This Selected Issues paper on the United States analyzes the measures of potential output, natural rate of unemployment, and capacity utilization. Traditionally, measures of resource utilization have been used as indicators for the potential build-up of inflation pressures, and hence as guides for the formulation of macroeconomic policy. The paper highlights that the most commonly used indicators of resource utilization in the United States are the output gap, the employment gap, and capacity utilization in industry. The paper also analyzes the wage and price determination and productivity trends in the United States.

Abstract

This Selected Issues paper on the United States analyzes the measures of potential output, natural rate of unemployment, and capacity utilization. Traditionally, measures of resource utilization have been used as indicators for the potential build-up of inflation pressures, and hence as guides for the formulation of macroeconomic policy. The paper highlights that the most commonly used indicators of resource utilization in the United States are the output gap, the employment gap, and capacity utilization in industry. The paper also analyzes the wage and price determination and productivity trends in the United States.

IV. Potential Implications of a Sharp Correction in U.S. Stock Prices1

1. The sharp rise in U.S. stock prices over the past four years has raised concerns about a bubble in the market and the potentially adverse consequences for the economy in the event that such a bubble bursts. Following a sharp correction in August–October 1998, stock prices recovered in the latter part of 1998, and they have reached new all-time highs in mid-1999. Concerns about a stock market bubble have also revived the debate as to whether the reforms that have been implemented in the U.S. equity market over the last ten years are sufficient to avoid a repeat of the disruptions that took place during the October 1987 crash in the event of a similar collapse in prices.

2. According to traditional indicators of stock market valuation, reconciling current valuation levels in terms of investors’ risk premia or expected real earnings growth is possible, but difficult to justify in terms of the historic averages for these variables. If there were to be a sharp correction in stock prices, it would affect the economy directly primarily through consumption, but the magnitude and length of these effects are subject to considerable uncertainty. Indirect effects through the financial system could have more detrimental effects on the economy. In this regard, structural and regulatory reforms implemented in the securities market since the 1987 crash appear to have significantly improved the ability of the market to withstand the strains associated with a sharp decline in stock prices in a relatively short period of time. Although the experience from the October 1997 stock market correction provides some support to this view, it still remains uncertain whether the existing market infrastructure can withstand more severe and sustained declines.

A. What Do Traditional Indicators Suggest for Stock Prices?

3. Traditional indicators of stock market valuation have generally moved far out of line with historical norms. For instance, in the first five months of 1999, the price-earnings (P/E) ratio for the S&P500 stocks was 35, compared to a post-World War II average value of 17.2 The dividend yield for S&P500 stocks stood at ¼ percent, compared to a post-war average of 3½ percent. Deviations in the P/E and the dividend yield from their historical averages have been frequent and highly persistent (Figure 1).

Figure 1.
Figure 1.

United States: S&P500 Dividend Yield and Price Earnings Ratio

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A004

Source: Standard and Poor’s.1/ The average excludes the higher inflation subperiod of 1970–84.

4. The current P/E ratio would suggest that investors may have developed unreasonable expectations as to the future growth of corporate earnings. Since 1994, real earnings per share have grown at a 6 percent annual rate. In contrast, during the post-war period, real earnings growth has been in line with the growth rate of real GDP, reflecting the fact that the capital share of national income has been relatively stable over time. The valuation of stocks based on a constant-growth model shows that the current P/E ratio would imply that investors expect real earnings to continue to grow by 6¼ percent a year, if it is assumed that the dividend payout ratio and the equity premium return to their historic averages of 50 percent and 4½ percentage points, respectively (Table 1). If, instead, expectations for real earnings growth were to move back down in line with real output growth, then this would suggest that investors were willing to accept an equity premium of only 1 percentage point. Alternatively, if the risk premium was 6 percent (its average over the period 1985–94) and the dividend payout ratio was 40 percent (its average over the period 1995–98), then a P/E ratio of 35 would suggest that investors expect real earnings growth of 7¾ percent, which would require an unrealistic sustained increase in the share of corporate profits in GDP. 3

Table 1.

