Capitalism For The Multitude

The securities industry association and the Investment Company Institute--the trade groups for stockbrokers and mutual funds--recently released a survey showing that 48 percent of U.S. households now own stocks or stock mutual funds. This is a huge increase from the 19 percent in 1983 and may be the highest level in history. The explosion in stock ownership ranks as one of the great social movements of the 1990s and, in the eyes of many, represents a significant achievement.

People's capitalism (so the story goes) is triumphant. More Americans have a stake in the nation's businesses--and not just as wage earners. Class conflict and consciousness, always muted in the United States, will continue to subside. On a more practical level, owning stocks will (the story continues) enrich average Americans, because stocks do better over time than other investments. People can save more for retirement or college tuition by being in the market as opposed to buying bonds or holding cash.

We will know in five or 10 years whether this pleasing story proceeds according to script. The outcome may depend on something suggested by the boom in stock ownership: the spreading conviction that the U.S. economy has become almost riskless. Capitalism has never existed without risk and uncertainty. But people are acting as if the separation is occurring. They think that the economy's become more stable and productive. If they're wrong, the foray into stocks could spawn disappointment and disillusion.

Time was when many Americans considered stocks too dangerous for their savings. Well, perish the thought. Since 1989, the number of shareholders has jumped 50 percent to 79 million. Of today's owners, 46 percent bought their first shares in 1990 or later. The enthusiasm stretches across generations. Among Generation-X households (ages 19 to 35), stock ownership is 42 percent. For baby boomers (ages 36 to 54), the proportion is 53 percent. It's 54 percent for the so-called Silent Generation (ages 55 to 74). Only the World War II generation (ages 75 and over) has low stock ownership, 27 percent.

Of course, few shareholders have consciously concluded that economic risk is gradually vanishing. The question is too cosmic. People have bought stock mainly because the market keeps going up. No one wants to be left out. But confidence in the market's advance amounts to a judgment that economic risk is falling.

Proof lies in the decline of the so-called equity risk premium: a once obscure concept that's become fashionable. The basic idea is simple. Stocks are risky because profits--the source of stocks' value--are uncertain. Recessions, new competition or management blunders can cut profits and stock prices. To compensate for risk, investors demand an extra return over the most dependable investment, a Treasury bond. You may pay $100 for a Treasury security that provides $6 of annual interest (a 6 percent return). But you won't pay $100 for a company's stock with profits of $6 a share. You'll typically pay less, because you'll want a higher return. (We're ignoring--for the moment--sheer speculation.) This extra return is "the risk premium."

But if risk drops, investors will accept lower returns, and stock prices will rise. A simple example shows why. Suppose a company has profits of $1 a share and that investors demand a 20 percent return on investment. They'll pay $5 for the stock ($1 is 20 percent of $5). Now assume that an acceptable return drops--the reasons don't matter--to 10 percent. Then the stock's price will double to $10 even if profits remain $1 a share ($1 is a 10 percent return on $10).

Here lies the magic of the market boom. Between 1990 and 1998, corporate profits roughly doubled to $846 billion. This boosted stocks. But the larger cause of their rise is the fall in "the risk premium." There are many slightly different ways to calculate this. A study by Regional Financial Associates puts the present "risk premium" at about 4 percent, down from 13 percent in the early 1980s and an average of 7 percent since 1965. As perceived risks dropped, stocks soared.

But why? Have investors simply gone on a speculative binge, raising prices relative to profits? Everyone buys because everyone else is buying. Or has the economy become less risky?

Well, there's a case for less risk, starting with the decline of inflation. High inflation in the 1970s and early 1980s hurt profits and stock prices in two ways. It eroded their "real" (inflation-adjusted) value; and it led to periodic recessions as the Federal Reserve tried to suppress rising prices. Low inflation--other things being equal--should mean fewer and milder recessions. Since late 1982, the economy has spent only eight months in recession (in late 1990 and early 1991).

"Globalization" and new information technologies also may enhance economic stability and growth. Competition compels companies to hold down prices and raise efficiency. Better information--about buying patterns, for example--improves control of inventories (supplies of unsold goods). In the past, surplus inventories contributed to recessions; production dropped while excess supplies were sold.

But these forces can also magnify risk. By its nature, new technology creates uncertainty. Profits are not ensured. No one knows what will work. Older companies may suffer from new competition. "Globalization" poses dangers, starting with ignorance of other societies. It must be safer to invest in Connecticut than China. Finally, faith in a riskless economy may inspire risky behavior. People may become imprudent because they think they're insulated from danger. They may overborrow, overspend and overinvest.

Economic risk is not static; it constantly shifts and slides. The rush into the stock market may produce the blessings that its admirers anticipate. But there's a nastier prospect--a backlash of some sort--if Americans have underestimated risk and pushed stocks too high. No one can be sure which it will be, because we are inevitably uncertain about uncertainty.