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Home Publications Blogs Beat the Press Is There a Stock Bubble? Joining the NYT Debate

Is There a Stock Bubble? Joining the NYT Debate

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Tuesday, 03 December 2013 05:59

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!

Comments (13)Add Comment
underline the point about interest rates
written by Andy Harless, December 03, 2013 7:49
I agree and would particularly emphasize the point about interest rates. Relative to prospective returns on government bonds, prospective stock returns based on cyclically adjusted P/E are, if anything, a bit higher than what is typical in historical experience. The point to note is that either (1) there will be a more substantial recovery, in which case earnings will presumably continue to rise more quickly than usual in the near future or (2) there won't be a more substantial recovery, in which case bond yields will stay low. My underlying idea is that, in a time of prolonged economic weakness, when too much propensity to save is chasing too few attractive opportunities for physical investment, the way to get close to full employment is for asset prices to rise, so that the return on saving goes down and the return on physical investment (relative to cost of capital) goes up.
...
written by AlanInAZ, December 03, 2013 8:51
Nearly 50% of sales for S&P500 companies are outside the USA. I don't know if there is a bubble but I do think that it is necessary to factor in the global economy at least as much as the domestic GDP trends.
Where would prices be...
written by ifthethunderdontgetya™³²®©, December 03, 2013 9:31
.
...without $85 billion a month in quantitative easing?

It's sad that our only current policy to combat high unemployment is trickle-down economics, but here we are.

http://business.time.com/2013/...-disaster/

~
eh
written by jim, December 03, 2013 11:24
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.)

equity risk premiums are well elevated compared to historical norms. index funds account for ~8 pcnt of market cap of us equities, hardly large enough to cause stocks to rise. i would point out the a key determinant is the corp profits as percent of gdp, which are again elevated due to higher profit margins, which are sustainable. therefore high stock prices are justified
...
written by joe, December 03, 2013 12:10
Another reason there is not a bubble is that investors are bubble phobic. Anyone comparing this with the nonsense from the late 90s has a bad memory. Remember all those idiotic internet companies that were going to shine your shoes online or whatever. All those economists who were claiming we were living in a new reality where everyone was going to get a pony. There was a tremendous amount of exuberance and a detachment from reality. A major reason home prices got out of control was because people did not want to give up this fantasy.
The Bubble This Time is Real
written by Sustainable Gains, December 03, 2013 4:49
"In other words, if we didn't have a bubble in 2007, then we don't have one today."

But we did have a bubble in 2007!

And today's corporate profits (relative to GDP) are both excruciatingly high and historically unsustainable. I say excruciating because wages as a share of GDP have been squeezed to make room for those profits, and that means that for the 99%, incomes are lower than one would expect from history. The 1% gets the benefit of the stock bubble while the 99% suffer declining standards of living.

Mean-reversion in corporate profitability is both inevitable and desirable. It's inevitable because the rich cannot get richer indefinitely without the producers waking up and claiming their share. It's desirable because once it takes place, corporate earnings will be generated from the mass-market spending of labor income, which is far more sustainable than the current financial gimmickry.

If earnings mean-reversion it occurred now, then even with stable price/earnings multiples, one would expect the S&P500 to sit around 1000… not counting the historical tendency for P/E multiples to contract as earnings fail to expand… or for stock-market mean-reversion episodes to overshoot fair-value.

http://blog.i4sg.com/2013/10/29/the-bubble-this-time/
...
written by watermelonpunch, December 03, 2013 6:29

This comment thread is confusing, and seems to go all over the map.
I'm not usually a stickler for demanding on-topic adherence, but does anyone else think peeps are all over the field here?
prospective
written by tew, December 03, 2013 11:38
It's ironic to compare today's valuations with those of the 2000 and 2007 peaks. Those peaks were followed by dramatic bear market declines.

Even today, when people are debating whether we're in a bubble, returns since those 2000 and 2007 peaks are barely breakeven on a real basis with dividends included.

Such initial conditions are hardly a comfort when making comparisons.

Here's a grim analogy: Bobby jumped off a 100 foot cliff. Jane jumped off a 70 foot cliff. Both died. You're standing on a 40 foot cliff. Is it safe?
risk ...
written by Squeezed Turnip, December 04, 2013 1:05
prospective
written by tew, December 04, 2013 12:38
...
Here's a grim analogy: Bobby jumped off a 100 foot cliff. Jane jumped off a 70 foot cliff. Both died. You're standing on a 40 foot cliff. Is it safe?



Well, that ranks as the most meaningless risk analysis I've ever heard. Congratulations! 100? 70? Meaningless drivel in the context of the topic here.

Let's continue with this rotten analogy, shall we? Next to Bobby was Mitt. Mitt knew that Bobby knew nothing about cliff climbing or cliff jumping. Mitt had a parachute. After Bobby "jumped" (i.e. got shoved), Mitt landed softly next to his body and then cleaned out Bobby's pockets before the undertakers arrived. So was Mitt safe? Absolutely. The entire damned time.

Meanwhile, Bobby's cousin Bobo is standing on the ground. A shadow banker sneaks up behind him and bashes his head in with a hammer. I'm standing on the same earth as Bobo. is it safe to do so?

jeez, Louise.
Useless analysis
written by Specialist, December 04, 2013 9:16
Current interest rates and corporate earnings trends have ZERO ability to predict future equity prices over ANY time period. Using them to justify current equity prices is ridiculous. You will note that trailing ten year rainfall had a higher correlation with future equity prices then either of these metrics. PE1 ratios have a marginal predictive value over ten years; too limited to be of any help in justifying the reasonableness of current valuations.

https://personal.vanguard.com/pdf/s338.pdf

analogy vs. analysis
written by tew, December 04, 2013 11:20
Squeezed Turnip,

I did not provide a "risk analysis". I provided a convenient analogy that, though imperfect, relates P/E ratios and subsequent market performance to height. All the stuff with parachutes and shadow bankers is indeed nonsense.

The main point is simple: If current conditions appear favorable only with respect to past periods that turned out to be extremely unfavorable, then you have *not* established that current conditions are favorable.
Specialist - read Hussman
written by Sustainable Gains, December 04, 2013 6:47
http://www.hussman.net

Hussman's team has a fairly accurate market forecasting model, having debunked most of the models which Vanguard also debunked, and built his own with data back to pre-1929. Hussman has been worried about the market being too high for about 2 years. He's been early in that call, thanks in large part to Fed interventions, but in my opinion he's not wrong.
what's PE?
written by john, December 04, 2013 9:28
You lost me when you started talking PE. Could you maybe use the convention of putting the abbreviation in parenthesis, after the phrase it is meant to denote, the first time you use it?
Muchas gracias.

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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.

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