United States: Price-Earnings Ratio, Expected Earnings, and Equity Premium for S&P500 Stocks

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Source: Fund staff estimates.

5. The implications for future returns of current dividend-yield levels are less certain given that part of the trend decline in the dividend-yield may have been associated with a shift in corporations’ dividend policy. For tax considerations, corporations have increasingly relied on share repurchases rather than on dividends to make cash payments to their shareholders since the mid-1980s. The value of S&P500 stocks repurchased has increased steadily since the early 1980s, rising from US$8 billion in 1983 to about $140 billion in 1998 (Table 2). Gross issues and repurchases have accelerated sharply since 1995, with net repurchases of stocks rising from roughly US$11 billion in 1994 to US$64 billion in 1998. Adjusting the S&P500 dividend yield for an estimate of net repurchases of S&P500 stocks (Figure 2) suggests that its decline has been less severe, but it is still below its adjusted historical average. 4

Table 2.

Gross Issuance and Repurchases of S&P500 Stocks

(In billions of U.S. dollars)

article image
Sources: Cole, Helwege, and Laster (1996); and Fund staff estimates.
Figure 2.
Figure 2.

United States: S&P500 Dividend Yield

(In percent)

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A004

Source: Federal Reserve Flow of Funds; Standard and Poor’s; and Fund staff estimates.

6. Whether net repurchases of stocks by corporations help predict future returns is also subject to considerable uncertainty. In principle, corporations would be expected to reveal their superior knowledge about the fundamental value of their equity, and hence of future returns, by repurchasing undervalued stocks and issuing overvalued ones (Nelson, 1999). In these terms, the sharp increase in net repurchases of stocks over the past few years would seem to suggest that corporations perceive stocks to be undervalued. However, the recent upward trend in net repurchases of stocks may also be the result of incentives faced by corporate managers. With corporate compensation increasingly tied to stock options, stock repurchases have increased firms 5 return on capital and the value of managers’stock options. Managers may have financed stock repurchases by primarily increasing leverage, whose negative effects on firms’ cash flows may have been partly offset by the decline in interest rates and rising stock prices that has occurred over the last few years.

7. Another traditional indicator of corporate performance is Tobin’s q, which is defined as the ratio of the market value of firms to the replacement cost of their capital 6 In theory, when q equals or exceeds 1, firms use their capital efficiently, as they have been able to allocate resources in a way that exceeds the alternative-use value of assets, as proxied by the replacement cost. Tobin’s q has been rising significantly since 1995, reaching 1.4 in 1998, compared with its historical average of 0.6 (Figure 3). While Tobin’s q exhibits a tendency to revert to its historical average, suggesting that a sharp correction in stock prices should take place in the period ahead, deviations from its mean value have been highly persistent in the post-war period. 7 In addition, the increased importance of new technology firms may have contributed to shift the equilibrium value of q upwards, as the value of these firms may depend heavily on the ideas and human capital of their workforce rather than on their capital stock. Nevertheless, current q levels show that use of resources by the nonfarm, nonfinancial business sector is being priced at historically unprecedented levels.

Figure 3.
Figure 3.

United States: Tobin’s q

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A004

Source: Federal Reserve Flow of Funds Accounts.

8. Following the October 1997 stock market correction, and the events associated with Long-Term Capital Management’s (LTCM) demise in September 1998 and with the turmoil in emerging capital markets last summer, a significant proportion of the rise in equity prices has been attributable to large capitalization stocks. Concerns about the potential implications from these events for mid-cap and small-cap firms’ earnings may have induced a “flight to quality,” with investors shifting their portfolios toward large-cap stocks. Some observers interpreted this shift as evidence that the U.S. equity market may have been losing momentum, and that it could signal a price correction in the period ahead. In fact, several indicators confirm that the dispersion of returns across stocks with different capitalization levels has increased considerably over the last two years. The ratio of the S&P100 to the S&P500 has increased markedly since the October 1997 market correction, and especially, since the third quarter of 1998 (Figure 4). Likewise, the ratios of the S&P100 and S&P500 to the Russell 2000 has also been trending upwards sharply since October 1997, and their current levels may suggest that stocks remain vulnerable to potential adverse shocks, as their present levels exceed those prior to the October 1987 crash and the 1991 recession. 8

Figure 4.
Figure 4.

