Sunday, September 21, 2008

A long way left to fall?

With the stock market withering like a plant in the desert sun, and commentators everywhere beginning to genuinely ponder the idea that the financial crisis could be as bad as the 1930's, it seems time to ask ''how bad is it going to get''?

I'm not an expert on stock markets by any means, but there is an interesting fact that could have relevance to today's crisis. The reason that people buy shares is, fairly evidently, for a share of the company's profits. In the long-term, shares need to give a higher return that the rate of interest in a bank. Otherwise, there'd be no reason to buy them in the first place. Historically, the rate of return on shares that the market has settled at means that people make their money back in 14.5 years, in other words an interest rate of 6.89%. That's a reasonable return, and enough more than putting your money in the bank to make the risk of buying shares worthwhile.

As the above graph shows, the prices at the moment are still well above that level. At the moment, the price of shares is around 25 times the annual earnings, or an interest rate of around 4%. Given that you can get a rate that's higher than that from a lot of banks' saving accounts, and the current market turmoil, there is every chance that share prices will continue to fall.

Notes: 1. I wrote this before the announced bailout, but think it is still relevant
2. The inspiration for this came from the Undercover Economist, a book I'd highly recommend

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