With the tremendous growth in stock prices during the 1990s, and the stock
market's vertiginous path over the past two years, stock investing has
been a major drama of our times. Some educated observers foresee the stock
market's imminent collapse and others predict a Dow of 36,000. In their
fall 2000 Quarterly Review article, Minneapolis Fed senior economist Ellen
McGrattan and University of Minnesota Regents' professor and Fed adviser
Edward Prescott join the fray with Is the Stock Market Overvalued? The one-word answer to their titular question: No. As of the first half
of 2000, they conclude, the market was properly valuedaccording
to standard economic theory, at least.
While many estimates of market value look at current price/earnings
ratios relative to historical averages, McGrattan and Prescott
take a different approach. As macroeconomists, they look at the
value of market equity relative to the underlying corporate productive
assets for which investors, essentially, are bidding. According
to economic theory, if net indebtedness is small, the value of
corporate equity should equal the value of the productive assets
owned by those corporations, including both domestic holdings
and those held by foreign subsidiaries, and looking not only at
tangible capital (buildings, equipment, inventory), but also intangible
capital (the value of patents, human capital, trademarks).
In simpler terms, people should get what they pay for. Or as
Warren Buffett recently said, the secret to successful investing
is buying stock "when businesses sell for less in the market than
The easiest step for McGrattan and Prescott is determining the
market value of all domestic corporate equity: not the 30 stocks
that comprise the Dow Jones Industrial Average, nor just the 500
in the S&P 500, but the full market. By looking at Federal
Reserve Board of Governors data, they find that the value of all
U.S. stock, averaged across the first two quarters of 2000, was
1.77 times gross national product (see Chart A). Adding in corporate
debt levels of about 7 percent of GNP implies a total value of
U.S. corporations (equity plus debt) of 1.84 times GNP.
More difficult is calculating the other half of the equation: the value
of underlying corporate assets. In a painstaking exercise of macroeconomic
accounting, the authors calculate the value, relative to GNP, of each
piece of the jigsaw puzzle.
They begin by using national accounts data from the U.S. Department
of Commerce to calculate the worth of domestic tangible capital:
the sum of corporate capital stocks (.821 GNP), inventories (.161
GNP) and land (.060 GNP). Tangible corporate assets in the United
States, then, are worth 1.042 times GNP.
But what about intangible capital assets like patents, or brand
names like Coca-Cola? Plus, of course, the hard-to-capture worth
of human capital: the unutterable value your own innate brilliance,
for example. Economists have long been stymied by this measurement
problem. (In fact, one recent analysis of the stock market, Valuing
Wall Street, ignores the worth of intangible capital and
suggests that the market is vastly overvalued.) The problem called
for an ingenious solution, and McGrattan and Prescott deliver
it by, in essence, going through the back doorby deriving
a formula whose only unknown value is the one they seek. Simplifying
the math drastically, here's their backdoor solution: The ratio
of profits to capital equals the rate of return. Capital includes
both tangible and intangible capital. So if you can determine
an overall profit level, calculate the value of tangible capital
and estimate a rate of return, you can solve for the remaining
unknown: the value of intangible capital.
Using national accounts data, the authors calculate the economy's
overall profits. The value of tangible capital is already in hand
(1.042 GNP), as determined above. But calculating the rate of
return for corporate capital is a bit trickier. McGrattan and
Prescott first estimate a rate of return for noncorporate
capitalcapital held by households, noncorporate businesses
and governmentsince national accounts data provide figures
for profits and capital stock in that segment of the economy.
Their estimate (4.1 percent) turns out to be quite close to the
interest rate on inflation-protected Treasury bonds.
By assuming that this noncorporate rate of return is equal to
the rate of return for both tangible and intangible capital in
the corporate sector economysince profit-maximizing managers
will keep investing in one asset type until its rate of return
is the same as every otherthe back door is opened. With
a quick bit of math, the unknown variablethe value of intangible
corporate capitalis found: .415 GNP. A similar calculation
yields an estimate for the value of capital of U.S. foreign subsidiaries:
Adding up these three pieces that comprise the assets of U.S.
corporationsdomestic tangible capital, domestic intangible
capital and U.S. foreign subsidiary capitalgives a sum of
1.839 GNP, which, remarkably, equals the market value of U.S.
corporate stock, previously determined: 1.84 GNP.
Conclude the authors: "Corporate equity is not overvalued."