United States: Stock Market Developments

Citation: IMF Staff Country Reports 1999, 101; 10.5089/9781451839579.002.A004

Source: Bloomberg.

9. Additional evidence related to S&P500 value and growth stocks 9 shows that, since 1994, the rise in equity prices for growth stocks has outpaced value stocks, reaching in early 1999 levels not seen over the last 25 years (Figure 4). Part of the relative underperformance of value stocks may be related to the fact that firms in this category have traditionally been more dependent on commodity prices and energy and on higher inflation rates. Also, investors’ expectations about technology and telecommunication firms’ growth prospects may have improved considerably over the last few years. In fact, computer and technology stocks have increased their share in the S&P500’s market capitalization markedly, rising from 8½ percent in 1988 to about 18 percent at present, which has contributed to the sharp rise in the S&P500’sP-E ratio.

10. Based on these traditional indicators and models, it would appear that stock prices may have moved significantly out of line with their fundamental determinants, but such a judgement cannot be made with a high degree of confidence.10 Investors’ expectations of high real-earnings growth might be realized over the next few years as firms continue to experience gains in productivity (and profitability) associated with the adaptation of computer technology and other technological advances. It is also possible that the equilibrium-equity premium has fallen. Innovations in financial markets have made it easier and more cost effective for individuals to hold diversified stock portfolios. At the same time? the increased availability of self-directed, tax-deferred retirement accounts has increased the demand for stocks, and changes in favorable income tax treatment afforded to capital gains also may have boosted demand for equities.

B. The Real-Side Consequences of a Sharp Decline in Stock Prices

11. The real-side consequences of a sharp decline in stock prices takes into account not only the standard effects on aggregate demand—on consumption and investment through a decline in wealth and a higher cost of capital—but also emphasizes dynamic aspects related to credit and collateral and how their interaction poses systemic risks on financial institutions with further potentially severe consequences on economic activity.

12. While empirical analyses suggest that the long-run impact on consumption of an adverse shock to household equity wealth may not be significantly high but subject to considerable uncertainty, more recent theoretical literature seems to suggest that a sharp decline in stock prices could potentially be highly detrimental to economic activity. Recent studies 11 indicate that the estimated marginal propensity to consume out-of-stock market wealth ranges between 3 and 7 percent, and that estimates of wealth effects are highly unstable across periods, and have even declined in more recent periods.12 Taking the midpoint of this range, a 25 percent drop in stock prices would reduce wealth by about $3 trillion and consumption by around $150 billion (about 1¾ percent of GDP) after two years. However, the effect of such a decline in stock prices could be less than this estimate suggests, because such a decline would return prices to roughly their levels of last year, and a portion of the increase in wealth since that time has probably not yet been reflected in the level of consumption.13 Moreover, the analysis of personal savings behavior presented in Chapter 5 of this paper, which controls for the effects of improved access to credit by households, suggests that a correction in equity prices would have a significantly smaller effect on consumption. Fixed investment might also be adversely affected, but the effect is likely to be more indirect through business confidence and a higher cost of capital. Equity issuance has not been a major source of funding for investment in the corporate sector as a whole; as explained above, corporations have made large net repurchases of stocks in recent years, while significantly increasing their net debt.

