Are We in an Asset 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 the economy will 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 (you can read a review of the book here). 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. (Click here for more on these numbers.)

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.

Comments

[enigmaman:]

Maybe the bubble your looking for is the "WS Ponzi bubble" where Wall Streeters sell to each other to make it appear like everything is all right, they keep drawing in more and more W Streeters to keep the ponzi scheme going until there are no more left but when they turn to main street they find its not interested so the entire scheme collapses because there is not enough stocks changing hands to keep driving prices higher. Main street has in the face of this huge rally voted using with its "Gut feeling indicator" they will let this train go by and wait for the next. IMO it will be WS with egg on its face this time

Oct 20 10:51 AM

[Larry House:]

The government is desperately trying to save us from economic bubbles by creating a new bubble! Makes perfect sense--for a government. No, I really don't think there is a good way out of this. The government determined last fall that they could not/would not allow the system to heal itself (which is the only way for true healing) becuase this meant more deflation to pension funds, retirement accounts, etc. So this new bubble has been created with the hope that somehow a total bust can be avoided. It will be a miracle if that occurs. Now we will have to go through the bursting of another bubble. We may still have to feel all the agony of the system healing itself. To the government I would say--heal thyself.

Oct 20 02:21 PM

[untrusting ...:]

John,
A good summary. Mirrors our view of the big picture of what is happening, an asset bubble, particularily in US and worldwide equites, and to a lessor extent in commodities and gold.

All it will take to force the Fed's hand is trouble in the bond market and selling yet more US debt. If the bond market forces interest rate hikes, as they should, then this artifical asset bubble and equity rally will probably crash very rapidly. One wonders who will then win the fight to the death, the prop.desks/HFT's or the hedge funds in their rush to exit the markets?

Oct 20 02:36 PM

[untrusting ...:]

John,

One wonders why the government did not attempt what some others have suggested, namely shore up the housing market with something like "equity participation mortgages".

They would have worked something like:
1) Primary homeowner - mortgage underwater by say 50% on $200K home.
2) Could have set up a hugh Government Mortgage Finance Bank and hired tens of thousands of appraisers, underwriters, mortgage brokers. etc. and funded it with hundreds of billions of dollars of TARP.
3) Every underwater homeowner could have applied to get their mortgage re-written via the GMFB. If they qualified, could afford to continue paying for the non-underwater part, then the government could have paid out the underwater part and taken an equity interest/second mortgage in the underwater part.
4) The banks would have been massively recapitalized by the government paying out the underwater part/second mortgage to the banks and government taking the equity interest in the 2nd mortgage part.
5) Of course it would take many years for the government to get their money back as the houses resold over time at higher prices and gradually the 2nd mortgage/equity interest was repaid.
6) Just seems to us that this would have been a lot more productive. But at least it would have helped substantially helped slow down the foreclosure crisis, kept viable homeowners in homes, would have prevented the wasteful home buyer credit program, and could have employed tens or hundreds of thousands of people. It could also have saved the government probably trillions in loan guarantees to the banks as well as prevented the Fed from having to purchase over a trillion in mortgage backed and agency securities. Not all homeowners could have been saved, but probably a large percentage could have. In additon, they could have "fried" the housing speculators and fraud cases and let them and the banks get the foreclosures they deserved.

We just think that a government program like the above would have been a much smarter way to attempt to help with the crisis, than many of the haphazard approaches they did take.

Oct 20 03:34 PM

[DormRoom:]

Wasn't a solution for this problem proposed by Keynes. It was a world currency based on 30 commodites as a store of value: It's called the Bancor.

en.wikipedia.org/wiki/...

It's my belief the Chinese are secretly buying up controlling interests in resources across the globe as a preemptive move in favor of a Bancor.

Oct 20 04:39 PM

[bob adamson:]

I follow Mr. Mason’s analysis but suggest that the asset bubble to which he refers is simply a holding pattern while the markets see whether the G20, through coordinated action, can satisfactorily resolve a massive debt bubble. What is the nature and form of this debt bubble? It’s almost impossible to clearly understand and describe briefly but here’s an attempt! I would appreciate any suggestions to improve or supplant what follows.

