That U.S. stock market prices are at record levels in nominal terms has sparked a debate over whether price trajectories reflect that of an asset price bubble. There remains, however, little evidence suggesting that current prices reflect a grossly overvalued market.
The importance of whether stock prices are reaching excessive levels reminiscent of the late 1990s and from 2003-07 cannot be overstated.
Stock and other asset prices have a tendency to undergo upswings for extended periods of time — the S&P 500 has increased 82 percent since bottoming out in February 2009. But ultimately such expansions are bounded and prices experience dramatic and sharp reversals, inflicting painful shifts in household consumption and savings patterns while depleting investment spending of firms.
The avalanche of stock prices in September 2008 is but the most recent example.
Two key features of current stock market conditions suggest prices are not on a bubble path.
First, it is convention in the news to quote equity prices in nominal terms, which ignore changes in the overall price level over time, commonly known as inflation (or deflation).
In real terms, current S&P 500 Composite Index prices would need to increase by 24 percent to match their inflation-adjusted all-time high set in July 2000. Furthermore, real S&P 500 prices are still 6.5 percent away from a recent peak attained in October 2007.
And, although inflation continues to be a non-issue economically speaking, any complete discussion of historically rich stock markets should take this factor into account.
The second feature of stock markets to consider is that they traditionally serve as a leading indicator of economic activity. That is, high stock prices have a tendency to reflect promising economic times while downswings in prices signal impending business contraction.
As such, the value of the stock market should be assessed relative to the size of the underlying economy. Here, economists commonly invoke the price-to-earnings ratio to capture this relation.
In December 1999 the PE ratio for the S&P 500 reached a historic high of 44. That is, investors were willing to pay $44 for every dollar in overall company earnings. Today, the PE ratio sits at 23. Despite being above the S&P 500 50-year average of 19.5, current PE ratios fail to provide compelling evidence indicative of an asset bubble episode.
So why have stock prices increased in great leaps while overall economic growth has remained moderate? Two reasons: Near zero interest rates on risk-free bonds and post-recession stagnating wages.
Regarding the former, fixed income securities like bonds act as a competing asset with stocks for individuals’ scarce savings. Investors considering both investment options may be willing to bear a greater equity risk in light of historically low returns on bonds.
Consequently, investors’ expected return on stocks over risk-free bonds, known as the equity risk premium, is at an all-time high. This is, however, more a consequence of the Federal Reserve’s unwavering commitment to keep short-term rates near zero through 2014 rather than abnormal expectations of future stock performance.
The latter reason for an apparent stock market and economy disconnect deals with wage growth, or lack thereof.
Wage growth over the last three and a half years has diminished relative to pre-recession rates. For instance, from 2006 through 2009, total private sector earnings increased on average by roughly .3 percent per month.
Since 2009, earnings have increased by only .15 percent per month on average — hardly enough to compensate one for minimal upticks in the cost of living. In general, depressed wage growth exerts upward pressure on corporate profits and thus stock prices.
Many people, seemingly unconvinced by apparent evidence, still perceive a frothy market, prime for correction. What direction stock prices may turn is beyond the limits of our knowledge. Be wary of anyone claiming different. But, whichever way market prices swing, the argument for inflated valuations leaves much to be desired.
Nicholas J. Mangee is assistant professor of economics at Armstrong Atlantic State University and can be reached at Nicholas.mangee@armstrong.edu.