Saturday, November 23, 2013

Stagnation as an excuse for sustained high P/E

Bubbles will arrive before inflation

When I was six or so, I had an idea that many other kids – and many of you – probably have also arrived to. If one may buy anything for the money and someone is able to print the money, why doesn't he print an unlimited amount of money in order to make everyone happy and solve all the world's problems?

The Keynesians and similar folks believe that this is a great idea even when they are adults. But many of us have managed to figure out – or were told – why this isn't such a great idea. After all, the nominal information expressed in the units of currency means nothing. A dollar or a crown or a deutschmark is just a lame unit of wealth. If everyone owns 10 times greater an amount of money, everyone will also demand a higher price for his goods and services.

So I quickly realized that the fact that a dollar was 30 times greater than the Czechoslovak crown was just an inconsequential choice of the units, just like the difference between meters and feet. One may design physically and socially equivalent situations by simply multiplying all the prices by \(C = \exp(\lambda)\) – by reducing the money by the factor of \(C\).

This "financial gauge invariance" may be used even for a single currency which evolves in time. You may rescale all the prices and related quantities expressed in the units of currency, \(P_i\), by a function of time \(t\),\[

P_i\to P'_i= C(t)\cdot P_i = \exp[\lambda(t)] P_i

\] and it's quite possible that nothing really changes. There are things like "rates" – interest rates, inflation rates, and so on. They're defined as the time derivatives of some quantity \(P_i\) divided by the quantity itself. So if you switch from the numerical value \(P_i\) to \(P'_i\), the new rate will be\[

\frac{1}{P'_i}\cdot\ddfrac{P'_i}{t} &= \ddfrac{\ln(P'_i)}{t} =\\
&=\frac{1}{P'_i}\ddfrac{\zav{\exp[\lambda(t)] P_i}}{t} = \\
&= \frac{1}{P_i} \zav{\ddfrac{P_i}{t} + P_i \ddfrac{\lambda(t)}{t} }

\] by the Leibniz rule (for the derivative of a product).

The first term on the right hand side is nothing else than \(\dd \ln( P_i)/\dd t\), the old "rate", but there is one more term, \(\dd \lambda(t)/\dd t\): old rates are additively shifted by this universal quantity.

This shift is mathematically analogous to the transformation of charged fields and the gauge fields under the \(U(1)\) gauge symmetry in physics. All the charged fields get multiplied by \(\exp[i\lambda(x,y,z,t)Q]\) while the gauge field, analogous to rates, is shifted by \(e\partial_\mu \lambda(t)\).

The only different feature of the "financial gauge invariance" is that the argument of the exponential contains no imaginary unit \(i\). This difference means that the gauge group isn't really \(U(1)\) but its noncompact version, \(\RR^+\), the multiplicative group rescaling all the prices at time \(t\) by a positive factor. In fact, Hermann Weyl has introduced this \(\RR^+\) gauge symmetry (rescaling the distances, not prices) to the physics of general relativity, too. String theorists doing perturbative calculations use the Weyl symmetry (on the world sheet, in their case) all the time.

I am not saying that the "financial gauge invariance" implies that any procedure whose goal is to change the inflation rate will create a physically equivalent situation and that it will be inconsequential. I am saying that it's possible to have physically equivalent situations with (arbitrarily, vastly) different inflation rates. All the prices will get rescaled; all the rates (including all the interest rates) will get an extra additive universal contribution of the "enhanced inflation".

It's my feeling that many people, especially the Ron Paul types, don't quite get this gauge invariance – the point that the numerical value of the prices and even its change in time doesn't really matter.

That's a good initial insight but for some years, I as a kid didn't make much progress in understanding the world of the finance. For quite some time, I was assuming that there was only one interesting "rate". It was the inflation rate mixed up with the interest rate, and so on. The discount rate was probably the same thing, I would be thinking if I were told something about the discount rate. There may also be some "real GDP growth rate" but I wasn't thinking about its impact on the logic of the finance much. It took a long time for me to appreciate that these rates are different in general and the differences are extremely important. In particular, banks are increasing the interest rates if they want to lower the inflation rate and (much more likely these days) vice versa.

A closely related basic example: the interest rate on your saving account isn't the same thing as the inflation rate. In some "ideal world", you could be promised that they are equal – a vanishing real interest rates. But the real world is not an ideal one; these two rates may differ. A central bank may be legally obliged to target the inflation rate (the interest rates may only be specified after the inflation is calculated – unless we use a predicted inflation – so there may be a delay). But the central bank may also creatively change the interest rate so that the "real interest rate" is nonzero. The real interest rate (nominal interest rate minus inflation rate) has been negative in most Western countries for many years.

At the beginning, I wanted to convince you that the "nominal rates" don't really mean anything – physically equivalent situations related by the "financial gauge invariance" may have rates differing by an arbitrary function of time. But now we see that the difference between two rates is physical. The real interest rate is an example. If it is positive, the savers are getting "really richer"; if it is negative, it's the other way around.

This opens many basic yet important questions: Can the central banks really influence the real interest rates? If they can, isn't it always a counterproductive market intervention that makes the economy less efficient? In principle, can the free market determine the real interest rates by itself (in an idealized world that is naturally identified as a "world without government interventions")? What are the drivers that determine its value?

The answer to the first question is Yes, a central bank may influence the real interest rates. The central banks define the interest rates paid on the commercial banks' reserves. For banks, it may be a better idea to lend the money to real-world people and companies, at a higher interest rate, so you could think that the interest rate on the reserves is irrelevant. However, a fraction of the bank's holdings must be in cash – the actual reserves, banknotes – so the interest rate paid on these reserves does influence what the bank may pay to the savers.

In most countries, laws define "reserve requirements" that guarantee that a bank doesn't go bust well before someone notices that something is wrong. Between 3 and 30 percent of the banks' holdings are required to be in the form of actual banknotes or the reserves. So the rate on the reserves determined by a central bank does determine what you get on your saving account, too, although the expected influence is smaller than the change of the central interest rate (essentially by the fraction that says what part of the banks' holdings are kept as safe reserves).

The second question was whether the central banks should try to "engineer" the "right" real interest rates. Keynesians surely answer "Yes". They view the central banks as a miraculous part of the government that can make everyone happy. I, as a free-market advocate, realize that the engineering of real interest rates is de facto a form of wealth redistribution. If you lower real interest rates by an intervention, you de facto make the savers poorer and you defend this step by helping someone else. That's the reason why I agree with the Tea Party types that a central bank shouldn't be active in this way.