By late 2005 a massive load of debt which had swollen over the past generation was inflating at increasing speed and was clearly becoming unstable. It had two primary interrelated components: (a) a real property, secularized and derivative debt bubble (with some commodity inflation latterly) that had been allowed to accumulate through the investment banks and near banks of the US, UK and Western Europe and (b) a foreign exchange and government debt bubble that had accumulated on an US/East Asia axis and on a Western Europe/Eastern Europe axis. Essentially, components (a) and (b) existed and grew because the investment banking sector and the governments involved had seen it to have been in their short term interests that the apparent profit and growth fueled by the enlarging bubble was worth the risk; especially as the usual dangers entailed by the growth of such bubbles (inflation and balance of payments crises) could apparently be held at bay indefinitely by the application of Monetarist policies by central banks, on the one hand, and, on the other, by the eagerness of East Asia and Western Europe to accumulate and hold massive amounts of US and Eastern European currency and government debt (rather than clear that debt in a traditional manner) to further economic and political objectives that were unique to the era.

Central banks became concerned by the end of 2007 that component (a) might become beyond control and the Japanese and other central banks took initiatives to restrict the source of cheap money internationally that was fueling that component of the bubble. This continued in 2008 with some success but these efforts exposed the weakness of the US and UK investment banking sector and the crisis of the fall of 2008 ensued. That crisis was contained by the coordinated stimulus actions of the G8 which had two effects relevant to our discussion:
1. governments assumed a significant portion of the debt obligations of the investment banking sector (i.e. component (b) was enlarged and component (b) reduced so that the banking sector would not implode and credit freeze solid), and
2. once markets became satisfied that the debt bubble would not be allowed to implode and the world sink into a deflationary depression, some of the lost market value of the debt assets returned.

With that rather wordy back-story finished the asset bubble question can be addressed.

Real property and commodity prices had inflated as a side effect of the growth of the debt bubble prior to the 2008 crisis (side effect because, while overt signs of inflation had been averted by Monetarist practices, speculation and overconsumption were encouraged by low interest rates and easy credit over an extended space of years and this fueled demand for property and commodities). These prices threatened to collapse in the wake of the banking crisis but are firming as stimulus measures take hold.

In short, the current appreciation in asset values is, for now, in significant part a ‘dead cat bounce’ rather than a bubble. As Mr. Mason says, there are no attractive options as we work our way out of the debt bubble and its attendant asset reflation.

Oct 21 03:16 AM

[Chris Cook:]

@untrusting
"One wonders why the government did not attempt what some others have suggested, namely shore up the housing market with something like "equity participation mortgages"."

I'm with Taleb and Buiter, who think that if debt is unsustainable - which it clearly is - then we need to look at equity instead.

My proposal is to rent distressed properties (using a custodian to hold the properties) at an affordable, but index-linked, rental, and then to pool the rentals and then divide the resulting Rental Pool into proportional "units" eg billionths.

So far it's like a REIT. the difference is that the Units are actually redeemable against the right to occupy property.

So, anything the co-owner/occupiers pay more than rent - either in cash or in sweat equity eg maintenance - buys them Units, and when they have enough they are - in economic terms - the owner,

Banks get far more from selling their Units to co-owner/ investors than ever they can from any debt-based securisation.

A debt/equity swap: just not equity as we know it.......

I outlined this proposal last year in Dublin in a lecture on the Irish property disaster.

www.slideshare.net/Chr...

Also a post on the Index Universe site

www.indexuniverse.eu/s...

Oct 21 11:35 AM

[artkarl:]

There's no good way out.
No real recovery is fragile.
How can we realistically run 0% interest rates?
With capacity percentages way down, and the US not really producing anything industrially anyway, what recovery is there, short term?
How can anyone really, in their heart, believe the market isn't overbought? I mean really? -Karl Krachenberg

Oct 21 06:03 PM