As of the first half of 2000, in other words, the U.S. stock market
was not exhibiting a "bubble" of irrational stockholder behavior,
but instead providing a very good indication of the value of corporate
assets on which investors bid. We got what we paid for.
Why was the market so low before?
If economic theory supports the current state of affairsequity
prices at historically high levels relative to GNPwhat then
accounts for the fact that stocks were valued so low in the past?
The answer, argue McGrattan and Prescott in a second paper, lies
in one of life's great certainties: Taxes.
In Taxes, Regulations, and Asset Prices, the Minneapolis
Fed economists examine equity values relative to GNP in two historical
periods with relatively stable tax policies: the period before
the 1963 Kennedy tax cuts and the years after the Tax Reform Act
of 1986. According to their estimates, the value of the stock
market, compared to GNP, roughly doubled from one period to the
next (see Chart B). Said differently, since World War II, stock
prices rose far faster than GNP.
One promising explanation for a doubling in equity prices relative to
GNP might be that capital became more productive over time, raising the
capital-output ratio. When they look at the underlying productive assets,
howeverusing the same techniques employed in the previous paperthe
authors find that the total value of tangible, intangible and foreign
capital changed little, relative to GNP.
But what did changedramaticallywas the rate at which
distributions to shareholders (that is, dividends and stock buybacks)
were taxed. The Kennedy administration reduced marginal tax rates
for the highest income bracket from 91 percent to 70 percent.
Reagan reduced the top rate still further, to 50 percent in 1981
and to 33 percent after 1986. Even more significant, say the authors,
were regulatory changes that allowed dividend income to be sheltered
from taxes in retirement accounts, including 401(k) and pension
funds, which now hold over half of all corporate equity.
As effective tax rates fell, argue McGrattan and Prescott, investors
recognized the increased value of stock investing. It's as if
the local bully decided to stop taking a nickel out of every dime's
worth of profit made at neighborhood lemonade stands: Young entrepreneurs
would begin bidding up the price of lemons and sugar. Demand for
equities increased and stock prices rose.
By measuring the changes in marginal tax rates, and estimating
the proportion of equity returns sheltered, the authors calculate
that effective tax rates fell from about 50 percent in the pre-Kennedy
period to about 10 percent by the 1990s. Theoretically, that large
a drop in taxes should translate into a doubling of equity prices
relative to GNPprecisely what occurred.
Returns on equity
The authors also point out that tax rate changes have had a major
impact on returns on equity. Total returns equal dividends plus
capital gains, and the latter include both anticipated gains due
to growth in productive assets and unanticipated gains due to
changes in tax rates that no one could have foreseen.
In the immediate post-war period, dividend yields were high
(over 3 percent) because high tax rates implied low equity prices.
The growth rate in productive assets has been steady, on the order
of 3 percent. And unexpected capital gains, the result of dropping
tax rates, is the growth rate in equity prices due to lower taxes,
roughly 2 percent. Total returns to equity, then, in the post-war
period, should have equaled the sum: approximately 8 percent (3+3+2).
But now that taxes have declined substantially, and equity prices
have climbed, dividend yields have decreased to about 1 percent,
anticipated gains are still roughly 3 percent, and unanticipated
gains due to tax changes are (by definition) 0 percent, so equity
returns should, they predict, average a little over 4 percent.
A corollary of this finding relates to the equity premium, the
difference between stock and bond returns. In their related Quarterly
Review article, Jagannathan, McGrattan and Scherbina describe
how the premiuminexplicably high in the pasthas now
diminished significantly, consistent with economic theory. With
their analysis of tax rate changes, Prescott and McGrattan have
explained that high marginal tax rates in pre-Kennedy years help
account for the high equity yields of the past: Investors had
to be "compensated" for the fact that their dividends would be
But whywhen stocks held the promise of much higher returnsdid
pension fund managers hold bonds? Indeed, pension funds held virtually
no equity in the early 1960s. Why didn't they try to capture the
The economists suggest that until the 1970s, pension fund managers
faced unclear fiduciary liabilities that encouraged investment
in debt rather than equity. When regulatory changes in the 1970s
(especially the Employment Retirement Income Security Act of 1974)
clarified the fiduciary responsibilities of pension administrators
and provided them with more flexibility in fund allocation, they
shifted heavily toward stocks.
With increased purchases of equity, and a move away from bonds, equity
yields declined and bond yields increasedin inverse relationship
to their pricesand the equity premium diminished.