But it's important that I am talking about real interest rates, not the nominal ones. Nominal ones don't really matter for the real world. They are not gauge-invariant.

For these reasons, I find the inflation targeting to be among the most neutral monetary policies. Along with some similar policies, it involves the least amount of redistribution of the "real wealth". This anti-socialist virtue is almost equivalent to another virtue: it makes the currency unit as predictable as possible and in average, it's good for everyone. The amplitude of oscillations is minimized. The amount of "lottery" in your financial results is reduced. In other words, the correlation between "good work" and "income" is maximized. Whatever the detailed policy is, I think it is healthy if the central banks have as little influence as possible, if the policies are "automatized". As a bonus, this condition automatically reduces the room for inside trading and speculations (those that are unproductive for the society), too.

Drivers affecting the real interest rates

Can the market determine the real interest rates by itself? What do they mean if we imagine that the government interventions are eliminated (in particular, you can't borrow from the government and you don't lend to the government, or at least the government is treated just like "another company" trying to maximize its well-being rather than an omnipresent institution intervening into the markets)? Well, borrowers offer low real interest rates if it is easy for them to borrow the money elsewhere – if the lenders have a lot of competition. And vice versa: Lenders may achieve high returns if many people want to borrow, and if they badly want to borrow. In other words, the real interest rates are high if there is a competition between borrowers, if too many people want to borrow. And vice versa: they are low if no one wants to be in debt.

(Their being near zero today is a sign that people and companies are (relatively) afraid of creating new debt. Savers have a special, sensible reason for that: they feel that they are poor and will be poorer. They can't afford to spend too much. At least when it comes to savers, policies trying to hurt them and discourage saving actually reduce consumption. The chronic borrowers are encouraged to borrow by low interest rates but it comes with a price – an increased risk of insolvency.)

The paragraph starting with "Can" explains how a healthy economy should decide about the real interest rates. Real interest rates should be determined by the balance between the supply and demand, too. If people want to save (and lend) too much, the market automatically discourages them because with too many fellow savers (and lenders), the real interest rates go down due to the competition and the saving (and lending) becomes less attractive. And on the contrary, if too many people get mad and start to borrow too much, there is a competition between them which allows the lenders to increase the real interest rates. This ultimately discourages the borrowers from borrowing.

Because of this simple mechanism – one that is fully analogous to the invisible hand's ability to dictate the right prices of everything and anything – the market knows best whether it's right for the savers to lose the money in the real terms or not. It seems to me that the world's economy is so brutally distorted by the Keynesians that most people don't even realize what I wrote in the previous paragraphs of this section – i.e. how the markets should decide about the real interest rates in an ideal world (and that they have a solid, "automatic" mechanism to do so at all). In fact, I think that even central bankers who are typically drowning in the ocean of the Keynesian feces fail to understand the right mechanisms that should decide about the real interest rates – and that normally protect the economy from oversaving as well as overborrowing. We clearly live in an overregulated world in which Keynesian and other ad hoc superstitions largely overshadowed something that I would consider the textbook knowledge about economics – e.g. that the market determines relative prices and rates most efficiently and most safely.

Particular distortion by the central banks in the recent years

The central banks kept on inventing all sort of Keynesian and quasi-Keynesian excuses for various random distortions of the market. Because the free market is the best tool to decide about the optimal allocation of the capital and all prices and (real) interest rates, any intervention that distorts the prices and interest rates reduces the efficiency of the economy.

This comment would apply regardless of the "sign". However, we live in a particular era and in recent years, the economies were distorted in a particular direction. I think that everyone knows what the direction was. The central banks were printing tons of money, pumping them into the economy. They were pushing banknotes to the people's throats (assuming that this will make the people more hungry), intervening, and trying to "punish the savers" by steps artificially lowering the real interest rates as much as possible. The interventions took the form of keeping the interest rates near zero or at zero and other non-standard procedures. Some of the non-standard procedures (like QE) don't really matter. Others, like the interventions against the Czech crown, surely matter but only locally – distorting the Czech economy exactly in the opposite way than what is their (more diluted) impact on the eurozone (euro reserves were being piled by the Czech Central Bank for a few weeks: about EUR 8 billion were bought for freshly printed Czech banknotes).

The motivation for this artificial loosening is a (partly irrational) fear of a recession and the obsession with the positiveness of the GDP growth rate, regardless of the fact that much of the added GDP results from an increased debt (a thing that one should really be worried about much more than about a smaller GDP growth) and from various tricks that imply that much of the activity in the GDP is really "fake".

At any rate, these interventions have had no severe consequences yet – like hyperinflation. Everything looked like a relatively smooth sailing. But something has been changing about the underlying numbers. Look at these scary graphs from Harvard's PolicyMic:

Between early 1980s and now, the currency in circulation increased 7-fold or so, to $1.2 trillion. Clearly, this growth by the factor of 7 vastly exceeds the increase of the GDP, even the nominal one. At least, the graph above looks uniform and sustainable. But there are more shocking graphs.

This is the St Louis adjusted monetary base that contains not only the banknotes and coins in circulation but also the commercial banks' cash reserves, roughly speaking. Since 2009, just in four years, it grew by a factor of 4 or so. That more or less means that the commercial banks' cash reserves have grown dramatically.

This huge, four-fold relative increase of the monetary base in 4 years certainly hasn't led to a quadrupling of prices. The prices in the U.S. have barely changed and the GDP growth has been minor, too. If you just print lots of banknotes and lock them in the basement, they will not influence anything. And that's really what was more or less happening so far. The dramatic increase of the monetary base above didn't mean much because it's mostly spurious. Banks' balance sheets were increasing, much of their assets are kept as reserves, these reserves are included into the monetary base graphed above, but the increased debt of the banks isn't counted even though it really "cancels" the increased reserves.

The monetary policies have largely affected the flows of loans between the arms of the government and banks only – the real-world loans of the real-world people are determined by other things than the government apparatchiks' proclamations.

Those procedures behind the quantitative easing are the ultimate prototype of the interventions that shows why these interventions are slightly counterproductive but more clearly, futile. The goal of all these interventions, the printing and pumping of the money, is to accelerate the real economy. However, much of the extra money that is being printed and pumped remains locked in basements and they influence nothing. They only influence mostly unphysical (thank God, so far) graphs like the St Louis monetary base graph above.

