WHY TECHNOLOGICAL REVOLUTIONS ONLY HAVE TEMPORARY EFFECTS ON SHARE PRICES

New research explains how share prices can rise dramatically and then fall back in the wake of a technological revolution – like the internet – which raises productivity.

The study by Professors Jakob Madsen and Philip Davis, published in the July 2006 Economic Journal, shows how initially a technological revolution may increase share prices because earnings per unit of capital are temporarily higher. But the profit rate returns to its initial level after a short period in time because the higher share prices have lowered capital costs and, consequently, led firms to invest more.

The higher investment increases the capital stock, which in turn lowers the profit rate again because the higher capital stock has brought the profit rate back to its initial level. These forces entail an offsetting decline in share prices and help explain the profile of share prices over 1995-2003, including the run-up of 300% between 1995 and 2000.

The researchers acknowledge that other factors may have played a role in share price developments and some may justify higher share prices – such as a declining share of income going to labour; and greater risk tolerance due to demographic ageing.

But even if other factors can help explain the stock market run-up, they argue that they have identified the most fundamental one, namely errors in understanding the long-term impact of a technological revolution on share prices.

At a basic level, what their theoretical and empirical work suggests is that the profit rate is determined by the real returns required by investors (the interest rate) and other macroeconomic factors, apart from taxes, have no impact on share prices in the long run. By their decisions, investors and savers determine the interest rate and companies invest until the profit rate equals the real interest rate.

Using historical data going back to 1925 on the productivity of R&D capital, patent capital and fixed capital for 11 OECD countries, the empirical evidence gives strong support for the analysis by suggesting that technological innovations indeed have only temporary effects on equity returns.

The stock market run-up of approximately 300% in the OECD countries in 1995-2000 has often been attributed to the productivity-enhancing growth effects of the information and communication technology revolution. Investors assumed that accelerating labour productivity growth would permanently increase the growth in corporate earnings, consequently justifying higher share prices. On this argument, the decline over 2000-3 has been a puzzle.

This study shows that this reasoning is mistaken and rests on two myths:

• that corporate earnings per unit of capital increase over time;
• and that earnings per share are linked to labour productivity growth.

On the first point, the research shows that the profit rate, or earnings per unit of capital, has decreased rather than increased since 1870. This result may seem strange since earnings per share have increased substantially over the past two centuries and this increase has often been attributed to increasing corporate income per capita or per hour worked.

But earnings per share can only increase because of goods price inflation or because the earnings are retained in the company for investment. If all earnings were paid out, real share prices would not increase at all but remain flat.

On the second point, output per hour worked is a bad proxy for earnings per unit of capital. Labour productivity increases over time because of technological progress and because of an increasing capital stock per worker.

An increasing stock of capital, however, lowers the profit rate because an additional unit of capital stock is less productive than the productivity of the existing capital stock when combined with a given level of other factors of production (so-called diminishing returns to factor proportions). Consequently, any increase in labour productivity per capita induced by higher capital increases output but lowers earnings per unit of capital.

ENDS

Notes for editors: ‘Equity Prices, Productivity Growth and ‘The New Economy’

by Jakob Madsen and Philip Davis is published in the July 2006 issue of the Economic Journal.

Madsen is at the University of Copenhagen and Monash University. Davis is at Brunel University.

For further information: contact Philip Davis via email: e_philip_davis@msn.com; or Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).