Is the Dow Showing a Major Stock Market Bubble?

Dec.26.10 | About: SPDR Dow (DIA)
The stock market is not bubbled up, you say? Well then, let's take a serious macro macro look at the situation and raise the matter as a question.

How is it that from about 1950 (or 1965 at least) up to about 1985, the Dow Jones Industrial Average stayed mostly in the range from about 250 to 1200, when America was growing and doing pretty well on average, and then, from about 1985 to the year 2000 or so -- a mere fifteen years -- the Dow shot up to over 10,000, when middle class America realized almost no income gains in real terms and the economy basically cycled from one boom and bust cycle to the next?

I argue we face one of the biggest bubbles of all time. Let me explain and lets address the problem by focusing on the DJIA. Here is what the DJIA has done since 1965.

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What we observe is the DJIA has gone up about ten fold from 1965 to the year 2000 or so. But what has industrial production in the US done during that time frame?
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Industrial production has increased to be sure, but only by a factor of three or so. It certainly has not increased anything like the DJIA. But there is slippage, you say. To be sure, we now generate more services, the time series data have been smoothed and more importantly changed, etc., etc. But these explanations simply don't bridge the gap.

Here is another one that doesn't either.

Back in the early-to-mid 1980s macro economists noted that the risk premium being paid on equities over bonds was far higher than was warranted by standard measures of individuals’ attitudes towards risk. In short, the risk premium agents were being paid more than compensated them for the risk. This was particularly surprising since over the long run, the risk on equities was no different than that on bonds. As a result, there appeared to be an arbitrage opportunity by shifting one’s portfolio from bonds to stocks and holding the equities for a long time.

Do you believe that? We simply had a financial epiphany and corrected. More importantly, do you want to believe that or anything except we are bubbled up?

As we know, Japan had this problem with its stock market and here is what happened. But that can't happen here you say. I ask, why not?

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Even GDP and profits have not caught up with this market. They too have only increased three and a half fold at best.

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(The data in these charts are smoothed to conceal recessions and ease presentation.)

Why is it that we don't have a serious bubble in our stock market now? Were our valuations all wrong for years on end earlier, or do we have it wrong now? I think we have a problem and our heads are in the sand.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.