Dem Bubbles Be Crazy

I don’t usually talk about the stock market. For good reason, I don’t know much about it. In fact, since I started blogging this January, I don’t think I’ve mentioned stock prices as a financial phenomenon even once. But it’s as if we’re experiencing a bubble in bubble-speak. Gillian Tett, in the Financial Times, warns us about financial instability and bubbles. Brad DeLong and Paul Krugman both remind us that market fundamentals are strong, and price-to-earnings is nothing like it was in 1999. Of course some people are wondering why this is the case:

Wait – with lower interest rates, the question should be why hasn’t the price to earnings ratio increased? 

So it looks it looks like market predictions are as vogue as ever. So before I start let’s just note a few obvious characteristics of today’s market:

The short term yields – more or less the Fed’s prerogative – are not significantly lower than the natural rate. That is, yield spread between 30-yr and 1-yr Treasuries is just not unnaturally high. Quite simply, this means investors expect 1-yr yields to be low in the foreseeable future. (This is quite a long time, as far as markets are concerned). But I don’t think anyone expects prolonged QE either. This means real factors like a global savings glut, shortage of safe assets, and dare I say confidence in American government have kept our yields low, in real terms.

There’s a darker side to things. A low yield premium on long-term bonds means investors aren’t expecting any serious boom in employment over the next decade, but why would they. This has been one of the weakest recoveries – take a look at this simple graph I made plotting output gap by months after the trough:


Crappy. I know. Now what do we know about stock markets. In the short-run, there’s generally little correlation between returns and economic growth:


But over the long-run, the S&P 500 has always moved in tandem with consumer confidence. And in the United States, where consumer spending accounts for roughly 70% of GDP, this isn’t surprising. But it’s clear that long-run growth expectations are meek (otherwise yield premiums would be higher). The economics behind this is clear, higher rates imply:

  • Lower trade deficits
  • More business investment and borrowing
  • Healthier bank lending
  • Higher tax revenues (because outside of a liquidity trap, government borrowing does crowd out private investment) implying higher incomes.

Therefore the next ten years will basically be a mean reversion on crazy returns. When EconoSpeak asks whether the market is undervalued with regard to the price/earnings ratio, it’s looking at the wrong part of the equation:

In other words, with higher earnings and lower interest rates, shouldn’t stock prices be even higher?

The “higher earnings” are illusory. The Federal Reserve has effectively brought future returns into the present. That means P/E will rise as relative profits fall. If profits don’t fall relative to prices, then I’ve seriously misunderstood the basic structure of our economy. And I’m not suggesting a causal relationship or anything, but here’s a graph that took me aback:


Profits and public debt – as a % of GDP – track each other pretty well, eh? 

If we are to believe there’s a structural factor that correlates the two, as American debt stabilizes we would expect – at least in a naive interpretation as for P(A|B)=P(A&B)/P(B) – profits to level off. 

That seems to further the case that quantitative easing has just allowed investors to realize future profits today. It doesn’t at all advance the idea that stocks are overvalued or, worse, there’s an imminent bubble.

Of course, the strongest evidence that fundamentals are strong is that no one is predicting Dow 36,000. 


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