October 28, 2014, The Hankyoreh
The recent volatility of stock prices has led many people to fear that the market is again in a bubble. These fears are misplaced for two reasons. First, the market is not especially high. Adjusted for inflation and growth, it is roughly in line with 2007 peaks. Second, unlike in 2000, the stock market is not driving the economy.
The first point is straightforward. Other things equal, we would expect the stock market to rise roughly in step with the economy. The S&P 500 peaked in 2007 at just over 1560. Inflation over the last seven years has been just over eight percent. If the economy had grown at a trend rate of 2.4 percent, it would be almost 18 percent larger today than it was in 2007.
If we adjust the 2007 peak for inflation and the economy’s trend growth rate, the market would be almost 28 percent higher today. That would put the S&P 500 at just under 2000, slightly above current levels. This would imply that there is no more reason to think the market is facing a bubble today than there was in 2007, and virtually no one thought the market was in a bubble in 2007. (Some of us did warn of a market that had not factored in the imminent collapse of a housing bubble.)
The other factor that has to be considered in assessing current stock prices is the returns available on alternative assets. In 2007, the yield on 10-year Treasury bonds was close to 5.0 percent. That compares with a bit over 2.0 percent today. While inflation was somewhat higher in 2007, that could at most make up 1.0 percentage point of the difference. And it was possible to get 5.0 percent interest rates on short-term deposits back in 2007, compared to the near zero rates available today.
For these reasons, it is difficult to make a case that the stock market is seriously over-valued. While there is no foolproof rule that tells us exactly what price level is appropriate, the stock market does not appear to be in a bubble when current values are placed in context.
By contrast, the stock market in 2000 was more than 40 percent higher relative to the economy than it is today. At that time the yield on 10-year Treasury bonds was more than 6.0 percent, with short-term interest rates not much lower. There were clearly high yielding alternatives to holding stock at the time.
More importantly, the stock market was driving the economy. There was an investment boom in which Internet start-ups were able to raise hundreds of millions or billions for ideas where they didn’t even know how they could make a profit. Today’s social media boom has some of the same characteristics, but it is nowhere near as important to the economy.
The other part of the story of the stock bubble was its impact on consumption. The wealth effect from trillions of dollars of ephemeral bubble wealth led to a consumption boom. The savings rate fell below 4.0 percent, the lowest levels on record at the time. (The saving rate fell to just over 2.0 percent at the peak of the housing bubble.)
The current saving rate is just over 5.0 percent. This is still low by historic standards, but not hugely out of line. It is not likely that it will rise substantially even if the stock market were to drop by 10-15 percent.
The relationship between the stock market and the economy is the key question, because there would be a good case for the Fed to try to beat down the market if it were driving the economy, as it did in the late 1990s. The reason is that bubbles burst, and when they do burst it is easier to repair the damage from a small bubble than a big bubble, as should be very clear to everyone by now.
However the cost of attacking the stock market, especially if done through raising interest rates, is slower growth and higher unemployment. Given the continuing weakness of the labor market, higher interest rates would be taking the economy in the wrong direction.
Federal Reserve Board Chair Janet Yellen has been following exactly the right line in assessing the stock market. Back in the summer she noted that stock prices in some sectors (social media and biotech) appeared to be out of line with fundamentals. She also presented the evidence that supported her case. She also noted that junk bonds did not seem to be pricing in risk appropriately. Her warnings produced the desired response in the price of all three assets.
Providing solid evidence to the public and market actors is the best way for the Fed to deal with asset prices that appear out of line. It should continue to have a monetary policy that focuses on growth and increasing employment. Trying to use monetary policy to pop bubbles that do not exist will inflict needless pain on tens of millions of workers through higher unemployment and lower wages. For once the Fed seems to be getting things right.