13. A sharp decline in equity prices may adversely affect the economy indirectly through the financial sector. Since financial markets are incomplete, the intermediation of claims requires significant market-making and information-gathering services; but as the real costs of these services usually rise at times of distress, the effectiveness of intermediating claims toward certain groups of borrowers is usually significantly impaired, which induces a sharp contraction of credit and output.14 Kiyotaki and Moore (1997) have also emphasized that the dual role played by durable assets as an input in production and as collateral for loans results in a powerful propagation mechanism by which the effects of certain shocks persist and spread out across the economy.

14. Traditionally, commercial banks in the United States have not directly financed purchases of stocks.15 However, banks have more recently experienced a sharp increase in equity derivative and swap transactions with other market participants, such as hedge funds. In particular, banks have engaged in total return swaps and have provided indirect financing to hedge funds speculating in stocks related to mergers and in U.S. equity volatility derivatives.16 A sharp correction in U.S. equity prices could trigger significant losses among some market participants in equity derivatives, heightening liquidity and credit risks. This risk may be particularly important since market makers, specialists, and clearing houses have arranged committed credit lines with domestic commercial banks. However, the magnitude and risk of U.S. banks’ exposure is difficult to assess, as most of these transactions are off-balance sheet. Notional values for commercial banks’ transactions in equity derivatives have increased markedly over the last few years, although, the actual credit exposure or capital at risk associated with these values is usually significantly smaller. Nevertheless, the decline in personal wealth could confront banks with immediate and considerable adverse selection problems among customers who had faced easier access to credit due to the rise in personal wealth. Such a development could intensify a squeeze in household credit and induce higher default rates, with additional adverse consequences for economic activity.

15. The severity of the disruptions experienced by market participants during the October 1987 crash prompted the U.S. authorities to review the existing equity market microstructure and led to the implementation of several structural and regulatory reforms across U.S. equity markets, primarily targeted at minimizing systemic risk.17 These reforms have been broadly concentrated on enhancing the operational and financial capacity of markets and members to accommodate sharp increases in the level and volatility of trading volume. The settlement cycle for equity transactions was reduced and payments are being effected with same-day funds. Information-sharing systems on posted collateral across markets have been developed among participants and procedures for cross margining and guaranteeing transactions among clearance houses extended. Market operations have become more transparent, as the Securities and Exchange Commission (SEC) established execution rules and enhanced incentives for market makers not to withdraw from the market at times of distress. These reforms appear to have improved the market’s ability to withstand sharp declines in equity prices. According to the SEC, the experience in the October 1997 market crash demonstrates that the market was able to withstand a three-fold increase in transactions to be settled and cleared without major disruptions. Notwithstanding, it still remains less evident whether the market would be able to withstand more severe and sustained declines in equity prices.

List of References

  • Bernanke, B. (1983) “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great DepressionAmerican Economic Review, pp. 257276.

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  • Carr Bettis, J., Bizjak, J, and Lemmon, M. (1999) “Insider Trading in Derivative Securities; An Empirical Examination of the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders,” Working paper, Arizona State University.

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  • Cole, K. Helwege, J., and Laster, D. (1996) “Stock Market Indicators: Is This Time Different?Financial Analysts Journal May/June 1996, pp. 5664.

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  • Kiyotaki, N. and Moore, J. (1997) “Credit Cycles”. Journal of Political Economy, Vol. 105, No.2, pp. 211248.

  • Lamont, O (1998) “Earnings and Expected Returns”. Journal of Finance, Vol. LIE, No. 5, October, pp. 15631587.

  • Ludvigson, S. and Steindel, C. (1998), “How Important is the Stock Market Effect on Consumption? Federal Reserve Bank of New York, Working Paper.

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  • Nelson, W. (1999), “Why Does the Change in Shares Predict Stock Returns?”, Federal Reserve Board, January 1999.

  • OECD, (1998) “Stock Market Fluctuations and Consumption Behavior: Some Recent Evidence,” Working Paper 208.

  • Poterba, J. (1998) “Population Age Structure and Asset Returns; An Empirical Investigation,” NBER Working Paper Series 6774.

