CEPR - Center for Economic and Policy Research


En Español

Em Português

Other Languages

Home Publications Blogs Beat the Press Is the Stock Market Getting Bubbly?

Is the Stock Market Getting Bubbly?

Sunday, 27 April 2014 08:00

Washington Post columnist Steve Pearlstein argues it is, taking issue with fellow columnist Barry Ritholtz who says it isn't. I'm going to come down in the middle here.

The market is somewhat above its historic levels relative to trend earnings. Pearlstein cites Shiller who puts the price to earnings ratio at 25 to 1, compared to a historic average of 16. (Pearlstein seems to place a lot of faith in Shiller who he tells us got a Nobel for his knack for spotting bubbles. Shiller may have gotten the Nobel, but I got the bubble story right. In 2003 he argued that there was no bubble in the housing market by making a comparison of real house prices and real incomes. I had recognized the bubble a year earlier by noting that inflation adjusted house prices had been rising since the late 1990s after remaining largely flat for the prior half century. Shiller later did research agreeing with my assessment that quality-adjusted house prices should track inflation, not income.) Anyhow, I would agree that stock prices are somewhat above trend, but not by quite as large a margin as Shiller.

To get some perspective, at the peak of the stock bubble in early 2000, the S&P peaked at just under 1530. The economy is almost than 70 percent larger today (in nominal dollars), which would mean that the S&P would be over 2600 today if it were as high relative to the economy. If we throw in that the economy is still operating at 5 percent below its potential then the S&P would have to be over 2700 now to be as high relative to the economy as it was at the peak of the stock bubble. With a Friday close of 1863, we can see the market is at a level that is a bit more than two thirds of its 2000 bubble peak, relative to the size of the economy.

It also is much lower relative to the economy than it was in 2007 when almost no one was talking about a stock bubble. The S&P peaked at just over 1560 in the fall of 2007. Taking into account the economy's 18 percent nominal growth over this period, and the fact that we are still 5 percent below potential GDP, the S&P would have to be over 1900 today to be as high relative to potential GDP as it was in 2007. Given recent patterns, it certainly doesn't make sense to talk about a bubble for the market as a whole.

However, there are some points worth noting. The social media craze has allowed many companies with no profits and few prospects for making profits to market valuations in the hundreds of millions or even billions of dollars. That sure looks like the Internet bubble. Some of these companies may end up being profitable and worth something like their current share price. The vast majority probably will not.

The other point is that the higher than trend price to earnings ratio means that we should expect to see lower than trend real returns going forward. This is an important qualification to Ritholtz's analysis. While there is no reason that people should fear that stocks in general will take a tumble, as they did in 2000-2002, they also would be nuts to expect the same real returns going forward as they saw in the past.

With a price to earnings ratio that is roughly one-third above the long-term trend, they should expect real returns that are roughly one-third lower than the historic average. This means that instead of expecting real returns on stock of 7.0 percent, they should expect something closer to 5.0 percent. That might still make stocks a good investment, especially in the low interest rate environment we see today, but probably not as good as many people are banking on.

In short, there is not much basis for Pearlstein's bubble story, but we should also expect that because of higher than trend PE ratios stocks will not provide the same returns in the future as they did in the past. Anyone who thinks we can better have their calculator checked.

Comments (23)Add Comment
written by Jesse, April 27, 2014 10:37

The housing bubble was easy to spot. Stocks are in a bubble, but it is not as easy, because the valuations are based on accounting that is deeply flawed. The bubble is more easy to spot in junk, where there is the desperate search for yield.

The stock market is sustainable only through easy money. So any shock to that money flow from the Fed will send the stock market tumbling.

Was it a bubble? Because it is a bubble does not mean it cannot go higher. It is important to look into what it is, not to fasten on a single measure like PE. One might as well fasten on unemployment, CPI, and GDP to say whether there is a recovery.

