Monday, October 19, 2009

The Stock Market: A Bubble or Not?

Questions are now being asked about the nature of the rise in the stock market. These questions have to do with the reality of the rise, how high the market will go, and when will the economy produce results that are consistent with the optimism captured in the stock market rise.

There is another way to look at the rise in the stock market since March 2009: the rise could be just another asset bubble.

Asset bubbles are a form of inflation. As we have learned over the past fifty years, excessive monetary or credit ease can come out in one of three ways. First, there can be outright inflation. In this case, popular price indices, like the Consumer Price Index, can rise by inflated amounts. Second, prices of assets in one or more sectors of the economy can rise at a pace that exceeds the rate justified by the underlying fundamentals of the sector. Third, when the economy is facing supply side adjustments that constrain the healthy growth of the economy, excessive monetary or credit ease can force economic growth in areas that have declined in productivity. That is, the excessive monetary growth can force resources back into declining industries rather than allow them to adjust into the more productive areas of the economy that are in the process of expanding. In these cases nominal growth of the economy is higher than it would be otherwise and inflation is muted by the re-kindling of industries that needs to change or modernize. This results in a form of “stagflation” where we get the worst of both slow growth and masked inflation.

There is little doubt that the monetary authorities have pumped plenty of liquidity into the banking system. The year-over-year increase in the monetary base (currency in circulation plus bank reserves) has been increasing at a rate of around 100% for the past year. As yet, little of this liquidity has found its way into bank lending.

Still, the two basic measures of the money stock have shown year-over-year rates of increase that, historically, can be considered to be substantial. The M1 measure of the money stock has been rising for months in the range of 15% year-over-year, while the M2 measure of the money stock has been rising in the 8% range over the same span of months. Some of this growth can be attributed to a re-arranging of asset portfolios into more liquid assets. Still, all of this money is not sitting idle even though interest rate levels are historically low.

How might this expansion of the monetary variables be used? In the past, rates of growth like this would be considered to be inflationary. Yet, there is no evidence that spending on final goods has increased appreciably and, hence, the rate of increase of consumer prices has remained just above zero, year-over-year. There has been some growth of the economy and some of this growth can be attributed to areas where resources had been leaving (autos) to move to more productive operations. The government stimulus spending has produced a spike in output here and there but does not seem to have produced any sustained increases in economic growth. The possibility of stagflation seems to lie in the future. Therefore, it seems as if two of the three outlets for monetary ease can be excluded from the present analysis.

That leaves us looking for the existence of an asset bubble. Certainly the movement in the stock market since March is a good place to look for a possible asset bubble.

We certainly have some experience in stock market bubbles having just gone through the stock market bubble of the 1990s. Could we be having a repeat performance?

In terms of assessing this possibility I am going to turn to two measures of stock market valuation that were discussed in a book I recently reviewed. The book is titled “Wall Street Revalued” and was written by Arthur Smithers. The review can be found at The two measures are Tobin’s Q ratio and the Cyclically Adjusted Price/Earnings (CAPE) ratio developed by Robert Shiller. In mid-September, these ratios were already showing that the U. S. stock markets were 35% to 40% overvalued, and that was before the run-up that took the Dow above 10,000. (For a report on these numbers see

Is the rise in U. S. stock markets a bubble?

Bubbles, of course, are easier to define after-the-fact than when they are occurring. But, the “Q” ratio and the CAPE have done a pretty good job historically of indentifying times when the stock market is overvalued.

If the stock market is overvalued right now because the Federal Reserve has created another asset bubble--it’s third in about 15 years—then the economic and financial situation in the United States is quite tenuous. The economy sucks, the banking system is still faced with major credit problems, and the dollar has fallen close to 15% since January 20, 2009. What kind of a policy can the government throw at this dilemma?

Any tightening to brake the expansion of the bubble and/or combat the decline in the value of the dollar threatens the solvency of the banking system and the fragility of the economic recovery. But, as we have seen over the past 15 years, bubbles eventually collapse on their own. Are there any “good” ways out of this situation?

This is not a pretty sight, but it is one we must take into consideration. As we continue to learn, though, once we lose our discipline, all the good choices in policy seem to disappear!

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