Well that should teach me never to go on vacation again. I blogged pretty intensively for just over two years, from February 2009 through March 2011. This frenzied activity was correlated with (or caused?) one of the great bull markets in American stock market history. Then stocks started falling. I had planned to return to blogging on July 5th, after a short vacation. But with the market doing so poorly I felt duty bound to do something last week, and hence I came up with a few posts. The effect on Wall Street was immediate and electrifying.
But (seriously) are stocks now overvalued? Because I’m an efficient markets-type, the only answer I can give is no. So why does Robert Shiller say yes? Apparently because the P/E ratio is relatively high by historical standards. And he showed that for much of American history investors did better buying stocks when P/Es were low than when P/E ratios were high. Of course hindsight is 20-20.
I’d rather not get into the minutia of all the various ways of calculating P/E ratios. And I have no idea where stocks are going from here. Instead I’d like to focus on three arguments for relatively high P/E ratios in the 21st century American economy (however you’d like to measure them):
1. Stocks have done very well since the 1920s, which suggests that 20th century P/E ratios were usually too low.
2. American companies are making lots of money in the worst recession since the Great Depression. This is partly because US multinationals are making huge profits in the developing world. And this suggests that traditional market indicators based on the ratio of US corporate profits to US GDP may be outdated. US GDP is no longer the relevant denominator. So “E” may be relatively high for the foreseeable future.
3. My most important argument is that low real interest rates might be the “new normal.” The most striking characteristic of the US economy over the past decade is the unusually low level of both nominal and real interest rates. And it’s not just because of the current “unpleasantness;” rates also fell to very low levels in the early 2000s. Why have people missed this story? I believe it’s because they’ve assumed the low rates are some sort of Fed policy, not a free market outcome. But if the low rates since 2001 were an easy money policy, then why didn’t we see high rates of inflation and NGDP growth? So money hasn’t been easy, which we should have obvious all along, given that INTEREST RATES ARE NOT THE PRICE OF MONEY, THEY ARE THE PRICE OF CREDIT. And these low real interest rates should support a higher P/E ratio.
Why has credit been so cheap? Perhaps it’s been special factors, but rates have been ultra-low in Japan since the early 1990s, and I don’t see any reason to assume that it can’t happen here as well. (Of course Paul Krugman came up with this argument long before I did.) All it would take is a combination of low demand for credit and high supply of credit. For low demand, we have slowing population growth in the developed world, and fewer good investment opportunities (what Tyler Cowen calls fewer low hanging fruit.) On the supply side, we have Asian countries that already have high saving rates at relatively low incomes, and which are rapidly becoming a larger share of world GDP. Then think about the fact that the 1.3 billion people of China will soon live in a country with a falling population (i.e. similar demographics to Japan, but in a country 10 times larger.)
BTW, some people try to deny the “savings glut” argument by citing the relatively stable world savings ratio. But if we are seeing both more global saving and less global investment, then you’d expect little change in the global savings/investment ratio. (And yes, S does equal I at the global level.)
Once again, I’m not trying to predict stock prices, just suggesting why Shiller might be wrong. Fans of Shiller might want to think about this. He failed to give a strong buy call in March 2009, when stocks were at barely half current levels. If he has the right model, why didn’t he scream out BUY in March 2009?
Yes, you can go back into history and find lots of other times when pundits like me claimed that high stock prices were the “new normal.” But how many of those stock bubbles occurred in the midst of a severely depressed US economy, with very high unemployment?
How does it feel to be back blogging again? Remember the look on Humphrey Bogart’s face as he was about to go back into the leech-infested waters for the second time? I really wish the Fed would aim for a bit higher liquidity levels, so that we can float free from these reeds, er, I mean a bit faster growth in AD, so I can have my life back.
I’ll do a couple more posts this evening, and then go full blast starting tomorrow.
Update: I guess I’m still rusty. Commenter Steven pointed out that more aggregate earnings (point #2) doesn’t raise the P/E ratio. When I wrote the post I was actually trying to explain the high ratio of stock values to GDP, but ended up using the P/E ratio terminology. However Shiller uses a 10 year moving average P/E ratio, so his method arguably overlooks the importance of the recent growth in the foreign earnings of US multinationals.