The real economy isn't affected much (or detectably) for a simple reason: The desire of the actual people to lend and borrow isn't actually affected by extra banknotes that appear in the basements. It's determined by the free market, by the balance of the supply and demand – i.e. ultimately by the people's desire (or need) to save and lend or, on the contrary, borrow. As I have argued at the beginning, most of the real interest rate is dictated by the people's own situation and psychology, by the balance of the supply and demand (real-world lenders and real-world borrowers and how they evaluate the importance of the debt and the risks). The "activist", Keynesian manipulation with the interest rates only influences a small part of the interest paid on savings (the percentage equal to the percentage of banks' assets that are or have to be kept as reserves). The rest – the majority – is unaffected by the central banks' interventions.

Similarly, operations such as QE only distort some relative prices, relative interest rates i.e. the detailed shape of the yield curve and they redistribute the wealth in some way, creating some losers and some winners (according to what they were holding and what they are going to buy). But they don't really change anything about the "total activity" in the economy and any redistribution reduces the efficiency and fairness of the economy which ultimately reduces the GDP (by terms of second order in the magnitude of the intervention).

So thankfully, much of the misguided activity of the central banks has only affected "mostly spurious" graphs such as the monetary base in the graph above. So far. But the purpose of all this loosening and interventions has always been that the money will eventually be flushed out of the basements and they will get to real economy. Will they? There are trillions of dollars waiting in various basements that haven't really begun to circulate in the real economy but they were printed with the purpose to circulate ($4 trillion in the semi-locked basements is like 3 average monthly salaries waiting to be donated to each American including infants). Lots of things could change – and a huge inflation could start – if the original goals started to materialize.

I think, surprisingly, that the answer to the question "Will they?" above will depend on the collective thinking of the people which isn't quite predictable. If the people were thinking in a particular way, they just wouldn't care about the extra trillions in banknotes that are waiting in the basements. In effect, the Federal Reserve and other central banks may keep on printing obscene amounts of money but they will remain locked in the basements because people's "hunger" isn't really affected by the amount of food that they may buy and that is waiting in a basement. Balance sheets may be increased by balance sheets mean nothing – it's some equity that is immediately subtracted from itself to yield zero.

However, at some moment, inflation expectations are probably bound to emerge. A sufficient, critical amount of people will start to realize that due to the interventions, it's just a question of "when", not "whether", for the money to get out of the basements. Once a person who is effectively deciding about some reserves – even cash that he has borrowed – realizes that the banknotes will lose their value sometimes in the (foreseeable) future, he will start to get rid of them and convert them to something.

Once this motion starts, people will notice and an increasing number of people will bet that this trend is inevitable and it's time to get rid of the money. So I would say that we may have been in an equilibrium in which the continuing printing didn't matter but it's an unstable equilibrium because the banknotes are not hermetically locked in the basements and there is a risk that due to a perturbation, trillions of dollars will be flushed out in an unstoppable avalanche. (A future avalanche is the only possible ultimate result of some policies that hugely change some underlying graphs like those above but have virtually no effects on the real economy for a few years. That's why dangerous imbalances and instabilities are the only possible result of similar interventions – an explanation why the government should always better f*ck off, to put it very mildly.)

Because of this risk, some people are bound to think that this risk is a reality which means that they will effectively start the avalanche themselves. The apparent equilibrium we have been seeing for years – the Keynesian distortions of the financial markets by the activist central bankers – is an unstable one. It will start to collapse at some point and the instability will be only stoppable by a dramatic increase of the interest rates that the central bankers – who have been insanely dovish – won't have enough courage to set. Because of the limited influence of the central interest rates on the real-world interest rates, they could very well need 20% central interest rates to help to achieve 10% real-world interest rates that may be needed. Such a spike would produce an inverted yield curve that would lead to negative yields for some timescales in the future. All these things are problematic.

So if you agree that the money is not quite "hermetically" isolated and there's a risk that it will be flushed out due to a perturbation, you should agree that the process by which they will be flushed out is inevitable at some point and the only remaining question is where they will flow from the basements at the beginning.

I think that inflation – quickly increasing prices of common products and services – is likely if not guaranteed to arise. But I think that this won't be the first manifestation of the "semi-locked" money in the basements. Why? Because people's desire to spend the money for common goods and services is not directly affected or determined by the central banks' distortion of the financial markets.

Instead, they have a pretty much intrinsically, psychologically dictated level of desire to save and ensure themselves for the future, or to borrow. Because the "real spending" won't be affected, the risk of a deteriorating value of the money will mean that they will convert their cash to some other investment which is not "obviously" threatened by the flood that will flush out the cash from the basements.

So I tend to think that various bubbles in equities – stocks and perhaps real estate – will emerge before the inflation. People will first realize that it's safer to convert the cash holdings into a different form of investments. The flood from the basement will go into these other investments which will increase their value but not to "real spending", i.e. to everyday products and services which will continue to be unaffected.

In other words, bubbles will grow before the inflation will kick in. You might argue – especially if you look at Dow Jones above 16,000 etc. – that the bubbles have already begun to grow.

However, the word "bubble" implicitly means that we expect it to pop. My bonus point is that it doesn't have to be necessarily the case. Because of this flood of printed money, we may enter a long era in which the price-to-earnings ratio, P/E, will be much greater than the values we have been used to. If that long-term change materializes, people will effectively be gradually switching to stocks (and equivalent investments) as the money. An increasing number of people will hold their wealth (even borrowed cash) in the form of stocks which may continue to grow for quite some time.

Only once many of these people will find out that they're really richer, they may start to "really spend" and inflation will kick in.

So I am suggesting that P/E may be higher than the usual values of order 10 for many years. We must ask the question: What market forces dictate P/E?

Well, if a company is expected to grow and/or the recent earnings are seen as downward flukes, P/E may be much higher than 10. On the contrary, if a company is apparently declining or at risk to go bust, P/E may be much smaller than 10. Companies that are "guaranteed" to exist for many more years tend to have a higher P/E and vice versa. And of course, an unjustified bubble may inflate P/E, too. You might also think about antibubbles if you wish.

The basic logic that determines that some companies have a higher P/E than others is pretty clear. But what about the overall or average P/E? I used the number 10 in the previous paragraph which was mostly random but why is it 10? Can't it be a completely different number like 2 or 50? What is a company really worth?

Well, a company is a tool to produce profit. It has an expected lifetime. If you own stocks, you will get all the dividends from this expected lifetime. So P/E is "comparable" to the number of years over which the company will produce the dividends "comparable" to the last ones. If the company's profit will be halved every year, it will only generate a finite amount of profit in the whole future (equal to 2 years of the initial profit rate). A company that will last for "centuries" may be programmed to produce an infinite (total) amount of money in the future. But it's not a good idea to be too certain about the very far future, like 30 years from now, and a particular person whose lifetime is finite will be getting the income for a limited amount of time, anyway.