Let's see what the economists say again after the fact. A new crisis is coming and it is going to be notable. The reasons for it are obvious, but too many are paid too well and too heavily invested in the status quo to see it.
corp profits versus market cap
written by jim, April 27, 2014 11:10
how dense is everyone? the market was very undervalued. now its fairly valued. there is a wide range of fair value. why do we use the word bubble so much?

further this makes no sense
written by jim, April 27, 2014 11:16
However, there are some points worth noting. The social media craze has allowed many companies with no profits and few prospects for making profits to market valuations in the hundreds of millions or even billions of dollars. That sure looks like the Internet bubble. Some of these companies may end up being profitable and worth something like their current share price. "

internet index is trading at 28-30x earnings. their historical average is 36. in 2000 it was 200(a bubble). similarly the nasdaq is around 19 versus 25 and 100 in 2000. sure some companies are horrid but no one has taken into account that alibaba is bringing 150 billion of market cap to the market. the day this was announced amazon was trading at 375 now 300. this year sets the record for internet ipos and for bolt on offerings as we are now at 2 and 85 billion, the best pace this decade. that means supply is high and demand is scared off by geopolitics. the biggest bubble is in defensive stocks like utilities which are 30 pcnt overvalued versus historical norms. similarly 75 pcnt of utility stocks are at all time highs, while only 10 pcnt have earnings highs. if you want to talk about a bubble in stocks your sniffing up the wrong tree.
Shorter Pearlstein: Fed Should Sabotage the Economy to Crash the Stock Market
written by Paul Mathis, April 27, 2014 11:59
Pearlstein's thesis is common conservative claptrap: the Fed's "easy" money policies to fight unemployment and spur economic growth have created a stock market "bubble" because companies can borrow at low interest rates to expand their businesses. The Fed, according to these cons, should "normalize" interest rates by raising them arbitrarily to a level that will halt the stock market's advance. Also, the Fed should ignore its statutory mandate to achieve full employment with low inflation. Instead, the Fed should implement deflation and ignore the unemployed apparently to help the 1% increase the value of their loans while holding down wage increases. Sabotaging the economy is an added benefit of this con policy.
No, it's a bubble. And a bad one.
written by jm, April 27, 2014 1:43
Dean wrote:

"... the S&P would have to be over 1900 today to be as high relative to potential GDP as it was in 2007. Given recent patterns, it certainly doesn't make sense to talk about a bubble for the market as a whole."

But it is nearly 1900, margin debt is at an all-time high (http://www.nyxdata.com/nysedat...category=8).

And the claimed earnings on which the P/E ratios are based are far above normal levels as a percentage of GDP, partly because the Fed's policies have allowed companies to sell enormous quantities of bonds -- especially junk bonds -- at ludicrously low interest rates. The funds gained from those bond sales have often been used to boost stock prices further through stock buybacks. If and when interest rates ever return to normal levels, those companies will be on the hook to roll over those bonds at much higher interest rates, reducing their claimed earnings at the same time the higher rates negatively impact stock prices in general (rising interest rates will simultaneously raise the cost of margin debt). Some of the companies will be considered too risky and won't be able to roll over their bonds at all.

It's said that insider selling is currently at a very high level, another hint that we're at or near a bubble high.

The record high level of margin debt ensures that when this bubble starts to deflate and "investors" start getting calls from Mr. Margin, the bubble will deflate in a great hurry.

Among the factors that have made current P/E levels appear to be not far above "historic levels", are:

1. the Fed having pursued zero- or near-zero-interest-rate policies for a very long time,

2. the general public having been induced to buy stocks through the replacement of defined-benefit pension plans with 401(k) accounts,

3. the reduction in Federal capital-gains tax levels, partially enabled by the funding of government through the Social Security fund surplus engineered by Greenspan's raising of FICA taxes 30% above the level needed to fund the program on a pay-as-you-go basis.

These and other factors have been supporting stock prices at unrealistic levels for a very long time. They are about to reverse, as:

1. Fed board members are increasingly concerned about the negative effects of ZIRP, and higher rates are coming,

2. because low interest rates deprive retirees of income from CDs and bonds, they are going to have to start selling stocks just to live,

3. the Social Security tax surplus the governemt could borrow to make up for lack of general-fund income is now disappearing as the baby boom generation is forced to draw on the program through retirement or disability, and younger workers' wages are too low to maintain a surplus; capital gains taxes have already risen, and are likely to rise more.

Supposedly, the value of a stock lies in the income streams one can expect from it -- and if part of that income stream is expected to come from a higher future stock price rather than from dividends, then that higher future price should be based on potential for higher dividends in the future. Currently, the S&P 500 dividend yield is 1.94% -- an astoundingly low level considering the high level of reported earnings and the degree to which earnings payments are being funded by corporate borrowing at today's unsustainably low interest rates.

