Home > Uncategorized > Is the stock market in another bubble?

Is the stock market in another bubble?

from Dean Baker

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 repeatedlywarned 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.

View article at original source.

  1. BC
    May 1, 2015 at 3:50 pm

    It’s a bubble.

    Hyper-financialization has occurred to the extent that the stock market is now the economy. That is, total annual net flows to the financial sector (and its top 0.001-1% owners) are now the equivalent of annual GDP output.

    Effectively, all value-added output of the economy is pledged to the rentier top 0.001-1% in perpetuity. No growth of output after rentier flows is possible in real terms per capita.

    If the Fed raises the funds rate at this point, it risks catastrophically disrupting the term structure supporting the hopelessly levered carry trade for equity index futures by the offshore shadow banks’ pass-through entities in Caribbean banking centers and elsewhere. Disrupt the growth of net flows to the financial sector and the economy stalls and contracts.

    Moreover, total stock market capitalization (CPI and US$ adjusted) as a share of GDP is back to the 1999- 2000 Dotcom and 2007 bubble peaks:

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=19R3

    Similarly adjusted and as a share of GDP, the Wilshire 5000 Full Cap Market Index is back to the level of the 1999-2000 Dotcom blowoff bubble peak:

    https://research.stlouisfed.org/fred2/graph/fredgraph.png?g=19R6

    Non-financial corporate debt is at a record high as a share of GDP, matching the period of the 1880s (railroad and bank debt), 1928-30 (industrial, utilities, and bank debt), and Japan in 1987-93 (industrial, bank, and insurer debt):

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=19Rc

    Non-financial corporate debt is at a record to wages and salaries:

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=19Rm

    Record low for wages to GDP:

    http://research.stlouisfed.org/fred2/graph/fredgraph.png?g=19Rn

    Overvalued financial assets are synonymous with debt/asset bubbles, low labor returns to GDP, extreme wealth and income inequality, non-productive rentier speculation, falling money velocity, and “secular stagnation”.

    Rather than cheer stock market booms/bubbles, historically valuations at current levels are precusors to decelerating 10-year real GDP per capita and ~0% real final sales per capita from the secular peak. Central bank policy that encourages ongoing leverage, associated financial bubbles, and net flows to the financial sector and its rentier owners ensures slow or no real growth indefinitely.

    Establishment economists are captured by Wall St., The City, and Frankfurt, the TBTE banks, and the rentier Anglo-American and European Power Elite, as are politicians and Fed officials, of course; therefore, they are not permitted to see bubbles or publicly identify them and discuss the negative effects.

  2. May 1, 2015 at 5:52 pm

    I don’t know what is mor interesting: the -reasonable- analysis of Dean or the argument of BC

  3. Larry Motuz
    May 4, 2015 at 12:20 am

    I’d like to applaud BC’s far more thorough research and thought-out consequential conclusions over Dean Baker’s more hastily drawn ones. The economy is being kept afloat by indebtedness against far less than optimal collateral which will vaporize if ever called into serious question.

  4. May 4, 2015 at 3:22 pm

    Dean, I think you’re saying it’s reasonable to expect a high Price/Earnings ratio at a time of “creative destruction” such as the transition from gasoline to electric cars, or from TV to internet media. The older companies in those sectors will lose valuation in line with their earnings, while investors can expect to pay a high P/E premium to buy into the rising stars. Generally when physical capital does this technological transition the price of physical capital rises. It doesn’t mean it’s overvalued.

    I’m more concerned about the aggregate growth of margin debt. If financial assets are held outright someone can absorb the losses from any adjustment. Same if houses are owned outright – no big deal. But a significant fraction of the stock market is currently held on margin: speculators take loans, essentially flash mortgages with stock as collateral. If equities drop speculators are forced to sell, triggering a crash and potentially wiping out investment banks that do the lending and brokerage.

    Socially it doesn’t matter if finance is a casino, if what it does is randomly distribute wealth between wealthy people. The flows in and out of that wealthy class matter.

    • BC
      May 4, 2015 at 6:26 pm

      Pavlos, the margin debt is but a small fraction of the total leverage in the system, most especially since the 2000s in the form of netted derivatives positions in the largely unregulated (“self-regulated”) TBTF/TBTE banks’ offshore shadow banking system’s pass-through entities in Caribbean banking centers and elsewhere. Leverage to banking system capital is 50-80:1 vs. 25-30:1 in 2005-08. As little as a 1.25-2% decline in the value of bilaterally and multilaterially netted positions risks a global debt-deflationary wipeout larger than 2008-10.

      When perceived via the netted equity index futures in terms of the S&P 500, as little as a 10% decline in the S&P 500 that persists, say, for several months risks a decline similar in scale to 2000-02 and 2008-09.

      This is why I suggest that the Fed cannot raise the funds rate or risk a catastrophic disruption to the term structure for the MASSIVELY leveraged interest rate and equity index future carry trade. The Fed is trying to convince “the market” that it is going to raise the funds rate as a means to “manage” expectations that the economy is poised for “escape velocity” (which it is not), as well as discourage further speculative levering of assets at the margin.

      They cannot have it both ways, as a slowing economy will signal to the market that the Fed will “pause” rate hikes and perhaps resume QEternity, which will be perceived as bullish, encouraging further levering at ZIRP/NIRP.

      If the economy does strengthen and the Fed follows through with small, gradual rate hikes (futures and the 1-year Treasury bill yield implies no hike until the earliest Nov-Dec), this implies a reacceleration of earnings, which is the expectation and is likely bullish for equities, encouraging further levering and higher stock prices.

      IOW, the Fed (which is to say the TBTE banks, actually) has (have) encouraged and sustained yet another MASSIVELY leveraged financial asset bubble as in 1998-2000 and 2005-07. They cannot raise rates but neither can they say that they can’t raise rates because of the risk of pricking the leverage bubble underlying the global financial asset bubble.

      The larger the financial bubbles become as a share of wages and GDP, the larger then net rentier flows/claims on the non-financialized sectors of the economy, and the slower growth is indefinitely, or no trend real GDP per capita post-2007.

      Few seem to realize the extent to which risk is higher today for a global debt-deflationary implosion than in 2007-08. Those who know cannot say so for fear of precipitating a 1929- and 2008-like collapse.

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