Everyone is looking for bubbles these days. I, too, am looking for bubbles, so I do not feel alone.
The problem is…how do you identify a bubble.
Alan Greenspan is famous for saying one time that a bubble cannot be identified, before it bursts! The conclusion he drew from this is that monetary policy cannot fight a bubble…because…if you cannot identify a bubble before it bursts…then there is nothing you can do to fight against a bubble.
There are some markets where, theoretically, it seems easier to spot a bubble than others.
The real estate market lends itself to identifying a bubble. Check out the op-ed piece by Peter Wallison called "The Bubble is Back" in the New York Times. Wallison draws on the idea that the price of an asset should be equal to the discounted present value of future cash flows. In the case of a house, the price of the house, the asset, should be equal to the discounted value of the future rent collected on the house. If this is the case then if rents on houses are increasing, say at three percent a year, the price of the house should increase by three percent a year.
If this equality is broken, then either the price of the house or the rental value of the house should adjust so that the equality is achieved once again.
Wallison states that using the cost of renting a house put together by the US Bureau of Labor Statistics we find that over the past thirty years, rental prices have risen by about 3 percent per year. He, therefore, argues that housing prices should rise, over time, by about the same rate.
He goes on to report that between 1197 and 2002 the average compound rate of growth in housing prices was 6 percent while the compound growth rate in rentals was 3.34 percent. In his mind, this was clearly a bubble. The rate of increase in housing prices continued to exceed the rate of increase in rentals further into the 2000s.
Now, Wallison argues, between 2011 and the third quarter of 2013, "housing prices grew by 5.85 percent, again exceeding the increase in rental costs, which was 2 percent." Hence, to Wallison, "the bubble is back."
One famous identifier of bubbles, the economist Robert Shiller, wrote several weeks ago in his column in the New York Times that we seemed to be on the edge of a bubble in housing prices.
So, there seems to be a coherent concept for identifying bubbles in the housing market.
But, what about the stock market?
Well, Mr. Shiller's work comes into play again when it comes to discussions about the stock market. Here we get into discussions about the price of a stock, or, the price of a stock market, which should be equal to the discounted present value of the future cash flows from the stock, in this case the earnings achieved by the stock under examination or the earnings of the stock market.
This relationship is captured in the well-known measure, the price/earnings ratio. But, Mr. Shiller says that current figures jump around so much that a better measure is something he created called the cyclically adjusted price earnings ratio, or, CAPE. Mr. Shiller argues that CAPE tends to vary around its long-term average, which for the 1945 through 2013 period is 18.3. If CAPE moves above this estimate of the mean, eventually it will "regress to the mean" and return to the long-term average. If CAPE rises excessively above the mean, then one can argue that a bubble exists in the stock market. Right now, CAPE is estimated to be 25.
Is this a bubble…or not? Does this mean the stock market will collapse…or not?
In both the case of housing prices and stock prices the answer to these questions is…it depends.
In both cases, we are dealing with a relationship and it depends upon what is driving that relationship.
In the case of housing prices, the demand for housing could be such housing prices are rising to meet the future demand for housing services and that, as demand gets translated into rental prices, the rental prices will rise to justify the current increase in housing prices. However, if the future demand does not materialize then the rise in house prices must adjust back to a more proper relationship with rental prices. This, of course, is what happened when the bubble burst in housing in the 2007 collapse of housing prices.
Wallison, in the New York Times article, also contends that housing prices could be inflated by government programs requiring little or no down payments and interest only monthly charges that provide financial leverage to borrowers without the means to withstand an economic problem.
In the case of the stock market, the future expectations of rising corporate earnings could be used to justify the rising stock prices, which would mean that as the economic recovery continues, business profits would rise to justify the increases in stock prices that have already occurred. Thus, CAPE would decline over time because earnings would rise to a level that would match the rise that had previously occurred in stock prices.
If the future earnings don't materialize…then stock prices would have to make the adjustment.
The "bubble" effect occurs when stock prices get inflated when expectations about future increases in corporate earnings are unsustainable.
So, the issue reduces to one about the future of rental payments…in the case of housing…and future corporate earnings…in the case of the stock market.
In both cases, the prices of the underlying assets may be high relative to the cash flows that support them for an extended period of time. And, this is especially true in an environment where the monetary authorities are doing extraordinary things in order to stimulate the economy and produce higher rates of economic growth.
The operating objective of the Federal Reserve System is to err, if it errs at all, on the side of too much monetary ease. Therefore, the Fed will continue to provide an ample amount of liquidity to financial markets to get the economy growing faster and to reduce the unemployment rate. This policy stance will tend to support those investors who are straining to find good news that will support future rental increases and future corporate earnings. These investors have been looking for "green shoots" for four and one-half years now. They see in the numbers relating to the fourth quarter of 2013 the evidence that the economy, after four and one-half years, seems to be picking up speed. And, these are the investors dominating the stock market right now.
CAPE could remain around or above 25 for another year or two. Professor Shiller's research does not give any indication about when CAPE will "regress to the mean." Then it could decline because earnings rise to catch up with stock prices.
On the other hand, the earnings may not come about and stock prices will decline. What sets off the realization that earnings will not continue to support the earlier rise in stock prices is anyone's guess right now.
Stock prices, however, will continue to remain at their relatively high levels as long as expectations are not broken. Could it be two to three years? Or, will it be less? That is the question!
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.