These are some of the hand-waving arguments why it is strange for P/E to exceed values like 30 or at least 50. But are these arguments waterproof? Can't the numbers be changed to totally different values because of the flood of trillions of dollars that will be flushed out of the basements?

I think that they can change, even in a (semi-)sustainable way.

The average or typical P/E may very well grow arbitrarily high, at least in principle. (In that case, the P/E ratios should increase globally – otherwise there would be clever transactions that would tend to make the P/E more uniform, anyway.) What would it mean and why would it be sustainable?

Well, if the people will start to decide that the cash is doomed, they will have an increasing fraction of their wealth, even "cash", in the form of stocks. To understand the idea, we may imagine that people will keep 90% of their salaries and all the savings in stocks and everyone will try to buy a "fair basket" or an "index fund" of stocks for most of his money. If that's so, the short-term fluctuations of the stock prices will be reduced. People will be effectively using the stocks or (approximately speaking) index funds as currency.

Once this trend reaches the people buying the everyday products and services are used to calculate the inflation rate, the inflation (growth of prices in the original currencies) will kick in. But there won't be any significant inflation if the prices are expressed in the "new currency" or "new currencies", the index funds.

If the average P/E reaches 100, it will still mean – in some careful interpretation – that the accumulated expected income from the company is equal to 100 years of recent dividends. But the reason why it's 100 won't be that something has fundamentally changed about the resilience of the companies etc. Instead, it will mean that the income is generated in the inflating old currencies such as dollars and this income is expected to grow.

If you knew that the inflation will be high (100%) but the interest rates will be kept at zero, and company's "real profit" is constant, to assume a simple situation, the company will produce something like 31 times recent dividends in the next 5 years (exponential growth etc.) So this is a justification for the P/E of the company to be vastly higher than just the number of years for which it is going to produce the same profit. Note that the condition needed for this increase of the "natural P/E" is the expectation of very low real interest rates for several years. Such conditions may justify higher stock prices (higher P/E). These sentences and this paragraph are therefore the most relevant ones for the claim promised in the title of this blog post. (In the real world, the real interest rates will not be of order –50 percent like here but closer to zero – but we may extrapolate companies to more than 5 years and the inflation [more precisely, loss of real wealth in savings] over the expected lifetime of the company may still be substantial.)

It's also sensible to expect a higher P/E in the environment of very low interest rates on savings because the dividends are successfully competing with the low interests even if these dividends are low.

So I do expect some rather dramatic changes in the years to come – changes that will result from the insanely loosened policies of the recent decade and something, especially the last 5 years. But I also do think that this will lead the people to de facto switch to different units of wealth that don't inflate that much so it won't be the end of the world. In fact, it's possible that nothing will change legally and the U.S. dollars etc. will continue to exist. Just the people's habits about how they store their holdings at various timescales may be vastly different than today and this will also mean that the numerical values of prices and even P/E may be very different than today.

Note that people rationally abandon units of currency whose value is decreasing too quickly (due to inflation) because it's dangerous to hold such "money". But when the value of some "coins" increases too much (deflation), it stops circulating as well because it's stupid to get rid of such a permanently growing miracle object (and it's better to keep it in the mattress than to lend it for zero or negative interest rates). In effect, only units of wealth whose inflation rate is "sufficiently" close to zero (which may perhaps include 10%) are picked by rational market players as something that is good to be used for payments for extended periods of time.

To summarize practical implications of the ideas above: I don't think that 16,000 is the end of the growth for Dow Jones, among related forecasts. The inflation will ultimately arrive to much of the world but equities should grow earlier and in the extended process of this growth, we may see a quasi-sustainably elevated P/E. This new, unusual regime isn't "quite" sustainable because at the end, the inflation will be tamed and there will be some ordinary real growth again.

The invisible hand spanks the government and restores some justice

You might interpret my point as a claim about the "long-term justice" that the invisible hand of the free markets is able to impose despite the distortions by the government. The observations can't guarantee that an investor will find the right timing for all transactions; he may be lucky or unlucky. But if the government or the central bank manages to artificially reduce the real interest rates – and especially their expectation – (well) below zero, it automatically means that the justifiable P/E ratio becomes (much) higher and stocks should be growing exactly when the expectation about the real interest rates in the future (comparable to the companies' lifetime) deteriorates. Once the expectation about the real interest rates improves again, the justifiable P/E decreases again and the bubble may pop. But it was not really an irrational bubble; there was a rational reason why the P/E was higher. As a result, the investor with an appropriately "averaged" portfolio cannot be punished by the government's interventions designed to punish investors, at least not in the long run. The government may only achieve a redistribution, a (more or less random) transfer of wealth from some people to others.


  1. If money is losing value due to inflation it is wise to hold a negative amount of it, i.e. to be in debt.

  2. Dear Gene, this comment of yours is neither an advise to an investor nor a rational analysis of the justifiable prices or rates. It is a *moral* recommendation to change the behavior according to the way how someone from above wants to change your behavior, a recommendation that a person who understands his priorities will ignore.

  3. It's not unrealistic. Well, it depends what numbers you call examples of those "arbitrarily high" figures.

    Let me give you an example. The extended monetary base may easily ignite a 5% inflation in the U.S. The unemployment rate etc. will not be decreasing, the real GDP growth will be zero, and the Feds will decide that it's right to keep on stimulating the economy for years. After several years, it will look like this stagflation will take decades.

    If the real interest rates are expected to be at minus 5% for 30 years, a sensible lifetime of a company over which an investor into stocks expects the price of the stocks to be returned, the inflation will mean that the profits will be not 30P over those 30 years but the sum of an increasing geometric series P(1+1.05+1.05^2+...+1.05^30) which is about 66P. So with this expectation of -5% for 30 years, one doubles the justifiable P/E.

    The stocks are expected to double when the expectations for the next 30-year real interest rates go from 30 times 0 to 30 times minus 5. In this counting, the decrease of long-term expected real interest rates by 5 percent produced a 100% growth of the stocks. Similarly, if the long-term expected real interest rate were just by 1 percent, one would get something like a 20% stocks growth.

    There is a strategy (when to go to/from stocks and how much) that pretty much counteracts the changes in the long-term expectations of the real interest rates.

  4. One of the great ironies of Fed policy is that wage inflation is viewed
    as self-reinforcing, but other types of price rises are not. So if gas,
    food, energy, housing and stock prices rise (as they did pretty rapidly
    in 2002-5 for example), the Fed is fairly complacent or comfortable with
    that. But if wages began rising rapidly, they’d likely raise rates for
    fear of an inflationary spiral.

