The stock market isn’t in another bubble – yet

The stock market has recovered sharply from its lows during the 2008 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 repeatedly warned of a stock bubble. I argued that its collapse would likely lead to a recession, end the Bill Clinton–era budget surpluses and pose serious problems for pensions. In the last decade I sounded the dangers of 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 sound the alarm at every hint of froth.

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 regularly to reach new highs. We need get concerned only 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 overvalued. 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 more than 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 with 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 anomalous 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 appears 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 percent. By comparison, it was over 6 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 percent, the real interest rate on long-term bonds was close to 4 percent. By comparison, with a current inflation just 2 percent, the real interest rate is close to zero.

Here also an important question arises about future trends. If interest rates rise, that 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 plausible that they will trend upward (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 percent long-term 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 percent real return on stock, which has been the historic average. But given the low returns available elsewhere, stockholders may be quite satisfied with a real return in the 4 to 5 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. (Remember Pets.com?) 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 levels. And there is no investment boom in aggregate, even if some social media spending might be misguided.

This means that if the market were suddenly to plunge by 20 to 30 percent, we will see some unhappy shareholders, but it is unlikely to sink the economy. In short, this is not Round 3 of the bubble economy.