stock market, impoverishing their children and grandchildren who are still investing in that market.

This is an excellent theory with absolutely no logic behind it. A senior citizen who sells a share of Berkshire Hathaway at $245,000 in order to spend $245,000 in the US economy has liberated $245,000 in idle capital (from the person they purchased the share from) and converted it into $245,000 in consumption. The fact that the sale puts marginal downward pressure on the share price of Berkshire Hathaway is offset by the marginal increase in expenditures by the seller, raising the market’s overall earnings.

Now, it is certainly true that the across-the-board aging of the US workforce needs to be offset by increased immigration and births by people living in the United States in order to ensure the continued prosperity of the country, but the conversion of capital assets into cash, which is then spent on consumption, cannot on its own have a large negative effect on the earnings of US companies. Their decreased share prices will be precisely mirrored by increased earnings when that cash is spent.