    The Little Guy is the last to see the benefits of Fed policy and the first to see the cost.

  5. Dear Cynthia, in reality, there are very good reasons why e.g. the food price inflation is not self-reinforcing while wage inflation is reinforcing. The former doesn't have any inertial and represents a white noise - roughly speaking, the harvest every new year is a random number and starts a new competition between food producers from scratch; while increasing wages somewhere force others to increase wages as well to protect themselves against the loss of employees, and this "protection against others" may start to grow.

    One could argue that food *deflation* is self-reinforcing, however.

  6. Well your example is (hopefully) so unrealistic as to be becoming bizzare. 30 years of stagnation with 5% inflation is so bad that it looks like a major economic disaster. If you have only these 2 options for investors, stocks and banks with massive negative interest, everybody is in fact doomed and some wars or revolutions etc will eventually restore some other mode of economic/political life. Another thing to remember: when buying stocks, I am asking for an expected return that would compensate my delayed consumption AND the risk which is always bigger with stocks compared to say gov´t bonds. One or two percent of annual yiled WITH the extra risk of stocks would not be enough to satisfy investors. So your model situation would arguably trigger massive spending, because in your environment is simply investing/saving not attractive any more. This spending might eventually pull the country out of the stagnation and restore more realistic way of economic life. Another point of view: if you don´t prohibit free movement of capital, there will always be countries with more attractive P/E, so your 100 or 66 would not be sustainable in globalized world.

  7. Maznak, fine, I deliberately exaggerated the numbers. But you may divide the figures in "percent" by 5 to get a completely realistic picture. The long-term expected real interest rate may have very well dropped by 1 percent per year and by the counting above, it justifies the increase of P/E by something like 20 percent.

    So the whole increase of the Dow Jones in the last year or so may arguably be justified by the deteriorated long-term expectation about the returns on the saving accounts. An investor with some reasonable percentage of stocks saw a growth of the stocks' value that provided him with a compensation of the money he won't see in his savings account.

  8. Well, now we are in full agreement. Myself being one of the rather happy stock investos. I only want to repeat that there are some magnitudes of P/E where stocks are losing attractivity, no matter what the real interest rates are doing.

  9. And I did not even mention that high P/E is increasing the probability of bubble bursting (because it is becoming "more expected"). So you have a critical mass of panicking investors and amazing things begin to happen.

  10. Dear Maznak, as I wrote, the word "bubble", especially in this case, is just an emotionally justified label or libel.

    The higher value of P/E is justified by the solid arguments - the justification is as rational as the justification why some companies naturally have a higher P/E than others - so it is definitely wrong to call it a bubble. At any value of P/E, whether it is 10 or 40, the price of stocks may still go down.

    What you offer is just the irrational interpretation of instincts and habits but you don't analyze what is actually behind the habits and whether it will change under certain circumstances.

    It is *not* true that the average P/E must be around 10 forever.

  11. I hope your analysis is right because, on related grounds, we (meaning my wife and me) have moved the bulk of our investments into stocks - although not US stocks, which, it seems, it something you are ignoring (there is a strong correlation involved but still the difference is significant).

    However, like many other investors, we expect to bail-out relatively soon. Of course, we only keep a rather limited share of our liquid investments in dollars so the effect of the huge amounts of dollars in circulation is, in our case, even harder to predict .

    Also, your long term analysis ignores a number of quite likely "shocks", coming both from the international situation (each of them a possible cause of a major global stock crash) and from the results of US congressional and presidential elections. Because of such matters I would not venture to forecast anything beyond (at most) 2016, although if one ignores all such factors I can't find anything in your analysis to disagree with.

  12. Luboš, nobody is proposing 10 as the average P/E. In postwar USA, which is a good example of stock market, the average value is 14. Whenever it was higher (and I use some simplification here), it was because the expected growth in companies was above average (see the dotcom bubble). In your stagnant model, I would expect average P/E to be (very low number + some number brought by your inflation). But history shows that the "expected growth" component is dominant. What it means for your model is clear.

  13. Once I came to the realization that when the elites speak, the word “inflation”
    is interchangeable with “rising wages”, it became much easier to
    understand what they’re rambling about. The stuff we consider inflation
    doesn’t concern them a bit, except of course as a device to scare us
    into submission when it comes time to set policy.

  14. Central banks can either inflate assets or have asset wealth die by deflation. The only way to support consumption in an era of declining wages is to enable more borrowing, and the only way to enable more borrowing is to: 1) lower interest rates to near-zero so stagnant income can leverage higher debt, or 2) inflate assets to create phantom collateral that can then support additional debt.

    Marx calls this fictitious assets. Central banks are not providing ample liquidity to stimulate borrowing, they do it to support existing debt.

  15. I understand fully what you are saying, Lubos, but I was only pointing out that a fixed mortgage rate (which they usually are), in inflationary times, hurts the lender and helps the borrower. My wife and I have, in fact, benefited substantially from this obvious fact.
    Of course gambling on future inflation is still gambling. US law encourages such gambling in several different ways.
    Of course a house has no intrinsic value; it is worth whatever you can sell it for. We are lucky to have owned California real estate. It is also true that the fixed-rate lender is gambling on low inflation.

  16. Through the mechanism of QE, central banks (and therefore governments) have bought back hundreds of billions of dollars of their own debt. They have replaced liquid securities with pure cash. This is value neutral. Money has been added to the economy (if you do not include T-Bonds in your definition of money). Part of the rationale behind this was to push down long term bond yields - if you buy a hundred billion dollars of 10 year T-Bonds then their prices will rise and yields will fall and so companies and individuals will be able to finance long term lending at lower rates.

    However the main question I want to raise is whether governments will reverse this process. At some point in the future they could trickle these hundreds of billions back into the market and by doing so they will remove the cash. This will counter any inflation.

    However they could so something else. They could just cancel the debt that they hold. Then the money stays in the economy and it may not be inflationary. It will also eliminate the high debt to GDP in the countries where it happens. I expect it to happen, but quietly. It is the secret solution to the debt problem. The yanks will do it and so will the brits. The problem is europe where the germans would resist such a move due to their memories of the Weimar inflation.

  17. Printing money is no problem if it's just sitting there. Money supply is determined not only by it's volume but also by it's velocity, which has been rather sluggish lately.

    Since price is theoretically the present value of all future cash flows, with a low discount rate it's not surprising we have a high P/E ratio.

