Wednesday, May 27, 2009

The Poverty of Economics

A paper over at VoxEU has some interesting data about the boom and bust in railroad stocks in England during the 1840's.  The question is whether you could have identified the bubble in shares and done something about it in order to mitigate the effects that the bust had.  The author's argument is that shares of railroad companies were priced at a premium to the rest of the market, but that their dividends were also growing more rapidly, so there was no way to see that a bubble was inflating.  Here's the money quote:

These results suggest that dividends had a highly influential role in determining share prices during the Railway Mania, with there being evidence of a relationship between share prices and both current dividends and short-term dividend growth. However, investors seem to have been unable to forecast the longer-term dividend changes, and this is why prices rose and fell in the way that they did.

Investors initially embraced railway shares as dividends rose following a period of sustained economic growth and widespread fare reductions which had led to a doubling of passenger numbers. These investors seem to have been initially unable to predict the Irish Famine, or the Commercial Crisis of 1847, both of which would eventually reduce incomes and trade. They also failed to forecast the extent and unproductiveness of new railway construction, which occurred as a result of the Mania and reduced the overall profitability of the railway industry. When these threats to dividends eventually became clear, the prices of railway shares began to fall. However, during the boom in prices it would have required considerable foresight for anyone to have successfully predicted the extent of these threats, and railway shares were not obviously mispriced.

As an investor, I find this logic absolutely comic; only an economist could be so narrow-minded as to believe that the high growth of the railroad dividends would go on forever.  You don't need to predict the Potato Famine or the Commercial Crisis or anything else to know that trees don't grow to the moon.  Eventually, the growth rate of every industry reverts back to the growth rate of the whole economy, if only, at the extreme, because an industry that grows fast forever eventually IS the economy.  The only relevant question is how long this process takes. 

Only an academic could imagine that the short term spike in dividend growth rates contained all the information available to the market, and so could rationally justify the prices, because only an academic could manage to so thoroughly ignore the fact that common sense and simple logic are also source of information.  I am reminded of certain scenes in the original Star Trek series in which Kirk reasons the superior intellect of an alien computer into a flashing, smoking, that-does-not-compute heap.

At any rate, the paper leaves out the only relevant number in the whole damn calculation, which is just how long the high dividend growth would have to continue to justify the premium to the market.  This was the same logic that escaped folks in the tech bubble, where at one point, Cisco was priced at such a premium valuation that it's extraordinary growth would have had to continue unabated for 20 years to produce the same return as a treasury bond, at which point the company would have encompassed something like 99% of all US economic activity.  Oh ... but the shares were not obviously mispriced because the company was growing faster than average.

God help us if these are the people we have in charge of controlling monetary policy.

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