Al Jazeera America, April 27, 2015
The stock market has recovered sharply from the lows hit in the financial crisis. All the major indices are at or near record highs. This has led many analysts to worry about a new bubble in the stock market. These concerns are misplaced.
Before going through the data, I should point out that I am not afraid to warn of bubbles. In the late 1990s, I clearly and repeatedly warned of the stock bubble. I argued that its collapse was likely to lead to a recession, the end of the Clinton-era budget surpluses, and pose serious problems for pensions. In the last decade I was yelling about the dangers from the housing bubble as early as 2002.
I recognize the dangers of bubbles and have been at the forefront of those calling attention to them. However, it is necessary to view the picture with clear eyes, and not scream “fire” every time someone lights a cigarette.
First, we should not be concerned about stock indices hitting record highs; that is what we should expect. Unless we’re in a recession we expect the economy to grow. If profits grow roughly in step with the economy, then we should expect the stock market to grow roughly in step with the economy, otherwise we would be seeing a declining price to earnings ratio for the market. While that may happen in any given year, few would predict a continually declining price to earnings ratio.
This means that we should expect the stock market indices to regularly be reaching new highs. We need only get concerned if the stock market outpaces the growth of the economy. Outwardly, there is some basis for concern in this area. The ratio of the value of the stock market to GDP was 1.75 at the end of 2014. This is well above the long-term average, which is close to 1.0, and only slightly below the 1.8 ratio at the end of 1999 when the market was approaching its bubble peaks.
It is worth noting that this run-up is primarily in the stock of newer companies. The S&P 500 is only about 40 percent above its 2000 peak, while the economy has grown by roughly 80 percent. This doesn’t mean that the newer companies are necessarily over-valued. It could prove to be the case that the older companies will rapidly lose market share and profits to the upstarts in the next decade.
If we look beyond GDP to corporate profits, the case for a bubble looks much weaker. In 1999, after-tax profits were 4.7 percent of GDP. By comparison, they were 6.3 percent of GDP in 2014, and over 7.0 percent in 2012 and 2013. Just taking the single year number, this gives a price to earnings ratio of 27.7 at the end of 2014 compared to 38.7 in 1999. This is still high by historical standards, but far below the bubble peaks.
Whether this figure proves to be excessive will depend in large part on whether the extraordinarily high profit share is anomaly or whether it is the new normal. My guess (and hope) is that it is largely anomalous, and if the labor market is allowed to tighten further, then we will see a further shift back toward wages. But if the profit share stays near its current level; there seems little basis for concerns about a bubble in the market.
There is another important factor that we have to consider in assessing stock prices. The interest rate on 10-year government bonds has been hovering just under 2.0 percent. By comparison, it was over 6.0 percent at the end of 1999. This matters hugely in assessing whether the market is in a bubble, since it is necessary to know what the alternative is. In 1999, with an inflation rate just over 2.0 percent, the real interest rate on long-term bonds was close to 4.0 percent. By comparison, with a current inflation at just 2.0 percent, the real interest rate is close to zero.
Here also there is there is an important question about future trends. If interest rates rise, then that increase should have some negative impact on the stock market. But those who have been predicting a huge jump in interest rates have been wrong for the last five years and they are likely to continue to be wrong long into the future. It is certainly is plausible there will be some upward trend (that’s my bet), but given the weakness of the economy, it is likely to be many years before we see anything like a 6.0 percent long bond rate.
In short, there doesn’t seem much basis for concern about a market crash. However, with price to earnings ratios well above normal levels even assuming no further fall in profit shares, there is no way investors will see anything resembling the 7.0 percent real return on stock, which has been the historic average. But given the low returns available elsewhere, stockholders may be quite satisfied a real return in the 4.0-5.0 percent range.
There is one final point worth emphasizing about the current market. In the 1990s, the stock bubble was driving the economy with the wealth effect propelling consumption, and the saving rate hitting a then record low. The bubble also drove a tech investment boom. In the last decade bubble generated housing wealth led to an even larger consumption boom and a surge in residential construction.
It is hard to make the case that current market valuations are driving the economy. Consumption is somewhat high relative to disposable income, but not hugely out of line with past experience. And, there is no investment boom in aggregate, even if some social media spending might be misguided.
This means that if the market were to suddenly plunge by 20 to 30 percent, we will see some unhappy shareholders, but it is unlikely to sink the economy. This is not Round III of the bubble economy.