  18. Dear Lubos, I'm not sure whether you would agree or not but John Stuart Mill remarks somewhere that central banks can influence the real rate of interest in the short run (by unexpected changes in the money supply) but that it cannot effect the real long-term rate, which is a function of the supply and demand for real capital in the real world -- how much of people's real incomes they want to save and invest for future consumption on the one hand and how much businesses want to borrow those savings to finance real capital investments (which itself is a function of things like new inventions, new markets, etc, which effect the demand for capital.

    The real long-term interest rate is just the price of capital is the way I think Irving Fisher put it.

  19. In the real blue collar world introducing a little inflation into the economy is a way to get real wages down that may not (in fact is not) be so easily available from an employer's point of view. It's one thing to raise nominal wages each January a little slower than the inflation rate when there is inflation going on and another to come in on a Monday morning and announce to all your workers that come Friday they will see that their hourly pay rate has been reduced by 50 cents an hour or whatever.

    Of course if the workers were not so dumb and were better organized it wouldn't make any difference. But they are not. We live in an imperfect world.

  20. Of course money in the economy is not actually gauge invariant (in your sense) that was part of Keynes point.

  21. The gauge invariance is a mathematical fact which a reader who is not stupid may easily verify so if Keynes were building on the assumption that it failed, well, then he was building castles on sand.

    The only issues in the practical world one has to be careful about is

    1) when the inflation is very high, people need to rewrite the stickers too often - and store cash to saving accounts even for shorter periods of time - and this may steal them some extra time (or money)

    2) when the inflation rate is very low, the interest rates on some financial products implied by gauge invariance may go negative which is bad because people may always get 0 in the mattress (although in a system where money holding is administered electronically, mattresses could be made non-existent, so it wouldn't be a problem).

    So the point of a central bank is to guarantee that the rates are neither too low nor negative (at any scale), Sometimes they deliberately want to create one of the two scenarios - or both - which is "actively bad". But as long as one avoids the two traps above, there's a lot of room in between and infinitely many scenarios in this interval are exactly gauge equivalent to each other so they will have the same physical implicattions.

  22. No Marxist politician will ever get my vote. But on occasion, as a dispassionate analyst and critic of "capitalism" (taken as shorthand for the way our world is organized), not as a proposer of an alternative way to organize society, Marx was capable of achieving insight and articulating it well.

  23. Dear maznak, it doesn't matter, imagine I wrote 14 instead of 10 everywhere.

    The point is that there is some "tradition" what the P/E "should" fluctuate around but this tradition is only justified to stay constant if everything else is constant but it's not.

    Your description of the correction as "some number bought by inflation" is misleading. This extra number doesn't depend just on inflation, it depends on the expected overall growth, too. I wrote it as real interest rates.

    But the potential growth rate could have been close to 3% for centuries. It's totally plausible that the 21st century average will be just 1% or 2% - we're entering to a long era of a low growth. If that's so and if the governments will keep on trying to "stimulate" the economy to achieve the growth rate that these "omniscient" arrogant minds consider right, it will result in an artificial suppression of real interest rates for quite some time.

    The effect won't be that people will start to spend, however. The effect will be that their preexisting desire to spend or save will be moved to different places than cash.

  24. Dear Cynthia, could you please reduce this would-be emotional Marxist shit on my blog at least by an order of magnitude? I can bring you a receipt from my doctor that I have suffered through this shit for 16 years and have been overwhelmed by that.

    Thank you.

  25. Dear Gene, no doubts about that, a fixed mortgage rate starts to burn the lender once the inflation rate jumps up.

    But the point is that not all people who are in "plus" numbers are fixed-rate mortgage lenders. In fact, if you average over all the people who are in "plus" numbers, their average loss after pretty much any intervention like that is zero. Some people gain, some people lose. It's a redistribution that has no reason to help the aggregate economic activity.

  26. Dear Luke, yup, it was pretty much the same main point I was trying to make. The real long-term interest rates are dictated by people's intrinsic psychology and futurist expectations - one can't change it by similar interventions into the structure or size of money supply and bonds.

    Even the argument I presented for a higher P/E in the environment of expected long-term trends talks about a "temporary" distortion of the interest rates only - over the time comparable to the time in which a company is expected to produce dividends for the holders. In some "very long" timeframe, it's clear that the government's efforts to keep all the interest rates including "real long-term interest rates" low has to fail.

  27. LOL, if they were "even better organized" - I suppose you mean "even more self-confident labor unions", that would be a pretty bad world.

    I prefer to think about the right world. In the right world, a company may lower the nominal salaries as well when it's needed, and it *is* sometimes needed. People are free to leave once their contracts allow them to do so.

    The average nominal salary is perhaps in no need to decrease most of the time. But the fate of individual companies is more oscillating, I think, so a lowering of the nominal wages may very well be the right step that many companies should do to make themselves more viable etc. It's too bad that similar common-sense things have become a near taboo. It's the influence of the labor unions and similar influences that have reduced the growth rate of the economy relatively to the 19th century.

  28. Eugene, I hope you're OK if I disagree with this assertion of yours. He could achieve some insights but in his reasoning about pretty much any social or economic question, there was a fundamental blunder that made all his major conclusions invalid.

    This is also true about all of his criticism of "cartels" and "imperialism" as a stage of capitalism that "threw away" the competition, and all this garbage. In reality, much of the cartel-like process is just another creative stage of capitalism, another stage of the concentration of capital, and it also allows to things be even more productive and efficient than before. The free competition is never quite eliminated (by agreements between existing businesses) unless it is eliminated by "force".

  29. Sure, but how many 19th-century economists (if we view Marx as an economist rather than a philosopher) continue to be read, discussed, challenged and refuted? So if nothing else, he has been a spur to productive debate.

    Semi off topic, isn't it strange how physics and economics seem to differ? In physics, at least in principle there is the idea that a single individual today could, and perhaps, should be able to grasp the entire edifice, from elementary particles to solid state physics and complexity theory or wherever you draw the boundary. (No physicist actually does have the whole of physics at his fingertips, but it's my secret theory that a certain Plzen physicist has the ambition of becoming the only one in the world who does... and that this is part of the motivation for this weblog.)

    Whereas in economics, it's accepted that economists are blind men each grasping a different part of an elephant. And that's the optimistic version, assuming that they are indeed all touching the same animal. Different worldviews lead to different premises and methodologies, ending in radically different prescriptions and predictions. Yet the body of equations -- assuming that economics could be distilled to a mathematical form -- is much smaller and the equations are relatively much simpler.

    Is it only because one discipline studies nature -- eternal, unchanging -- and the other deals with intractable humanity?