Reversion to the mean on any or several of relevant metrics such as corporate profits (now said to be 70% above normal levels), margin debt, dividend yield, interest rates will send the market lower, and margin calls will accelerate the decline. As the current bubble is said to have sucked in a lot of individual investors -- having proven to many people that you can't lose money in stocks as long as you hold through the occasional anomalous downturns ('cuz the Fed's got your back) -- it's likely that the next stock market plunge is going to wipe out another large fraction of upper-middle class wealth already severely impacted by the housing bubble collapse (especially as it will send home prices, too, down again). Since it's been largely the rise in spending of stock market gains by the well-to-do that's fueled what little recovery we've gotten, there will be additional feedbacks there.

This is a yet another Fed-induced bubble, and it too will burst.

S&P 500 historical dividend yields
written by jm, April 27, 2014 1:48
Neglected to include this chart link above:

jm you are lost
written by jim, April 27, 2014 2:06
everything you said is off base. there is no such thing as reversion to the mean. corp profit margins have risen since 1981 at an annualized rate of 2.7%. you fail to realize the s and p leverage ratio is at 104 versus 170 historically. in other words there has been substantial deleveraging. further the added benefit of lower interest expense has been at the expense of financials in the form of net interest margin, which when interest rates rise will replace the added benefit of lower rates for non-financials. finally you bring up capital gains rates when stock ownership is well below historical levels under 60%. what republican world are you living in?
comparing to extremes
written by tew, April 27, 2014 2:27
Generally speaking when you need to compare current conditions to previous extreme conditions you are admitting that current conditions can only be understood in the context of extreme conditions.

Specifically, one of the previous extreme conditions cited - the 2000 stock market bubble - was the MOST EXTREME in U.S. stock market history. In fact, many historical bear markets have started at levels the same as or even lower than the current conditions.

Also, the "norm" of 7% real returns is based on historical periods of rapid economic growth. Even if we close the output gap, nobody is predicting sustained 3% real growth in the next couple decades. So a 5% real return is probably a better estimate for the future. Taking off that 1/3 for current overvaluation indicates a 3%+ forward real return. The majority of that would be comprised of the dividend yield, leaving less than 2% real price appreciation. With that level of expected future price return - call it 4% nominal - it doesn't take much to have a bear market (20%+ decline).
Tew- analysis correct diagnosis wrong
written by Jim, April 27, 2014 2:36
Historical real yield is 2 pcnt versus 4 pcnt today hence undervalued gven current conditions
historical real yield
written by tew, April 27, 2014 3:21

Are you referring to the S&P500 dividend yield?

The S&P500 dividend yield is currently 1.9%. The historical average is 4.4% (back to 1870; post-WWII it is 3.4%). So the current dividend yield is well below the historical average.

Source: http://www.econ.yale.edu/~shiller/data/ie_data.xls but you have to calculate the yield yourself from the data in the file.
jim on net interest margin
written by tew, April 27, 2014 3:31
Jim writes "...further the added benefit of lower interest expense has been at the expense of financials in the form of net interest margin, which when interest rates rise will replace the added benefit of lower rates for non-financials..."

What would make somebody believe that nominal interest rates govern net interest margin? Net interest margin is based on the spread between borrowing cost and lending rate. When lending volumes are strong and demand for credit is high, banks can earn higher spreads and thus higher net interest margin. It doesn't matter if the ten year is yielding 2% or 10%.

For any folks confused by jim's claim, here is a quick primer: http://www.investopedia.com/fe...anking.asp
Net Interest Margin (NIM) = (Total Interest Income - Total Interest Expense)/Total Earning Assets
written by jim, April 27, 2014 3:32
nope. real earnings yield is trailing p/e - core cpi inflation. 50 year avg is 2.5 and we are over 4. you have made 2 observations, 1 regarding dividend yields which have historically low payout ratios, and 1 regarding earnings yields. both are supportive of higher valuations. the low dividend payout ratio should be supportive of higher p/b ratios as the reinvestment rate is ~15%, and low inflation would be supportive of higher p/e ratios. so you have brought up two points proving the market is fairly or under valued.
written by jim, April 27, 2014 3:43
you don't seem to get net interest. here is some empirical examples. so 100 bp shift in short end yields 3 billion extra a year to bank of america.

