For the third time in the last 17 years, Federal Reserve researchers are out with a “this-time-is-different” research piece on asset markets. This version seeks to justify the bubble conditions in the stock market that ultra-loose monetary policy has helped foster.
Titled Stock Market Valuation and the Macroeconomy, this piece concludes that even though more than a century of stock market data shows that extremes in the cyclically adjusted price-earnings ratio have signaled an overvalued stock market, today’s lower interest rates justify today’s inflated valuations.
You can read the full piece here. Print it and file it away for entertainment purposes. This research piece is likely to look as misguided as the two below from the last two big asset bubbles.
The first is from the real estate bubble. Here in November of 2005, researchers at the Federal Reserve Bank of St. Louis try to explain away the bubble conditions in the real estate market. The real estate market peaked a couple of months later and began to crash not long after that. To wit (emphasis is mine):
Yet, do the P/I [Price-to-Income] ratios observed on the two coasts constitute a bubble? Note that when real estate is evaluated as a potential investment, housing prices should be determined by discounting the expected flow of income (rents) and other services using an appropriate risk-adjusted capitalization rate. Considering the difference between capitalization rates implied by house price indices and long-term government bond yields, we find indications against the presence of a bubble. House price data imply that the spread between capitalization rates and long-term bond yields has increased from an average level of 0.7 percent for the period 1975-99 to an average level of 2.3 percent for the period since 2000. These positive spreads imply that house prices have in fact remained consistent with risk-adjusted discounting of future rents.
In conclusion, the evidence in favor of a recent housing bubble is controversial at best. Ongoing research is struggling to isolate real house price increases justified by underlying fundamentals from irrational, possibly harmful, excesses.
The next comes courtesy of the Kansas City and Minneapolis Federal Reserve banks. Both pieces were published in late 2000—right near the peak of the greatest stock market bubble in U.S. history. The paper from the Kansas City Fed concluded that (emphasis mine)
Some analysts view the current high price-earnings ratio of the stock market as a sign that the stock market may be headed for a downturn. This view receives some support from historical evidence that very high price-earnings ratios have usually been followed by poor stock market performance. When price-earnings ratios have been high, stock prices have usually grown slowly in the following decade. Moreover, at times such as the present when high price-earnings ratios have reduced the earnings yield on stocks relative to interest rates, stock prices have also tended to grow slowly in the short run. Forecasts based on such evidence are subject to much uncertainty, however, because history may not repeat itself. Specifically, the possibility cannot be ruled out that this time will be different due to fundamental changes in the economy that will allow high price-earnings ratios to persist and thus stock prices to continue growing both in the near term and in the coming decade.
The Minneapolis Fed, using a more mathematically rigorous approach concluded the following
“We find that corporate equity is not overvalued. Theory predicts that if indebtedness is small, the value of corporate equity should equal the value of productive assets. We show that it does; both values are today near 1.8 times the value of GNP. With our estimates of productive assets, theory also predicts that the real returns on debt and equity should both be near 4 percent. Therefore, barring any institutional changes, we predict a small equity premium in the future.”
To be fair, the paper did acknowledge a small equity premium going forward, but it was more of a “stocks are at a permanently high plateau” statement than a “stocks are going to crash statement.”
There is always going to be an explanation for inflated stock market values and even inflated values in individual stocks. Stock market valuations wouldn’t be trading where they are if a majority of investors didn’t believe that low interest rates justify inflated valuations, but as history has shown time and again, this time is rarely different.
Jeremy Jones, CFA
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