  30. Marx was enormously well read and he borrowed ideas from everywhere - so a great many of these ideas were themselves insightful and even correct ones. But his own contribution was only to glue them together with the glue of millenarian utopianism and dogmatism - which are actually one of his very few “original” contributions (of course he did not invent either millenarianism or utopianism themselves since these are among the most ancient ideas of mankind) and add one very successful element of pure propaganda.

    To mention just the most obvious of his borrowings: his economic ideas were, as is well known, borrowed from Adam Smith and even more from David Ricardo ( ). His idea of class struggle was taken from his reading of the great French historians and politicians Guizot and de Tocqueville (except the social and historical analysis found in their works are vastly superior to Marx’s and have the virtue of having been proved correct by the passage of time, unlike those of Marx). Everybody knows that Marx’s notorious “dialectics” was borrowed from Hegel, except that Marx replaced Hegel’s Mind by economic forces. The idea of communist utopia and of the Proletariat as the “vanguard” of society was current among socialist leaders long before Marx and Marx’s main contribution was to successfully discredit them all by labeling them as “utopians”.

    Finally the idea of creating a world wide communist movement to bring about the Utopia was due to due to Frederick Lasalle, against whom Marx directed a constant stream of disgusting anti-semitic and racist abuse e.g. "he is descendant from the negroes who joined in the flight of Moses from Egypt (unless his mother or grandmother on the father’s side was crossed with a nigger)".

    Marxist own brilliant contribution belonged purely to one area: propaganda. He gave his own utopian ideas the appearance of “impartial analysis” and labeled them “scientific” and kept calling all his rivals “utopians” until it stuck. The timing was perfect: in the second half of the 19-th century the prestige of science was continually growing and reached its peak in the first half of the 20th century, and the idea that Marxism was “scientific” was certainly the most important cause of its appeal to intellectuals.

    Of course it also affected me in my childhood: I remember wondering as a child how it was possible that so many intelligent people in the West failed to recognize the “scientificness” of Marxism. Naturally communist propaganda always made use of the fact that so many famous Western scientists were sympathetic to marxism. I read quite a lot of Marx even before I was 15 - I never managed to get through “Das Kapital”, which was just too unreadable but I was very impressed with shorter works such as “The 18th of Brumaire of Louis Bonaparte” until I acquired enough historical knowledge to notice that it was, like all works of Marx, a propagandist pamphlet masquerading as political analysis.

    Nowadays people often forget that both Karl Popper and Michael Polanyi originally became interested in understanding the nature of scientific inquiry in order to debunk the claims of marxism to being “Science”. These days, of course, only the most naïve take these claims seriously mostly becuse they have so spectacularly refuted but also because we understand the concept of “science” so much better, but once this claim was a very potent propaganda weapon and because of it Marx deserves to be remembered (along with Muhmammad) as one of the most successful propagandists in history.

  31. OK, the fact that the people who keep on reading Marx are apparently relatively *numerous* doesn't mean that they're reasonable.

  32. Hmm, lucretius, even independently of Marx, I just don't think that this kind of eclectic mixing of almost all ingredients is what makes a great thinker.

    A sensible coherent teaching or theory on *anything* must pretty much ignore most of what has been written because it's just not internally consistent.

  33. I am pro-union based on freedom of association which is a bedrock principle for me. People have the right to band together to enhance their bargaining power vis-a-vis employers (just as employers have the right to maximize their profits). Some of the side-effects are harmful: a minimum wage negotiated via collective bargaining may raise unemployment. It is still preferable to government intervention in the marketplace or to a regime in which unions are either outlawed or executive arms of The Party.

    In the U.S., during its heyday of manufacturing unions significantly contributed towards American workers enjoying the highest living standards in the world outside of Switzerland and Luxembourg. But that was an age when the AFL-CIO, the umbrella association for U.S. unions, was staunchly anticommunist. Some years ago I dealt with the Teamsters union and in preparing for the assignment I was shocked to find that their pamphlets were spouting pure, hardline, academic Marxist rhetoric -- an impression that was confirmed upon meeting their officials.

  34. Dear Eugene, I am also for freedom of association, whatever, but I also respect the freedom of any employer to instantly fire people who organize efforts directed against the company such as members of "labor unions".

  35. I don't in principle have a problem with your view. In the U.S. today, apart from a number of exceptions and subject to state law, the doctrine of "at-will employment" still holds, which the Supreme Court, I think it was, memorably summarized as: An employer has the right to terminate an employee for good reason, for bad reason, or for no reason at all.

  36. Eugene, it seems to me that supply and demand is what is eternal and unchanging in economics...

  37. Well if history is teaching anything, it is that predictions often fail. I personally do not believe that average growth would go down - in the modern times, it keeps going up. The reason being, it depends on capital and technology and there is getting more of both all the time. As for the "traditional values" of P/E: they are what they are for a good reason, much more to do with investor psychology (but in fact very rational preferences, not some kind of "irrational habit") than macroeconomic environment. If one has to give up immediate consumption and also put her money at risk, she is right to expect certain expected payoff. There are alternative investments to stocks and there will always be. Well I feel I am getting redundant so this is where I am going to leave it.

  38. Yes, I agree. However, it obviously does make for good propaganda, since most people, if they have any expert knowledge at all, it is of only a narrow area. So, unless they are like Feynman and have a strong predisposition to be skeptical of such kind of claims until they have carefully considered them themselves, they are likely to be impressed. Marxism has one other aspect that helps it to spread: it can be easily simplified to appeal to the ignorant and the feeble minded. It is perfectly parodied in "Animal Farm" by Snowball's slogan (meant for the sheep who were too stupid to understand anything more) "Four legs good, two legs bad". This is about on the same level as the arguments of the great majority of “marxists”. Unfortunately, like all successful ideologies, marxism has also a “sophisticated version” which appeals to many intellectuals (I guess, though I might be wrong, CIP is an example among the contributors to these discussions). This version is just as wrong as the simple-minded one but of course much harder to refute.

  39. Eugene,

    Not only has the share of income that goes to labor as opposed to capital been dropping, but the fraction of that part of the pie, the part that goes to labor is skewed towards the upper quintile by massive CEO compensation and the entertainment/sports industries. It is interesting
    that when we talk about the divisions between capital and labor from a corporate governance perspective, the top executives of a company are placed on the side of ownership, management.

    But statistically, when we talk about how the economy is divided between wages and income from capital, the executive class and their
    salaries are put into the column that counts as labor! There is something that is on the order of "heads I win, tails you lose" to the
    way that is counted. The Kansas City Fed did a study looking at where productivity gains had gone over the past several decades. It found that although gains in productivity had been shared relatively equally between income from labor and income from capital, it was only the very highest income levels of labor that have gained over the past thirty
    years. The gains have been limited to a thin layer of scum at the top.

