Home > Bubbles > Is there a stock bubble? Joining the NYT debate

Is there a stock bubble? Joining the NYT debate

from Dean Baker

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!
  1. BC
    December 9, 2013 at 7:27 pm











    When the glaringly obvious is obviously not obvious to those who should know better and prudently say so, we’re in BIG bubbly trouble.

    Financial profits are now 4.5-5% of GDP (6-7% of private GDP), which is 4 times the average before the 1990s. Bank net margin growth after charge-offs and delinquencies now far exceed the change against a year ago of nominal GDP.

    Non-financial profits are contracting yoy in real terms, even as the non-financial corporate sector has added $1 trillion in debt in 2013, a growing share of which is being used to buy back shares to reduce flow, pad earnings/share, and goose the stock price so CEOs and other execs can sell their shares en masse just as the public is piling back into equities.

    Margin debt is soaring.

    Bearish sentiment is at a record low going back to 1987.

    The 55- and 56-month rates of acceleration have gone super-exponential, taking on Sornette’s super-exponential, log-periodic blow-off trajectory that ALWAYS resolves in an “anti-bubble” crash wave taking prices back to AT LEAST where the super-exponential blow-off commenced, which in this case is the S&P 500 1100s-1300s. (There is 70-month rhythm in the stock market that often includes a ~55- to 56-month super-exponential blow-off phase before the cyclical top and subsequent bear market, often resolving in a crash of an average of 30-40%.)

    The real spread between the Baa and T-bill yields is again blowing out as during the late stage of previous bubble blow-offs, including 1929, 1937, 1987, 2001, and 2008.

    There are bubbles EVERYWHERE, including stocks, corporate bonds, real estate, subprime auto loans, student loans, bank reserves, bank assets/GDP, margin debt, farmland, trophy properties, college tuition, deficits/GDP, profits/GDP, debt/GDP, sports franchise prices, CEO compensation, and an inflating bubble in the number of people denying that there are any bubbles anywhere.

    No bubble? Good grief.

  2. Jeff
    December 9, 2013 at 9:21 pm

    Regarding the two reasons that may justify a higher PE – (1) low interest rates and (2) ease of stock ownership – it seems to me that while those may be reasons to explain an elevated price level, neither justifies why higher PEs ought to persist in the medium to long term.
    If anything, (1) suggests that a return to average interest rates would deflate stock prices.
    And (2) just seems to suggest that a stampede one way or the other (into or out of stocks) will be more rapid and more violent.

  3. Jeff
    December 9, 2013 at 9:30 pm

    Also: “potential GDP” according to whom?
    And how do today’s prices look if instead of extrapolating from the peaks in 2000 and 2007, you instead chose 2003 and 2009 as starting points?
    I’m not drawing any conclusions, just casting doubt.

    • BC
      December 9, 2013 at 10:22 pm

      @Jeff: “And how do today’s prices look if instead of extrapolating from the peaks in 2000 and 2007, you instead chose 2003 and 2009 as starting points?
      I’m not drawing any conclusions, just casting doubt.”

      Precisely. On the basis of long-term earnings and the secular P/E cycle, profits are 65-70% above the average trend and profits/GDP and 120% above the average cyclical lows, implying that the elusive cyclical “fair value” for the S&P 500 is somewhere in the range of the 600s to 900s-1000s, not counting an outsized contraction of profits/GDP that typically occurs following bubbles that we currently have.

      To suggest that bubble conditions do not exist implies that (1) one does not know which metrics to examine in order to perceive a bubble, or (2) one does not want to see a bubble because one is not paid to do so and thus will never see nor publicly acknowledge a bubble.

      If those who are allegedly the most informed and well positioned to discern bubbles and warn of their inherent risks and likelihood of causing severe losses and economic dislocation cannot be counted on to publicly acknowledge bubbles when they are obvious, what else are we not being informed about by these same “experts”?

      What we don’t know, or what economists are not paid to tell us, can hurt us, and hurt us a lot as is abundantly clear since 2000 and 2007 (and 1987, 1937, 1929, and 1893).

      Oh, it’s a bubble alright, and the largest bubble as a share of GDP and wages globally in all of history.

      We should consider ourselves sufficiently warned.

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