Brian Moynihan - President and CEO
Yes and by the way everything is on the NIM is still the short rate move drives a lot of profit because the deposit franchise is an advantage to funding source as you all know
Bruce Thompson-Chief Financial Officer
You know, in each quarter we look at our asset sensitivity on the balance sheet, and our constant metric that we look at is what does 100 basis points do to our net interest income, and obviously that flows directly to the bottom line. And at the end of the year, a 100 basis point move up was worth between $3 billion and $3.1 billion to us from a net interest income perspective.
The See Saw Destruction Of Fiat Investments Commences On The Failure Of Credit In China, In Russia, And In The US
written by theyenguy, April 27, 2014 4:34
Risk-on investing has turned to risk-off investing; global asset prices are falling as the money bubble has finally burst, as both Equity Investments and Credit Investments, as well as Nation Investment, and Small Cap Nation Investment, and Global Financial Institutions, are trading lower from their April 9, 2014, highs, this coming on the failure of credit in China, in Russia, and in the US.

The failure of credit coming at the end of the week of April 25, 2014, constitutes the most significant economic event since President Nixon took the US off the gold standard in 1971, it pivots the world out of the age of credit and into the age of debt servitude, and is evidenced by the parabolic turn lower in Chinese Financials, CHIX, China Investments, YAO, as well as Regional Banks, KRE, the US small Caps, IWC, IWM, as well as Credit Providers Visa, V, and Mastercard, MC, the nation of Russia, RSX, ERUS, and Leveraged Buyouts, PSP, and manifests as the death of Major World Currencies, DBV, such as the Australian Dollar, FXA, and Emerging Market Currencies, CEW, such as the Chinese Yuan, CYB.

Now, the investor is literally going extinct; especially the fixed income investor; that is those invested in a Pursuit Of Yield like those invested in Electricity Utility Stocks, PUI, XLU, such as New Era Energy, NEE, Real Estate REITS, RWR, such as General Growth Properties, GGP, in Energy Partnerships, AMJ, such as Cheniere Energy, LNG, and Oiltanking Partners, OILT.

The failure of credit is an extinction event, that pivots the world economy out of liberalism, that is the paradigm and age of credit and investment choice, and into authoritarianism, that is the paradigm and age of diktat and debt servitude, which features the debt serf, is the centerpiece of economic activity.

Under the power of the Rider on the White Horse, as is seen in Revelation 6:1-2, the bond vigilantes are effecting a global economic coup d’etat, transferring sovereignty from democratic nation states to sovereign regional leaders and sovereign regional bodies, such as the ECB, by calling the Interest Rate on the US Ten Year Note, ^TNX, higher from 2.48% on October 23, 2013, and are powering up the singular dynamo of regionalism to establish regional security, stability, and sustainability, to deal with the destructionism of unwinding currency carry trades and debt trades.

Investors greed has turned to fear; fear that debtors will not repay lenders, with the result that the Pursuit Of Yield Investments such as Leveraged Buyouts, PSP, Emerging Market Financials, EMFN, Shipping, SEA, Chinese Real Estate, TAO, Water Resources, FIW, Energy Partnerships, AMJ, and Global Utilities, DBU, which underwrote the age of credit, are now trading lower. It’s “Hasta la vista baby” to Shippers, specifically the Greek shippers, NM, SB, DSX, NNA, TNP and GASS.

A new currency and governmental regime is coming out of the failure of credit and the death of currencies; it is the regime of regional diktat money and regional economic governance, something that is implicit in Daniel’s Statue of Empires, seen in bible prophecy of Daniel 2:25-45, where the two iron legs of global hegemonic power, these being the UK and the US, flow into the ten toes of iron diktat and clay totalitarian collectivism; these toes are the same reality seen in the governance of the ten horns, that is the ten world regions, and the totalitarian collectivism experience of mankind’s seven institutions, foretold in the Beast prophecy of Revelation 13:1-4.
jim's misleading net interest margin statement, part 2
written by tew, April 27, 2014 5:57
In addition to the flawed logic of the statement, the empirical evidence clearly shows how net interest margin is NOT correlated with interest rates. You can compare to various interest rates, but here I plot against the 10-year treasury. (I recommend setting the 10-year to the right axis to see more clearly - but the link doesn't carry this setting.)