  • Runkle, D. (1988) “Why No Crunch From the Crash?”, Federal Reserve Bank of Minneapolis Quarterly Review.

  • Starr-McCluer (1998), “Stock Market Wealth and Consumer Spending.” Finance and Economic Discussion Series, Federal Reserve Board of Governors.

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  • U.S. Securities and Exchange Commission (1998), “Trading Analysis of October 27 and 28, 1997. Report by the Division of Market Regulation, September.

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1

Prepared by Martin Cerisola and Alex Keenan.

2

This average is calculated for the period 1954–98, excluding the higher-inflation subperiod 1970–84. This subperiod is excluded because the price/earnings ratio was biased downward, owing to earnings being inflated largely on account of inventory profits.

3

The results of two multivariate econometric models show that most of the parameters characterizing fluctuations in excess returns become highly unstable after 1995. In particular, these models that aim at explaining fluctuations in the excess return on the S&P500 in terms of deviations of a risk-free interest rate from its trend, the dividend yield, and the payout ratio, and, alternatively; in terms of prices, dividends, and earnings, all normalized by a moving average of earnings, also reveal structural breaks during periods associated with sharp market corrections such as in 1987.

4

This adjustment implicitly assumes that the dollar value of stock issuance and purchases closely matches the actual number of shares exchanged. However, it may be the case that the issuance and repurchase of certain stocks may have been done at prices different from market values.

5

In addition, Carr Bettis et al. (1999) explain that managers have increasingly hedged the value of their holdings of stock options against the risk of an adverse stock-price movement through the use of several trading strategies such as zero-cost collars and equity swaps.

6

Tobin’s q is calculated based on the nonfarm, nonfinancial corporate business sector balance sheet, as reported in the Federal Reserve Flow of Funds Accounts.

7

Tobin’s q was above its average between 1958 and 1972 (15 years) and below it from 1973 to 1991 (19 years).

8

In addition, the ratios of the Dow Jones Industrial Average to the S&P100 and S&P500 companies have recovered sharply since February 1999? following steady declines since the beginning of the Asian crisis in mid-1997.

9

Value stocks are those that exhibit low price-earnings or price-to-book ratios, while growth stocks are those that exhibit high price-earnings or price-to-book ratios.

10

Campbell and Shiller (1998) note that valuation ratios may have departed significantly from their historical averages as a result of a trend shift in investors’ attitudes toward stocks. In particular, they explain that baby boomers may be driving stock prices up, and such a trend would influence valuation ratios as long as this demographic effect persists. Poterba (1998) finds weak support for demographic factors driving stock returns.

12

No evidence of instability or recent change in the marginal propensity to spend out-of-stock market wealth was found in an error-correction model that explains real consumption as a function of real disposable income, a measure of improved access to credit by households, and household real holdings of equity and non-equity wealth.

13

Runkle (1988) presents some evidence that the strength in economic activity and confidence observed after the 1987 crash was possibly due to the fact that the large increase in stock prices in the year prior to the crash may not have been associated with an increase in permanent wealth. In his view, had price increases during the first half of 1987 been incorporated into permanent wealth, the consumption of durable goods should have increased rather than actually decreased in that period.

14

In a very influential paper, Bernanke (1983) has emphasized the role of financial crises and credit squeezes in inducing protracted declines in aggregate demand and output.

15

Margin credit at broker dealers has risen from 3 percent of total loans and leases by commercial banks in 1995 to 4½ percent in 1998.

16

In a total return swap, a hedge fund agrees to receive the return of a portfolio of stocks by paying a floating interest rate to an investment bank. Regulation T limits borrowing against equities to 50 percent, although it does not apply to total return swaps, making leverage primarily a function of a U.S. financial institutions credit risk assessment.

17

For a more detailed description of reforms in the U.S. equity market infrastructure, see the forthcoming International Capital Markets Report.

United States: Selected Issues
Author: International Monetary Fund