December 03, 2013
Since the NYT decided to devote a Room for Debate on the question of whether the stock market is currently in a bubble, I thought I should join the party as one of the stock bubble warners from the 1990s. To my mind the story for the overall stock market is a fairly simple one. Look at the ratio of stock prices to trend earnings.
This one doesn’t look too terrifying. Obviously the market is hitting record highs measured in nominal dollars, but if we expect the price to earnings ratio to remain more or less constant over time, then we should expect the nominal value to regularly hit new highs as the economy grows. In this context, an S&P at 1800 doesn’t seem especially scary. The S&P had previously peaked at 1525 back in 2007, six years ago.
Since 2007 the price level is up by roughly 9 percent. If we assume potential growth of 2.3 percent, then the economy’s potential GDP would be 14.6 percent higher today. Taking the two together, the S&P would be 25.3 percent higher today, or at 1910, to be as high relative to trend earnings as it was in the fall of 2007. In other words, if we didn’t have a bubble in 2007, then we don’t have one today.
If we go further back to the bubble days of 2000, we had a peak S&P of roughly 1500. Since then prices have risen by roughly 30 percent. Actual growth from 2000 to 2007 was 18.4 percent. If we multiply that by my calculation of potential growth since 2007, we get a growth in potential GDP of 35.7 percent since 2000. (I am using actual growth from 2000 to 2007 since I am assuming that the economy’s growth over this period was pretty much in line with its potential.) Multiplying this 35.7 potential growth figure by the rise in prices gives us an increase of 75.6 percent since 2000, which implies that the S&P would be a bit over 2430 if it were as high relative to potential GDP today as it was at the peak of the 1990s stock bubble.
Another way to put this is that, relative to the potential of the economy, the stock market is about 68 percent of its bubble peak. Would this mean we have a bubble now? By my assessment the answer is no. The PEs at the peak in 2000 were above 30 to 1 (using trend earnings, defined as the average share of profits in GDP). That was more than double the historical average. The current ratio would put the PEs around 20. This is still well above the historical average, but not obviously in bubble territory.
There are two reasons that a higher than normal PE might be justified. The first is simply that we have unusually low interest rates. The real short-term interest rate is -1.5 percent and the real interest rate on 10-year Treasury bonds is hovering around 1.0 percent. These low rates would justify higher than normal stock prices.
The other reason that stock prices might reasonably be higher than normal is that people may feel more comfortable holding stocks today, with the easy availability of low-cost index funds, than they did in prior decades. This implies a reduced risk premium. That would mean both higher PE ratios (plausibly around 20 in my view) and lower future returns on stock. (Real returns going forward would average @ 5 percent, instead of the 7 percent return in the past.)
I could be wrong, but that’s my take — No Bubble!
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