October 16, 2014
I have a pretty good track record in warning about bubbles and the damage their collapse will cause. I warned frequently and as loudly as I could about the stock bubble in the late 1990s. I quite explicitly predicted that its collapse would lead to a recession (e.g here and here). (This recession was far more serious than generally recognized — 4 years with zero net job creation). I also predicted that the collapse would cause troubles for the pension funds whose projections effectively assumed that the stock bubble would grow ever larger.
I was the earliest and clearest warner of the housing bubble. Also pointing out as early as 2002 that it would likely lead to serious trouble for Fannie and Freddie (that was easy), as well as many banks who would be stuck holding the bag at the time of the bust.
Given my past concern about bubbles, I am quite open to the view expressed by David Leonhardt in his Upshot piece that the stock market is over-valued. Leonhardt is right that price to earnings ratios are somewhat higher than their historic average. (I make comparisons of the current market valuation against average profit shares of GDP — that gets rid of the impact of the extraordinarily high profit share of recent years and the lows of the downturn.) However the key item left out of Leonhardt’s analysis is that interest rates are extraordinary low.
The decision to hold stock depends on what alternatives are available. If someone is considering buying a 10-year Treasury bond they would be looking at a nominal return of just over 2.0 percent and a real return of around 0.5 percent. By comparison, in 2000, when price-to-earnings ratios were around 30 percent higher, the nominal return on 10-year Treasury bonds was around 6.0 percent, for a real return of around 3.5 percent. To most folks those numbers would make bonds look considerably more attractive back in 2000, and therefore make stocks less attractive.
The takeaway for fans of arithmetic everywhere is that stock prices are indeed high. If you are expecting the market to give its historic 7.0 percent real returns, contact me immediately so I can sell you some swamp land in Florida. But if you are expecting a collapse like we saw in 2000-2002 or in the housing market from 2007-2011, you are going to be seriously disappointed.
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