October 12, 2014
Worrying About a Stock Bubble
Nowadays about three-quarters of households will eventually own retirement plans. This makes most of us dirty capitalists who wish to see our retirement funds grow. This motivates us, or more typically the financial firms that manage our funds, to seek out the optimal mix of risk and reward for our hard-saved dollars. Today’s financial markets offer few good choices for retirement investments, and that is both a symptom and cause of a problem.
Stock markets in the U.S. are hovering at near-record levels. If you get your quarterly retirement fund reports this week you’ll be pleased to see the rapid growth. But there is real reason to worry. While any investment advisor will tell you that the price-to-earnings ratio (a measure of how much the average stock costs relative to its rate of return) is not especially high, that should be scant comfort. Something called the cyclically adjusted price-to-earnings ratio (developed by Nobel Laureate economist Robert Shiller) is at alarmingly high levels. In fact, by Shiller’s calculation, the only three times that measure has been higher in the past century were in 1929, 2000 and 2007. Worried yet?
Luckily, this publication will not print my initial reaction to this news. Instead, let’s ask how can it be that we might be back in financial bubble zone, and what on earth is going to happen.
Despite election season exuberance over jobs numbers, the simple fact is that labor markets are progressing poorly and the U.S. economy is a long way from solid. Potential workers continue to leave the formal economy at a shocking pace, and wages are effectively unchanged from last year. This has led the U.S. Federal Reserve to maintain a very loose monetary policy. This means that lots of money floating around the economy, which depresses nearly all interest rates. This is happening all around the world, and just this week the International Monetary Fund again downgraded global growth, warning of ‘frothy’ stock markets.
To put it plainly, investors have very few other places in which to invest other than the stock market. So stocks are at record levels and more buyers seem to enter the market each day. So what does the future hold?
With growing evidence of a global slowdown, there is plenty to fear from a stock market bubble. Sadly, there’s no good way to say how or when financial markets will respond, and no one has yet effectively developed a model to predict bubbles.
Perhaps a slow and careful effort by the Federal Reserve to raise interest rates could boost investor confidence. It might spark a run for safe investment options, which is the bursting of a bubble. A black swan event such as a major war or significant terror attack is far more worrying. The only certainty is that we are in a very challenging and forbidding period in financial markets. So, don’t get too exuberant over that retirement fund statement.
About the Author
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