Capital Returns

If you measure the return on capital by looking at profits (for example, corporate profits in the US national accounts), it has been huge over the last 3 years. But if you measure the return on capital by looking at (real) interest rates, it has been somewhere between small and tiny. What’s going on here?

I really don’t know, but it seems like a critical issue in understanding the world today, so it’s worth thinking about. One possibility is that the equity risk premium has been particularly high. In other words, people expected profits to be high, but they’re still scared to invest in stocks, so they have preferred the ostensibly safe but unimpressive return of bonds. The equity risk premium almost certainly did rise some in 2000-2002 as investors became more timid. But that stock market disaster wasn’t just a matter of becoming timid; investors also reduced their expectations for future profits. In any case, credit spreads today suggest that investors are no longer timid: why would they be willing to invest in junk bonds at not-very-impressive interest rates but not to invest in stocks in companies that are generating huge profits?

Another possibility is that the big profits are seen as a windfall. That is, they weren’t expected, and they aren’t expected to continue. This explanation is probably not consistent with analysts’ earnings estimates, which did anticipate much of the rapid earnings growth of the last 2 years and still call for respectable growth. But perhaps analysts’ earnings estimates don’t represent the view of the general investing public. The “windfall” explanation might be supported by the observation that earnings have been widely dispersed – that is, some industries, such as oil, and some particular companies, such as Microsoft, have experienced extremely high profits that have formed a substantial part of the total. This explanation also might be supported by the observation that corporations have been holding on to large quantities of cash.

A third possibility is that stock prices were already too high relative to the value of the underlying capital, so that, despite high rates of return on capital, the return on stocks was not (and is not expected to be) very high. Certainly, stock returns over the past 3 years have not been nearly as spectacular as the profit statistics would lead one to expect. But if stock prices are so high already, why do we not see more companies issuing stock to take advantage of the high prices? Wouldn’t this be a perfect time to do an IPO, so you can invest the capital and earn some of those huge profits that we see in the statistics?

None of these explanations is very satisfying. Something weird is going on, and I don’t know what it is.