  40. It annoys me is how often "inflation" (of a currency) is officially conflated with all kinds of other reasons for price-increases. Most commonly and annoyingly, this confusion is perpetuated by unduly self-confident publicly opining politicians (political pricks, of either sex) who erroneously (IMO) perceive the notion and then mouth it inappropriately or in a wrong context.

    As I see it, "inflation" (in respect of money) should only refer to the effect of a greater than necessary endogenous injection [i.e. an injection greater than necessary to facilitate a 'substantially growing economy' (predominantly taken by me to be an economy whose "growth" is elastically proportional to and resulting from an increasing number of people supplying and seeking products and services] into an economy utilizing a specific electronic (possible these days) or almost entirely physically tangible (enumerated in printed text on paper or on plastic bills invented and pioneered in Australia) currency.

    Also I see an inflating currency as a tendency that basically driven by a tacitly accepted expectation/promise/'trickery' - i.e. most traditionally in the form of 'the institution' of interest on money lent and borrowed.

  41. Dear Cynthia,

    I know it sounds convincing and persuasive to you but I find what you write infuriatingly vague.
    Not only has the share of income that goes to labor as opposed to capital been dropping
    Who/what is labor? Who/what is capital? More working people (i.e., labor) than at any point in history have money in various retirement schemes from 401k to steelworkers' pension fund to real property to mutual fund and on and on. So, "capital" is to a great extent "labor".

    On your planet, "capital" (which, apparently, means anyone in a three-piece business suit -- of course the very first Capitalist Exploiter Space Alien in John Carpenter's movie They Live is a grey-haired white man wearing such a suit!) is constantly grabbing money from "working people" (= Julia Roberts in China Syndrome or Jane Fonda in Erin Brockovich or was it the other way around).

    On your planet, the welfare state never creates powerful disincentives by sponsoring a huge class of civil-servant drones that contribute nothing productive but have a vested interest in maintaining a "clientele" while demanding that "the rich" (= the middle class) cough up even more taxes to keep them in their cushy jobs with maximum security.

    On your planet, no entrepreneur ever goes bankrupt because his employees pulled down top salaries but did not deliver commensurate performance, took his intellectual property, stole his clients, and left the entrepreneur, who had the ideas and did the work and took the risks to build the business, behind in the dust.

    Maybe I should move to your planet and you to mine.

    On occasion you sound some right notes, for example about "too big to fail" banks, but I'm afraid this is more by accident than by design. I don't recognize the picture of life presented in the International Socialist Worker as something approaching my experience.

  42. "by its volume", "by its velocity" ;-)

  43. Eelco HoogendoornNov 24, 2013, 3:41:00 PM

    Of course it is gauge invariant. The point of Keynes was however not to apply a gauge transformation to money; and not just because doing so is rather impractical, but because when rather than performing a gauge transformation on the money supply, you give money to a limited subset of economic actors, you have political favors to sell.

  44. The problem with unions is that they always end up being political... and therefore on the left side...

  45. Due to loss in wage gains, most Americans workers live paycheck to paycheck., Eugene. So how in the world are they gonna save for retirement, much less get rich off of capital appreciations?

    Corporate- and state-sponsored pensions are still around, but many of them are on the way out. I'm lucky enough to have a pension, but anyone who was hired at my place of work after 2010 doesn't have one. They have to finance and manage their own retirement. My pension won't make me rich, but at least I don't have to worry about losing my shirt in the stock market.

    Most of the gains in the capital markets are artificially induced by the Fed. There's nothing natural about these gains and the fundamentals don't add up, which is why we are teetering on the edge of a huge market correction, which could set the average Joe investor back a decade, if not longer. If you think you can beat the Vampire Squid at this grossly distorted game of making money, you are sorely mistaken.

    Financial security in retirement will return to the average Joe worker ONLY if Capital rejoins itself at the hip of Labor, as it did when we had a real economy driven by production, instead of finance. I'm not hopeful that this will happen anytime soon, but when it does, it'll be a big shot in the arm for the economy as a whole.

  46. Dear Lubos
    PERs are actually rocket science.
    Or more precisely microscopical semi-science.
    Like somebody wrote, an "average" local PER is irrelevant and about as irrelevant as an average temperature is for understanding or predicting the regional climate which is the only thing that matters for people.

    The time scales that matter in fixing stock prices are much shorter than what you suppose in your post - you may distinguish one scale at or less 1 year and another around 5-7 years.
    The reasons to invest in stocks are also multiple and don't rely only on interest rates and their cousins inflation - these things actually matter mostly only locally and in a limited way.
    Broadly you may consider 3 categories of stock investments :
    1) Stock price expectation. Here you consider that the company has an above average growth potential for a given time scale. Typically you may find here gold (mines), Net companies, Biology (enzymes, genetic manipulations) etc. An investor expects a dramatic increase in turn over and in the value of the shares. The short term net profit doesn't matter and so doesn't the PER (it may even be negative what wouldn't fit in your thesis anyway). This kind of investor works with shorter time scales and basically obeys only a simple but fundamental principle : buy cheaper than you sell. The rotation speed is high.
    2) Dividends expectations. Here the time scales are longer. The investors are betting on mature and solid businesses (Exxon, hospitalized residences, coal etc). Also here the PER doesn't matter much because the dividend policy doesn't necesarily impact the stock price. On the other hand this kind of investment motivation is typically one where the dividends policy (dividends/stock price) competes with bond rates and in a way with interest rates. The rotation speed is low.
    3) Basket investments. Here the motivation is the same as in 1) but one tries to equal and perhaps to slightly beat some index. This may be the DJ for the most primitive and naive strategies. But more sophistically it is an index crossing regions (countries) and business sectors.
    For instance I invested along an index I created - India and X business sector (won't give the nature of X) and doubled my investment. But there are banks that offer sectorial index investments too.
    For this kind of investment PERs don't matter much because one is mixing countries and businesses with very different PERs, currencies and interest rates. The rotation speed is semi low.
    Considering that the above is what real investors do in a real world, you see that there is little to no correlation between (average ?) PERs in a country and the macroeconomical policies all over the world.
    In fact what I find discutable in your post is that you neglect spatial variability. Yet it is the spatial gradients (like in climate) in taxes, inflation, exchange rates, growth rates and interest rates that drive more the profitability in stock investments than the time variability of different parameters.
    If the whole Earth was a single state with same rules and behaviors then your arguments could apply. But it is not.