You can see interest rates declined sharply in the 80s while net interest margin rose sharply. Then in the 90s both declined. There's no correlation.

net interest - yield curve
written by tew, April 27, 2014 7:34

I was focused only on refuting your statement that low rates mean lower net interest margin. Banks borrow short and lend long, so the question has to do with steepness of the yield curve. If the yield curve is steep there is more net interest margin available. (Credit spreads and demand also matter.)
banks don't borrow short and lend long
written by jim, April 27, 2014 8:52
common misperception. they actually have 66 pcnt of earning assets from 0-5 years and 60 pcnt of deposits in transaction accounts. Only 20 pcnt of earnings assets are held >15 years. further net interest margins had a 10 year lag because the yield/cost spread. costs came down quicker than yields because banks lock in longer durations. so you need to realize there is a yield/cost spread and a gain/loss on net interest position in order to attain the net interest margin. Banks have increased the duration of their earning assets and reduced the duration of their interest-bearing liabilities. This means you are completely wrong and net interest margin is directly correlated to rates.

what bubbles?
written by Bubba L, April 27, 2014 9:00
According to Eugene Fama, bubbles don't exist, so, no worries. :-P

Another thing to remember is that interest rates on treasury notes are pretty low right now, so many investors are willing to pay a premium for risk-adjusted returns on stocks (but not commercial paper so much), depending on their time frame and level of risk aversion. Hence there is some upward pressure on PE ratios in the current environment. But nothing outlandish.
link fixed?
written by Bubba L, April 27, 2014 9:19
That last link was to a New Yorker article from 2010, found here
written by rob urie, April 28, 2014 8:39
The long term average P/E before the dot-com bubble is around 14. That bubble skewed the long term average higher. Over 30% of earnings are from finance which is being subsidized both directly and through Fed liquidity. P/E tends to rise after strong market decline because earnings fall faster. Stocks looked cheap in 2008 just before the larget decline in modern histroy. Good luck with that stock market thingy.
I'm with Ritholtz
written by ibilln, April 28, 2014 3:52
This from Connor Sen is pretty persuasive: http://is.gd/c9OZW1
written by Fizo, April 29, 2014 10:59

You should not brag about calling a housing bubble FOUR years before home prices peaked (and putting down Shiller in the process).

Shiller became quite concerned about a bubble in the 2004-2006 period. So he did call the bubble and nailed the timing of its bursting. So did Calculated Risk- who also called the bottom in prices at the beginning of 2012.

And claiming the current valuations are not that out of line by comparing them to 1999 and 2007 seems a bit insane. 1999 valuations represent the biggest stock bubble in history and 2007 valuations reflect the biggest credit bubble in history. Thats like saying someone is not that overweight by comparing them to a Sumo wrestler.
The bubble did not begin the day before it burst
written by Dean, April 29, 2014 10:44

My point with Shiller was not that I saw it before he did. I used his methodology to identify the bubble before he did -- and yes, by my and Shiller's methodology the market was seriously over-valued in 2002. I will concede that I would not have expected the bubble to continue as long as it did, primarily because I did not imagine that bankers and regulators could possibly be a reckless as they turned out to be.

I don't know many people who either at the time or today considered the 2007 stock market to be in a bubble. So I consider that a fine basis for comparison. (I did at the time warn of a serious downturn in the stock market because it had not priced in the impact of the collapse of the housing bubble, but that doesn't mean the stock market was inherently over-valued.) The 2000 PE was used as a point of reference. The valuations relative to the economy is now roughly 2/3rds of the 2000 level.

So how over-valued do we think the market was in 2000? If you want to use your Sumo wrestler comparison, I am noting that someone weighs 40-50 percent less than a Sumo wrestler to get an idea of where that may put them relative to their proper weight. This would only be problematic if it assumes that the Sumo wrestler's weight or the bubble valuation is the correct value -- I don't.

Write comment

(Only one link allowed per comment)

This content has been locked. You can no longer post any comments.


Support this blog, donate
Combined Federal Campaign #79613

About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.