The New Regime Revives the Common Stock Market
The new regime outlined in chapter 2 dramatically changed the stock market. At the macroeconomic level, returns on the S&P 500 rose from an annual average of only 5.9% (-1.5% real) in the 1970s to 14.8% (9.7% real) between 1979 and 1984, 1 despite the fears kindled by the twin budget and trade deficits and crises in the banking system. Most of this improvement was not due to higher actual earnings, however, but rather to both a 20% rise in price-earnings ratios (adjusted for interest rates) and earnings projections by analysts that were steadily 30-40% above those realized. On a microeconomic level, there was a harsh sorting out of winners and losers according to how various industries were affected by declining inflation and oil prices, high interest rates, the strong dollar, the 1981-1982 recession, and the eventual expansion in consumer spending.
In this chapter I will consider the macroeconomics of the stock market, sorting out the causes of its recovery, particularly the fundamentals of earnings, interest rates, and taxes, and the psychological factors of confidence, optimism, or reduced risk premiums.
To do this I will use the analytical procedures of a market practitioner. My discussion will focus on what Fischer Black called "the magic in earnings" rather than on dividends. Stock prices are too volatile to be explained by dividends, as Robert Shiller has shown, and, as any practitioner knows, the analytical effort directed at earnings outweighs that directed at dividends by over one hundred to one. The relevant earnings are expected earnings, however, which almost never correspond to actual earnings and are strongly affected by changing levels of optimism. Most