Is There A Stock Market Bubble? Evidence Suggests Caution Is Necessary

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by: APAC Investment News

Summary

Trump claims that we are currently suffering a financial bubble, and that unemployment is near 20%.

It's exceptionally difficult to spot bubbles. Data suggests speculation may be high, but not unwarranted.

While the real unemployment rate does not approach 20%, the real rate is higher than 5%.

In an interview with the Washington Post, Trump mentioned two things that could be rather disturbing for investors. First, that we are in the midst of a financial bubble, which Trump believes is being fed by the Fed's low interest rates. Second, that the true unemployment rate isn't anywhere near 5 percent, but instead 20 percent.

Whether or not Donald Trump should be trusted for economic and market advice is debatable, but the claims are interesting, and if true, are of vital importance for investors. Many investors have been wary of a stock market bubble, given the mixed economic data coming in across the globe. Meanwhile, the labor market appears to be improving, but some evidence suggests that the labor market might not be as healthy as it seems.

Is There A Stock Bubble?

The alleged stock bubble is, according to Trump, the result of low interest rates set by the Federal Reserve. While it's tempting to dismiss such claims, investors should be cautious. Interest rate hawks within the Fed have been warning of the risks of asset bubbles, along with inflation, for years.

Before diving into interest rates, it's also important to remember that up until 2014 the Fed also engaged in an aggressive policy of quantitative easing, increasing the money supply and buying new assets. The effects of QE on stock markets have been hotly debated. The chart below shows that stock prices did rise as the Federal government engaged in QE, but this does not prove causation.

Click to enlarge

Determining whether or not stock prices have reached bubble levels is going to produce contentious results either way. The fact is, no one has the answer and no one knows for certain, not myself, not Donald Trump. Still, there are some factors we can consider.

First, have revenues for corporations increased substantially over the last five years? Increasing revenues, especially when coupled with increasing profits, generally boost stock prices and hint at a relatively strong economy. This, in turn, could be used to justify high stock prices.

Unfortunately, companies have been facing strong headwinds over the past few quarters. The S&P 500 saw a 2.9 percent decline in revenues in the 4th quarter of 2015 (YOY). This decline followed declines in the previous 3 quarters, with the first and second quarters showing declines of 4.6% and the third quarter dropping 5.1%.

Meanwhile, P/E ratios, arguably the best basic indicator for checking whether stocks are overpriced, continue to climb.

S&P 500 P/E Ratio Chart

S&P 500 P/E Ratio data by YCharts

The chart above does show that the S&P 500 P/E ratio is steadily climbing, and since 2014, the rate of the increase appears to be accelerating. Historically, however, a P/E ratio of 21.18 is quite normal and of itself nothing to worry about. During the 1999 tech bubble, P/E ratios actually approached 50, as the chart below shows.

S&P 500 P/E Ratio Chart

S&P 500 P/E Ratio data by YCharts

Given these headwinds, it's fair to wonder if it is justifiable for stock markets to be as close to historical highs as they are. The S&P 500 is trading above 2,000 points, while the NASDAQ is just under 5,000 points and the DJIA is above 17,500 points, even as revenues have been declining. Further, the current P/E ratios may simply not be justifiable given the larger macro problems in the United States, Europe, and China.

It's difficult to say that Trump is correct about a stock market bubble, but we shouldn't write his arguments off too quickly either. There are plenty of factors for investors to be worried about and no one could blame the risk adverse for getting out of the market while prices are still quite high.

Is The Unemployment Rate Really Closer to 20%?

Fortunately, examining the employment rate, while complex, is easier than trying to ascertain whether or not an asset bubble is forming. First, the employment rate that politicians tend to cite, the U-3 rate, does seem to be designed to make politicians and policy makers look good. The official U-3 rate is officially at 5 percent.

US Unemployment Rate Chart

US Unemployment Rate data by YCharts

This rate does not include people who have grown so discouraged that they have dropped out of the job hunt altogether, nor does it include people marginally attached to the labor force, or people forced into part-time employment for economic reasons. All these factors, however, are very real for workers. If you were once a middle manager earning $60,000 at a company, for example, but are now working part-time at a department store, you're going to struggle to make ends meet.

A more accurate rate would be the U-6 employment rate, which is currently at 9.8%. While 9.8% is not 20%, it is far higher than the rate frequently suggested by policy makers.

US U-6 Unemployment Rate Chart

US U-6 Unemployment Rate data by YCharts

There are other factors that are also worth considering. First, the labor force participation rate remains historically low, though it is rebounding. Compared to pre-recession levels, however, fewer people are currently participating in the labor force. This could be because of school, retirement, or other issues, however.

US Labor Force Participation Rate Chart

US Labor Force Participation Rate data by YCharts

The bigger concern might not be unemployment, but instead declining earnings. Trump has frequently proclaimed that the United States has outsourced many of its good jobs to foreign countries, and especially China. Others have noted the rise of low-paying service jobs, and the declining value of college degrees. Median incomes, for their part, have steadily declined since the Great Recession. In 2007, the median income in the United States was $57,936, in 2012 it bottomed out at $52,970, before rising to $53,657 in 2014. These are "real" numbers, not adjusted for inflation.

Household income data provided by http://www.deptofnumbers.com/income/us/

Meanwhile, while median incomes have declined, costs have steadily rose. The average healthcare costs for American families, for example, have increased dramatically, far outstripping inflation. Inflation, for its part, has been relatively mild. In the chart below, we can see that from 2009 to 2014 healthcare costs rose 3% or more per year, before rising "only" 2.8 percent in 2015. Since 2010, the CPI rose at least 1 percent each year up until 2015, before declining 0.4%. In 2011 and 2012, the CPI rose by 3.2% and 2.1% respectively.

Click to enlarge

These numbers are important to understand because while median incomes have been declining for American homes, each dollar brought in is buying less and less. These numbers also probably help explain why economic confidence is so low, with the Gallup poll coming in at -8, suggesting that Americans are indeed worried about the economy.

While Trump might be exaggerating about the "20 percent" unemployment rate, it does appear that the more general assertion that things are worse than politicians like to admit, is correct.

Disclosure: I/we 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.